Source: https://www.thetaxadviser.com/issues/2009/aug/thelongarmofcommunitypropertylaws.html
Timestamp: 2019-04-20 22:59:20+00:00

Document:
By Michael G. Stevens, CPA, J.D., LL.M.
Nine states have some form of community property laws. These laws govern the interests of spouses in property and income acquired or earned during their marriage.
In general, in a community property state, the husband and wife are considered to own equal and undivided half interests in each item of community property, and income earned by one spouse generally will be treated as if it had been earned half by each. However, there is considerable variation in the community property laws in the different states.
Taxpayers living in community property states who separate or divorce are in some circumstances treated much differently for federal tax purposes than taxpayers living in common law states, particularly with respect to pensions and retirement accounts.
Relief from the effects of community property laws is available in certain situations under the innocent spouse provisions in Sec. 6015.
The impact of community property laws on a client’s tax situation can be unexpected and diverse. The fact that a tax adviser practices in one of the 41 common law (non–community property law) states does not mean the adviser can pretend that community property laws are not possibly relevant to some of his or her clients. Community property laws may affect married clients if they ever lived in a community property state.
Nine states follow community property rules, which affect the interests of spouses in property and income acquired during a marriage.1 Under community property laws, a marriage is viewed essentially as a partnership. Accordingly, the husband and wife are considered to own equal and undivided half interests in each item of community property. Income earned by one spouse generally will be treated as if it had been earned half by each.
Part of the considerable complexity inherent in this area is a result of the fact that the community property laws vary among the nine community property states. For example, Arizona deems income earned by a spouse after a married couple has separated to be community income, but California treats it as separate income. Therefore, practitioners should check the laws of the particular jurisdiction applicable to their client.
Since federal tax law respects the characterization of property under the relevant state law of the state of domicile,6 a client’s tax situation may differ from one community property state to another.7 In fact, the impact of state and local property laws on federal tax results can be substantial because these laws govern the fundamental aspects of property ownership such as transferability and basis.
Legal issues pertaining to certain concepts, such as where a spouse or couple live (domicile) and what a marriage is (based on the state of domicile),8 also complicate matters. For example, the tax rules for reporting community income do not apply to registered domestic partners in California.9 It remains to be seen what uncertainty may be thrown into this area as gay marriage laws evolve. It is incumbent upon the practitioner to monitor changes in state community property laws that may affect a client’s tax situation.
Income from separate property is generally the separate income of the spouse who owns the property. However, in Idaho, Louisiana, Texas, and Wisconsin, income from most separate property is deemed to be community income.
Never before has our society been more mobile. Population shifts are dynamic, and people will move to wherever professional opportunities, quality of life, and affordability overlap. Retirees tend to move to the “sunbelt” states. Thus, many clients may have lived in a community property state, leading to the possibility that community property rules may still affect property and related income, depending on the laws of the state they now live in.
Practice tip: It is prudent to advise clients who have moved or are planning to move across state lines to keep excellent records of property transactions and where they occurred. In complicated situations, legal counsel may be needed to properly determine the tax consequences related to property that has been moved.
While married taxpayers who file joint returns are not directly affected by community property laws for federal income tax purposes, married taxpayers who file separate returns, perhaps because they are living apart or are getting a divorce, are affected by those laws. Community property laws apply in a community property state to a “marital community.” This community may end when spouses divorce or separate or when one of the spouses dies.
When a divorce or separation ends the marital community, the spouses divide the community property. Each spouse is taxed on half the community income for the part of the year before the community ends unless special relief applies (see the “Relief from Community Property Laws” discussion below).25 The dissolution of a marriage may also trigger other issues.
Payments that would otherwise qualify as alimony are not deductible by the payer if they are the recipient spouse’s part of community income. Payments may be deductible by the payer and taxable to the recipient only to the extent that they exceed the recipient’s share of community income.
An important issue in this area, particularly in community property states, is the transfer of interests in IRAs and pensions. For example, in Balding,29 the taxpayer received payments in settlement of her claim to a community property share of her ex-husband’s military retirement pay. The court held that because the payments were incident to divorce, they should be treated as nontaxable gifts under Sec. 1041(b).
