- 25.18.2 Income Reporting Considerations of Community Property
- 184.108.40.206 Income Reporting Considerations of Community Property
- 220.127.116.11 Self-Employment Tax
- 18.104.22.168 Claiming of Deductions
- 22.214.171.124 Alimony or Separate Maintenance
- 126.96.36.199 Claiming of Credits
- 188.8.131.52 Disclosure Considerations
- 184.108.40.206 Third-Party Contacts
- 220.127.116.11 Statutory Notice Considerations for Community Property Adjustments to Income
- 18.104.22.168 Bureau of Labor Statistics
- 22.214.171.124 Classification of Community Property Limited Liability Companies
Part 25. Special Topics
Chapter 18. 8 Community Property
Section 2. Income Reporting Considerations of Community Property
March 10, 2017
(1) This transmits revised IRM 25.18.2, Community Property, Income Reporting Considerations of Community Property.
(1) Updated legal references, IRM references, and made minor editorial changes throughout this IRM.
(2) Significant changes to this IRM are reflected in the table below.
|IRM 126.96.36.199||Updated guidance to reflect changes in IRM 188.8.131.52.23, Mixing or Commingling Community Property With Separate Property.|
|IRM 184.108.40.206||Added citation to Stewart v. Commissioner.|
|IRM 220.127.116.11||Clarified guidance when working an uncooperative nonfiler whose spouse filed a separate return.|
Michael W. Damasiewicz
Director, Examination–Field and Campus Policy, SE:S:E:HQ:EFCP
If joint returns are filed, there is little or no impact from reporting community property income. All income of both spouses is reported on the return. If separate returns are filed, each spouse reports half of each income item that is community property. Poe v. Seaborn, 282 U.S. 101 (1930). Income that is not community property is reported by the spouse who earned or accrued it.
Therefore, the characterization of income items will determine how they are reported. In the context of income items, the characterization rules are not always simple to apply. The following is a brief list of income items and their characterization. For additional information, reference should be made to the characterization section of this IRM section.
Earnings, wages and profits. A spouse's wages, earnings and net profits from a sole proprietorship are community property and must be split.
Partnership income. If an interest is held in a partnership, and income from the partnership is attributable to the efforts of either spouse, the partnership income is community property. If it is merely a passive investment in a separate property partnership, the partnership income will be characterized in accordance with the discussion in subparagraph f, Income from Separate Property, below.
Income Acquired Before Marriage or Community Property Domicile. Separate property includes property acquired before the spouses were married, or during marriage but before both spouses domiciled in a community property state. Income received under these circumstances would be separate property and not community property.
Income in Year of Divorce. Income received in the year of divorce, but before dissolution, is community property and must be split. Kimes v. Commissioner, 55 T.C. 774 (1971). Generally, when spouses file a separate return for the year of divorce, an allocation must be made between community property income and income earned after divorce. See subparagraph e, Income After Death, Divorce, or Other Termination of Community Estate, below.
Income After Death, Divorce, or Other Termination of Community Estate. Income acquired after death, divorce, or some other termination of the community estate is not community property. States have different rules for determining when the community estate is terminated. See IRM 18.104.22.168.4, Termination of the Community Estate.
Income From Separate Property. Whether income from separate property (e.g., dividends, interest, rents) is community property or separate property depends on the state involved. In some states, dividends, interest and rents from separate property are separate property. These states include Washington, Nevada, California, Arizona and New Mexico. Other states characterize interest, dividends and rents from separate property as community property. These states include Louisiana, Wisconsin and Texas. See IRM 22.214.171.124.14, Income from Separate Property Received During Marriage.
Dividends, Interest and Rents from Community Property. Dividends, interest and rents from community property are community property and must be split.
Illegal Income. Income earned illegally is taxable. James v. United States, 366 U.S. 213 (1961); Rutkin v. United States, 343 U.S. 130 (1952). In community property states, property must be "acquired" by a spouse for it to become community property. The term “acquired” has been interpreted to mean the passage of title. Thus, if the payor or victim of the illegal income intended to pass title to the income to the spouse, it is community property income. If not, the income is separate property. Johnson v. Commissioner, 72 T.C. 340 (1979), acq. 1980-2 C.B. 1 (Texas law); Berenbeim v. Commissioner, T.C. Memo. 1992-272 (California law); Hilton v. Commissioner, T.C. Memo. 1990-379 (Louisiana law). For example, in Johnson, fraudulent tax refund checks paid in the name of the spouse are community property, while those paid in the names of third parties, which the spouse appropriated, are separate property. In Berenbeim, the court held that funds received under the guise that they would be invested, but that were later embezzled, are not community property because title did not pass under California law. The issue is most likely to appear in the context of a theft, embezzlement, or misappropriation and whether the income is community property will depend on state law. Illegal income from the sale of prohibited services or goods (e.g., drugs) is likely to be community income, because the payor intended to make the payment and pass title. See discussion in Costa v. Commissioner, T.C. Memo. 1990-572.
