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Tax Controversy & Resolution: Reporting of Community Property Income (IRC § 66)

(1) IRC § 66(a) Exception to General Rule of Community Property Income Splitting (Spouses Live Apart)​

​Under IRC § 66(a), if spouses meet certain requirements, they do not report most community property income under community property rules.​ IRC § 66(a) provides an exception to the general rule that community income is taxed one-half to each spouse domiciled in a community property state and instead allocates earned income to the spouse who earned the income if certain statutory requirements are met based on the following:

  • The spouses are married to each other at any time during the calendar year;

  • The spouses live apart at all times during the calendar year. For purposes of this requirement, living apart requires that spouses maintain separate residences;

    • Spouses who maintain separate residences due to temporary absences are not considered to be living apart. See Treas. Reg. § 1.66-2(b) for more information.​

  • The spouses do not file a joint return with each other for the taxable year beginning or ending in the calendar year;

  • One or both of the spouses have earned income for the calendar year, which is community income; and

  • No portion of the earned income is transferred between the spouses, directly or indirectly, before the close of the calendar year

    • Transferred income does not include de minimis amounts of earned income transferred between spouses. Amounts transferred for the benefit of the spouses’ child are not treated as direct or indirect transfers of income. Income transferred between spouses is presumed to be a transfer of earned income, although the presumption is rebuttable. See Treas. Reg. § 1.66-2(c) for more information.

  • If all of these criteria are met, spouses in community property states must report their income according to rules of IRC § 879(a) which provides:

    • Earned income (within the meaning of § 911(d)(2)), other than trade or business income and a partner’s distributive share of partnership income, shall be treated as the income of the spouse who rendered the personal services.

    • Trade or business income is taxed to the spouse who owns the business unless the other spouse exercised substantially all of the management and control of the business, in which case it is treated as the other spouse’s income. See IRC § 879(a)(2) and IRC § 1402(a)(5).

    • A distributive share from a partnership is taxed to the spouse who is the partner.

    • Income derived from the separate property of the one spouse is taxed to that spouse. See IRC § 879(a)(3)

      • Caution: All other forms of income are taxed in accordance with normal community property laws. See IRC § 879(a)(4). This includes dividend, interest, rents, royalties, capital gains, and earnings of unemancipated minor children.

 

See IRM 25.15.5.12, IRC § 66(a) Treatment of Community Income Where Spouses Live Apart, for additional information.

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(2) IRC § 66(b) Denial of Community Property Benefits (Spouse Not Notified)

IRC § 66(b) allows the Service to shift the incidents of taxation to the other spouse if certain requirements are met. ​​IRC § 66(b) provides an exception to the general rule that community income is taxed one-half to each spouse. IRC § 66(b) authorizes the Service to disregard community property laws by denying the benefits of income splitting between the spouses.

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  • IRC § 66(b) may be applied under the following conditions:

    • The spouse acted as if he/she was solely entitled to such community income, and

    • The spouse failed to notify the other spouse of the nature and amount of such income before the due date of the return (including extensions) for the taxable year in which the income was derived.

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IRC § 66(b) entitles the Service to shift the item of income and assess additional tax against the spouse earning the income in accordance with deficiency procedures. See IRC 66(b) and Treas. Reg. § 1.66-3(b). ONLY the Service may invoke IRC § 66(b). It is not a relief provision that can be invoked by a taxpayer to escape liability. Hardy v. Commissioner, 181 F.3d 1002 (9th Cir. 1999); Drummer v. Commissioner, T.C. Memo, 1994-214, Aff’d without published opinion, 68 F.3d 472 (5th Cir. 1995). Where IRC § 66(b) is asserted, it must be clearly reflected on the notice of deficiency. The determination must be supported by evidence that IRC § 66(b) applies. If the notice fails to do this, the burden of proof may be shifted to the Service. Shea v. Commissioner, 112 T.C. 183(1999).

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Solely Entitled to Income: to determine whether a spouse has acted as if he or she was solely entitled to the income, consider the facts and circumstances focusing on whether the spouse used, or made available, the item of income for the benefit of the marital community. See Treas. Reg. § 1.66-3(a).

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  • For instance: Where the community property at issue is deposited into a joint account or an account over which both spouses have signature authority, this is a strong indication that the spouse who deposited the funds did not act as though he or she was solely entitled to the funds. See Cox v. Commissioner, T.C. Memo. 1993-559; Drummer v. Commissioner, T.C. Memo. 1994-214, aff’d without published opinion, 68 F.3d 472 (5th Cir. 1995).

 

Similarly, where a spouse sends a portion of the funds to the other spouse, that spouse has not acted as though he or she was solely entitled to the funds. See Mischel v. Commissioner, T.C. Memo 1997-350; Treas. Reg. § 1.66-3(c), Example 1(ii). If the community income is retained by one spouse and spent at his or her discretion, that spouse has acted as though he or she was solely entitled to the income. See Treas. Reg. § 1.66-3(c), Example 1(i) for more information.