Hazel and Joe Balding married in 1962, less than one year after Joe entered the military. In December 1981, after Joe’s retirement from the military, they were divorced. The divorce court ordered a division of their community property and affirmed that Joe’s military retirement pay was his sole and separate property. In 1984, because of changes in California’s community property law, Hazel asked the divorce court to reopen the case and awar d her a community property share of Joe’s military retirement pay. At the time of the couple’s divorce, military retirement benefits were not divisible in a divorce proceeding as community property (see McCarty v. McCarty).30 However, under the Uniformed Services Former Spouses’ Protection Act (USFSPA),31 Congress provided that the states may treat military retirement benefits as community property and made the statute’s effective date retroactive to the day before the Supreme Court decided McCarty (June 25, 1981).
Before the divorce court could act, Hazel and Joe settled with regard to the retirement pay. Hazel relinquished any claim to Joe’s military retirement pay in consideration of Joe’s promise to pay to her $15,000, $14,000, and $13,000 in 1986, 1987, and 1988, respectively. Hazel did not include the settlement payments in her original returns for the years in question. After she received a private letter ruling concluding that the settlement payments were includible, she fi led amended returns including the income and then challenged the IRS’s determination in Tax Court.
The IRS argued that Hazel’s relinquishment of her community property interest in the retirement benefits in question constituted an anticipatory assignment of income such that the consideration she received for it (the settlement payments) was immediately taxable to her. Outside the marital context, the Tax Court said it would agree. However, because the settlement payments were received from her ex-husband incident to her divorce (and in consideration of her release of any claim to his military retirement benefits), the Tax Court concluded that they were nontaxable gifts under Sec. 1041.
The Tax Court held that the assignment of income doctrine does not apply to the relinquishment of an interest in a government pension to a former spouse. Since the court interpreted Sec. 1041 broadly, Balding may also apply to transfers of property interests such as deferred compensation. These issues may be more likely occur in community property states because in other states the recipient spouse usually has no ownership interest in the business generating the property interest.
A recent Tax Court decision, also involving transfers related to military pensions, shows how dynamic and difficult to reconcile this area has become. In Mitchell,32 distributions made under a qualifying domestic relations order (QDRO) to a former wife for her community property interest in her former husband’s military retirement pay were includible in her gross income. The Tax Court rejected arguments that the payments were subject to double taxation because the former wife provided no evidence that they were. The court concluded that since the former wife received the distribution under a QDRO, she was a distributee of a pension distribution and taxable under Sec. 402(e) as an “alternate payee.” It also noted that because California is a community property state, the former wife was treated as having earned her distribution and was thus liable for tax on it even if the QDRO was defective.
In Dunkin, the IRS appealed a decision of the Tax Court allowing John Dunkin, an employee of the Los Angeles police department, to reduce his taxable income in 2000 by the amount he paid his former spouse, Julie, incident to a division of community property assets upon divorce. In 1997, a California divorce court awarded Julie one-half of the marital community’s interest in pension benefits provided by John’s employer. However, because John chose to continue working until 2002 and did not terminate his participation in the plan following divorce, the pension administrator did not begin making distributions right away.
California courts have recognized that an employee spouse like John might attempt to defeat a nonemployee spouse’s community interest in a pension by continuing to work. As a result, under California law, Julie could (and did), prior to John’s retirement, demand monthly payments in lieu of her community pension interest under California law known as “Gillmore rights.”34 In 2000, John satisfied Julie’s Gillmore rights by making payments out of the wages he earned by continuing to work.
John claimed that the payments were deductible alimony on his 2000 return, but the IRS disallowed the deduction. John challenged the IRS’s determination in Tax Court, which held that John could reduce his income for 2000 by the amount of the payments because they represented Julie’s community property share of John’s pension income.
The Ninth Circuit reversed the Tax Court. The court noted that there was no statutory exclusion applicable in this case to the wages paid to John. Althoug h John owed a debt to Julie, this alone is not a reason to exclude the wages used for that debt from his gross income.
It also held that in Gillmore the California Supreme Court did not create a “new species of community property” consisting of post-divorce wages used to replace pension income that would have flowed to the community had the employee retired. Under California law, actual distributions of pension benefits earned during marriage are community property. Such distributions would be taxable to the spouses in proportion to their community property shares. In this case, however, the pension administrator made no distributions in the year 2000. Instead John chose to continue working and made the additional choice to satisfy Julie’s Gillmore demand for reimbursement out of his wages; those wages were John’s separate property under California law.
The Ninth Circuit also held that the payments were not alimony within the meaning of Sec. 71(b), so John could not deduct them under Sec. 215. The bottom line is that interests in different kinds of retirement accounts in a community property state can trigger complex issues. These cases illustrate the need for careful planning in such situations.