Capital Gains From Separate Property. Generally, appreciation in value of separate property is also separate property, unless the appreciation in value is attributable to the labor of the non-owning spouse and not compensated by the owning spouse. For example, market appreciation on publicly traded stocks held as separate property is also separate property. If the increase in value is attributable to the skills of the non-owning spouse or to the application of community property to the separate property asset, a different result may occur depending on the facts and the applicable state law. See IRM 126.96.36.199.21, Capital Gains From Separate Property, and IRM 188.8.131.52.23, Mixing or Commingling Community Property With Separate Property.
IRA withdrawals and related penalties. Individual retirement accounts by law are deemed to be separate property. Therefore, taxable IRA distributions are separate property, even if the funds in the account would otherwise be community property. The withdrawal and any penalties are wholly taxable to the spouse whose name is on the account. Bunney v. Commissioner, 114 T.C. 259 (2000); Morris v. Commissioner, T.C. Memo. 2002-17.
Sole Proprietorship. Net income from a trade or business (other than a partnership) is treated as income of the spouse who exercises management and control over the trade or business. Treas. Reg. 1.1402(a)-8(a). Heidig v. Commissioner, T.C. Memo. 1986-411; Tolotti v. Commissioner, T.C. Memo. 1987-13. Management and control means actual management and control, not management and control imputed from husband to wife under community property laws. Treas. Reg. 1.1402(a)-8. Therefore, the self-employment tax is imposed on the spouse actually carrying on the trade or business.
Partnership. The distributive share of each married partner's income or loss from a partnership trade or business is attributable to the partner for computing self-employment tax, even if a portion of the partner's distributive share of income or loss is otherwise attributable to the partner's spouse for income tax purposes. Treas. Reg. 1.1402(a)-8(b). If both spouses are partners, the self-employment tax is allocated based on their distributive share. Treas. Reg. 1.1402(a)-8(b).
There is limited impact of community property laws on the claiming of deductions if joint returns are filed. If separate returns are filed, in some circumstances a deduction may be required to be split between the spouses’ separate returns. The following are rules with respect to deductions claimed on separate returns:
Expenses Associated With Income. Expenses associated with income are characterized in the same manner as the income. Johnson v. Commissioner, 72 T.C. 340 (1979), acq. 1980-2 C.B. 1. Thus, for example, deductions associated with a Schedule C law practice generating community property income must be split, even if they are paid from separate property. Finley v. Commissioner, T.C. Memo. 1982-411. The rationale behind this rule is that the community income that is allocated to the spouses is not gross, but net, taxable income, computed by deducting expenses incidental to its production. Stewart v. Commissioner, 35 B.T.A. 406, 410 (1937), aff'd, 95 F.2d 821 (5th Cir. 1938). Similarly, if the income is characterized as separate property, then the associated deductions are also treated as the separate property of the spouse who must report the income. If the income is allocated between separate and community property, the expenses should also be allocated proportionately. Johnson v. Commissioner, 72 T.C. 340 (1979), acq. 1980-2 C.B. 1.
Deductions Not Related to Income. Deductions that are not related to income (e.g., medical, charitable contributions, property taxes, state taxes) are split, unless it is established that they were paid with separate property, in which case they would be deductible by the spouse whose separate property was used to pay them. See Stewart v. Commissioner, 35 B.T.A. 406, 410 (1937), aff'd, 95 F.2d 821 (5th Cir. 1938); Powell v. Commissioner, T.C. Memo. 1967-32; see also Hunt v. Commissioner, 47 B.T.A. 829 (1942); Bishop v. Commissioner, 152 F.2d 389 (9th Cir. 1945); Commissioner v. Newcombe, 203 F.2d 128 (9th Cir. 1953); Keeter v. United States, 97-2 U.S.T.C. ¶ 50,940, 80 A.F.T.R.2d ¶ 97-5640 (E.D. Cal. 1997).
Losses From Separate Property. Losses sustained on the sale of separate property are reportable by the spouse who owned the separate property. Stewart v. Commissioner, 35 B.T.A. 406, 410 (1937), aff'd, 95 F.2d 821 (5th Cir. 1938). Losses sustained on the sale of community property are community property losses and must be split. Allen v. Commissioner, 22 T.C. 70 (1954), acq. 1954-2 C.B. 3.
