California’s community property system has a broad range of impacts that require careful consideration and review. For one, the community property system requires certain tax treatment regarding separate assets and community assets. Frequently these classifications become relevant during tax or divorce proceedings. In a number of circumstances, assets are significant and considerations must be made regarding the tax impact of dividing a business, home, and other properties.
The tax attorneys and CPAs of the Tax Law Offices of David W. Klasing have prepared a brief Q&A regarding some common divorce tax issues. However, please do keep in mind that this information is general in nature. Please consult with a tax professional regarding your facts, concerns, and other relevant factors before taking any action.
For divorce tax concerns, an understanding of both state and federal law is essential. While federal law determines how property is taxed, state law determines a taxpayer’s rights to property. Since, federal tax is assessed and collected based on a taxpayer’s property rights, an understanding of how both bodies of law interact is essential to a proper handling of divorce tax issues.
Married couples and registered domestic partnerships (RDPs)(if recognized under state law)), who file separate tax returns, must follow the property rules in their state of domicile. Since CA is a community property state, each spouse must report according to community property rules.
Spouses are therefore required to report his or her half of the community income, plus his or her separate income on their respective tax returns.
The general rule to determine whether property is separate or community property is based on the timing of its acquisition. Typically, 100% property acquired during a marriage is community property. [Ca Fam §§760, 771(a)]. Likewise, income derived from a spouse’s work or labor is also typically community property. The profits from a spouse’s business are also typically community property.
By contrast, separate property is the property acquired before marriage and the income earned on separate property such as rent. [Ca Fam §770(a)(1) & (3)]. In addition, a spouse’s wages and other “earnings and accumulations” after the date of separation while living “separate and apart” are also his or her separate property (Ca Fam §772); (Ca Fam §771(a)). Separate property also includes property acquired during marriage by “gift, bequest, devise, or descent” meaning that inheritances are separate property. [Ca Const. Art. I §21; Ca Fam §770(a)(2)]. Individual spouses may also purchase and hold separate property provided that they negotiate and execute a written agreement. Some spouses may consider a prenuptial agreement to accomplish this goal while others may take a piecemeal approach.
The community property estate in CA is terminated when the spouses physically separate and both spouses intend to permanently end the marriage. Not all community property states require that the spouses be physically separated. While essential to a comprehensive handling of all divorce and tax issues, the existence of a formal separation agreement, alone, will not terminate the community property estate. The determination regarding the existence of mutual intent is made by examining the individualized facts and circumstances of each case. (See In re Marriage of Davis, 61 Cal 4th 846, 2015 for details.) As such, a tax attorney can assess the various events and circumstances to determine when a separation occurred. An earlier separation date often has a tax impact because it is likely that more property will be separate property.
In a divorce situation, it is common that one or both spouses will not get to enjoy the other spouse’s community income. However, taxpayers in California are nevertheless legally required to report all of their community income and deductions. However, IRC §66(a) sets forth exceptions to the general rule for reporting community property and income including:
If these criteria are met, spouses in community property states may report their income according to rules of IRC 879(a). Under this provision of the Tax Code, the taxpayer will only need to report their specific income concerning:
All other forms of community income are taxed in accordance with state law. For more information on how this will apply to your situation, please contact a tax professional.
In general, it is possible to receive tax-free treatment regarding certain transfers between spouses provided that IRC §1041 applies. This section of the U.S. Tax Code applies when a transfer is “incident to a divorce.” A transfer is incident to a divorce when it:
While the “related to” category provides a tax lawyer with some discretion, in order for a transfer to be considered “related to” the ending of a marriage, such transfers must take place within 6 years after the divorce and be made pursuant to divorce or separation instrument. [IRC §1041(c)].
When either of the above applies, this section provides that there is no recognized gain or loss on a transfer of assets. However, if §1041 does not apply, then the taxpayers will need to consider the tax basis for their property and the gain or loss that will be realized through the transfer. The failure to make these considerations can result in unexpected tax obligations on the property where significant gain is realized.
Consider a hypothetical couple (Spouse A and Spouse B) who separated in late 2012. Since the separation, the spouses have lived separate and apart and have had no intention of resuming marital relations. Spouse A exclusively runs Company A, Company B and Company C, which were all formed and began operations during the marriage. As such, they would be considered community property. Company A was originally capitalized with a transfer of cash and securities from an account owned by both spouses as joint tenants with right of survivorship (JTWROS). Company A owns 100% of Company C, a single member LLC disregarded for tax purposes. Company B is also a limited liability company owned 98.0% by Company A and 1.0% each by Spouse A and Spouse B.
Spouse A took a distribution from Company A in 2013 and used the proceed to buy a house. In 2014, a court order forced spouse A to sell the house and the proceeds were split 50% each between Spouse A and Spouse B.
Since the spouses have been living separate and apart since 2013, and intended to permanently end the marriage, it is likely that 100% of the post-separation, pre-divorce income from Companies A, B, and C should be included in Spouse A’s married filing separate income tax returns. It follows that Spouse A’s tax basis in these entities should be adjusted 100% for the income, losses, and other contributions. However, the distributions will be sourced to the recipient shareholder who actually received the distributions since the distributions are initially a return of capital for contributions made to Company A prior to the separation.
Under this fact scenario, an unfortunate and inequitable result is most likely reached for Spouse A because it appears that 100% of the 2014 distribution will be charged to Spouse A, since the proceeds from the sale of the house were not contributed back into Company A before they were divided between Spouse A and Spouse B. However, a tax attorney or tax professional may be able to show, that the division of proceeds of the sale of the home should actually be traced back to Company A as a distribution and therefore avoid this potentially inequitable tax result. An experienced tax professional can develop a strategic approach to divorce tax issues.
If a taxpayer wishes to leverage Section 1041 or other favorable tax treatment following a divorce, it would be wise to work with a tax professional. Furthermore, individuals who wish to avoid an unexpectedly inequitable divorce settlement that saddles one spouse with an unexpected tax liability can protect him or herself by working with a tax professional. The tax attorneys and CPAs of the Tax Law Offices of David W. Klasing can assist with divorce taxation, community property, and related tax concerns. To schedule a confidential reduced rate consultation, please call 800-681-1295 today.