Individuals

Treatment of Community Income for Spouses Living Apart (Part I)

Sec. 66 may relieve a separated spouse of the duty to report a portion of the other spouse’s community property income. Part I of this two-part article discusses the requirements for relief under Sec. 66(a) and denial of community property benefits under Sec. 66(b).

Allan Karnes, M.A., J.D., CPA
KPMG Tax Research Professor
School of Accountancy
Southern Illinois University–Carbondale
Carbondale, IL

Scott Salmon, M.Acc., CPA
Partner
KPMG LLP
Washington National Tax
Washington, DC

Darla Karnes, M.Acc., CPA
Instructor
School of Accountancy
Southern Illinois University–Carbondale
Carbondale, IL

For more information about this article, contact Dr. Karnes at karnes@cba.edu.

Authors’ note: The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.

Executive Summary

Sec. 66 can provide a spouse relief from reporting and liability for the other spouse’s income when the nonearning spouse does not receive a benefit from such income.
If a spouse qualifies for Sec. 66(a) treatment, all items of community income must be allocated under the Sec. 879(a) rules.
Under Sec. 66(b), a spouse may be disallowed the benefits of reporting only his or her share of community income.

This two-part article offers guidance on Sec. 66 relief for married clients who are separated and reside in community property states. Part I, below, discusses the requirements for relief from the community property laws under Sec. 66(a). It also examines Treasury’s power to deny the benefit of the community property laws to a spouse under Sec. 66(b). Part II, in the April 2006 issue, will explain Sec. 66(c), which provides traditional or equitable relief to spouses in certain cases. By properly advising clients who may benefit from Sec. 66 relief, practitioners can determine that those clients do not unwittingly cause a relief request to be denied.

Background

The basic premise of state community property laws is that marriage is a partnership. As a result, all earned income by either spouse (community income) is arbitrarily allocated evenly between the two spouses, much like a business partnership with two equal partners. The question of whether items of income, earned or unearned, are considered community income to be allocated evenly to each spouse is determined under state law. Prior to the enactment of Sec. 66, allocating community income between spouses on separately filed returns often had significant tax consequences.

Example 1: C and M separated in December 1977. They live in a community property state. M stayed in the family home and supports herself with a $12,000 annual salary. C moved to another city and supports himself with an $88,000 annual salary. No funds are transferred between the spouses; C did not make the mortgage payments on the family home or pay any other household expenses after they separated. If M and C did not file a joint return for 1977,¹ M would face a tax liability on gross income of $50,000 (.5 ($12,000 + $88,000)), even though she had access only to the $12,000 she earned. Additionally, C may be unjustly enriched by only owing tax on $50,000 of gross income, instead of the $88,000 to which he had access.²

Congress recognized this potential inequity and provided relief by enacting Sec. 66 as part of the Miscellaneous Revenue Act of 1980.³ Originally, Sec. 66 allowed spouses to disregard state community property laws for Federal income tax purposes if they lived apart, did not file a joint return and met certain other criteria. However, in 1984, Congress expanded the scope of Sec. 66. The provision was broadened to provide (1) criteria under which the IRS may disallow the benefits of community property law to a spouse, and (2) additional circumstances under which a spouse might otherwise seek relief from the operation of the community property law, even if Sec. 66’s original criteria are not satisfied.⁴ In July 2003, final regulations under Sec. 66⁵ were issued to replace 2002 proposed regulations. Later that same month, Rev. Proc. 2003-61⁶ established threshold requirements for taxpayers requesting equitable relief under Sec. 66(c) or 6015.

Although income earned from separate property⁹ generally is separate income, Idaho, Louisiana, Texas and Wisconsin usually treat it as community income.¹⁰ Idaho, Louisiana and Texas adopted the Uniform Marital Property Act¹¹ (UMPA), which follows the Spanish-influenced “Louisiana Fruits” rule and classifies income from separate property as marital or community income.¹² Wisconsin also follows the “Louisiana Fruits” rule, but modifies the UMPA to allow a spouse with separate property to unilaterally declare in a written statement that income therefrom is separate income.¹³ The statement only works prospectively and may not be executed before marriage.¹⁴ The remaining community property states follow the “American Rule,” first adopted in California as a result of George v. Ransom.¹⁵ That case held that it is unconstitutional in California to characterize the income from a wife’s separate property as community income.

