The Downside of Taxes for Self-Employed Registered Domestic Partners in Community Property States
By Robert Castillo, ADPA ®
Tax season is upon us once again so it’s time to start going through earned income, deductions, and the like. Same-sex domestic partners in community property states like California have it even worse because they must file separate state and federal tax returns. That’s right, even though same-sex marriage has been legal across the nation since 2015, many gay and lesbian couples continue to maintain their domestic partnerships. Whatever their reason, one important planning strategy for same-sex couples to remember is that domestic partners are granted the same rights and responsibilities as married couples which include community property rights. While the advent of community property typically yields more benefits than not, domestic partners may have one huge disadvantage: they must report community income on their respective federal tax returns, which can mean paying more taxes.
Since 2010, the IRS has declared that domestic partners in community property states must report 50% of their community property income and earnings on their federal tax return. Despite having to claim half of each other’s income, they are not entitled to file their federal return as Married Filing Jointly or Married Filing Separately. Instead, same-sex domestic partners must continue to file as Single or Head of Household on the federal level—even though they may file Married Filing Jointly on the state level. Along with splitting community property income, domestic partners must also split their withholdings, itemized deductions, and any self-employment taxes. This last factor is a huge one. Imagine you live in California and are unemployed while your domestic partner runs a catering business that has nothing to do with you. Well, you’d be responsible for reporting 50% of the net income of your partner’s business; which means you must pay self-employment taxes on that newly found income. You might be thinking, well isn’t the total tax due going to be the same? The answer is No, and this is because of the social security wage base limitation ($128,400 in 2018). You may not know this, but if you are an employee for a company, you are forced to make a social security withholding of 6.2% of your income up to an annual income of $128,400. Your employer matches that 6.2% as well. However, if you are self-employed, you must pay both portions or 12.4%. Allow me to break this down in dollars:
1) Domestic Partner A earns a self-employment income of $220,000 in 2018. He must then make a social security withholding of 12.4% on $128,400 of his annual income, or about $15,921.
2) Let’s split that self-employment income with unemployed Domestic Partner B, now each partner reports $110,000 for 2018. Each partner must make a social security withholding of 12.4% on $110,000, or about $13,640. This means that the total amount of social security taxes they will owe for 2018 is $27,280 (versus the $15,921 they would pay if they were married or not in a domestic partnership).
Before you question why anyone would want to be in a domestic partnership, there are many benefits, but I’d like to focus on one silver lining that is relevant to the example above. Domestic partners can avoid paying higher taxes by establishing a domestic partnership agreement that allows them to transmute property and earnings from a community to separate property. This stipulation would avoid having to split self-employment taxes and allow the business owner partner to itemize his deductions while the other partner takes the standard deduction. Although the law prohibits a taxpayer from itemizing deductions if the taxpayer’s spouse claims the standard deduction, this provision does not apply to registered domestic partners, because registered domestic partners are not spouses for federal tax purposes.
While splitting self-employment income will usually lead to domestic partners paying more taxes, they are certainly able to avoid that higher bill with proper planning. If you are in a same-sex relationship and aren’t married, meeting with a Financial Planner who has experience with domestic partners is essential before signing that tax return.
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Investment advice offered through Gerber Kawasaki Inc, a registered investment advisor. Gerber Kawasaki and Gerber Kawasaki Wealth and Investment Management are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor. No strategy assures success or protects against loss.
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