Potential pitfalls: financial planning challenges for registered domestic partners.

California's Domestic Partner Rights and Responsibilities Act (AB 205) went into effect Jan. 1, 2005.

Though a number of clean-up provisions went into effect Jan. 1, 2006 that provide clarity and additional protection for domestic partners, the newness of the law and inconsistencies between state and federal regulations create some legal uncertainty that complicates financial planning for domestic partners.

This article provides an overview of a few selected issues that CPAs who provide financial planning for domestic partners may face.

CHANGE IN OWNERSHIP

Among the first domestic partnership issues to reach the California courts is the narrow question of whether or not a surviving registered domestic partner whose partner died prior to Jan. 1, 2006, will be treated the same as a surviving spouse by local property tax assessors. While the regulatory authority seems to support such treatment, this interpretation is under challenge.

For guidance, SB 565 is a good place to start. It's been in effect since Jan. 1, 2006, and provides registered domestic partners protection against reassessment that parallels the protection provided to spouses.

Further, Article 13A of the California Constitution excludes certain transfers from the definition of "change in ownership" that usually trigger a reassessment of property to fair-market value and a corresponding tax increase. Article 13A, Sec. (g)(2) provides that "[t]ransfers to a spouse which take place upon the death of a spouse" are not "change[s] of ownership," and hence, not subject to reassessment. Article 13A does not define "spouse" or characterize the enumerated limitations as exclusive.

Also, the chief counsel for the California Board of Equalization, which has the authority to administer California's property tax programs, issued a memorandum March 14, 2003, requesting an amendment to Rule 462.240 that specifies transfers that do not constitute a "change in ownership" for reassessment purposes. The amendment added a specific exclusion for the death of a domestic partner from the definition of "change in ownership."

The BOE issued the amendment (Subsection (k) to Rule 462.040), stating that a "change of ownership" does not include "[a]ny transfer of separate property inherited by a surviving domestic partner, as defined in subdivision (b) of section 37 of the Probate Code, by intestate succession, upon the death of a registered domestic partner."

A final rule incorporating this change was issued to county assessors Oct. 23, 2003.

The BOE then issued "Questions and Answers Regarding Changes to Property Tax Rule 462.240-Exclusion for Registered Domestic Partners" April 25, 2004. Although the amendment's language appeared to be limited to intestate succession, the Q&As clarified that domestic partners who take under a will are entitled to the Article 13 reassessment exemption.

In 2005, the assessors of Sutter and Orange counties filed suit in the Superior Court of Sacramento County arguing that categorizing transfers to domestic partners upon death as transfers not constituting a "change in ownership" for property taxation purposes was invalid.

The California Attorney General is defending the BOE's approach. The trial court recently upheld the BOE regulation. An appeal may be forthcoming.

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COMMUNITY OR SEPARATE PROPERTY

The IRS released a memorandum Feb. 24, 2006, concluding that "a registered domestic partner in California must report all of his or her income earned from the performance of his or her personal services."

This guidance, available at www.irs.gov/pub/irs-wd/0608038.pdf, appears to preclude domestic partners from dividing their community property income equally between them as spouses do, which allows some couples to receive favorable tax treatment.

The IRS interpretation seems to contradict the U.S. Supreme Court's 1930 decision in Poe v. Seaborn, which left the issue of classification of property as community or separate property to the states. The Seaborn decision was in keeping with the general federal income tax rule that state law determines property of ownership, although the federal law governs how it shall be taxed.

COMMUNITY PROPERTY

Under California law, retirement plans often constitute community property. While federal law, specifically 29 U.S.C. Sec. 1056(d)(3)(A), authorizes penalty-free liquidation of certain assets held in federally regulated retirement accounts upon marital dissolution, it does not provide similar treatment upon the dissolution of a domestic partnership.

A California court, however, might use its equitable authority to make up for any shortfall out of non-federally regulated partnership assets. This disparate treatment of domestic partners under state and federal law will likely require the state courts to grapple with this question in the dissolution context and provide clarification.

Domestic partners may face a similar conundrum when seeking to "spend down" assets to qualify for long-term care under Medicare or when seeking bankruptcy protection. As the federal government seems to treat community property owned by California domestic partners as separate property for income tax purposes, it seems unlikely that it would classify such property as community property owned by both partners for purposes of determining an individual's net worth in the Medicare or bankruptcy context.

However, state domestic partnership laws impose mutual debt and support obligations. In some circumstances, federal authorities may interpret those duties in ways that impose typical burdens of married spouses on domestic partners, while not providing the federal benefits of marriage. Financial planners should be aware of the potential impact of such inconsistent treatments.

OTHER PITFALLS

Other potential pitfalls involve the retroactive effects of certain provisions of AB 205. The bill's provisions relating to community property are effective as of the date of registration as domestic partners. California offered registration to domestic partners beginning Jan. 1, 2000, but community property rights were not added to the domestic partnership law until passage of AB 205.

It is possible that, as a result of AB 205's passage, millions of dollars in separate property were converted into community property by operation of law. There are arguments that the conversion of separate property into community property may constitute a taxable event under the gift tax laws, while others believe there can be no gift taxes assessed because the change in ownership was caused by operation of law, not as a result of gifting.

As the IRS has said that it will not consider the classification of the property of California domestic partners as community earnings for purposes of income splitting on tax returns, it is arguable that the IRS should not consider the conversion of separate property into community property as a taxable event for that reason as well.

Still, financial planners should be aware of the uncertainty surrounding this issue, though prior judicial opinions hold that state law controls the classification of particular property as owned by the legally recognized "community" as a vested property interest.

CONCLUSION

When it comes to financial planning for California registered domestic partners, there seem to be more questions than answers. Though some guidance is available, moving forward, it is advisable to remain abreast of the still evolving regulations impacting California registered domestic partners.

BY BRIAN CHASE, Esq.

Brian Chase, Esq. is a Los Angeles-based attorney with Lambda Legal Defense and Education Fund. You can reach him at [e-mail].