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There will be some major changes in tax planning for Registered Domestic Partners (RDP’s) in California this year.
A recent Chief Counsel Advisory (CCA 2010210) issued by the Office of Chief Counsel, Internal Revenue Service, recognizes California as a community property state, and now accepts its treatment of earned income as community property for Registered Domestic Partners. As with opposite sex married couples, RDPs have an automatic right to one-half of each other’s earned income.
Such partners will no longer have to report earned income one way for the state and a different way for federal returns.
The ruling states “for tax years beginning after December 31, 2006, a California Registered Domestic Partner must report one-half of the community income, whether received in the form of compensation for personal services or income from property, on his or her federal income tax return.”
Greg Barton, a CPA in Palm Springs who specializes in RDP tax issues, points out the new filing requirements are mandatory for years ending after June 1, 2010, and for those RDP’s who have not yet filed their 2009 Federal income tax returns. Beginning in 2010, all income will need to be considered as community property and divided equally on Federal income tax returns, so tax returns that are prepared in 2011 will need to adopt this ruling.
Before this ruling, RDPs had multiple issues when reporting income to the IRS. Each partner had to determine ownership of income and assets, exemptions, tax credits, and there were Alternative Minimum Tax, and head of household issues, just to name a few.
Often, when one partner earned virtually all of the income and the other was a stay at home parent or low income earner, the partner with the all the earnings received none of the tax benefits that a similarly situated opposite-sex married couple would receive.
The ruling now changes this outcome, and the low income earner may be able to use tax deductions he or she previously did not have against the income, thus possibly reducing the overall tax burden to the couple.
Approximately 58,000 RDP’s in the state are affected by the ruling. Most of these couples are same-sex partners. About 3,000 of the RDP’s are heterosexual couples with at least one partner over the age of 62. It is possible that this change will also apply to RDP’s and/or civil unions in other community property states such as Washington and Nevada. But for the moment, it applies specifically to California.
Why this sudden change?
The IRS Memorandum explains: “California community property law developed in the context of marriage and originally applied only to the property rights and obligations of spouses. The law operated to give each spouse an equal interest in each community asset, regardless of which spouse is the holder of record.”
“By 2007, California had extended full community property treatment to Registered Domestic Partners. Applying the principle that federal law respects state law property characterizations, the federal tax treatment of community property should apply to California Registered Domestic Partners.”
Will the U.S. government now treat registered domestic partners the same as married heterosexual couples?
Unfortunately, no. All federal agencies must operate under the Defense of Marriage Act (DOMA) which recognizes only a man and a woman as a married couple for purposes of most federal obligations and benefits. Therefore, the IRS will continue to prohibit same-sex RDP’s from filing joint income tax returns or to benefit from certain other tax breaks such as the ability to transfer an estate, no matter the size, tax-free from one RDP to the other.
The only change is in the way earned income is reported on a federal income tax return, which will now recognize how California allocates income between registered partners.
Does this ruling apply to same-sex married couples in California? Should such couples also register as domestic partners?
Good question! DOMA prohibits recognition of same-sex marriages, but California’s community property laws apply equally to heterosexual and same-sex married couples. The Memorandum refers only to Registered Domestic Partners.
Some same-sex married couples are also RDP’s, so they would be included in the ruling. For the others, we will need clarification. It is likely, however, that the ruling applies to all couples who have community property as defined by the state of California, which means same-sex married couples and RDP’s.
There are some advantages for same-sex couples to be both registered and married. For example, more states permit or recognize registered domestic partnerships than they do same-sex marriages. California residents traveling or working in these states are more likely to find legal support for their relationships if they are registered. However, before registering, you should consult with your CPA and your estate planning attorney to fully understand the implications of your decision.
The ruling says “For tax years beginning after December 31, 2006.” Does everyone have to file an amended return for the last three years?
No one is required to file an amended return. The Memorandum states “For tax years beginning before June 1, 2010, Registered Domestic Partners may, but are not required to, amend their returns to report income in accordance with this” memorandum. Greg suggests that while you are not required to amend your returns from 2007 to present, you may wish to consider it, if the result will benefit you as a taxpayer.
It may be beneficial to amend your returns if:
Both partners had earned income, but one earned more than the other. The partner earning the larger amount was most likely taxed at a much higher rate than the other partner. Reallocating the income at 50 percent each may mean that the lesser earning partner would pay a little more in taxes, but the reduction in taxes for the other partner would be much greater. By sharing income, both partners take advantage of lower tax brackets.
The total tax bill for the two will likely be less under the new ruling.
What should we do to prepare for 2010 tax returns? How will the ruling benefit us? How will it potentially hurt us?
Here is a real life example that should help:
Greg is currently working with an RDP couple, where one partner is a higher wage earner and the other is receiving unemployment benefits. They are considering refinancing their home mortgage. However, by refinancing, the higher earner will lose some of the interest deduction on the home, since they are refinancing to a lower interest rate.
Greg points out to this couple that it just might work to their overall tax benefit, because the loss of the interest deduction may now be offset by splitting the income equally between both partners.
In addition to the above example, in some cases, splitting the income between two partners may reduce the impact of the Alternative Minimum Tax, thus creating additional potential tax savings.
Another example of how this ruling may have a possible negative tax impact on RDP’s, is the elimination of the earned income credit and the possible taxation of Social Security benefits. As Greg explains, when a lower earner is receiving Social Security benefits, it may not be taxable, however, if their income is now split with their partner who is a higher wage earner, those same benefits may now become taxable. Of course, the overall calculation would need to be run to see if the resulting net taxes of the couple would be lower or higher.
Greg and his staff are currently analyzing all of their clients’ tax situations to determine who may be affected by this new ruling, and if amending their tax returns will be beneficial.
He finds that his clients often underestimate the full reach of this ruling and therefore don’t consider it worth the ‘hassle’ to amend their returns. It is a constant topic of dinner conversation among friends, and Greg now considers dining out as a useful event for some serious tax planning with the clients.
Are there other questions about how this IRS ruling will affect registered or married same-sex couples?
Yes, there are several issues that will need to be resolved. For example, a couple in which only one partner has earned income and is carrying health care and other benefits for the non-working partner as a dependent will need to get clarification about whether this arrangement can continue. As a dependent, no taxes were paid on the health and other benefits. If the dependent partner now shares the earned income equally, will the benefits now become taxable?
By now your head is probably spinning with the complexity of this new IRS ruling and its potential impact to your tax situation. That is understandable. Since everyone’s tax situation is unique, I highly encourage you to contact your tax advisor and discuss with him or her whether your previous returns should be reviewed for possible tax benefits, and how best to prepare for future tax issues in light of this IRS ruling.
This article is part of an ongoing series of articles pertaining to legal issues in the LGBT communityPrevious articles can be viewed at heritagelegal.com. This information is intended for general information purposes only, and is not intended to provide legal advice. Christopher Heritage is an attorney in Palm Springs, and San Diego, CA, who focuses on LGBT estate planning, domestic partnerships, same-sex marriage, probate, trust administration, and bankruptcy. He welcomes questions and comments, and can be contacted at 760.325.2020, or by email: email@example.com; Greg Barton, of Gregory D. Barton, CPA & Associates, Inc., has offices in Palm Springs, and Palmdale, California. He can be reached at 760.969.6499, or by email: firstname.lastname@example.org