Marriage in the Tax Code, Part 6: Community Property Laws

wedding-rings-150300_1280Most 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.

Example:

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.

 

Marriage in the Tax Code, Part 5: Examples of Taxes in 1920

wedding-rings-150300_1280This post is part of a long-term project I’ve been working on regarding the history of marriage in the tax code.

As I finish sections of the research paper I’m working on, I’ll post them here. This is a big project, one that will likely take years, literally, to finish, so I can’t guarantee when the next post on this topic will appear.

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At the end of Part 4 of this series, I mentioned that I would give some examples for why most married couples continued to file combined tax returns even with the major rate increases of 1917.

As detailed in Part 4, the workforce in those days was predominantly male. Married women typically didn’t work outside the home and so they didn’t have income of their own to report. These couples, by default, filed “joint” or combined tax returns.

Additionally, there were no filing statuses in those days, and just one tax bracket. In cases where both couples had income, it made sense to just file a combined tax return because there was no savings involved with filing separately.

Example 1:

In 1920, John has gross income of $5,000; Jane has gross income of $1,000. Subtracting out the $2,000 exemption amount leaves them with 4,000 of taxable income, which puts them in the 4% range of the tax bracket. They would still be in the 4% range if they filed separate returns. There is no benefit to filing separate returns, so for the sake of convenience they would likely file a combined return.

Note that $5,000 in 1920 is the equivalent of about $57,000 today; $$1,000 is the equivalent of about $10,000 today.

Example 2:

In 1920, John has gross income of $10,000; Jane has gross income of $2,000. If they file a joint return, their taxable income is $10,000. The tax on $10,000 is $750.

Or, they could file separate returns. John would likely claim the full $2,000 exemption amount himself, knocking his taxable income down to $8,000. The tax on $8,000 is $530. Jane’s taxable income would be $2,000, which creates a tax of $80. The total tax owed filing separately is thus $610 ($530 + $80), a savings of $140.

John and Jane would most likely file separate returns.

Note that $10,000 is the equivalent of about $114,,000 today, and $2,000 is the equivalent of about $23,000 today.

As these examples illustrate, filing a separate return was only advantageous if both spouses had income and their combined taxable income pushed them enough above the surtax level to make it worthwhile to file separately.

The tax changes made between 1917 and 1919 did not affect the way most married couples filed tax returns at the time, but the changes planted the seeds for the current system of filing statuses that we still use today. All because some high-income taxpayers discovered that they could have large tax savings by filing separate returns – even if only one spouse had income.

Those couples were fortunate to live in a “community property” state. And that is where the next part of our filing status story will continue.

Marriage in the Tax Code, Part 4: Joint Returns Still the Norm in 1917

wedding-rings-150300_1280This post is part of a long-term project I’ve been working on regarding the history of marriage in the tax code.

As I finish sections of the research paper I’m working on, I’ll post them here. This is a big project, one that will likely take years, literally, to finish, so I can’t guarantee when the next post on this topic will appear.

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As detailed in Part 3, the tax code changed in 1917 and drew millions more people into the tax system. But one thing that didn’t change for most married couples was the way they filed tax returns.

There were still no filing statuses and there was still just one tax bracket that applied to everyone. Married couples received no preferential treatment.

But just as in 1913, most married couples continued to file joint tax returns. Indeed, the percentage of joint returns filed in 1920 was actually slightly higher that the percentage of joint returns filed in 1913 (98.0% in 1920; 97.6% in 1913). By 1923, the percentage of joint returns had decreased (to 96.4%) but joint returns were still the overwhelming choice for most married couples. (Source: a memo by a “Ms. Coyle” at the IRS in 1941: http://taxhistory.tax.org/Civilization/Documents/marriage/hst28695/28695-1.htm)

There are two explanations why joint returns were so common even after the changes from 1917-1919:

  1. There were fewer women in the workplace and thus more one-income married couples. According to the U.S. Department of Labor, women made up just 21% of the labor force in 1920, compared to 47% in 2010. By default, a tax return filed by a one-income married person was counted as a “joint” return.
  2. Even though the tax rates after 1917 were different from what the tax rates were in 1913, many taxpayers still fell within the first range of the tax bracket and thus out of the higher “surtax” range. The 4% tax bracket applied to the first $4,000 of taxable income. There was a $2,000 exemption amount for married couples, and an additional $200 exemption for each dependent. So a family of four could have combined gross income of $6,400 (the equivalent of about $73,000 today) and still fall in the 4% range.

