In Texas and eight other states, community property laws govern the interests of spouses in property and income acquired or earned during their marriage. In general, community property laws affect how a couple will figure their income on their federal income tax returns if they are married, yet file separate returns. While there are benefits to filing a single tax return – married filing jointly – sometimes it can be to the couple’s advantage to file separate returns. Ultimately, however, filing of separate returns can result in one spouse having to disproportionately pay taxes. Under Internal Revenue Code (“IRC”) § 66, this liability may be avoided.
This article is directed at married taxpayers who live in one of the following community property states:
- New Mexico;
- Washington; and
Generally, in a community property state, the spouses are considered to own equal and undivided half interests in each item of community property – property earned during the marriage – and income earned by each spouse will generally be treated as if it had been earned half by each. Due to state laws, there may be variation in specific community property laws depending on where the couple lives.
Unlike the innocent spouse provisions of IRC § 6015 where a taxpayer may avoid tax liability on a jointly filed return, Congress enacted IRC § 66 to relieve married taxpayers of tax liability who would otherwise suffer inequitable tax treatment. For more information on Innocent Spouse or Equitable Relief, see our other articles: Surprise! Spouse Leaves IRS Debt You Did Not Know About and No Innocent Spouse Relief? No Problem.
Under IRC § 66(a), if two individuals are married during the tax year, but have lived apart at all times during the year, have not filed a joint return for the tax year, and have not transferred any earned income between the two, then the following income can be treated as separate property:
- Earned Income (e.g., payment for services rendered);
- Trade or Business Income; and
- Partnership Distributions.
All other community income will remain subject to normal community property rules.
Under IRC § 66(b), the IRS may disregard community property laws where one spouse was not notified or made aware of community property income. Moreover, if the spouse who the income was attributable to acted as if they were solely entitled to such income and failed to tell the other spouse where the income came from and the amount of such income, then the IRS may disallow any benefits of community property laws. This allows the IRS the ability to relieve the requesting spouse of liability in the event that the other spouse was taking advantage of community property laws to the detriment of the requesting spouse. For example, if the non-requesting spouse had gambling winnings which they later used to purchase a luxury watch, but never disclosed the winnings to the requesting spouse, such income may be considered separate property of the non-requesting spouse.
If a taxpayer does not qualify for relief under IRC § 66(a), IRC § 66(c) provides certain conditions under which the requesting spouse may be relieved of separate return liability for items of community income attributable to the other spouse. The requesting spouse may be relieved of liability if:
- The requesting spouse did not file a joint return;
- The requesting spouse did not include in gross income for such taxable year an item of community income that would be treated as income of the other spouse under IRC § 879(a);
- The requesting spouse establishes that he or she did not know or have reason to know of the item of community property income; and
- Under all the facts and circumstances, it would be inequitable to include the item of community property income in the requesting spouse’s gross income.
If these four conditions are met, then the IRS may strictly include the income item in the other spouse’s income.
The last sentence of IRC § 66(c) additionally grants the IRS added authority to provide equitable relief in the event that other relief cannot be granted (for example, the taxpayer simply fails to meet one of the required elements listed above, but holding the taxpayer liable would offend principles of equity in the IRS’ view). Under Revenue Procedure 2003-61, there are a list of non-exclusive factors that the IRS should weigh when considering the facts and circumstances that may be taken into account in such a situation. Such factors include:
Factors weighing in favor of relief:
- The requesting spouse is separated or divorced from the other spouse;
- The requesting spouse would suffer economic hardship if equitable relief is denied;
- The requesting spouse was abused by the non-requesting spouse, but such abuse did not amount to duress;
- The requesting spouse knew or had reason to know of items giving rise to a tax deficiency or that the tax liability would not be paid;
- The non-requesting spouse already has a legal obligation under a divorce decree or separation agreement to pay the tax; and
- The liability for which relief is sought is solely attributable to the non-requesting spouse.
Factors weighing against relief:
- The unpaid liability or items giving rise to the deficiency are attributable to the requesting spouse;
- The requesting spouse knew or had reason to know of the items giving rise to a tax deficiency or that the tax liability would not be paid;
- The requesting spouse has significantly benefitted (beyond normal support) from the unpaid liability or items giving rise to the deficiency;
- The requesting spouse will not experience an economic hardship if equitable relief is denied;
- The requesting spouse has not made a good faith effort to comply with federal income tax requirements in the tax years following the tax year(s) for which the equitable relief request relates; and
- The requesting spouse already has a legal obligation under a divorce decree or separation agreement to pay the tax.
With an overlap of state law issues affecting the classification of property interests, it is extremely important to seek the help of a professional. To ensure that a claim for relief under IRC § 66 is made correctly, contact The Wilson Firm today.