Tax filing status--are joint tax returns always best?

Most taxpayers don't realize that there are more than 60 separate provisions in the Internal Revenue Code (the "Code") that vary with marital status--most of these can produce marriage bonuses or marriage penalties. Couples especially benefit from joint returns when one spouse earns a disproportionately greater amount of income than the other spouse. However, circumstances may be such that one spouse does not want to incur the potential liability for tax on a joint return and would, therefore, rather file a separate return even though the resulting tax liability may be higher. In a few, somewhat unusual situations, married couples could have a lower combined tax liability by filing separate returns rather than by filing a joint return. When these situations arise, the tax liability should be computed under both the married filing separate returns rules and the married filing jointly provisions.

The roots of the joint tax return date back to 1930 when the Supreme Court, in its decision of Poe v. Seaborn, (1) allowed a form of "income-splitting" for married taxpayers who resided in community property states. Thus, from 1930 until 1948, when Congress authorized the now-familiar joint tax return, the tax liability of a married couple in a community property state differed significantly from that of a married couple in a common-law state whenever only one spouse had taxable income.

The single household (income-splitting) influence of community property states caused many common-law states to begin adopting community property characteristics in state laws. Congress responded to the community property/common-law disparity in 1948 by authorizing married couples to file joint returns. Once the tax disparity between community property and common-law states was largely eliminated, the new community property provisions created by many of the states were repealed and the States returned to their common-law statutes.

Since the inception in 1948 of the joint return rules, there have been many interesting twists in their application. This article analyzes the joint tax return rules, examines some of the divergences in their application, and highlights some restrictions that may apply under current law.

Determination of Filing Status

A taxpayer's filing status is important because it is used to determine whether a tax return must even be filed, the amount of the standard deduction, the correct tax liability, and whether certain tax deductions and credits can be claimed. The filing status that can be elected depends mostly on the taxpayer's marital status on the last day of the tax year.

When a taxpayer is considered unmarried, his or her filing status is normally that of a single taxpayer. However, if certain requirements are met, taxpayers can choose head of household or qualifying widow(er) status. When a taxpayer is considered married, the filing status is either married filing a joint return or married filing a separate return. However, determining marital status is not always immediately apparent.

Divorced or Separated Taxpayers. An individual who, as of the last day of the tax year, is legally separated from a spouse under a decree of divorce or separate maintenance agreement, is not considered married for that entire year for purposes of filing status. (2) State or local law determines the taxpayer's marital status as of the close of the year. An interlocutory decree of divorce does not end a marriage until the decree becomes final. (3) Thus, a couple living apart under a separation agreement, but without any court decree, will still be treated as married taxpayers. A physical separation order or an order of alimony is considered a legal separation. A decree of separate maintenance does not render an individual unmarried unless the court order effectuates a legal separation under local law. (4)

Sham Divorces. If a married couple obtains a divorce for the sole purpose of filing as unmarried individuals and at the time of the divorce they intend to remarry each other in the succeeding tax year, they must file as married individuals. (5) This type of divorce is a sham transaction designed to manipulate marital status for tax avoidance purposes. However, if a couple obtains a valid divorce, but intends to continue living together without getting remarried, the IRS has privately ruled that if there are no factors indicating that the couple should not be considered as unmarried, it would not object to their filing as unmarried individuals. (6)

Married Individuals Treated as Unmarried. Certain taxpayers, even though they are legally married, may be treated as unmarried for purposes of determining filing status if they live with a dependent child but apart from their spouse. These types of taxpayers, often referred to as "abandoned spouses," generally qualify for head of household status. The head of household rates are more favorable than those for single taxpayers, but less favorable than those for married filing jointly.

The requirements for a married taxpayer to be considered unmarried for purposes of filing status include: (1) the taxpayer files a separate return; (2) the taxpayer maintains a household for more than one half of the tax year that is the principal place of abode of a dependent child, or a child who would be considered a dependent under a noncustodial declaration signed by the custodial spouse; (7) (3) the taxpayer furnishes more than one half of the cost of maintaining the household; and (4) during the last six months of the tax year, the taxpayer's spouse is not a member of the taxpayer's household. (8) This last rule actually requires geographic separation. (9) The Tax Court has refused to adopt a constructive absence rule when both spouses continued to live under one roof even though they have separate bedrooms and bathrooms. (10)

Invalid Divorces and Annulments. When a taxpayer receives a divorce from a first spouse, marries a second spouse and subsequently finds out that the divorce from the first spouse is invalid, the taxpayer is considered still married to the first spouse and cannot file a joint return with the second spouse. (11) This is pretty standard treatment when the divorce and remarriage occur within the same state. When the divorce and remarriage are granted from different states, there is a disagreement among the circuits as to what effect this has for tax purposes and to which jurisdiction to give significance.

