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The Tax Prophet Newsletter   Issue # 17 November, 2004

In This Issue:
Introduction
Community Property Quagmire
Example
Effective Date
Tax Return Filing
Gift-Tax Complications
Tax Trap on Termination

CALIFORNIA'S DOMESTIC PARTNER ACT


Introduction Commencing January 1, 2005, California's Domestic Partner Rights and Responsibilities Act of 2003 (Act), becomes a reality for registered domestic partners. The Act provides, in essence, that registered domestic partners have all the rights and responsibilities of married couples. Although the Act touches on many aspects of a domestic relationship, this newsletter will focus on tax uncertainties created by the Act.


Community Property Quagmire

The Act states that domestic partners shall be treated as married couples for purposes of property rights and obligations. This means that California's community property laws will apply. In general, community property consists od income earned during a domestic relationship or property converted from the separate property of one partner to community property.

However, for tax purposes, the Act states that domestic partners cannot file joint returns and state income tax laws are not affected by the Act. How can earnings and property be considered community property for ownership, but not, presumably, under federal and state tax laws?

Example

Assume John and Hank, California residents, registered as domestic partners in 2000. From 2000 to the present, assume that John earned $300,000 per year and Hank did not work. John paid $80,000 in federal incomes taxes and $20,000 in California income taxes each year. The couple spent $100,000 on living expenses and John saved $100,000 each year ($400,000 in total) from 2000 through 2004.


Effective Date

The first unanswered question is when did the Act become effective: on January 1, 2005, or when John and Hank first registered as domestic partners? Unfortunately, the Act is silent as to its effective date, but since the law contains an opt-out provision - registered domestic partners may opt out of the Act on or before December 31, 2004 - it seems the Act applies retroactively.

Tax Return Filing

The Act states that John's earnings are community property which means that John and Hank should report 50% of John's earnings on their individual tax returns. However, the Act states earned income is not community property for state income tax purposes. Do John and Hank report income and expenses under traditional community property rules or does John (as the person earning the income) report it on his return?



Gift-Tax Complications

There are no restrictions regarding gifts made between U.S. citizen spouses, but there is no equivalent exception for domestic partners. Each partner is limited to the gift-tax rules that apply to gifts to a non-spouse. There is an annual gift-tax exclusion for present gifts of $11,000 per year, per beneficiary. In addition, an individual has a $1 million lifetime gift exemption. If John paid Hank's share of taxes attributable to community property earnings reported entirely on John's return, has John made Hank a gift of the taxes paid ($50,000)?



Tax Trap on Termination

When a married couple terminates a relationship and divides property pursuant to a divorce, the transaction is considered tax-free, but there is no similar provision for domestic partners. Suppose John transferred stock (John's separate property) to Hank that was worth $200,000 which he purchased for $10,000 in satisfaction of Hank's community property interest pursuant to a termination of their relationship. Under federal and state tax law, John sold stock for $200,000, thus incurring $190,000 of taxable gain on the transaction.

 



S corporation issue

An S corporation requires that a spouse in a community property state join in the election of S corporation status. Does the domestic partner have to elect S corporation status?

 



Domestic Partner Consent

Under the Act, transfer of an ownership interest in a privately-held company, or real estate purchases or refinancing may require consent of the domestic partner. Does this mean that on January 1, 2005, existing company buy-sell agreements are no longer effective unless the domestic partner signs a consent or waiver to the arrangement? What about transfers of real property occurring after domestic registration but prior to January 1, 2005?

 



No Proposition 13 Exclusion

Unlike real estate transfers between spouses which are generally exempt from reassessment under Proposition 13 and are not subject to gift tax, there is no reassessment or gift-tax exclusion for transfers to a domestic partner. Note: San Francisco County has enacted an exclusion for domestic property transfers.

 



Conclusion

Given the uncertainty regarding the income tax consequences of community property and the potential for serious financial harm under the Act, those with substantial tax or financial transactions should opt out of the Act, until these issues are clarified.

 



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All contents copyright © 1995-2004 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.