Income Issues For RDPs
Knowing how the IRS views different kinds of income is crucial when it comes to properly preparing registered domestic partners' tax returns. You'll find all of the information you need in this guide.
Following is a list of various types of income and whether each is community or separate income for Federal filing purposes. In years where a registration began or ended, income shown as community income would be separate income before the registration and after the registration ends and would need to be prorated accordingly. In addition, federal law sometimes dictates how certain income must be reported.
Gross Income – In determining gross income, AGI, and MAGI, registered domestic partners must each report half the combined community income earned by the partners. In addition to half of the community income, a partner who has income that is not community income must report that separate income. (IRS Website - Q&A 9 and 15)
Earned Income – Even though community property laws are considered in determining adjusted gross income (AGI) or modified AGI (MAGI) (IRS Website Q&A 9), community property laws are NOT taken into account in determining earned income for purposes of certain credits. (IRS Website Q&A 18) Thus, the following credits would be based on the individual partner’s earned income without respect to community property rules:
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Earned Income Tax Credit (Sec 32(a))
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Child and Dependent Care Credit (Sec 21(d))
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Additional (Refundable Portion) Child Tax Credit (Sec 24(d))
However, for purposes of the AGI limitations for the above credits, use the return’s AGI, i.e., the AGI determined using community property rules. (IRS Website Q&A 19)
Alimony – Alimony arising from a previous heterosexual relationship is treated as separate income of the RDP who receives the alimony and deductible by the payer. (Note: For federal purposes, alimony from a divorce agreement entered after 2018 is not income to the recipient nor deductible by the payer; California has not adopted this change.) However, if the alimony is the result of an RDP relationship that is not recognized for federal purposes, the treatment of such payments and income is uncertain. IRC Sec 71 (prior to repeal by the TCJA) allows a deduction for alimony paid to a spouse. For federal purposes the partners are not spouses, so Sec 71 does not apply. Also see “RDP Spousal Support” below.
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Payments prior to divorce or termination of the registered domestic partnership – Pre-divorce or pre-termination payments of alimony or separate maintenance presumably are taxable to the recipient RDP partner only to the extent the payments exceed that individual’s share of reportable community income. In this situation in heterosexual or legal same-sex marriages, the payer is allowed an alimony deduction for the amount that exceeds his or her part of community income. Whether an RDP would be entitled to a deduction is not clear but probably no.
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Payments after divorce or termination finalized – The IRS has not issued a ruling on how to treat these payments. If the regular alimony rules do not apply (because the union isn’t recognized under federal law), then for federal purposes the recipient most likely would be taxed on the income and the payer would not be eligible to claim a deduction. Could these payments be considered a gift? Probably no because they are not being made voluntarily but under court order.
Social Security Income – Generally, state law determines whether an item of income constitutes community income. Accordingly, if social security benefits are community income under state law, then they are also community income for federal income tax purposes. If social security benefits are not community income under state law, then they are not community income for federal income tax purposes. (IRS Website Q&A 14)
Social Security benefits are based on the contributions of the individual; in the case of married individuals, a spouse who does not qualify based upon his/her own contributions can qualify for benefits based upon his/her spouse’s earnings and attaining retirement age. Here again, the term spouse is used and the RDPs are not spouses for Federal purposes. Thus, for purposes of RDPs, Social Security benefits are separate income.
Interest Income – Funds (accounts) generating interest income can be either separate or community funds. Thus, depending upon the source of the interest income, it can be either separate or community income.
Dividends – Funds (accounts) generating dividend income can be either separate or community funds. Thus, depending upon the source of the dividend income, it can be either separate or community income.
Unemployment Income – Since Unemployment income is a substitute for current earnings it is treated as community income.
Disability Income – Since disability income is a substitute for current earnings it is treated as community income.
IRA & SEP Distributions – Traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEP IRAs are separate property by definition and the distributions are reported to the individual who owns the IRA. This is not to say that at separation or dissolution of the registration that a judge might not consider some portion of them to be community property for purposes of dividing up the community assets.
Spousal IRA – There can be no spousal IRA for RDPs and the special provisions that apply to a spouse inheriting an IRA from their deceased spouse also do not apply.
Coverdell Education Savings Account (ESA) Distributions – ESAs, like IRAs, are deemed to be separate property, and the distributions are reported to the individual who owns the account.