Business Losses. Business losses funded with community property or which the taxpayer does not establish were funded with separate property are split between the spouses. Allen v. Commissioner, 22 T.C. 70 (1954), acq. 1954-2 C.B. 3. This also affects the amount that can be claimed in net operating loss carrybacks. Tseng v. Commissioner, T.C. Memo. 1994-126, aff’d without published opinion, 79 F.3d 1154 (9th Cir. 1996), cert. denied, 519 U.S. 820 (1996).
Casualty Losses. Casualty losses are deductible by the spouse who owned the property. If the property was community property, the loss deduction would be divided. Kamins v. Commissioner, 54 T.C. 977 (1970).
Bad Debts. Bad debt deductions are generally split if the money was loaned from community property during the marriage. However, bad debt deductions for premarital loans or loans made with separate property are not split. Stewart v. Commissioner, 35 B.T.A. 406, 410 (1937), aff'd, 95 F.2d 821 (5th Cir. 1938); Thorman v. Commissioner, Nos. 15,674 and 15,675 (T.C. Memo. 1949). Payment of a post-community loan guarantee that is an obligation of the community is split. Kleberg v. Commissioner, 43 B.T.A. 277 (1941).
IRA Contributions. Deductions for individual retirement account contributions cannot be split between spouses. The deduction for each spouse is figured separately and without regard to community property laws. IRC 219(f)(2).
Alimony or separate maintenance payments made prior to divorce are deductible by the payor and taxable to the payee only to the extent they exceed 50% of the reportable community property income. This is so because the payee spouse is already required to report half of the community property income, and will already be taxed on the payments. Hunt v. Commissioner, 22 T.C. 228 (1954).
If the payments exceed the payee spouse’s 50% share of the community property income, the excess is treated as being paid first from the payor spouse's share of the current community property income (which is 100% taxable to the payee spouse), and then from the couple's accumulated community property (which is 50% taxable to the payee spouse). Furgatch v. Commissioner, 74 T.C. 1205 (1980).
Withholding credits. Withholding credits from community property income are allocated 50% to each spouse. Treas. Reg. 1.31-1(a); Gilmore v. United States, 290 F.2d 942 (Ct.Cl. 1961), rev'd on other grounds, 372 U.S. 39 (1963).
Estimated Tax Payments. Estimated tax payments made in a separate declaration of estimated tax are the separate property of the spouse making the declaration. Janus v. United States, 557 F.2d 1268 (9th Cir. 1977); Morris v. Commissioner, T.C. Memo. 1966-245. These payments are separate property even if the source for them is community property. If spouses file a joint declaration of estimated tax and file separate returns, they may allocate the payments in any consistent manner that they may agree upon. If they cannot agree, and the source of the payment is know to be community property, the payment should be split. Usually, the source of the payment will not be known, however. Under these circumstances, the payments should be allocated in proportion to the tax liability reported on the returns as follows:
Separate Tax Liability ÷ Both Tax Liabilities12/12 × Estimated Tax Payments
Rev. Rul. 80-7, 1980-1 C.B. 296, amplified by Rev. Rul. 87-52, 1987-1 C.B. 347; Treas. Reg. 1.6654-2(e)(5)(ii)(B); United States v. Johnson, 75-1 U.S.T.C. ¶ 9144, 35 A.F.T.R.2d ¶ 75-354 (D. Minn. 1974). If the spouses file a joint return and the character of the estimated tax payments becomes material (e.g., for an injured spouse claim under IRC 6402), the source of the payment is considered. Elam v. United States, 112 F.3d 1036 (9th Cir. 1997).
Earned Income Credit. Community property income splitting is disregarded in calculating the amount of earned income for purposes of the earned income credit. See IRC 32(c)(2)(B)(i). However, community property income splitting is considered in determining adjusted gross income for purposes of income limitations under IRC 32(a)(2) and IRC 32(b), if a taxpayer qualifies to file as head of household and is subject to community property laws. It should be noted, however, that these limitations are the greater of adjusted gross income or earned income. IRC 32(a)(2)(B).
There are potential disclosure problems in sharing income information between spouses filing separate returns. Generally, it is a potential disclosure violation to provide income information of one spouse to the other spouse even if it relates to community property. Exceptions exist to this general rule. For example, in the context of an audit of a husband's return, the wife's return information may be disclosed if the information is directly related to the resolution of an issue in the husband's audit. IRC 6103(h)(4).
IRC 7602(c)(1) provides that the Service may not contact any person other than the taxpayer with respect to an examination or collection of a tax liability without first providing reasonable notice in advance that contacts with persons other than the taxpayer may be made. IRC 7602(c)(2) requires the Service to make a record of specific contacts and to periodically provide the taxpayer with a record of persons contacted during the period. These rules do not apply to contacting spouses where they have filed a joint return. Where separate returns or no returns are filed, contacting a spouse with respect to an audit of the other spouse is a third-party contact for purposes of this statute. Absent taxpayer authorization or some other exception, the notification and recording requirements of these provisions must be complied with.
