Tax Consequences of California Domestic Partners Law

The San Jose Mercury News has published a series of articles by Mark Schwanhausser on the tax consequences of California's domestic partners law:

• Domestic Partners Stuck in Tax-Return Limbo:

As interim chief of a San Jose gay and lesbian community center, Clark Williams is accustomed to making waves. But one place he'd rather avoid that is on his tax forms. This year, a new California law might give him no choice.

For the first time, Williams and his partner -- and roughly 71,000 other Californians who have registered with the state as domestic partners -- face a unique quandary: When a new state law gives you many of the financial responsibilities of a married couple but federal law still treats you as single, what's the safe way to do your taxes?

"This is one time where I don't want to be a leader," said Williams, 40, who heads the Billy DeFrank Lesbian Gay Bisexual Transgender Community Center in San Jose. "I will follow the advice of professionals on this. I don't want to do anything to trigger an audit."

The problem is, professionals don't agree on what to do. And the Internal Revenue Service is still grappling with the issue, which is likely to have national ramifications. The thorniest issue centers on the basic question of how to report income on a federal tax return.

For example, if one partner earns $100,000 but a stay-at-home partner earns nothing, are they now entitled to report $50,000 of income on their individual returns? If the stay-home partner's $50,000 share isn't considered income, is it a taxable gift -- or something else? Domestic partners can't assume they'll be safe simply reporting income separately, the way they did before the state law took effect, some experts say. If the IRS decides to treat domestic partners more like married couples, some could find out later that they owe taxes because they weren't entitled to tax breaks they claimed.

"It's so bad that I don't know if I'd be able to file a return for these folks," said Kathleen Wright, a Bay Area tax attorney and professor at San Jose State University. She and others recommended filing for an extension, in hopes that the IRS will clarify the rules.

• Income-splitting on Taxes a Gray Area:

Michael J. McIntyre, a law professor at Wayne State University in Detroit, predicts the courts would shoot down income-splitting. That said, he thinks there's a strong enough argument to press the case. If the IRS rejects income-splitting, it's unclear how partners should treat money acquired as community property. Is it income? A gift?

"How could it be a gift if it's a part of state law?" asked tax attorney Donald H. Read, who practices in Berkeley and with Lakin Spears in Palo Alto. He notes that because the state law was retroactive, this issue also casts a cloud over everything from pay and investments to real estate and stock options that domestic partners have accumulated jointly since registering. Other gray areas abound. For instance, if partners own a home and pay the mortgage jointly, who may deduct mortgage interest? Could one partner's contributions to the mortgage be considered rent -- and therefore be taxable income for the other partner? "I can't think of anything offhand where it was this muddled," McIntyre said.

• Tax Experts Give Advice on How to File with Care:

With the clock ticking down to the April 17 tax-filing deadline, tax experts worry that most of California's registered domestic partners are unaware what's at stake -- let alone how to complete their federal tax returns correctly. There has been little media attention on the issue. TurboTax, the top-selling software program, makes no mention of it. And tax preparers haven't seen or heard much about it either. As a result, tax experts advise registered partners to use heavy doses of caution and disclosure when they file their federal tax returns

(Hat Tip:  Lawrence F. Hinnenkamp.)