In that ruling, “John” and “Jane” were married in 1956, and by 1958 they had moved to a community property state, where John worked continuously for X Corp. until his retirement in March 1996. During his employment, he participated in X’s NQDC plan for certain high-level employees. John and Jane divorced in May 1993. In August 1993, the divorce court entered an order that divided their interests in the plan under state law. The order designated Jane as alternate payee and recognized her right to receive a specific portion of the retirement benefit determined by a formula.
Under state law, John and Jane each held a one-half interest in future benefit payments under the plan to the extent those interests accrued during John’s years of service with X while married to Jane. Under the domestic relations order, Jane was entitled to receive one-half of the future benefit payments attributable to the interests that accrued during the years of her marriage, and John was entitled to receive that proportionate amount under the plan not specifically awarded to Jane.
The IRS ruled that the proportionate amount under the plan not specifically awarded to the alternate payee (Jane) would be includible in John’s income for the tax year or years in which the proportionate amount would be paid or otherwise made available to him.
As noted previously, the IRA rules are applied without regard to community property laws.37 An interesting application by the Tax Court occurred in Bunney.38 There the court addressed for the first time the question of whether one-half of community funds contributed to an IRA account established by an IRA participant are, upon distribution, taxable to the participant’s former spouse because the former spouse had a 50% ownership interest in the IRA under applicable community property law. The court answered no.
The former husband (H) and his former wife (W) were divorced in 1992. They lived in California, a community property state. The divorce judgment ordered that H’s IRAs, which were funded with contributions that were community property, be divided equally between H and W. In 1993, H withdrew $125,000 from his IRAs and transferred $111,600 to W in a transaction in which he acquired her interest in the family residence. H reported only the remaining $13,400 of the distributions on his 1993 federal income tax returns.
The court held that under Sec. 408(g), W was not a 50% “distributee” of H’s IRAs for purposes of in clusion in W’s income under Sec. 408(d)(1). Therefore, only H was taxable on the distributions. The court also held that no portion of the $111,600 paid to W was excludible from H’s income under Sec. 408(d) (6) as a nontaxable tra nsfer incident to a divorce.
Although H acknowledged that Sec. 408(g) requires that the IRA rules be applied without regard to community property laws, he argued that his former spouse’s community property interest in his IRAs arose from the start and thus should have been considered in determining the taxability of the distributions. The IRS argued that H was the sole taxable distributee because he was the sole recipient of the dist ributions.
The court disagreed with the IRS that the recipient of an IRA distribution is automatically the taxable distributee. However, it still concluded that H was the sole distributee in this case. H established the IRAs in his name, and, by reason of Sec. 408(g) , W was not treated as a distributee of any portion of the IRA for federal income tax purposes despite her community property interest in it.
This decision is consistent with a letter ruling that the IRS had issued before Bunney.39 In that ruling, a participant received a single-sum distribution from his account in his employer’s qualified plan. The entire distribution, except for amounts retained to pay personal expenses, was rolled over into a number of IRAs. The participant and his spouse, who resided together in a community property state, entered a private separation agreement. Under the agreement, the IRAs constituted community property under state law and were to be divided with half of the balance to be distributed to the spouse as the spouse’s separate property. She would then invest some or all of the distribution in an IRA maintained on her behalf. The parties were not divorced or legally separated.
The Service ruled here that the distribution of half the balance of the participant’s IRAs to the spouse was taxable to the participant under Sec. 408(d)(1) and was not to be treated as the spouse’s property under Sec. 408(d)(6). This result, however, is not consistent with an earlier private letter ruling40 that favored the owner of an IRA in a similar situation, thus creating some uncertainty. Planning around these cases might be advisable using the Service’s more recent opinions or, if possible, by obtaining an opinion before the transaction is effected.
A husband ( H) owned two IRAs attributable to a rollover of an employersponsored plan. The wife (W) had established an unfunded spousal IRA. They made an estate plan that included a marital property agreement. In the plan, H and W classified H’s IRAs as marital property, so each spouse then owned an undivided one-half interest in them. W’s IRA was classified as her individual property. They also agreed to divide H’s two IRAs into two separate equal shares, one representing his marital property interest and the other representing W’s marital property interest that she wanted to transfer into her own separate IRA. The balance of H’s IRAs would then be classified as his individual property under state law and the marital property agreement.
The important issue in the ruling is whether Sec. 408(g) preempts W’s community interest under state law in H’s IRAs. Legislative history discussed in the ruling indicates that community property laws are not to apply to deductions taken for contributions made to IRAs. Because there is no specific language on what effect Congress intended Sec. 408(g) to have, and because of the general rule of statutory construction that federal statutes are construed as not preempting state law unless that was the clear intent of Congress, the ruling concludes that Sec. 408(g) does not abrogate any substantive rights under state law.