Cancellation of Debt – Treatment generally follows state law. Generally personal debt will be community debt, and business debt depends upon whether the debt is secured by community or separate property such as a business or rental.
| What CA Family Law Section 910(a) Says |
| Except as otherwise expressly provided by statute, the community estate is liable for a debt incurred by either spouse before or during marriage, regardless of which spouse has the management and control of the property and regardless of whether one or both spouses are parties to the debt or to a judgment for the debt. Sections 911 through 916 include a number of exceptions. |
Employment Stock Options – Are stock options community or separate property? Is that decision based upon the grant, vesting or exercise date? Perhaps the decision is based upon whether the stock was purchased with community or separate property funds. Presently there is no official guidance. Without official guidance it is up to the taxpayers to decide on the appropriate methodology. Again, this decision can have implication if the partners subsequently separate so it may be appropriate to have them agree in writing to the methodology used.
Generally, W-2 income is treated as current income which is community income. However, when an individual exercises a non-qualified option or has an early disposition of a qualified (incentive) option, the difference between the option price and FMV at the date of exercise gets added to the individual’s W-2 income. Again, no guidance is provided 01.12.05 but the portion of the W-2 income representing the imputed stock appreciation may need to be allocated between community and separate income.
Sales to Each Other – IRC Sec 267 bars losses derived from sales to related parties. For federal purposes RDPs are not related, and therefore Sec 267 will not apply. This creates some interesting tax planning opportunities as the laws now stand. However, California follows Sec 267, creating a difference in loss allowances and basis from the Federal transaction. One might not be too aggressive here for fear of a retroactive ruling.
Capital Gains and Losses – Here an RDP may have both separate property and community property capital gains and losses. Allocate as appropriate. However, keep in mind that on Form 1099-B (or substitute statement) the gross proceeds, and in some cases the basis (under the basis reporting requirements), will be reported under the SSN of only one RDP. Splitting the gains and losses will necessitate adjustment entries on IRS Form 8949 to avoid a mismatch with the IRS and follow-up correspondence.
Todd and Ron are registered domestic partners who maintain a joint brokerage account that was funded with community property funds. In 2021, they purchased 100 shares of XYZ Co. on Feb. 16 for $9,500 and sold the shares on May 12 for $10,422, resulting in a short-term profit of $922. The 1099-B from the broker was issued with Todd’s Social Security number. For federal purposes, Todd and Ron each include half the profit ($461) on their individual returns. Todd’s Form 8949 is completed by including 100% of the sales price and cost in columns (d) and (e), respectively, and showing a negative 461 (the half of the profit that belongs to Ron) in column (g). The code for column (f) is “N” (nominee). Todd’s Form 8949 is shown next.
- Example – Splitting Gains/Losses
Ron’s Form 8949, shown below, is completed using half of the sales price and cost amounts, and with box C checked since no 1099-B was issued in Ron’s SSN. By entering only 50% of the sales price and cost, no adjustment is needed in column (g) and no code entry is made for column (f). Since the 1099-B was not issued to Ron, box C of the 8949 is checked. When completing Form 8958 (not illustrated), enter 100% of the gain in column 1 on line 6 (identified as “total short-term capital gain/loss”) and 50% of the gain in each of columns 2 and 3.
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Capital Losses - In the case of capital losses, for federal purposes since the RDPs each file individual returns, each would be allowed up to $3,000 of loss, while on their CA joint return they would only be allowed a single $3,000 ($1,500 if filing separate), which will create different carryovers on the federal and state returns.
Wages – IRS Pub 555 indicates that only the RDP’s share of the income and deductions should be entered on the appropriate lines of the RDP’s separate tax return, so wages should be split for entry on line 1 of the 1040 (2021 version). However, in doing so the tax software will treat the community property allocated to the other partner as earned income for several issues, such as IRA deductions and the dependent care credit, the refundable portion of the child tax credit, and the earned income tax credit, which is not correct. The IRS website Q&As 18 and 24 clearly states that earned income for these purposes is determined without respect to community property rules.
Recommendation
Unless your software provides coding, you can use to exclude the wage income from the other RDP’s earned-income-sensitive items, include the entire W-2 on the return of the individual who earned it and make the appropriate community property adjustments on the 1040, Schedule 1, line 24z (2021 version), for each partner.