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Notification of Nature & Amount of Income: a spouse who provides a copy of a Form 1099 or Form W-2 to the other spouse satisfies the notification of the nature and amount of income requirement. If notification is done before the due date of the return (including extensions), IRC § 66(b) is inapplicable. See Treas. Reg. § 1.66-3(c), Example 2, for more information. See IRM 25.15.5.13, IRC § 66(b) Denial of Community Property Benefits Where Spouse Not Notified, for more information.

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(3) IRC 66(c) Relief to Spouses from Reporting Half of Particular Items of Community Property Income

​IRC 66(c) provides two additional exceptions to the general rule that community income is taxed one-half to each spouse. Unlike IRC § 6015, IRC § 66(c) provides relief for items of income only, as defined in IRM 25.18.2.1,Income Reporting Considerations of Community Property, not relief from disallowed deductions as defined in IRM 25.18.2.5, Claiming of Deductions.

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See IRM 25.15.5.14, IRC § 66(c) Innocent Spouse Relief, for more information.

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Traditional Relief

  • The first part of IRC § 66(c), known as traditional relief, applies only to deficiency cases. In cases where relief is granted, the Non-Requesting Spouse will be solely liable for the tax liability attributable to the item of community property income. See Treas. Reg. § 1.66-4. Traditional relief under IRC § 66(c) has the following requirements:

    • A joint return was not filed for the taxable year for which the Requesting Spouse seeks relief;

      • Note: If a joint return is filed, IRC § 66(c) does not apply. Relief on a jointly filed return may be available under IRC § 6015.

    • The Requesting Spouse does not include in gross income for such taxable year an item of community income which would be attributable to Non-Requesting Spouse under IRC § 879(a);

      • For example, if the spouses were not subject to community property laws the item would be reportable by the Non-Requesting Spouse

    • The Requesting Spouse establishes he/she did not know and had no reason to know of such item of community income; and

      • For purposes of the knowledge requirement of IRC § 66(c), a Requesting Spouse has knowledge or reason to know if he or she actually knew of the item of community income or a reasonable person in similar circumstances would have known of the item of community income. All the facts and circumstances are considered. Relevant factors include, but are not limited to, the nature of the item of community income, the amount of the item relative to other income items, the couple's financial situation, the Requesting Spouse’s educational background and business experience, and whether the item of community income was reflected on prior years' returns (e.g., investment income omitted that was regularly reported on prior years' returns).

        • See Treas. Reg. § 1.66-4(a)(2) for more information.

      • The knowledge requirement is interpreted strictly. If a spouse is aware of the source of community income or an income producing activity, the Requesting Spouse is considered to have knowledge or reason to know of the item of community income even if the spouse does not know the specific amount received.

        • See McGee v. Commissioner 979 F.2d 66 (5th Cir. 1992); Beck v. Commissioner, T.C. Memo, 2001-198; and Treas. Reg. § 1.66-4(a)(2)(ii) for more information. However, if the spouse knows that the earning spouse has some types of income but not other types, he or she may be relieved of tax liability for the latter but not the former. SeeRoberts v. Commissioner, T.C. Memo 1987-391, aff’d, 860 F.2d 1235 (5th Cir. 1988).

    • Considering all the facts and circumstances, it is inequitable to include such community item in the Requesting Spouse’s gross income.

      • An important factor is whether the spouse significantly benefited, directly or indirectly, from the item. This includes transfers of property or rights to property, including transfers several years after the fact. Normal support is not benefit. Other factors include desertion, divorce or separation. See Treas. Reg. § 1.66-4(a)(3) and Rev. Proc. 2013-34 for more information.

 

If all of the requirements are met, then the unreported item of income will be taxed wholly to the Non-Requesting Spouse, and not split.

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Equitable Relief Under 66(c) Generally

If the Requesting Spouse does not qualify for traditional relief under IRC 66(c) , and if taking into account all the facts and circumstances it is inequitable to hold the RS liable then the Service will consider equitable relief under IRC § 66(c). Relief is available for both deficiency (understatement) cases and underpayment cases.

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To qualify for equitable relief a Requesting Spouse must meet the threshold requirements of Rev. Proc. 2013-34. See IRM 25.15.3.9.2, Eligibility Threshold Requirements, for additional information.

 

IRC § 66(c) is available for spouses domiciled in a community property state who did not file a joint return, who do not qualify for the traditional relief under the first part of IRC 66(c), and who meet the following threshold requirements:

  • (1) The Requesting Spouse must apply for relief while the collection statute or refund statute remains open.

  • (2) No assets were transferred between spouses as part of a fraudulent scheme.

  • (3) The Non-Requesting Spouse did not transfer disqualified assets to the Requesting Spouse. If disqualified assets were transferred, relief can only be granted to the extent the income tax liability exceeds the value of those assets.

  • (4) The Requesting Spouse did not knowingly participate in the filing of a fraudulent return.