Allocation of income. Where spouses are living in a community property state and have not filed returns or filed separate returns and failed to report income, the Service is faced with the issue of how to allocate the income between the spouses. If the income is community property, it should be split between the spouses, and if the income is separate property, it should be taxed to the spouse who earned or accrued it.
Uncooperative Nonfilers. Often, in the case of nonfilers, the Service will have no specific information establishing whether income is community property, because the spouses are not cooperating and no other information is available. In this circumstance, state law presumes that the income is community property. For purposes of allocating income between the spouses for an examination report or a notice of deficiency, the Service will follow the state law presumption that the income is community property. All income should be split equally between the spouses, unless there is a federal preemption that requires treatment of an item as separate property (e.g., IRA withdrawals, social security benefits, etc.). In the case of an uncooperative nonfiler, where his or her spouse has filed a separate return reporting income without regard to community property, the filing spouse should be contacted to determine if community property reporting rules apply. However, if the filing spouse also does not cooperate, the state law presumption that the income is community property should be followed. If the statute of limitations on assessment is open with respect to the separate return of the filing spouse, and it appears that the return did not report income correctly, the filed separate return should also be considered for examination.
Income adjustments – filed returns. Where spouses have filed separate returns and failed to report an item of income, the Service can usually determine whether the unreported item is community property by contacting the spouses. If the spouses are uncooperative, the Service should follow the presumption that the item is community property and split it between the returns. If the spouses' returns were not filed on a community property basis, it may be necessary to adjust the returns to put them on the correct basis.
Whipsaws. In some cases, spouses will disagree about whether an item is community property, and the Service will not be able to make a determination with any certainty. In other cases, a spouse may seek relief under IRC 66. In these or any other circumstances where there is a realistic possibility that revenue will be lost if a protective position is not taken, the Service should whipsaw the income against both spouses. The whipsaw should not be set up simply because the Service has no information about the spouses' position on the issue, however. If the Service does set up a whipsaw, 100% of the item should be allocated to the spouse who earned or accrued the income as separate property, and 50% to the other spouse as community property. Since this would result in taxing more than 100% of the income, if the spouses subsequently agree to a consistent allocation or if a court imposes one, the inconsistent portion of the adjustment should be conceded. Any item whose treatment as separate property is mandated by federal law should be treated accordingly (e.g., IRA withdrawals, earned income credit, social security benefits).
Lost Revenue. Following the state presumption that income is community property can sometimes result in lost revenue. For example, assume a husband and wife do not file returns. The only income is wages in the husband's name. The Service treats the income as community property and issues notices of deficiency to each spouse allocating half of the wages to each spouse. The husband does not respond to the statutory notice and his case is closed. The wife files a petition with the Tax Court and produces a marital agreement that the husband's wages are his separate property. In that case, the adjustment to the wife would be conceded. The half of the income allocated to the wife, but actually taxable to the husband, could go untaxed. If this occurs, consideration should be given to reopening the other spouse's return to include the other half of the income. Whether the loss of revenue justifies reopening the other spouse's liability will depend on whether the failure to reopen would be a "serious administrative omission." This will depend on the same factors applicable to any other reopening, including whether there is an open statute for assessment and whether the lost revenue is sufficient to justify the administrative expense of reopening the liability. Note: If the other spouse has not filed a return, the statute of limitations for assessing the deficiency would not have begun to run. See IRC 6501(c)(3). For the criteria applicable to determining whether a tax liability can be reopened, see Policy Statement 4-3, reprinted in IRM 184.108.40.206.1, Cases Closed by District Directors or Service Center Directors Will Not Be Reopened Except Under Certain Circumstances.
If Bureau of Labor Statistics (BLS) are being used in a community property state as the basis for a reconstruction of income, the appropriate family figure for the cost of living (not the BLS income figure) for the spouses and any dependents should be used. This figure should be split and half allocated to each spouse. Before BLS can be used in any case, the Service should be able to demonstrate (1) that the taxpayer did not cooperate in the audit, and (2) that there is evidence of taxable income, but no information can be readily acquired to ascertain the amount of such income.
Where a limited liability company (an “LLC”) is wholly owned by a husband and wife as community property under the laws of a state, the Service will respect the taxpayers’ treatment of the entity as either a partnership or disregarded entity. Rev. Proc. 2002-69, 2002-2 C.B. 831; IRM 220.127.116.11.3, Community Property Considerations.