Treatment of Community Income

Congress recognized the inequity of community property laws that cause a nonearning spouse to pay tax on half of the earning spouse’s income if the nonearning spouse does not receive or benefit from that income. To qualify for Sec. 66 relief, spouses must meet several specific criteria, one of which, not surprisingly, is that the earned income could not have been transferred directly or indirectly to the nonearning spouse. However, the legislative history indicates that Congress did not intend a de minimis transfer to disqualify a spouse from relief.¹⁶ By 1984, Congress acknowledged that, even if a spouse does not meet all the Sec. 66 criteria, situations still could occur that would make it inequitable to tax a spouse filing separately on the earnings of the other spouse when the nonearning spouse received no benefit from the earnings.¹⁷

Example 2: R and S separated in December 2004. They live in a community property state. R provided S $1,000 per month from April through December of 2005, even though he was not legally obligated to do so. R earned $50,000 in salary and had a $10,000 gain on a capital asset he sold in October 2005. S maintains that the payments she received from R were from his capital gain. The income R transferred to S would nevertheless be considered as derived from R’s earned income under Regs. Sec. 1.66-2(c). As a result, Sec. 66(a) relief would be denied,¹⁹ even if the couple meets all the other Sec. 66 requirements.

Sec. 66(a) also makes no mention of a de minimis exception to this requirement. As mentioned above, Congress did not intend a de minimis transfer to disqualify a spouse’s otherwise successful request for relief. Thus, under both the proposed²⁰ and final regulations, a de minimis amount of earned income is not considered a transfer of income. In addition, Regs. Sec. 1.66-2(c) indicates that any amount of earned income transferred for the benefit of a couple’s children is not a transfer of income.

Example 3: A and B are separated. They live in a community property state. When A visits B and the children, she usually buys gifts for the children, takes them out to dinner and gives B money to buy groceries or school clothes. These types of transfers fit within the de minimis exception.²¹

The regulations do not specifically address which direct or indirect transfers for the benefit of the other spouse might qualify as de minimis. However, it is apparent from the examples in Regs. Sec. 1.66-2(d) that $1,000 per month in direct payments that are not court-ordered, for instance, are not de minimis transfers. On the other hand, amounts transferred for the benefit of children that may benefit the transferee spouse tangentially are de minimis transfers. There is no bright-line test.

Sec. 879(a) prescribes the general rules for the tax treatment of community income when one or both spouses are nonresident aliens. Earned income (comprised of wages, salaries or professional fees, and other amounts received as compensation for personal services rendered) is deemed the income of the spouse who rendered the services.²³ Trade or business income is treated as the gross income and deductions of the spouse carrying on the trade or business, or, if the trade or business is jointly operated, allocated to each spouse based on their respective share of gross income and deductions.²⁴ A partner’s distributive share of partnership income is attributed to the spouse who is the partner.²⁵ Under Sec. 879(a)(3), income derived from property that is considered separate property under the applicable community property laws of the state of domicile is treated as separate income of the spouse owning the property. Finally, Sec. 879(a)(4) provides that all other community income is attributed to the spouses under the community property laws of the state of domicile.

Example 4: N and O live in a community property state and meet all the requirements of Sec. 66(a). They have the following income:

The rental property is considered separate property under the community property law of N and O’s domicile.

Overall: N is responsible for total gross income of $232,000 ($200,000 salary, $30,000 rental income and $2,000 interest income). O’s gross income is $52,000 ($40,000 salary, $10,000 individual proprietorship and $2,000 interest income). Had the income been allocated under community property law (assuming the couple lives in a state in which income from separate property is treated as community income), each spouse would have had $142,000 gross income. Had O filed separately, without the benefit of Sec. 66(a), she would be responsible for Federal income tax on $90,000 of income ($142,000 – $52,000) to which she had no access.

Denial of Federal Tax Benefits of Community Property Law

Sec. 66(b) states:

The Secretary may disallow the benefits of any community property law to any taxpayer with respect to any income if such taxpayer acted as if solely entitled to such income and failed to notify the taxpayer’s spouse before the due date (including extensions) for filing the return for the taxable year in which the income was derived of the nature and amount of such income.

