• Community Property Interests and Recent Federal Income Tax Rulings
  • January 15, 2005 | Author: Judith M. Hecker
  • Law Firm: Michael Best & Friedrich LLP - Milwaukee Office
  • Wisconsin is one of nine community property states, having adopted its Marital Property Reform Act effective 1986. As a general matter, community property is a form of property ownership between spouses where each spouse owns an undivided one-half interest in each item of community property regardless of how the property is titled. Following are several recent Internal Revenue Service rulings that address certain federal tax consequences and options based on taxpayers being domiciled in a community property state.

    Entity Classifications

    Revenue Procedure 2004-35 S Elections in Community Property States

    Code Section 1362 provides that an election to be treated as an S corporation for a particular taxable year must be made on or before the 15th day of the third month of that year or at any time during the preceding year. To be valid, all persons who are shareholders of the corporation on the day the election is made must consent to the election. The election is made on a Form 2553 that is signed by all shareholders. Although regulations under Code Section 1362 provide that when stock of a corporation is owned by two spouses as community property, each person with a community interest in the stock must consent to the S election, consent of the spouse with a community property interest in the corporation's stock may be overlooked.

    Revenue Procedure 2004-35 provides automatic relief for taxpayers who are filing late consents to an S election for spouses of shareholders in community property states. To be eligible for automatic relief:

    • The S election must be invalid solely because the Form 2553 failed to include the signature of a community property spouse who was a shareholder solely pursuant to state community property laws; and

    • Both spouses must have reported all items of income, gain, loss, deduction or credit consistent with the S election on all affected federal income tax returns.

    To request relief, the corporation must file with the service center where it files its income tax return, a dated statement with the following information:

    • This representation: "This statement is being furnished pursuant to Rev. Proc. 2004-35 for a late filing of shareholder consents for community property spouses of S corporation shareholders in community property states.

    • The corporation's name, employer identification number, address, date of incorporation, state of incorporation, and the intended effective date of the initially filed Form 2553.

    • Each spouse's name, social security or employer identification number, tax year end, and the total number of shares owned at the date of the intended election.

    • A statement that the community property spouses reported all items of income, gain, loss, deduction and credit consistent with the S election on all affected returns.

    • A signed statement from each community property spouse that reads: "Under penalties of perjury, I [name of spouse], declare that I consent to the election to treat [name of corporation] to be an S corporation under section 1362(a) of the Internal Revenue Code as of [date that the corporation intended to be an S corporation] and to the best of my knowledge and belief, the facts presented in support of this election are true, correct, and complete."

    A shareholder that meets these requirements will be deemed to have reasonable cause for failure to consent to the S election, to have made a request for an extension of time to file a consent within a reasonable time under the circumstance, and to have satisfied the requirement that the Government's interests will not be jeopardized by treating the election as valid.

    Revenue Procedure 2002-69 Entity Owned by Spouses as Community Property

    Federal "check-the-box" rules permit taxpayers to elect how eligible entities will be classified for tax purposes. These rules generally provide that an eligible business entity with only one member may be classified as either a corporation or a disregarded entity, disregarded entity being the default classification when an election is not filed. A business entity with two or more members may be classified as either a corporation or a partnership, partnership being the default classification. The check-the-box rules also provide that certain entities may only be classified as corporations, including certain types of foreign entities that are identified in the check-the-box regulations.

    The Internal Revenue Service became aware of the fact that taxpayers were uncertain about how to classify an eligible entity, such as a limited liability company, that is wholly owned by a married couple as community property. Specifically, was the community property spouse a second owner that precluded classification as a disregarded entity. Revenue Procedure 2002-69 was issued to provide guidance on the entity's tax classification and generally provides that the Internal Revenue Service will respect the spouses' treatment of a "qualified entity" as either a partnership or a disregarded entity. A qualified entity is a business entity that (a) is wholly owned by spouses as community property; (b) no one other than one or both of the spouses would be treated as an owner for federal tax purposes; and (c) is not treated as a corporation under the check-the-box rules.