The ruling said that W may have a community property interest in H’s IRAs to the extent the existence of that interest is consistent with state law. The agreement’s reclassification of H’s IRAs as marital property did not provide for any distribution or transfer of assets from the IRAs and did not provide for a change of IRA trustee. Thus, the reclassification of the IRAs as marital property was not considered a taxable distribution. The ruling, noting that the owner of an IRA is the person i n whose name the account was established and that state law cannot change this, stated that a transfer of W’s interest in H’s IRAs to her spousal IRA would be a taxable distribution.
The Service has issued an interesting ru ling where a court awarded an ex-wife half of her former husband’s incentive stock options (ISOs) in a divorce and the couple had lived in a community property state.42 The options were kept in the husband’s name, but he had to exercise them according to the former wife’s instructions. The ruling indicates that this situation does not violate the nontransferability requirement of such options under Sec. 422(b)(5). In a non– community property state, this arrangement would have disqualified the options as ISOs under Rev. Rul. 2002-22.43 The ruling also holds that transfers of stock to the ex-wife when she exercises her ISOs will not be a disposition of the stock under Sec. 424(c) and that all subsequent tax consequences associated with that stock will affect the ex-wife.
The more one studies the impact of community property laws on federal tax issues, the more apparent it becomes that community property laws have an amazingly extensive reach. Tax advisers must always consider the possible ramifications that may result from contact with community property laws.
Example 2: H and W were married and owned community property that had a basis of $80,000. When H died, half the FMV of the community interest was includible in his estate. The full value was $100,000. The basis of W ’s half of the property after H’s death is $50,000 (one half of $100,000). The basis of the other half to whoever acquires it is also $50,000.
The IRS has provided relief for certain S elections filed late in community property states.48 The relief applies if the election is defective solely because a community spouse did not sign the election form and both spouses report all items of income, gain, loss, deduction, or credit consistently with the S election on their tax returns. All the shareholders on the date of an S election must consent to that election under Sec. 1362(a)(2). Regs. Sec. 1.1362-6(b)(2)(i) says that both spouses must consent to the election when they own the stock as community property.
The effect of community property laws on earned income for self-employment (SE) tax purposes is different from their income tax effects. In a community property state each spouse is generally allocated an equal share of earned income regardless of who earns it, but for SE tax purposes, Sec. 1402(a)(5)(A) indicates that for income from a trade or business (other than a partnership) that is otherwise community income, the spouse who carries on the trade or business is liable for the SE tax. If the spouses jointly operate the trade or business, the gross income and related deductions are allocated between the spouses based on their distributive shares of the gross income and deductions.
Accordingly, if a married couple lives in a community property state and only one spouse is self-employed, that spouse must pay SE tax on his or her total gross SE income, less total business deductions, despite the fact that half of that income will be attributable to the other spouse for income tax purposes.
There are situations in which a separated spouse might suffer an unfair income tax result if the community property laws were applied. A married taxpayer who files a joint return may avoid unfair tax consequences through the innocent spouse provisions of Sec. 6015. In 1980, Congress enacted Sec. 66 to provide relief to married taxpayers domiciled in a community property state who file separate returns and who without such relief would suffer inequitable tax treatment. Sec. 66 has since been expanded and modified several times.
The primary inequity that Sec. 66 addresses is that of a spouse who would have to pay tax on half the earning spouse’s income when the nonearning spouse does not receive any benefit from those earnings. The flip side of this would be an unfair advantage to the earning spouse relieved of tax liability on half the earnings.
Not transferred any portion of such earned income from one spouse to the other (directly or indirectly) before the close of the calendar year.
Sec. 66(b) allows the IRS to disallow the effects of community property laws to any taxpayer for any income if the taxpayer acted as if solely entitled to that income and failed to notify the spouse of the nature and amount of the income before the due date for filing the return for the year in which the income was derived.
Sec. 66(c) provides two more opportunities for a spouse to get relief from community property laws if he or she does not qualify under Sec. 66(a). There are four conditions for the first kind of relief. If the spouse seeking relief did not file a joint return; did not include an item of community income in gross income that would be treated as the income of the other spouse under Sec. 879(a); establishes that he or she did not know or have reason to know of the item of community income; and under all the facts and circumstances it would be inequitable to include the item of community income in the spouse’s gross income, then the income item will be included in the other spouse’s income.
