U.S. Tax Court has ruled that Wife must report half of the community property income from partnership that Husband started post-separation with community property funds on her separate federal income tax return. In the case of Carrino v. Commissioner, California residents Husband and Wife were married in April 1990. During their marriage, Husband was a highly successful hedge fund manager, but the stress of his success brought an end to the marriage. In January 2002, Husband and another person started a new hedge fund, CR Traders, LLC (CR LLC), with Husband as the managing member.
In June of 2002, Husband and Wife separated and Husband filed for divorce. Around that same time, Husband, as CR LLC manager, created CR Traders Partners, LP (CR LP), for which CR LLC would act as a general partner. In September of 2002, CR LP began acting as a hedge fund, which Husband managed through CR LLC.
During 2003, CR LP earned about $4 million on initial contribution of $850,000, and CR LLC contributed $9 million in capital to CR LP, bringing its total capital account to over $14 million by year’s end. When Husband filed tax returns for CR LLC and CR LP, he did not list Wife among their partners and Wife did not report any income from either entity.
Sometime later, Wife found out that Husband had invested in CR LLC and CR LP. In divorce proceedings, Wife claimed that Husband had used community property funds in making those investments (traceable from the hedge fund founded during marriage), but Husband disagreed. In November of 2006, Trial Court approved a settlement agreement providing that 72.5% of Husband’s interest in CR LLC was community property and the remaining 27.5% was Husband’s separate property. That agreement also required Wife’s community property share of that interest to be promptly liquidated, which Husband promptly did, paying Wife almost $6.5 million from CR LP.
On December 26, 2006, Trial Court entered Husband and Wife’s status-only divorce judgment, but reserved jurisdiction over remaining issues. Among those was Husband’s claim for reimbursement for income tax payments he had made on community property income between 2003 and 2005. In opposition, Wife asked Trial Court to consider the reimbursement issue along with other remaining issues when divorce case concluded.
On April 15, 2007, Husband “took matters into his own hands,” filing amended 2003 partnership returns for CR LLC and CR LP on which he claimed that Wife was a partner in those entities, and that Wife had received $759,196 in “other income” from them, plus $355 in interest. Husband also made corresponding deductions to reflect the alleged distributions. When Wife filed her 2003 federal income tax return, she did not include the alleged distributions.
Noting the discrepancy, IRS audited Wife’s 2003 return and assessed deficiency accordingly. Wife then petitioned U.S. Tax Court for review, claiming that she was not a partner in CR LP at any time, including 2003. Meanwhile, IRS began investigation of CR LP. When that investigation concluded, IRS sent notice to Wife determining that she was a partner in CR LP. Wife then petitioned U.S. Tax Court for determination that she was not a partner. After consolidating the cases, Tax Court has now ruled that Wife must report community property share of CR LP income.
Tax Court has found that (1) it need not decide whether Wife was partner, but only whether Wife had community property interest in the income generated by CR LP; (2) Husband and Wife were still married during 2003; (3) married persons who file separate returns, as Husband and Wife did here, must each report half of community property income earned during taxable year; (4) Wife had present, existing, and equal community property interest in 72.5% of Husband’s interest in CRL LC and CR LP during 2003; and (5) Wife should have reported half of the community property income from CRL LC and CR LP on her 2003 federal income tax return.