Back in 2014 and into 2015, I posted a multi-part series of posts about the history of marriage in the tax code. In 2016 I was asked to condense that series into a CPE presentation. Here are excerpts from that presentation. This series of posts will cover a lot of the same ground as was covered three years ago, but hopefully with a little bit fresher perspective.
Most states in the United States follow “common law,” but there are nine states that use “community property” law: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. A tenth state, Alaska, is a case unto itself, where couples can elect to use community property law if they want.
For tax purposes, community property law treats most items of income of married couples as belonging half-and-half to each spouse. When spouses file separate tax returns, each spouse reports half of their own income and half of their spouse’s income. (Note: this is, of course, a vast oversimplification of community property laws.)
The tax law changes between 1917 and 1919 created a highly progressive tax system, with progression that kicked in at lower income levels. This opened the door for higher-income couples in community property states to shift income and lower their tax burden as compared to couples in common law states.
John and Jane are a married couple in a common-law state. John has taxable income of $10,000; Jane has taxable income of $2,000. In 1920, their tax-filing options were: file a joint return showing $12,000 of taxable income, or file separate returns:
- Separate return: $10,000 = $750 tax; $2,000 = $160 tax; Total tax $910
- Joint return: $12,000 = $990 total tax
John and Jane would probably file separate returns, and thus would owe total tax of $910.
What if “John and Jane” from the example above lived in a community property state? In that case, they could file separate returns with each reporting half of each other’s income (so $6,000 each):
- Tax on $6,000 = $330 x 2 people = $660 total tax owed
John and Jane come out $250 ($910 – $660) ahead by living in a community property state. In modern-day dollars, that would equal about $3,500.
The discrepancy between community property and common law became even more pronounced at higher income levels, in particular when there was a large difference in income between spouses.
In 1920, John has taxable income of $30,000 (the equivalent of about $336,000 today). Jane does not work outside the home and has no income.
In a common-law state, their one and only option was to file a joint tax return showing $30,000 of taxable income. The tax on $30,000 is $4,050.
In a community property state, John and Jane could file separate tax returns. John would show $15,000 of taxable income on his tax return, and Jane would show $15,000 of income on her tax return. The tax on $15,000 is $1,390. John and Jane would both owe tax of $1,390, for a total of $2,780.
The tax savings for this couple in a community property state is $1,270 (more than $17,000 in today’s dollars).
Naturally, both the IRS and people in common-law states had a problem with this. We’ll go into more details on that in Part 6.