Income From Partnership Is Community Property

Gross Income

The Tax Court held that a taxpayer was taxable on her community property share of the income from a partnership that her husband funded without her consent with community property.

Background

In April 1990, Ann and Vince Carrino were married in California. In June 2002, Vince, a hedge fund manager, filed for divorce and the couple legally separated, but the divorce proceedings lasted for more than four years.

Vince started a new hedge fund the same year he separated from Ann. In January 2002, he formed a limited liability company called CR Traders LLC (CR LLC) and named himself the managing member. CR LLC served as general partner to a partnership that Vince (in his capacity as manager of CR LLC) created in June 2002, CR Traders Partners LP (CR LP). Although Vince made capital contributions to CR LLC (about $850,000) sometime in 2002, which CR LLC then contributed to CR LP, neither of those contributions occurred before he and Ann legally separated in June 2002. Even though they were still married (but legally separated) at the time, Vince apparently made this investment without notifying Ann or obtaining her consent.

CR LP was successful from the start, and CR LLC earned about $4 million from its interest in CR LP in 2003. However, Ann did not receive a K-1 from CR LP for 2003, was not listed as a partner on CR LLC’s partnership return, and did not report any income from CR LLC or CR LP on her 2003 return.

At some point after CR LP was up and running, Ann learned of Vince’s investment in CR LLC and CR LP. In their divorce proceedings, Ann asserted that all of the funds Vince used after their legal separation for that investment were community property because they were traceable to money from another hedge fund that Vince had founded and operated during their marriage—and that his investment in that earlier fund consisted entirely of community property.

In November 2006, the Carrinos signed a court-approved settlement agreement stating that 72.5% of Vince’s current interest in CR LLC was traceable to community property, while the remaining 27.5% was Vince’s separate property. The agreement also provided that Ann’s 50% community property share in that interest would be promptly liquidated and paid to her. Vince acted quickly, and by the end of November CR LP distributed nearly $6.5 million to Ann. In December 2006, the Superior Court of California granted the couple’s divorce.

In April 2007, Vince submitted amended 2003 partnership returns for CR LP and CR LLC to the IRS. CR LP’s amended return reported for the first time that Ann was a partner and included a K-1 that allocated to her a net distributive share of $758,841 and an amended K-1 for CR LLC that showed a corresponding decrease of $758,841 in CR LLC’s distributive share compared to its original K-1. Ann did not file a 2003 amended individual return reflecting the amounts shown on the K-1 that CR LP issued to her.

The IRS, after examining Ann’s return, determined that she should have reported the income from CR LP on her return and in 2009 issued her a notice of deficiency. Ann filed a petition with the Tax Court contesting the notice.

The Parties’ Positions

Ann argued that for her to be taxable on the income from CR LP, the 2006 court-ordered marital division must have made her a partner in CR LP in 2003. Under California community property law, before the 2006 settlement, she only had an inchoate or unvested one-half community property interest in the value of what Vince had invested in CR LP after their separation. It gave her only a claim in and against Vince’s partnership share in CR LLC and, through CR LLC’s own partnership interest in CR LP, a claim in and against CR LP’s capital and income, but only with respect to the part that was community property. Thus, she did not have a community property interest in CR LP’s assets and was not a partner in the partnership. Since she was not a partner in CR LP, she asserted the income from it was not taxable to her.

The IRS argued that it was immaterial whether Ann was a partner in CR LP in 2003. According to the IRS, in 2003 Ann held at least a present interest in half of the income from Vince’s community property share of CR LLC, and whatever that amount of income was, it was taxable to Ann.

The Tax Court’s Holding

The Tax Court held that Ann was taxable on her community property share of the income from Vince’s interest in CR LLC, regardless of her status as a partner in CR LP. The court concluded that in 2003 Ann had a present and existing community property interest in the 72.5% of Vince’s interest in CR LP awarded to Ann in the couple’s divorce settlement, which he held in the form of a membership interest in CR LLC. Thus, under the general community property rules, she was taxable on half of the 2003 income from 72.5% of Vince’s membership interest in CR LLC.

At the outset, the Tax Court noted that for the community property rules to apply for 2003, the Carrinos had to have been married in 2003. The IRS claimed that the couple’s marriage did not end until their divorce was granted in 2006; Ann claimed it ended at the date of their legal separation. Referring to California case law, the Tax Court found that a legal separation does not end a marriage in California, so the Carrinos were married in 2003 and the community property rules applied for that year.

The Tax Court next considered whether Ann had a present interest in the community property portion of the 2003 income from Vince’s membership interest in CR LLC under California law. The court found that under California law, whether property was separate or community property was determined at acquisition, and that if one spouse invested community property in a partnership, the partnership interest, because it was acquired with community property, was community property. It further found that based on a probate case, Kenworthy v. Hadden, 151 Cal. Rptr. 169 (Cal. Ct. App. 1978), a community property interest in a partnership was a present interest.

In Kenworthy, a husband used community property to fund a partnership. When the wife died, she left her community property to various devisees. Until the time of his death, the husband treated the devisees as having received a claim to a share of the partnership’s income, not an interest in the partnership, and the devisees did not object. When the husband died, the devisees did not file a creditor’s claim against the estate within the period allowed for filing a claim.

The estate later sought a ruling that the devisees had no claim against the estate. At that point, if the devisees were considered to have received an interest in the income from the partnership from the wife, their failure to timely file a claim against the estate would have prevented them from receiving anything from it. Therefore, the devisees argued that they had received an interest in the partnership. The California Court of Appeals sided with the devisees, finding that when the husband created the partnership, the wife did not give up a community interest in the property transferred to the partnership; rather, she had traded her community interest in one asset for a community interest in another asset. Further, it found that her community property interest in the partnership was a present interest. Thus, the devisees had received a present interest in the partnership when the wife died.

Because the Tax Court found Ann’s situation very similar to the one in Kenworthy, it chose to follow that holding. The court stated:

When Vince invested the community property in CR LP, Ann did not divest herself of her community interest in that property in favor of a money claim against him any more than the wife did in Kenworthy. She merely traded her community interest in one asset for a community interest in another asset, i.e., Vince’s membership share of CR LLC’s partnership interest in CR LP.

Thus, the court determined that Ann had a present and existing community property interest in Vince’s membership interest in CR LLC.

Reflections

At the end of its opinion, the Tax Court noted that it did not address two arguments that the parties failed to make that it considered credible. On one side, the Tax Court noted that the IRS could have argued that the taxation of the income was governed by Regs. Sec. 1.702-1(d), which states that if married couple in a community property state file separate returns and only one spouse is a member of a partnership, the part of the distributive share of any item of the partnership that is community property should be reported in equal proportions by the husband and wife. On the other side, the court noted that it was possible that Ann could have successfully argued for innocent spouse relief to the general rule that each spouse must report half of community income.

Carrino, T.C. Memo. 2014-34