If a marriage is legally annulled, the taxpayer and the spouse must file as unmarried individuals, because no valid marriage ever existed. If previous tax returns have been filed, the taxpayers are required to file amended returns (subject to the statute of limitations) claiming unmarried status for all tax years affected by the annulment. (12) An annulment, like a sham divorce, may be disregarded if it appears to have been obtained for purposes of lowering the taxpayer's tax liability. (13)

Surviving Spouse. In a year that a spouse dies, a taxpayer can file a joint tax return for that year and continue to do so for up to two years after the year of death if the "surviving spouse" meets certain qualifications. In order to continue using the married filing jointly rates, the taxpayer must (1) maintain a household for himself and at least one of his children for whom he is entitled to a dependency exemption; (2) the taxpayer must not have remarried before the close of the tax year; and (3) the taxpayer and the deceased spouse must have been qualified to file a joint return in the tax year of the spouse's death. (14)

Common Law Spouse. The marital status of two individuals for purposes of determining their eligibility to file a joint return is to be determined under the laws of the state of their residence. (15) In the state of Texas, for example, a couple that has not been married is considered married if each of the following three elements is present: (1) an agreement presently to be husband and wife, (2) cohabitation pursuant to the agreement as husband and wife, and (3) a holding out of each other as husband and wife. The agreement does not have to be in writing and can be inferred or implied from the cohabitation and the holding out as husband and wife. (16) Note, however, that the mutual agreement element is necessary at all times for one to live together as husband and wife. If there is no meeting of the minds at any time during the relationship, there can be no marriage. (17)

Once established, a common-law marriage valid under local law is recognized as a marriage for federal tax purposes and because there is no common-law divorce, continues to be recognized until the couple legally separates under a judicially ordered decree of divorce or separate maintenance. The marital status of a common-law husband and wife is not altered for federal tax purposes by their relocation to another jurisdiction that does not recognize common-law marriages. (18)

Same Sex Relationships. As a general rule, individuals claiming to be joined together in a same sex economic relationship will not qualify for married filing status. In the recent case of R.D. Mueller v. Comm., (19) the taxpayer who was unmarried but resided with his same sex partner claimed he was unconstitutionally denied the opportunity to file a joint return in recognition of his union with his partner.

The taxpayer lost the decision because he failed to identify any fundamental right impeded by the use of marital classifications in the tax code. Furthermore, he failed to claim discrimination as a homosexual; instead, he claimed that he was a person who shared assets and income with someone who was not his legal spouse. Thus, the taxpayer placed himself in a class including unmarried members of the opposite sex, family members and friends, none of whom are the targets of discrimination in the Code. The Court further suggested that whether policy considerations warrant narrowing the gap between the tax treatment of married taxpayers and homosexuals (or other unmarried economic partners) is for Congress to decide and not the judicial system.

It also appears that even if a state were to adopt a law permitting same sex marriages, domestic partners will not be considered married for tax purposes. This stems primarily from legislation enacted in 1996 called the Defense of Marriage Act (Pub. Law 104-199). This Act provides in part that:

...In determining the meaning of any act of Congress or of any ruling, regulation, or interpretation of the various administrative bureaus or agencies of the United States, the word "marriage" means only a legal union between one man and one woman as husband and wife, and the word "spouse" refers only to a person of the opposite sex who is a husband or a wife.

Thus, taxpayers of the same sex who are married under a state law approving same sex marriages would most likely not be considered married for federal tax purposes.

Income Considerations in Choosing a Filing Status

This article does not include an exhaustive list of all of the factors that affect the filing of a joint tax return. Rather, it presents a table of the economic costs that might be associated with not electing joint return status, followed by a summary of the issues that must be measured when selecting a taxpayer's filing status.

The Cost of Not Filing a Joint Return. Most married couples do not elect filing jointly for a non-tax purpose. For example, one spouse may want to be responsible only for his or her own tax liability, or perhaps the couples are going through a nasty divorce and choose not to deal with each other.

In all but unusual instances, filing separate returns will cost more combined federal tax than the couple would pay filing a joint return. This is because the tax rate is higher for married persons filing separately. Therefore, before the decision on filing status is made, both parties should understand some of the restrictions that may apply if a separate return is filed. A list of these separate return restrictions is presented below. The discussion that follows illustrates their impact.

Effect of a Separate Return. An individual who is otherwise required to file a return, who is considered to be married for filing status purposes, and who does not or cannot elect to file a joint return with his or her spouse, must file a separate return as a married individual. A married individual filing a separate return must report on that return her items of gross income, exemptions, deductions and credits. Many of the items that were highlighted above will now be discussed in more detail.

Income Inclusions/Loss Of Exclusions Issues. Certain states are classified as community property states that have unique methods under state law for classifying ownership of income. These states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. For taxpayers wishing to elect married filing separately in these states, it is important to determine which spouse is deemed to own income producing assets. A determination must be made as to what extent marital property is considered either one spouse's separate property or property of the marital community.

For federal income tax purposes, income from marital community property is considered as being earned one-half by each spouse. As to income from separate property, it depends on the community property state. In Idaho, Louisiana, Texas and Wisconsin, income from separate property belongs to the community and, therefore, each spouse is considered to have earned one-half of such income. Income from separate property in the other community property states is designated as separate income. Therefore, in those states, the owner-spouse must include all separate property income from separate property on that spouse's federal income tax return.

