It is certainly not uncommon for one taxpayer with significant federal tax debts to want to marry another taxpayer without any tax debts at all. In these instances, both taxpayers may naturally desire to enter into a pre-marital agreement to ensure that their respective assets and debts (including federal tax debts) are kept separate. This is particularly so in so-called “community property states” where the presumption is that each taxpayer is deemed to have rights to one-half of the other taxpayer’s community property income and assets.
Taxpayers in these circumstances should understand that the IRS will not always respect a pre-marital agreement. Rather, the IRS will, in many cases, carefully scrutinize the agreement itself and the surrounding circumstances to determine whether it can pierce through the agreement and reach the liable spouse’s community property share of assets. Accordingly, taxpayers should, where warranted, consult with a tax professional to determine whether the pre-marital agreement complies with federal tax law and IRS guidance.
Federal Tax Law
Although federal tax law determines how property should be taxed and collected, state law determines whether, and to what extent, a taxpayer has “property” or “property rights” subject to federal income taxation and collection. See, e.g., Aquilino v. U.S., 363 U.S. 509 (1960).
States vary in the methods that they utilize to allocate property and property rights amongst married individuals. In most states, each spouse is treated as a separate individual with separate legal and property rights. Accordingly, each spouse owns and is taxed on the income that he or she earns.
But, at least nine states have adopted community property systems. These states include Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin. Community property systems view each spouse’s property rights differently than the majority of states discussed above. Generally, under a community property system, each spouse is deemed to contribute their skills and labor to the community and therefore each spouse shares equally in the profits and income generated from the community income and assets.
Because each spouse is deemed to earn 50% of the other spouse’s community property income, federal tax law requires each spouse, even when filing a separate return, to report 50% of the other spouse’s community property income on his or her federal income tax return. However, if the spouse owns separate property, such spouse is generally permitted to report all of that income separately on his or her return.
For federal collection purposes, the IRS takes the position that it may collect federal taxes and penalties owed by one spouse entirely from community assets or a portion thereof. See IRM pt. 22.214.171.124.4 (3-4-11). Moreover, this includes community property earned or even titled in the name of the other spouse. Id.
As indicated above, for federal income tax purposes, a taxpayer’s rights and interest in property are determined under the laws of the taxpayer’s state of domicile. See U.S. v. Mitchell, 403 U.S. 190 (1971); Morgan v. Comm’r, 309 U.S. 78 (1940). In many community property states, including Texas, spouses may effectively “contract out” of the community property regime through executing a lawful and binding pre-marital agreement. For example, under Texas law, a pre-marital agreement is authorized by the Texas Constitution and Chapter 4 of the Texas Family Code. See Tex. Const. art. XVI, § 15. And, it is the public policy of the State of Texas to enforce these agreements. See Beck v. Beck, 814 S.W.2d 745, 749 (Tex. 1991). For simplicity and illustration, the remainder of this article will focus on pre-marital agreements in Texas.
Texas Pre-Marital Agreements
Pre-marital agreements executed in the State of Texas are effective on the date of marriage. See Tex. Fam. Code § 4.001. The only requirements for a valid and enforceable pre-marital agreement are that the agreement be in writing and be signed by both parties. See Tex. Fam. Code § 4.002. Moreover, pre-marital agreements have been recognized in the State of Texas even without consideration amongst the parties. See id.
Unlike some other states, Texas law does not require the parties to have judicial approval or a court order for the agreement to be effective. See, e.g. Patino v. Patino, 687 S.W.2d 799 (Tex. App.—San Antonio 1985, no writ) (“There is no requirement for judicial approval of such a partition or exchange agreement.”). Rather, pre-marital agreements are enforceable similar to any other written contract. See Williams v. Williams, 246 S.W.3d 207, 210 (Tex. App.—Houston [14th Dist.] 2007, no pet.),
Potential Issues with Pre-Marital Agreements and the IRS
Because pre-marital agreements are considered written contracts, careful consideration should be given to the terms and verbiage used in the agreement. Indeed, IRS guidance specifically advises IRS employees to carefully review the terms of the pre-marital agreement to determine what is covered, i.e., what property is considered separate and what property is considered community. See IRM pt. 126.96.36.199.25 (6-6-17). Moreover, IRS employees are further advised to determine whether there is proof that the parties are actually abiding by the terms of the pre-marital agreement itself. See id. Thus, at a minimum, parties to a pre-marital agreement should ensure that the language in the agreement is clear and that the parties have evidence that they are complying with its terms.
Moreover, because many states (including Texas) have adopted presumptions that any property acquired during the marriage is community property, the parties should ensure that they do not mix separate property and community property assets. In addition, the parties should attempt to keep careful records of where separate property funds originated and ideally should be able to produce written records to trace the funds from their origin throughout. To the extent a spouse fails to do so, the IRS (or even a title company in a real estate closing) may argue that the presumption of community property applies and that the funds should be subject to collection action.
Finally, spouses should be aware of fraudulent conveyance theories that the IRS uses, sometimes against pre-marital agreements themselves. For more on fraudulent conveyances and transfers, see our blog posts on Fraudulent Transfers Under Texas Law and Can You Transfer Assets to Avoid Paying Taxes to the IRS?
Pre-marital agreements that have been properly done are generally respected by the IRS. However, IRS guidance notes that the IRS will attempt to attack pre-marital agreements, particularly where the facts and circumstances demonstrate that the pre-marital agreement may be unenforceable or has not been properly adhered to. Accordingly, careful taxpayers may want to engage a tax professional to review a pre-marital agreement prior to its execution to better ensure that it will be respected for federal tax purposes.
Freeman Law aggressively represents clients in tax litigation at both the state and federal levels. When the stakes are high, clients rely on our experience, knowledge, and talent to help them navigate all levels of the tax dispute lifecycle—from audits and examinations to the courtroom and all levels of appeals. Schedule a consultation or call (214) 984-3000 to discuss your tax needs.