Wage Withholding – Pub 555 indicates that withholding associated with community income should be split between the partners. The IRS website Q&A 16 states (emphasis added), “Because each registered domestic partner is taxed on half the combined community income earned by the partners, each is entitled to a credit for half of the income tax withheld on the combined wages.” However, splitting the withholding is inviting correspondence from the IRS since the entire W-2 is reported to the individual who earned the income. While the W-2 income can be split using 1040, Schedule 1, line 24z (2021), matching and thus giving the IRS computer a matching number with regards to W-2 income, there is no similar ability to split the withholding. This essentially leaves two options: leave all the withholding on the return of the partner who earned the W-2 income or split the withholding and deal with the potential post-filing correspondence. Form 8958 helps to allocate the community property items, which helps IRS match what’s been reported on W-2s, 1099s, etc., to the return and minimizes IRS CP2000 notices. Where a practitioner wishes to split the withholding, most commercial software packages provide an entry for “other withholding” which allows positive and negative entries to accommodate the allocation.
Wage FICA Withholding – The FICA withholding cannot be allocated. It has already been reported to the Social Security Administration and credited under the SSN of the individual who actually earned it.
Employer Reimbursed Medical Care Plans – Employer-paid medical plans are excludable from taxable income (Sec. 105(b)) if the care is for the taxpayer, spouse or dependents. Thus, unless the partner qualifies as a dependent (as discussed earlier), any employer-provided care for the non-employee partner would not be excludable for Federal tax purposes. Unlike the requirements for the dependency of a qualifying relative, Sec. 105(b) does not require that the non-employee partner’s gross income be less than the exemption amount for that partner to qualify as a medical dependent of the employee-partner, provided the dependency support requirement is satisfied (IRS Website Q&A 12). Whether or not the exclusion applies will depend on individual circumstances. However, on the joint California return it would be excludable. When the exclusion does not apply for federal, the employer may or may not have taken the differences into account, and the W-2 should be analysed to see how the employer dealt with the situation.
If the employer handled it correctly, then the CA taxable W-2 income should be lower by the amount of the non-dependent partner’s plan costs that were not excludable for Federal taxable W-2 income. If not handled correctly on the W-2, an adjustment can be made on the California Schedule CA.
Self-Employment Income – Treat self-employment income as community income for income tax purposes. This includes sole proprietorships and distributive income from partnerships. Half of the income, deductions, and net earnings of a business operated by a registered domestic partner must be reported by each registered domestic partner on a Schedule C. In addition, each registered domestic partner owes self-employment tax on half of the net earnings of the business. (IRS Website Q&A 15)
Self-Employment Tax – Pub 555 states that RDPs report community income for self-employment tax purposes in the same way they do for income tax purposes. Thus Pub 555 dictates that partners that split SE income each also compute the SE tax based upon their share of the split income. Although the employment tax rules prohibit spouses from treating net earnings as community income (Sec. 1402(a)(5)), registered domestic partners are not spouses as defined by federal law and this provision does not apply to them. (IRS Website Q&A 15)
Splitting SE Tax or Not
Although it is clear that the SE income should be split according to community property rules, there are many practitioners who disagree with Pub 555 and the IRS Website Q&A and believe the SE tax should be applied solely to the individual who actually earned the income. IRS pubs and the IRS Website are neither code nor regulation and can be ignored with impunity so long as there is a basis for doing so. Thus, many practitioners are applying the SE tax to the individual who actually earned the income. The following are recommended ways of dealing with splitting the SE income depending upon whether you wish to split the SE tax or not:
Splitting the SE Tax – If you wish to follow Pub 555 and the IRS website guidance, then:
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Enter the entire Schedule C income and deductions on the return of the one who earned the income.
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On Schedule SE input for the one who earned the income, make a negative adjustment for 50% of the SE income.
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On the actual self-employed person’s 1040, Schedule 1, “other adjustments” line 24z (2024), back out 50% of the net SE Income.
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On the return of the other partner add a Schedule C and label it “RDP Community Income Split” and enter the community property share of net income under gross income. Ensure that this income is reported on Schedule SE for the partner to whom the income was transferred.
Not Splitting the SE Tax – If you wish to apply the SE tax entirely to the one that earned the income:
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Enter the entire Schedule C income and deductions on the return of the one who earned the income.
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On 1040, Schedule 1, “other adjustments” line 24z (2021), back out 50% of the net SE Income. Make no adjustment for Schedule SE.
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On the other partner’s 1040, Schedule 1, “other income” line 8z (2021), add in 50% of the net SE Income.