Summary of Monetary Thresholds Affected By Filing Status Decisions.

* Social Security Taxation. In general, an election to be married filing separately would result in more Social Security amounts being subjected to income tax. This is because of the potential loss of the base amounts used in calculating the 50% or 85% inclusion of Social Security benefits in taxable income.

* Married couples filing separately do not qualify for exclusion of interest income earned on savings bonds which is used to pay for qualified higher education expenses.

* Deductions of IRA contributions may more likely be reduced or disallowed where married taxpayers elect to file separately. If an election to file separately is made, any IRA deduction allowed is subjected to an immediate phase-out rule. In essence, if modified adjusted gross income exceeds $10,000, no IRA deduction would be allowed. Normally, for a couple filing a joint return, modified adjusted gross income would have to exceed $63,000 before the IRA deduction would be disallowed.

* Married couples filing separately would not qualify for up to $2500 of interest deductions on interest paid on qualified student loans.

* In general, married couples filing separately would not qualify for the special loss deduction allowed on actively managed rental real estate. When certain requirements are met, taxpayers can deduct up to $25,000 of rental real estate loss. The election to file separately will generally result in no loss deduction being allowed in this area.

* The credit allowed for the elderly or disabled is not available to spouses wishing to file separately unless they lived apart for the entire year.

* Tax credits related to expenses of higher education (Hope Scholarship and lifetime learning credits) are not available to spouses choosing to file separately.

Conclusion

For married taxpayers, whether a joint return or a separate return should be filed is a determination that is based on the factual circumstances of each couple. The implications of filing separate tax returns can be far-reaching for married taxpayers and have a broad impact on the financial cost of making such a choice.

Endnotes

(1.) Poe v. Seaborn, 282 US 101, 117 (1930).

(2.) IRC Sec. 7703(a)(2).

(3.) Reg. Sec. 1.6013-4(a); Rev. Rul. 57-368, 19572 CB 896.

(4.) W.M. Boyer v. Comm., CA-DC, 84-1 USTC J9375, 732 F2d 191.

(5.) Rev. Rul. 76-255, 1976-2 GB 40.

(6.) IRS Letter Ruling 7835076; M. Peveler v. Comm., 39 TCM 502, TC Memo. 1979-460.

(7.) IRC Secs. 2(c); 7703(b); 152(e)(2), (4).

(8.) IRC Sec. 7703(b).

(9.) W.C. Lyddan v. US, 83-2 USTC J 9706, 721 F2d 873 (CA-2, 1983)

(10.) D.S. Becker v. Comm., 69 TCM 2439, TC Memo. 1995-177. The Tax Court will continue to treat parties living under the same roof as married because the court refuses to investigate the quality of a marriage to determine whether one of the spouses is "constructively absent." See Chiosic v. Comm., TC Memo. 2000-117.

(11.) Est, of Buckley v. Comm., 37 TC 664, (1962) (Acq.).

(12.) Rev. Rul. 76-255, 1976-2 CB 40; and W.R. Wilson v. Comm., 35 TCM 1276, TC Memo. 1976-285.

(13.) B.J. Shackelford v. Comm., 70 TCM 945, TC Memo. 1995-484.

(14.) IRC Sec. 2(a)(l) and Reg.Sec. 1.2-2(a)

(15.) Von Tersch v. Comm., 47 T.C. 415 (1967).

(16.) Gary v. Gary, 490 S. W. 2d 929, (Civ. App. Tex. 1973); Texas Family Code, sec. 1.91(b).

(17.) Milton Peveler v. Comm., 39 TCM 502, TC Memo. 1979-460.

(18.) Rev. Rul. 1958-1 CB 60.

(19.) 2001-1 USTC J50,391 (CA-7, 2001) aff'g TC Memo. 2000-132.

RELATED ARTICLE: Restrictions for Separate Returns

1) Loss of the credit for child and dependent care expenses in most cases;

2) Loss of the earned income credit;

3) Loss of the exclusion or credit for adoption

4) Loss of the credit for higher education expenses;

5) Loss of the deduction for student loan interest;

6) Loss of the exclusion of the interest from qualified savings bonds that are used for higher education expenses;

7) If the spouses lived together any time during the tax year they cannot claim the credit for the elderly or the disabled;

8) If the spouses lived together any time during the tax year, they will have to include in income up to 85% of any Social Security or equivalent Railroad Retirement benefits received;

9) The spouses will become subject to the limit on the child tax credit, itemized deductions, and the phase-out of the deduction for personal exemptions at income levels that are half of those for a joint return; and

10) Neither spouse can roll over amounts from a traditional IRA into a Roth IRA during a year that a separate return is filed.

Steven C. Thompson, PhD, CPA, is Professor of Taxation at Florida Gulf Coast University in Fort Myers. Randall K. Serrerr is Assistant Professor at the University of Houston (Downtown) in Texas.