Registered Domestic Partnerships – New Tax Traps for the Unwary

With the dreaded April 15th (or this year, April 18th) behind us, most can breathe easy now that another Tax Day has passed.  However, for registered domestic partners in California, 2010 saw a major change, wrought with traps for the unwary, in the Internal Revenue Service’s position on how registered domestic partners are required to report their income for federal tax purposes (i.e., everyone’s favorite, Form 1040).  This major change is the “income splitting” requirement, and registered domestic partners were required to abide by this rule when they filed their federal taxes on April 18th, whether or not you, or your tax professional, knew about it.

The Change – Before and After

Prior to 2010, for registered domestic partners in California, each filed his (or her) own tax return, and reported only what he earned that year.  Let’s take Jim and Jeff as an example.  In 2009, Jim and Jeff were in a registered domestic partnership.  Jim had a steady job, and earned $80,000.  Jeff, a student, earned only $20,000.  In this scenario, Jim and Jeff would each file his own tax return, and would report, and pay tax on, only what he earned.

Starting in 2010, though, the IRS’ new ruling requires that each partner split his respective income (at least the community property portion) with the other partner, and each must report half of his and his partner’s income on his own tax return.  The IRS refers to this requirement with the none-too-creative term “income splitting.”  To see this in action, let’s say that Jim and Jeff each earned the same amount in 2010 ($80,000 and $20,000, respectively), for a total of $100,000 between them.  Under the new rule, Jim and Jeff must each report $50,000 on his own 2010 tax return.

This sounds easy enough, but there are a host of issues lurking in the background.  And, these issues can have a serious effect on your bottom line.

What this means to you.

In Jim’s case, he’s actually getting a benefit from income splitting, because he will report and pay tax on only $50,000, when he really earned $80,000.  However, Jeff will end up reporting and paying tax – not on the $20,000 he actually earned – but on $50,000.  Needless to say, Jeff’s tax bill will be much larger than he expected.

Jim and Jeff’s simple case is relatively easy to understand.  However, matters are quickly complicated where, for example, one partner is self-employed, where there is a mix of community and separate property, or where there are retirement accounts.  Even an employee who is a registered domestic partner can run afoul of the IRS if he doesn’t change his withholding rate with his employer.

Where tax matters get complicated, you increase the risk of paying more in tax, penalties, and interest for taking a wrong step.  An experienced tax attorney can help you navigate these murky areas, both upfront helping you with tax planning, and on the other side if you didn’t report correctly and need to determine the consequences.

If you are in a domestic partnership, please call me at 415-781-4000 if you have questions about your tax situation.