I’ll give some examples in Part 5.

Marriage in the Tax Code, Part 3: Big Changes in 1917

wedding-rings-150300_1280This post is part of a long-term project I’ve been working on regarding the history of marriage in the tax code.

As I finish sections of the research paper I’m working on, I’ll post them here. This is a big project, one that will likely take years, literally, to finish, so I can’t guarantee when the next post on this topic will appear.

—–

As mentioned in Part 2, the original tax code provided large exemption amounts. The result was that taxes were something that the average person didn’t have to think about.

The tax brackets and exemption amounts remained generous until 1917. U.S. involvement in World War I meant that the government needed more revenue. The result was legislation that made the tax brackets and exemptions much less friendly.

In 1917, the lowest tax rate within the tax bracket was increased to 2% on the first $2,000 of taxable income ($2,000 in 1917 was the equivalent of approximately $36,000 today). As a reminder, in 1913, the lowest tax bracket was 1% on the first $20,000 of taxable income (the equivalent of more than $460,000 today).

Let that change soak in for a moment.

In 1918, the lowest bracket was increased to 6% on the first $4,000 of taxable income ($60,000 in today’s dollars).

That bottom rate would be cut to 4% on the first $4,000 of income starting in 1919. The 1919 rate is the rate that would be in effect through 1923.

Surtaxes

A surtax kicked in at $4,001 of taxable income, pushing the tax rate to 8% for taxable income between $4,001 and $5,000. The rates rose progressively from there. The exemption amounts were also slashed during these reforms, to $1,000 for single filers and $2,000 for married couples.

The reduced exemption amounts meant that a single person was required to file a tax return on approximately $18,000 in modern-day dollars, and a married couple was required to file a tax return at $36,000 in modern-day dollars. Remember, in 1913 those exemption amounts were the equivalent of approximately $70,000 for a single person and $93,000 for a married couple.

The result of the tax reform during this period is that tens of thousands of citizens were drawn into the tax system. In just one year, the number of tax returns filed quadrupled. In 1916, only 437,036 tax returns were filed. In 1917, 1,832,132 tax returns were filed. By 1920, 7,259,944 tax returns were filed – an increase of over 3,000% from 1916.

But as we’ll talk about in Part 4, married couples still filed joint returns most of the time.

Glossary: Varnum Ruling

flag-36423_1280Whenever you see or hear reference to the Varnum Ruling in Iowa, it’s referring to the 2009 decision by the Iowa Supreme Court that legalized same-gender marriage in Iowa.

I used to do a lot of blog posts about the tax implications of same-gender marriage, and in those posts, you’ll see occasional references to the Varnum ruling.

Immediately after the ruling, the Iowa Department of Revenue issued a brief memo saying that couples in same-gender marriages in Iowa would need to file their Iowa tax returns as married and that “certain recalculations” may need to be made.

The tax lives of people in same-gender marriages was complicated. They had to file as single at the federal level but married in Iowa. And Iowa provided little guidance.

In the 4+ years between the Varnum ruling and the U.S. Supreme Court ruling striking down DOMA, that was all the guidance we got from IDR.

Most of those complications went away when DOMA was overturned, but there still can be complications with multiple-state filings if someone has to file a tax return in a state that doesn’t recognize same-gender marriage.

I don’t write about this topic as much anymore, but you can find my extensive archives here.

You can read more about the backstory of the Varnum case here.