9.2.2 Reporting Income on Separate Returns

If a married couple files separate tax returns in a community property state, each spouse must report one-half of the community income.1  In a community property state, each spouse should be limited to 50% of any cancellation of debt income claimed by the IRS.2

If the spouses have physically separated but not yet divorced, the higher-income spouse will typically benefit from this reporting requirement. A lower-income spouse may obtain relief by showing that one of 4 exceptions applies:

• The spouses lived apart for the entire year, filed separate returns, and did not transfer more than a de minimis amount of earned income between them.3
• The taxpayer was not notified by the other spouse of the nature and amount of the income before the due date (including extensions) for the filing of the taxpayer’s return, and the spouse acted as if solely entitled to the income.4  Only the IRS may invoke this exception.5
• Traditional innocent spouse relief6  from community property laws under I.R.C. § 66(c) for an item of community income if (a) the requesting spouse did not file a joint return for the tax year; (b) the income item omitted from the gross income of the requesting spouse’s income would be treated as the other spouse’s income under I.R.C. § 879(a);7  (c) the requesting spouse did not know of, and had no reason to know of, the item of community income; and (d) taking into account all of the facts and circumstances, it is inequitable to include the item of community income in the requesting spouse’s individual income.
• Equitable relief under the “flush language” of I.R.C. § 66(c) for spouses who don’t meet the requirements for traditional innocent spouse relief.8

Be aware that the time limitation for requesting traditional innocent spouse relief under I.R.C. § 66(c) is different from the time limitations for I.R.C. § 6015 innocent spouse relief or I.R.C. § 66(c) equitable innocent spouse relief.9  Traditional innocent spouse relief under I.R.C. § 66(c) must be requested no later than 6 months before the statute of limitation on assessment expires for the non-requesting spouse.10  By contrast, equitable innocent spouse relief under §66(c) must be claimed within 2 years of the first collection activity against the electing spouse.11

Some community property income may be excluded from a spouse’s income by other laws. For instance, a pension distribution in a community property state is usually considered community property and to be taxable income for both spouses. But spouses may have a state court judgment called a Qualified Domestic Relation Orders (QDRO). A QDRO establishes the non-employee spouse’s right to receive payments. Payments pursuant to a QDRO are taxable to non-employee spouse but not to the employee spouse, even when the employee spouse receives the distribution and turns the funds over to non-employee spouse.12  The employee spouse is not taxed on the non-employee spouse’s community property share of the IRA distribution.13  Similarly, this spouse would not be liable for the I.R.C. § 72(t) additional tax on an IRA distribution.14

• 1United States v. Mitchell, 403 U.S. 190, 196–97 (1971); Reg. § 1.66-1.
• 2Cf. Brickman v. Comm’r, T.C. Memo 1998-340.
• 3I.R.C. § 66(a); 26 C.F.R. § 1.66-2. I.R.C. § 66(a) relief is automatic if the requirements are met. For purposes of § 66(a), any amount of income transferred for the benefit of the spouses’ child is not treated as a transfer to the spouse. 26 C.F.R. § 1.66-2(c).
• 4I.R.C. § 66(b); 26 C.F.R. 1.66-3. The IRS may deny a spouse the federal income tax benefits of community property law on items of community income. Under the regulations, a spouse will not have acted as solely entitled if the income was “used or made available for the benefit of the marital community.” 26 C.F.R. § 1.66-3(a). It is not clear whether a small amount of funds paid for family support would bar the IRS from invoking I.R.C. § 66(b) against a taxpayer.
• 5I.R.C. § 66(b); Hardy v. Comm’r, 181 F.3d 1002 (9th Cir. 1999).
• 6If a married couple filed a joint return, I.R.C. § 6015 would govern requests for innocent spouse relief. I.R.C. § 66(c) does not apply to joint filers.
• 7The other spouse’s wages or income from a trade and business operated as a sole proprietorship are the most common examples of this type of income.
• 8See Rev. Proc. 2003-61, I.R.B. 2003-32; IRS Notice 2012-8. Note that the “absence of significant benefit” test is different for equitable relief under I.R.C. § 66(c) than for traditional relief under I.R.C. § 66(c)(4). See Felt v. Comm’r, T.C. Memo 2009-245. It is easier to meet the § 66(c) “absence of substantial benefit” test.
• 9For more complete discussion of innocent spouse relief, see Section 9.3.
• 1026 C.F.R. § 1.66-1(j).
• 11Rev. Proc. 2003-61, 2003-2 C.B. 296. Note that “collection activity” has a technical definition. See, e.g., McGee v. Comm’r, 123 T.C. 314 (2004).
• 12Powell v. Comm’r, 101 T.C. 489 (1993); see also Mitchell v. Comm’r, 131 T.C. No. 15 (2008) (QDRO distribution taxable to non-employee spouse in community property state). A different outcome may result when the employee spouse pays the non-employee spouse with the employee spouse’s separate wages rather than the pension distribution. Comm’r v. Dunkin, 500 F.2d 1065 (9th Cir. 2007).
• 13Bunny v. Comm’r, 114 T.C. 259, 262 (2000).
• 14Morris v. Comm’r, T.C. Memo 2002-17.