The complexity and differences between the community property statutes of the nine mostly western states* that have adopted them have created a tax consulting and preparation quagmire that can intimidate even the most knowledgeable accountants and attorneys. We will begin by addressing some basic Federal tax implications, and follow up in future posts with valuation issues.
Property
Definition: “Generally, community property is property that you, your spouse (or your registered domestic partner), or both acquire during your marriage (or registered domestic partnership) while you and your spouse (or registered domestic partner) are domiciled in a community property state”. IRS Publication 555.
While at first glance this might not seem terribly complex, the laws vary in the nine states* that recognize community property law. Federal tax law respects the laws of the state of domicile. Further, to the extent the respective states allow deviation from statute by written agreement, federal law will recognize that as well.
Normally, property acquired after marriage by either spouse is considered community property. Upon divorce the community assets are most typically divided by values. In California this is mandated by statute (California Family Law Code Section 2550) as an equal allocation of the property to the parties, although debt may be allocated ‘equitably’. Correspondingly this shifts the focus to the assigned value of the property as well as it’s status as separate or community. Nevada has a presumption of equal division unless there are other compelling circumstances such as wasteful dissipation of the community property by one spouse of the other; hiding assets; unlawful gifts; or financial misconduct. Texas and several other states do not require an ‘equal distribution’, but rather allow an ‘equitable distribution’.
Property that is purchased with separate funds, or owned by one spouse prior to the marriage, or is received by gift or bequest during the marriage is considered separate property. Prior to the marriage it is important to document the separate property of each spouse and the related value. There are instances where the separate status can be commuted to community property in part or in whole. Most typically by co-mingling community assets in support of the separate property asset.
Income
Community income for federal tax purposes is income from community property during the marriage; salaries, wages and pay for services; net profit from a sole proprietorship; dividends, interest and rents; and income from real estate that is treated as community property. Income from separate property belongs to the spouse who owns the property. While this again seems straight forward, it can get complicated for example in determining filing status during the divorce.
Married taxpayers may elect either filing ‘married joint’ or ‘married separate’. Disregarding the ‘innocent spouse rules’ for the moment, those who file jointly are jointly and severally liable for the tax on the aggregate income. While filing ‘married separate’ alleviates the joint liability, the total tax liability is most generally greater than if filed as ‘married joint’. For married taxpayers who file separate, they must include 50% of all community income along with 100% of any separate property income they received. Form 8958 can be helpful in determining the allocation between the parties and protecting from an innocent or willful failure on the part of the other party. Pension, profit sharing plans and annuities create complex valuation issues compounded by the length of term, the timing of distributions and of course domicile particularly if it has changed from a non-community property state.
Up Next
A blog post or even a series of posts cannot begin to cover the critical topics related to taxation in community property states. In future posts we will address: methodologies for valuation of businesses; the application of Pereira / Van Camp; and of course everyone’s favorite – double dipping.
*Arizona, California, Idaho, Louisiana, Nevada, New Mexico Texas, Washington and Wisconsin (along with Puerto Rico and Alaska sometimes)