The last sentence of Sec. 66(c) gives the IRS authority to grant equitable relief if the spouse does not qualify under the requirements discussed above. Guidance issued by the Service53 provides the requirements needed to initially qualify for this relief as well as a nonexclusive list of factors the Service should consider relating to the facts and circumstances that may be taken into account. The factors include economic hardship, the spouse’s knowledge, and evidence of spousal abuse or poor mental or physical health.
The impact of community property laws on tax issues is vast and complex. Advisers must be mindful of this when learning about their clients, whose geographical history may be as important to consider as their financial and business background.
The overlap of state law issues affecting the classification of interests in property and diverse federal tax rules intensifies the challenge to optimally represent clients. Because of the difficulty of properly determining whether community property laws apply, which state is the taxpayers’ proper domicile, what property is community or separate property, and especially how complexities can arise in divorce situations, this area deserves substantial attention by tax practitioners.
Michael Stevens is assistant professor of accounting at Queens College of the City University of New York in Flushing, NY. For more information about this article, contact Professor Stevens at michael.stevens@qc.cuny.edu.
1 The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
2 Poe v. Seaborn, 282 U.S. 101 (1930); Regs. Sec. 1.66-1(a).
4 IRS Publication 555, Community Property (2007), p. 2; Harmon, 323 U.S. 44 (1944).
5 Rev. Rul. 73-390, 1973-2 C.B. 12.
6 Mitchell, 403 U.S. 190 (1971); Morgan, 309 U.S. 78 (1940).
7 Internal Revenue Manual (IRM) Section 25.18.1.1.
8 See, e.g., Purdy, T.C. Memo. 1979-521.
9 IRS Publication 555, p. 2; IRS Chief Counsel Advice (CCA) 200608038 (2/24/06).
10 IRS Publication 555, p. 2.
13 IRS Publication 555, p. 3.
15 Sec. 408(g); IRS Publication 555, p. 4.
16 See Wissner v. Wissner, 338 U.S. 655 (1950); Free v. Bland, 369 U.S. 663 (1962).
18 IRS Publication 555, p. 5.
19 See CA Fam. Code §125.
20 IRS Publication 555, p. 3.
21 Phillips, 9 B.T.A. 153 (1927).
22 Rev. Rul. 80-325, 1980-2 C.B. 5; Wilkerson, 368 F.2d 552 (9th Cir. 1966), aff’g 44 T.C. 718 (1965).
23 IRS Publication 555, p. 8.
25 IRS Publication 504, Divorced or Separated Individuals (2008), p. 22.
28 Temp. Regs. Sec. 1.1041-1T(d), Q&A-10.
29 Balding, 98 T.C. 368 (1992).
30 McCarty v. McCarty, 453 U.S. 210 (1981).
31 Uniformed Services Former Spouses’ Protection Act, 10 U.S.C. Section 1408(c)(1) (1982).
32 Mitchell, 131 T.C. No. 15 (2008).
33 Dunkin, 500 F.3d 1065 (9th Cir. 2007).
34 See In re Marriage of Gillmore, 629 P.2d 1 (Cal. 1981). In California, if an employee spouse chooses to continue working after a divorce, the nonemployee former spouse may demand reimbursement for his or her community property share of pension benefits that would have been payable if the employee spouse had retired.
35 Dunkin, quoting CA Fam. Code §772.
36 IRS Letter Ruling 9647033 (8/27/96).
38 Bunney, 114 T.C. 259 (2000).
39 IRS Letter Ruling 9344027 (8/9/93).
40 IRS Letter Ruling 8040101 (7/15/80).
41 IRS Letter Ruling 199937055 (9/20/99).
42 IRS Letter Ruling 200737009 (9/14/07).
43 Rev. Rul. 2002-22, 2002-1 C.B. 849.
44 IRS Publication 551, Basis of Assets (2002), p. 9.
47 Rev. Rul. 2003-40, 2003-1 C.B. 813. See also Estate of Burris, T.C. Memo. 2001-210.
48 Rev. Proc. 2004-35, 2004-1 C.B. 1029.
49 See also IRS Publication 555, p. 5.
53 Rev. Proc. 2003-61, 2003-2 C.B. 296.
54 Ordlock, 533 F.3d 1136 (9th Cir. 2008). For more on the Ordlock case, see Tax Trends, 39 The Tax Adviser 702 (October 2008).
55 Christensen, 523 F.3d 957 (9th Cir. 2008).

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