  • (5) The income tax liability from which the Requesting Spouse seeks relief must be attributable to an item of the Non-Requesting Spouse, unless an exception applies.

  • (6) If all the above threshold requirements are met, the guidelines in Rev. Proc. 2013-34, Section 4.03, should be followed in determining whether to grant relief.

    • See IRM 25.15.3.9.4.1, Equitable Relief Factors (Section 4.03)for all the factors to consider.

    • Note: Rev. Proc. 2013-34, Section 4.03, applies to taxpayers seeking equitable relief from income tax liability under § 66(c) or § 6015(f). Therefore consider the factors listed at IRM 25.15.3.9.4.1, Equitable Relief Factors (Section 4.03), for 66(c) requests for relief. The factors in section 4.03 apply in determining whether to relieve a spouse from income tax liability resulting from the operation of community property law under the equitable relief provision of § 66(c).

 

If relief is granted, the item of community income is included in the gross income of the Non-Requesting Spouse and not in the gross income of the Requesting Spouse. The assessment made against the Non-Requesting Spouse must be made in accordance with the deficiency procedures of IRC § 6212 and IRC § 6213. Where IRC § 66(c) is invoked against the Non-Requesting Spouse, it must be clearly reflected in the notice of deficiency.

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Requesting Relief Time Period under IRC § 66(c)
A Requesting Spouse seeking relief from the operation of community property law under IRC § 66(c) must request such relief on a Form 8857, Request for Innocent Spouse Relief, or other written request, signed under penalties of perjury, stating why relief is appropriate. The Requesting Spouse must also comply with the Service's reasonable requests for information that will assist in identifying and locating the Non-Requesting Spouse. See Treas. Reg. § 1.66-4(j) for more information.

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  • Time Period for Filing a Request for Relief

    • To request relief from the federal income tax liability resulting from the operation of community property law under IRC § 66(c), a RS must file within the time period prescribed in the following subsections.

  • Traditional Relief

    • The earliest time for submitting a request for an amount omitted from the Requesting Spouse’s separate return, is the date the Requesting Spouse receives notification of an audit or a letter or notice from the IRS stating there may be an outstanding liability with regard to that year. See Treas. Reg. § 1.66-4(j) for more information.

    • The latest time for requesting relief, except for requests for equitable relief, is no later than 6 months before the expiration of the period of limitations on assessment, including extensions, against the Non-Requesting Spouse for the taxable year that is the subject of the request for relief, unless the examination of the Requesting Spouse ’s return commences during that 6-month period.

    • If the examination of the Requesting Spouse’s return commences during that 6-month period, the latest time for requesting relief is 30 days after the commencement of the examination.

  • Equitable Relief

    • The earliest time for submitting a request for equitable relief relating to a deficiency is the date the Requesting Spouse receives notification of an audit or a letter or notice from the IRS stating there may be an outstanding liability with regard to that year.

    • The earliest time for submitting a request for equitable relief relating to a liability properly reported but unpaid is upon the filing of the individual Federal income tax return.

    • The latest time for requesting equitable relief is within any time period that the collection statute or refund statute remains open.

  • Premature Requests

    • The Service will not consider a premature request for relief under IRC § 66(c).

      • See Treas. Reg. § 1.66-4(j)(2)(iii) for more information.

    • In the case of a claim for traditional relief, a premature claim is a claim for relief filed for a taxable year prior to a notification of an audit or a letter or notice from the Service indicating there may be an outstanding liability with regard to that year. Such notices or letters do not include notices issued pursuant to IRC § 6223 relating to Tax Equity and Fiscal Responsibility Act (TEFRA) partnership proceedings but do include notices of computational adjustment to the partner or partner’s spouse, Form 4549, Income Tax Examination Changes, which compute the partner’s or partner’s spouse’s share of the partnership liability.

    • In the case of a claim for equitable relief involving an underpayment, a premature claim is a claim for relief received prior to the date the RS files an individual federal income tax return for the taxable year in question.

    • In the case of a claim for equitable relief involving a deficiency, a premature claim is a claim received prior to notification of an audit or letter or notice from the IRS stating there may be an outstanding liability for that year.

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Form 8857 Filing Deadline Exception for Relief Based on Community Property Laws.

In general, if you are requesting relief based on community property laws, you must file Form 8857 no later than 6 months before the expiration of the period of limitations on assessment (including extensions) against your spouse or former spouse for the tax year for which you are requesting relief. However, if the IRS begins an examination of your return during the 6-month period the latest time for requesting relief is 30 days after the date of the IRS’ initial contact letter to you.

 

When a Form 8857, Request for Innocent Spouse Relief, is filed with the IRS, it may take up to 6 months before a determination is made. During the processing time, the Service is requesting your tax information and contacting the Non-Requesting Spouse. By law, the IRS must contact your spouse or former spouse. There are no exceptions, even for victims of spousal abuse or domestic violence.

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