RDPs and Community Income - not really a choice
December 20, 2010 at 2:51 PM
I know the new IRS Publication 17 (available online) appears to say that RDPs in California, Nevada, and Washington may choose to split their community income. But it isn’t really a choice. If it is community income, then the rule adopted in Poe v Seaborn, U.S. Supreme Court, 1930, applies and requires the splitting of community income.
When the IRS announced its position that Poe v Seaborn would be applied to RDPs, many people thought of the announcement as creating a new legal rule. But the rule of Poe v Seaborn has been with us since 1930. True, the IRS failed to recognize its application to California RDPs in 2006. But now the IRS says it will apply the income-splitting rule as of 2007. The CCA in which they made this announcement also said that taxpayers who had relied on the earlier IRS position (non-splitting) in reporting income for 2007-2009 were not required to amend their returns, but could elect to do so. Amending returns is always an option as there is no formal requirement to file an amended return. As to the future, e.g., returns for 2010, it is clear that the IRS position is that Poe v Seaborn applies to all community income. I do not believe taxpayers can choose whether to follow the income-splitting rule. The law is the law and you must follow it.
Some constituencies complained to the IRS after the 2010 CCA on income-splitting was released and asked that the new rule not be applied until 2011. There are many equitable arguments in support of such a delay in application. Taxpayers, reasonably relying on the 2006 IRS position, have been filing estimated tax payments based not on a splitting of income basis, but rather on the basis of who earned the income. Withholding has been computed on the same assumptions. Not knowing until halfway through tax year 2010 that income-splitting would be recognized puts these taxpayers in a bit of a bind. For this reason, I believe Chief Counsel did consider making a public statement that, although Poe v Seaborn was the law of the land, even as to RDPs, it would not seek penalties against taxpayers who failed to split income in 2010. Ultimately, however, a decision was made not to release such a statement.
I don’t know how the “choice” language ended up in the new Publication 17. Perhaps it was drafted during that period of time when Chief Counsel was considering whether or not to make income-splitting optional for 2010. But, in my view, there is no choice. The only way to avoid income splitting is to enter into a legally binding agreement that future community income will be the separate property of the person who earns it. You can’t agree to do that orally. And you can’t enter into an agreement now that would convert earlier community income into separate income. You can convert current community property into separate property by written agreement. But you can’t retroactively change the character of income that is already earned. [If you are thinking of entering into an agreement to opt out of community property, you should consult a lawyer to see what is required by your state for such an agreement to be enforceable.]
Income is either community or separate the moment it arises. And that is the time that matters for income tax purposes. State law determines the character of the income. If state law says the income is community at the moment it arises, then that income must be split for federal income tax purposes.
For most taxpayers, income-splitting is a good thing. It reduces taxes. But we are seeing that the practicalities of splitting income and expenses on a single taxpayer’s return are often difficult. So, it will take more time to complete tax returns in this manner. And there are still many unanswered questions about how to treat specific items. I’ll address some of these issues in future posts. But for now, one thing is clear. The Supreme Court opinion in Poe v Seaborn applies to all community income, even earned income of same-sex RDPs. The IRS is finally on board with that clear rule of law. And while it may not be stated clearly in Publication 17, it is clearly stated in the 2010 instructions for the 1040EZ (also available online). Those instructions provide:
Nevada, Washington, and California domestic partners
A registered domestic partner in Nevada, Washington, or California (or a person in California who is married to a person of the same sex) generally must report half the combined community income earned by the individual and his or her domestic partner (or same-sex spouse). See Pub. 555.