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.
For tax purposes, community property law treats many 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.
(The specifics of what income is split varies from state to state; for example, interest and dividends are sometimes reported separately rather than split 50/50. IRS Publication 555 is an excellent resource for the current community property rules.)
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 to higher-income couples in community property states to shift income and lower their tax burden as compared to couples in common law states.
In 1920, John has taxable income of $10,000 (the equivalent of about $115,000 today). Jane does not work outside the home.
In a common-law state, they would file a joint tax return showing $10,000 of taxable income. The tax on $10,000 is $750.
In a community property state, John and Jane could file separate tax returns showing $5,000 of taxable income on each return. The tax on $5,000 is $240.
John and Jane would owe $240 of tax each, or $480 total.
The tax savings for this couple in a community property state is $270 ($3,100 in today’s dollars).
Naturally, both the IRS and people in common-law states had a problem with this. The end result would be the creation of the filing statuses and multiple tax brackets we have today. But the wheels of government change move slowly, and it would take nearly 30 years for this to happen.
“This blog post, along with comments that may follow, should not be considered tax advice. Before you make final tax or financial decisions, please secure a professional tax advisor to give you advice about your unique situation. To secure Jason as your accountant, please click on the ‘Services’ link at the top of the page.”