All property that is acquired during marriage is called community property. There is an exception to the rule that properties acquired as gift or inheritance does not come under the category of community property. Spouses equally own community property. The tax laws apply to community properties also. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin are all community property states.
When a married person who lives in a community property state does not file a joint return, the person should report half the total community income earned by the spouses during a tax year. In the case of married taxpayers, who file joint tax returns, community property tax laws will not affect them. The tax payers should also file returns for 100% of their separate income. However, if an exception applies the person need not file the report of half the total community property earned by both spouses
Pursuant to 26 CFR 1.66-1, the exceptions that apply to spouses’ community income under applicable community property laws are as listed:
- When spouses live apart during the period of a calendar year.
- IRS can deny a spouse federal income tax benefits that result from community property law because the spouse acted as if that person is only entitled to the income. The person also failed to notify his/her spouse about the nature and amount of income.
- When a spouse didn’t know about the other spouse’s income that amounts to community income.
- When a spouse qualifies for equitable relief. An equitable relief is obtained when the IRS relieves a taxpayer from a liability for any unpaid tax or any deficiency attributable to an item of community income for which traditional relief is not available. If a spouse did not know about the rules, it will be considered inequitable to hold that person liable[i].
- When an innocent spouse who does not know about a community property qualifies for equitable relief.
These exceptions do not apply to income from properties that are not considered to be community property. Liabilities can arise over such properties even if exempted, under federal or state tax laws or property laws, other than community property laws.
However, if a person transfer’s property to his/her spouse with an intention to defraud IRS or a creditor, ex-spouse, or business partner, the person will not come under the exceptions provided. An innocent spouse who has no knowledge is not entitled to relief for any tax year for which the requesting spouse has entered into a closing agreement with IRS. A requesting spouse is also entitled to relief for any tax year for which the spouse has entered into an offer in compromise with IRS. Spouses who file joint federal returns are not affected by community property laws.
Community income means income from community property and salaries, wages and other pay for the services of either spouse during marriage. In some states, it also includes the income from separate properties. Spouses are allowed to get into agreements regarding income earned by them separately. In the state of Arizona, an oral agreement to keep a community property separate is also recognized[ii]. If a property is located in a state other than the owner’s domicile, law of the state where the property is situated will apply[iii].
In states where community income does not include separate property income, problems regarding allocation arise when a spouse has separate business property. When the income is due to a spouse’s personal efforts, an amount equal to a fair rate of return on the separate investment is subtracted from total business income, and the balance is deemed to be for personal services that come under community income[iv].
Community income earned by husband and wife can be divided equally between them. Tax exemption can be provided to expenses incurred to earn or produce separate business or investment income is deductible by the spouse who earns the income. Expenses that produce community expenses are community expenses. These expenses are shared equally by the spouses, even if the property that produced community income is separately owned. Spouse who pays for medical expenses out of separate funds is deductible by the person who pays them[v]. Alimony deductions have to be shared on separate returns filed by the ex-spouse and current wife[vi].
Spouses are considered to live apart when they maintain separate residences. When they do not form part of the same household they are considered to be living apart. However, when spouses are only living apart on temporary basis they are considered to be living together[vii]. When income from one spouse is transferred to another spouse it can be presumed to be community income. Amount transferred for the children’s benefit will also be considered as community income. However, earnings from business can only be treated as separate income of the business person alone, unless, the other spouse has any link in the management of the business.
Spouses living apart are exempted from paying tax under community property law, if they live apart all through the calendar year even though they remain married[viii]. They can be exempted if they do not file their returns in a joint manner. This rule can only be applied if any or both spouses have community income and no part of the income is transferred between both the spouses.
When a taxpayer fails to notify his/her spouse about the community income earned and treats the income solely as his/her own income the taxpayer is exempted from filing returns under community property law. The taxpayer will have to file returns as if the property is separate property. If the spouse is not duly notified in time about the earnings IRS can deny any benefit under community property law. All the property will form part of the gross income of the taxpayer[ix]. However, to consider the income of a person as separate, the manner of utilization of income of the person will be considered. If the income is used for the benefit of family, the income can be considered as community income. However, this provision cannot be used to get exempted from community tax liability. The IRS should provide evidence that the matter would come under separate income tax liability and not community property tax[x]. The IRS should prove that the taxpayer acted as if solely entitled to the property and that the taxpayer failed to notify the other spouse of the nature and amount of the income in due time.
A taxpayer can claim exemption from payment of community property tax when the person has not filed a joint return for the tax year because s/he did not know that the income was community income. In such cases, the other spouse’s gross income includes the item of property[xi].
Spouses’ who are ignorant of the community property should prove when requesting relief that they had no knowledge of the item of community income. The relevant facts and circumstances are considered before determining whether a requesting spouse had reason to know of an item of community income. When a spouse has erroneous knowledge about the property or has a lower educational background, the spouse may be presumed to not have knowledge about the property. However, if the requesting spouse had active participation in the income generated by the other spouse this will amount to knowledge and there can be no exception granted[xii].
When the IRS receives a request from a spouse for relief from operation of community property law, the IRS should send a notice to the non-requesting spouse’s last address and inform the non-requesting spouse about the claim for relief. The notice should provide the non-requesting spouse an opportunity to submit any information for consideration whether or not to grant the relief. The IRS should share information from both spouses to each other. However, the IRS need not share the information when it can disrupt tax administration. The IRS is supposed to protect personal information[xiii].
[i] 26 USCS § 66
[ii] Shoenhair v. Commissioner, 45 B.T.A. 576 (B.T.A. 1941)
[iii] In re Will of Clark, 59 N.M. 433 (N.M. 1955)
[iv] Oliver v. Commissioner, 4 T.C. 684 (T.C. 1945)
[v] Rev. Rul. 55-479 (I.R.S. 1955)
[vi] Moitoret v. Commissioner, 7 T.C. 640 (T.C. 1946)
[vii] 26 CFR 1.66-2
[viii] 26 USCS § 66
[ix] Porter v. Commissioner, T.C. Memo 1991-561 (T.C. 1991)
[x] McGee v. Commissioner, 979 F.2d 66 (5th Cir. 1992)
[xi] 26 USCS § 66
[xii] Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979)
[xiii] 26 CFR 1.66-4