Self-Employed Retirement Contributions – Self-employment income is community income for income tax purposes and each partner is required to report 50% of the income and pay the self-employment tax on the income on his or her federal return. (IRS Website Q&A 15) Therefore, based upon the presumption that each partner is subject to SE tax, then each partner can make contributions to an SE retirement plan based on their 50% of the reported income in the normal manner.
Out of Whack – The retirement plan contribution issue still seems out of whack! If one of the RDPs is a wage earner contributing to a 401(k), those contributions are presumably based on all that person’s wages, even though the wages have to be split for income tax reporting. So why should the non-self-employed RDP be allowed to contribute to an SE retirement plan based on the other partner’s SE income just because the income must be split for income tax and self-employment tax reporting purposes? Is it OK to use the 50% of net SE income reported by the non-SE RDP to qualify to fund a regular or SEP IRA?
IRA (including SEP IRA) rules are applied without regard to community property rules. (Code Sec 408(g)) To compute the amount that can be contributed to a SEP, the net SE income is reduced by a portion of the SE tax deductible on Form 1040, Schedule 1, line 15 (2024), and then the applicable contribution rate is applied.
Neither Pub 555 nor the IRS Website Q&As provides any guidance in this area of how to determine the SE tax to use – probably because there is no rational answer in light of the SE tax treatment discussed above. However, the IRS Website clearly states the partner is subject to the SE tax on his or her portion of the net SE income.
As an example, the net income from the Schedule C of an RDP before the community property allocation is $40,000. Each RDP includes $20,000 in income and pays SE tax on $20,000 (according to Pub 555). The RDP who actually owns/operates the business wants to contribute to a 25% SEP. Would the contribution amount be 20% x ($40,000 – 50% of SE tax figured on $20,000) or would it be 20% x ($40,000 – 50% of SE tax figured as if this RDP had reported all $40,000)?
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Pension Income – Income from qualified plan distributions can be either community income or separate income based upon the amount of separate and community income used to fund the account. One possible proration scenario would be prorating by the years before and after the registration. Other methods of allocation may be possible; however, Pub 555 only talks about “periods of service”.
Example – Prorating by Years - Suppose Dave has had a 401(k) plan since January 1 of 2014. He and Don register as domestic partners on Jan 1, 2021. On January 1 of 2024 Dave retires and begins taking distributions from his 401(k) plan. Dave had the 401(k) plan for 10 years, three of which were during the registration period. Thus, prorating by years, Dave’s 401(k) distributions would be 70% separate income and 30% community income. In this example, Dave would back out 15% (50% of 30%) of his pension on Form 1040, Schedule 1“Other income” line 24z, and Don would add 15% of the pension income to his 1040, Schedule 1
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“Other income” line 8z.
Lump Sum Distributions – Community property rules are disregarded for qualifying lump sum distributions where the 10-year averaging option is utilized.
Federal Civil Service Retirement – Whether a civil service annuity is separate, or community income depends on the employee’s status as an RDP and domicile when the services were performed for which the annuity is paid. Even if the taxpayer now lives in a non-community property state and receives a civil service annuity, it may be community income if it is based on services performed during the registered domestic partnership and while domiciled in a community property state.
Example – Mixed Income - Jake retired in January of 2020 after 30 years of civil service. He and his partner have been registered in CA since January of 2016. They have been domiciled in CA for the entire period. Thus 13.33% (4/30) of the pension payments are community income and the balance is separate income. Assuming Jake’s 2024 pension income is $40,000, the following is the allocation between Jake and his partner:
| Jake | Partner | ||
| Separate Income (86.67%) | $34,668 | $34,668 | |
| Community Income (13.33%) | $5,332 | $2,666 | $2,666 |
| Total | $40,000 | $37,334 | $2,666 |
Sec 199A Deduction – The TCJA added a deduction used to figure federal taxable income, effective with 2018 returns, that is generally 20% of the “pass-through” income from the taxpayer’s trades and businesses (see details in Chapter 3.24). This deduction presents us with the same issues discussed above related to self- employment. Should 100% of the deduction be claimed only on the federal return of the RDP whose business or rental income is the basis for the deduction, or because of the IRS’ requirement to treat such income as community property income, should each RDP claim the deduction on their individual federal return based on the split of community income? This is but one of many questions that has arisen on this code section.
California has not conformed to this deduction and isn’t likely to do so.