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CALIFORNIA'S DOMESTIC PARTNER ACT
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Introduction
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Commencing January 1, 2005, the nation's most radical domestic partner's Act becomes law. California's Domestic Partner Rights and Responsibilities Act of 2003 (Act), provides, in essence, that registered domestic partners have all rights and responsibilities of married couples. Although the Act touches on many aspects of a domestic relationship, this newsletter will focus on the uncertainties created by the Act.
Clearly, the Act serves an important political and social function, but the details regarding tax consequences for domestic partners remain unanswered. The Act's main pitfall is its distortion of traditional "community property" law which, under the Act, applies to property rights, but not to income, gift or estate tax reporting.
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The Community Property Quagmire
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The Act states that domestic partners shall be treated as married couples for purposes of property rights and obligations. Thus, California's complicated and often counter-intuitive community property laws will apply. In general, community property is property that is earned during the marriage (domestic relationship) or is converted from separate property of one partner into community property. Community property is both a property and a tax concept, and to decouple the property rights from the tax obligations will lead to unintended and potentially disastrous consequences.
Married couples usually report their combined earnings on joint returns so community property tax issues are not raised. Married couples filing separate returns report 50% of the community property on each separate return.
However, domestic partners cannot file joint returns and federal and state income tax laws are not affected by the Act. The issue confronting domestic partners is how earnings and property can constitute community property under the Act, but not under federal and state tax laws?
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Example
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Assume John and Hank, California residents, registered as domestic partners in 2000, the first year in which registration was permitted. From 2000 to the present, assume that John earned $300,000 per year and Hank did not work. John claimed itemized deductions for mortgage interest and real estate taxes and each partner filed tax returns as single individuals. 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 or $400,000 in total from 2000 through 2004.
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Effective Date
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The first unanswered question: When did the Act become effective -- on January 1, 2005, or when John and Hank first registered as domestic partners? In other words, is the Act retroactive? Unfortunately, the Act is silent as to its effective date. However, it appears that it applies when John and Hank registered as domestic partners, since the Act contains an opt-out provision (i.e. registered domestic partners may opt out of the Act on or before December 31, 2004).
In our example, are John's earnings community property from the date of registration or from January 1, 2005 forward? If John and Hank terminate their relationship on February 1, 2005, is Hank entitled to his community property share of 50% of John's $400,000 in savings, on the theory that the Act applies retroactively?
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Tax Return Filing
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The Act states that John's earnings are community property. Under community property concepts, John should report 50% of his earnings on his tax return and Hank should report 50% of John's earnings on his tax return. Thus, each should report $150,000 in earnings and each should claim 50% of the itemized deductions. However, the Act states earned income may not be treated as community property for state income tax purposes. Do John and Hank report income and expenses under traditional community property rules (50/50) or does John (as the person earning the income) report it on his return?
If we conclude that traditional community property rules apply and each should report 50% of the income, then how should we treat John's earnings from 2000 through 2004? Should John amend his return and report only 50% of earnings and deductions, and should Hank file a return reporting his community property share? Will IRS and California's FTB assert penalties and interest against Hank for his failure to report his share of community property earnings although the requirement resulted from a retroactive interpretation of the Act?
Assuming that traditional community property rules do not apply to tax return filings, and John and Hank dissolve their relationship, is Hank entitled to 50% of John's savings of $400,000? Likewise, is John entitled to a credit for paying Hank's share of the taxes?
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Gift-Tax Complications
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There are no gift-tax restrictions between U.S. citizen spouses. Not so with domestic partners. Each partner is limited to the gift-tax rules that apply to a non-spouse -- 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 that is part of the overall estate and gift tax lifetime exemption of $1.5 million (in 2004 and 2005).
For example: If John gives Hank a gift of $50,000, the annual gift-tax exclusion will cover the first $11,000, but John must use $39,000 of his life-time gift exemption to avoid paying gift taxes on the balance. Use of the life-time gift exclusion also reduces the $1.5 million gift and estate tax exclusion by $39,000.
If John paid Hank's share of taxes attributable to the community property earnings which were reported entirely on John's return, has John made Hank a gift of $50,000 subject to federal gift taxes?
More fundamentally, Hank has a community property interest in John's earnings, therefore, John is not making a gift (a gratuitous transfer of property owned by John). Rather, he is merely transferring to Hank that which already belongs to Hank. In short, under community property rules, John does not own 100% of his earnings in the first place, so it follows that a transfer to Hank of Hank's interest in John's earnings is not a gift.
Note: A transmutation (conversion) of separate property to community property involves a taxable gift. In this situation, married couples enjoy an unlimited gift exemption, however there is no similar provision for domestic partners. Thus, transmutations of property by domestic partners will result in taxable gifts. For example, assume that prior to registering as domestic partners, John held stock worth $100,000 in his name. After registering, John transferred the stock to himself and Hank as community property. In this instance, John has clearly made a gift of $50,000 to Hank.
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Tax Trap on Termination
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When a married couple terminates a relationship and divides property pursuant to a divorce, the transaction is usually tax-free. However, no similar provision exists for domestic partners. Suppose that John and Hank terminated their relationship and in satisfaction of Hank's community property interest, John transferred stock (which he originally purchased for $10,000) to Hank that was now worth $200,000. Under federal tax law, John "sold" stock for its fair market value, thus incurring a federal and state income tax on the $190,000 of taxable gain on the transaction.
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S corporation issue
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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? Will IRS recognize a domestic partner's community property interest or will it decide that only a spousal community property interest complies with S corp requirements, thus disqualifying an S corp whenever there is a domestic partner relationship?
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Domestic Partner Consent
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Under the Act, transfer of an ownership interest in a privately-held company may require consent of the domestic partner. The same is true with real estate purchases and refinancings. Does this mean that on January 1, 2005, existing company buy-sell agreements are no longer effective unless a domestic partner signs a consent or waiver to the arrangement?
What about situations where one partner has management and control over a business or entity, such as a general partner in a limited partnership or a manager of a limited liability company? Do the "fiduciary duty" provisions under family law require a written consent or waiver by the non-controlling partner to allow the partner in control to continue in that capacity?
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No Proposition 13 Exclusion
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Real estate transfers between spouses are generally exempt from reassessment under Proposition 13. However, there is no reassessment exclusion for a domestic partner transfer.
Note: San Francisco County has enacted an exclusion for domestic property transfers.
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Conclusion
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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. In short, the concept of community property for domestic-partner purposes, but not under the tax laws, makes no sense.
Couples with unequal income or property holdings should carefully consider whether they want to register under the Act. In the alternative, couples may enter into a property contract waiving their rights to community property and treating their respective earnings as separate property. Under current law, domestic partners cannot draft an agreement that will convert their earnings to community property for tax purposes.
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All contents copyright © 2007 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(TM) is a trademark of Robert L. Sommers.
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