This gives the Service the power to disallow the benefits of community property law to a taxpayer for any income item if it can be shown the taxpayer meets two criteria for the income in question. Sec. 66(b) is not another option for a spouse who fails to meet Sec. 66(a)’s requirements.²⁶ A successful Sec. 66(b) action by the Service, however, will result in the spouse being denied the benefits of community property law and having to report the community income at issue, and the other spouse being relieved of the duty to report his or her share of that community income.

Sec. 66(b) does not require spouses to live apart or explicitly keep them from transferring earned income. It also can be applied to a single income item. However, the spouses must not file a joint return and must reside in a community property state. It gives the Service the power to deny Sec. 66(a) benefits to a spouse who (1) acts as if he or she were solely entitled to the income in question, and (2) fails to notify his or her spouse of the nature and amount of the income in question before the due date (including extensions) of the other spouse’s return. Compliance with either of the duties bars the IRS from denying community property law benefits.²⁷

Whether a spouse acted as if he or she was solely entitled to the income at issue is a facts-and-circumstances determination focused on whether the spouse kept the income, used the income, or made the income available to benefit the marital community.²⁸ When a spouse does not inform the other of interest income received and gives it to his or her sibling, for example, that spouse would be deemed to have acted as if solely entitled to the interest income.²⁹ A husband who, while living apart from his wife, voluntarily pays her rent while she is temporarily unemployed, does not act as if he is solely entitled to the income at issue, even if he deposits all his earnings in a separate account and his wife does not know how much he earns. The critical factor is that he made at least some of his earnings available to benefit the marital community.³⁰

The wife was not involved in the husband’s business;
She did not know the extent of the gross income generated by the business;
She had no signing authority over the business account;
The business gross receipts were deposited in a separate business account rather than a joint household account; and
Only a portion of the business income was transferred to the joint account.

A similar result was reached in Layman II.³² The taxpayer made a substantial number of payments to his spouse over a period of several years. The Service argued that he acted as if he was solely entitled to all of the income, because the payments varied widely in amount (from $2,000 to $308). In total, the payments were roughly equal to 20% to 35% of the taxpayer’s income. The Tax Court rejected the Service’s argument, holding that the taxpayer varied the payment amounts based on his spouse’s needs and, thus, he did not act as if he were solely entitled to the income.

A spouse must notify his or her spouse of the nature and amount of the income in question before the due date of his or her spouse’s return (including extensions). Although “general knowledge” by the other spouse appears to play a role in determining whether a spouse acted as if he or she were solely entitled to the income, that determination is still based on all the facts and circumstances, of which general knowledge is only one. Here, the other spouse must be notified or gain knowledge of the income’s nature (i.e., the type and source) and amount.

Example 5: During 2005, T and V are married, but living separately in a community property state. They file separate returns. T earns $50,000 in wages and deposits the income in a separate account, but receives a Form W-2 that reports wages of $45,000. He provides a copy of the incorrect W-2 to V. V files an extension by April 15, 2006. In May, 2006, T receives a corrected W-2 showing $50,000, which he provides to V. In June, V files a separate return, reporting $22,500 as her portion of T’s salary (one-half of $45,000. T correctly files a separate return reporting $25,000 as his portion of his $50,000 salary.

Example 6: J and G live separately in California. Although married, they have not lived together for some time. J earns $240,000 in salary as a family practice doctor. G teaches elementary school and earns $36,000. G is having difficulty making ends meet on her salary and asks J for help. He agrees to pay G $2,000 per month. J does as agreed, but does not inform G how much he earned during the year and does not provide her with a copy of his Form W-2.

The Service would not be able to deny the benefits of the community property laws to J. By transferring $2,000 per month, J has provided part of his income for the benefit of the marital community and, as such, did not act like he was solely entitled to the income. The benefit is substantial. Under the community property laws, J would include only $120,000 of his salary and $18,000 of G’s in gross income. As a result, his gross income would be reduced by $102,000 ($240,000 – $138,000). The $102,000 reduction in income cost J only $24,000 in payments to G.

Conclusion

Part II, in the April 2006 issue, will discuss how a spouse can seek relief from the community property laws under Sec. 66(c), even if he or she does not meet the requirements for relief under Sec. 66(a) and the IRS has not disallowed the other spouse’s community property law benefits under Sec. 66(b).