During a divorce situation the responsibility to report and pay income taxes on all sources of community property can prove to be a heavy financial burden (see previous post re Reporting Income and Deductions on Separate Returns). Fortunately, the IRS offers several sources of relief from this burden. The Community Property Laws with respect to earned income may be disregarded in certain situations (IRC § 66(a)) if:
- The individuals are married at any time during the year;
- They live apart at all times during the year;
- They do not file a joint return; and
- No portion of the earned income is transferred (directly or indirectly) between such individuals before the close of the calendar year.
If these rules apply, all wage income will be treated as the income of the spouse earning the wage, all trade or business income will be treated as the income (or loss) of the spouse carrying on the trade or business, and all partnership income (or loss) will be treated as the income of the spouse who is the partner. Most other items of community income (e.g. investment income) will continue to be treated as community income as provided under state community property law.
Note that this rule is essentially moot in some states including California that treat earned income as separate property after the date of separation (in the case of California there is no requirement that the spouses live apart all year and that they do not transfer any of the income between themselves).