    Settlement of Marital Property Rights

    Private Letter Ruling 200442033 Nonqualified Deferred Compensation Plans

    Private Letter Ruling 200442033 (October 15, 2004) addresses the income and gift tax treatment of a lump sum payment to a former wife in exchange for her community property interest in her former husband's nonqualified deferred compensation plan. When the couple divorced, that community property interest was included in a marital settlement agreement that was incorporated into the judgment of dissolution. More than 6 years later, the parties sought a modification of the original court order to allow for the lump sum payment.

    Based on the facts in this case, the Internal Revenue Service determined that (a) the lump sum payment was a nontaxable transfer of property between former spouses related to the cessation of a marriage within the meaning of Code Section 1041; (b) the assignment of income theory did not apply and the former wife would therefore not be taxed when the former husband receives payments under the nonqualified deferred compensation plan; and (c) the lump sum payment in exchange for the community property interest was a transfer for full and adequate consideration under Code Section 2516 and did not result in a taxable gift. The Private Letter Ruling relies on Balding v. Commissioner, 98 T.C. 368 (1992) and Revenue Ruling 2002-22 in concluding that the exchange is nontaxable under Code Section 1041 and that the assignment of income theory does not apply.

    Application of Tax Credits and Refunds

    Code Section 6402 provides that the Internal Revenue Service may apply any overpayment of income tax against an unpaid tax liability of the person who made the overpayment, refunding any balance to that person. When a married couple files a joint tax return, each spouse has an interest in any overpayment. In that situation, the Internal Revenue Service may calculate the amount of a spouse's interest in the overpayment and then apply that amount to that spouse's separate tax liability. If the married couple resides in a community property state, the property laws of the state must be considered in determining the amount of overpayment from a joint tax return that may be applied to the separate tax liability of a spouse.

    Revenue Ruling 2004-71 Tax Offsets for Married Couples Domiciled in Wisconsin

    The Internal Revenue Service has issued a set of 4 revenue rulings, each of which addresses the amount of an overpayment on a joint tax return that may be applied against one spouse's separate tax liability if the married couple is domiciled in a specified community property state. Revenue Ruling 2004-71 discusses Wisconsin community law provisions and applies the following five-step process to a set of 4 fact situations.

    • First, identify the source of the overpayment; determine which spouse made the tax payments.

        The overpayment of tax in each situation was from taxes withheld from the wages of both the liable and nonliable spouses.

    • Second, characterize the source of the overpayment as either community or separate property.

        Since wages are presumed to be community property under Wisconsin law, the overpayment was from a community property source.

    • Third, apply the liable spouse's share of the tax overpayment from a community property source against that spouse's separate tax liability. Under Revenue Ruling 85-70 the Internal Revenue Service may apply the liable spouse's 50% interest in an overpayment from a community property source.

        Under Wisconsin law, each spouse has an equal interest in all community property and the Internal Revenue Service may therefore apply one-half of the overpayment from withholding from the liable spouse's wages and one-half of the overpayment from withholding from the nonliable spouse's wages to the liable spouse's separate tax liability.

    • Fourth, determine whether state law permits the Internal Revenue Service to reach the nonliable spouse's share of the overpayment from a community property source.

      Under Wisconsin law, the amount of community property a creditor may reach depends on the nature of the debt.

      1. In the case of a separate income tax liability incurred before marriage, Wisconsin law permits a creditor to reach community property that would have been the liable spouse's individual property but for the marriage.

      2. Where the separate tax liability arises during marriage, a creditor may reach all community property if the liability was for the benefit of the marriage or family under Wisconsin law.

      3. Where the separate tax liability arises during marriage, a creditor may reach only the liable spouse's separate property and interest in the community property if the liability was not for the benefit of the marriage or family under Wisconsin law.

  • Fifth, determine whether state law permits the Internal Revenue Service to reach a portion of the overpayment from a separate property source of either the liable spouse or the nonliable spouse.

      Under Wisconsin law, a creditor may reach all of the liable spouse's separate property to satisfy the liable spouse's separate tax liability, but may not reach the nonliable spouse's separate property. However, none of the overpayments in the 4 situations were from a separate property source so there is no amount of overpayment governed by this final step.