Complex Tax Rules For Same-Sex Couples
Unless you are a CPA, the very thought of filing federal and California tax returns can cause an anxiety spike. The stress is compounded for those who face complex tax scenarios, such as same-sex couples for whom federal and California laws are in conflict regarding the definitions of marriage, civil unions, and domestic partnerships. The resulting tax implications are not only unequal to what heterosexual married couples pay, but they are also confusing to apply. As we wait for the United States Supreme Court to hear arguments challenging the constitutionality of the 1996 Defense of Marriage Act (DOMA), same-sex couples should be careful in preparing their tax returns in order to avoid audits, potential penalties, and overpaying their taxes.
The good news for Californians is that for couples who were legally married in 2008, prior to Proposition 8, or who have become registered domestic partners, the state tax treatment is the same as for heterosexual married couples. Taxpayers simply combine all income, deductions, and credits on the same California Form 540 tax return. This year’s anticipated Supreme Court decision on Proposition 8 will not affect California tax treatment one way or the other because couples already are permitted to file jointly if they are either married or registered domestic partners.
By contrast, the Internal Revenue Service (IRS) currently requires same-sex couples to file separate federal returns as single taxpayers. This becomes a complex process because the federal government recognizes California community property laws, but not California’s recognition of same-sex unions. IRS Publication 555 (Dec. 2010) provides information on the application of community property for registered domestic partners, an arrangement which can include same or oppositesex couples who are not married according to the federal definition. For federal tax purposes, “community property” is defined as assets acquired or income earned after the inception of the domestic partnership. If the couple has a joint account and they pay all their expenses from this account, all expenses/deductions will be considered community. “Separate property” is defined as assets acquired prior to the inception of the partnership and any income/activity generated from said assets.
All of the couple’s community property—their combined income and any related tax www.ocbar.org February 2013 33 Creating these schedules requires significant additional preparation time and expense that most other married taxpayers do not incur. withholding, deductions, and credits, including child and dependent care credits—must be split between the two federal Form 1040 returns. The returns must be filed with supporting spreadsheets that show the details of how the various elements are divided. Creating these schedules requires significant additional preparation time and expense that most other married taxpayers do not incur. Due to these additional schedules, the separate federal tax returns cannot be filed electronically, but must be prepared in paper form and mailed, requiring IRS employees to manually process the returns, which increases the chances of processing mistakes and IRS inquiry. If a same-sex couple does not precisely prepare the detailed schedules, the likelihood of receiving correspondence from the IRS is high.
Social Security and business incomes also qualify as community property and therefore must be split. For example, for those who use a Schedule C to report business income, the income and deductions should be split between two federal tax returns, with half of the income reported on the earner’s return and half on the partner’s return. The splitting of deductions becomes difficult when depreciation, vehicle expenses, and home office expenses are involved. Half of the self-employment tax must also be reported on the partner’s return. Tax on net Schedule C income and self-employment tax are not subject to withholding. These taxes are typically paid during the year as estimated taxes. Both partners are responsible for paying their separately reported taxes, and should consider paying estimated taxes separately since each individual can only take credit for the payments they make.
Income derived from separate property is reported in total on the individual federal return of the person it belongs to. A person who enters into a domestic partnership or marriage owning a share of a business partnership or having separate trust or investment accounts, for example, would list these assets and the income generated from them on a single-filed federal tax return, while income from other assets acquired during the union would have to be split.
The outcomes from the required federal treatment described above compared to the results if a married filing jointly status was allowed can result in overall taxes that are higher, similar, or lower. It depends on the particular facts. Beyond what is mentioned here, there are numerous special circumstances to consider such as adoption credits and other facets of business partnerships. In anticipation of the possible overturning of DOMA, same-sex married couples and registered domestic partners can file protective amended tax returns, as married filing jointly, when doing so would save federal tax. The IRS will summarily reject these returns, but if and when DOMA is overturned, the amended returns will become valid, requiring the IRS to pay the claimed refunds.
Same-sex couples are encouraged to seek the advice of a CPA experienced in working with these tax rules to determine the allocation of income and deductions between partners for any special circumstances, and to consider filing amended tax returns after the currently required preparation is filed.
Timothy D. Evans, CPA, Master of Science in Taxation, is the lead tax partner and tax researcher at Vicenti, Lloyd & Stutzman in Glendora, CA. He can be contacted at TEvans@vlsllp. com. Megan Asselin, CPA, is the lead tax and audit manager. She can be reached at MAsselin@vlsllp.com and is offering a free initial 30-minute consultation.
This article first appeared in Orange County Lawyer, February 2013 (Vol. 55 No. 2), p. 32. The views expressed herein are those of the Authors. They do not necessarily represent the views of Orange County Lawyer magazine, the Orange County Bar Association, the Orange County Bar Association Charitable Fund, or their staffs, contributors, or advertisers. All legal and other issues must be independently researched.