Main Body

8 Tax Consequences of Divorce and Intra-Family Transactions

Chapter 8

Tax Consequences of Divorce and Intra-Family Transactions

I. Introduction

The tax consequences of marriage, support of a family, and divorce reflect how we choose to apply the basic principles that we tax income once and only once and that expenditures for personal consumption are not deductible. Taxpayer chooses whether to have a spouse or a child, so expenditures for the support of a spouse or a child presumably are not deductible. The Supreme Court’s decision in Poe v. Seaborn assured that the legal ownership of income within a family unit would be an important issue. We consider now the extent to which we recognize the family as a taxpaying unit.

We already know that the filing status “married filing jointly” implies that married persons are in fact one taxpaying unit, whether one or both contribute to its taxable income. The fact that a taxpayer provides financial support to another person may give that other person the tax status of “dependent” and entitle taxpayer to a dependent deduction. We learn shortly that whether taxpayer may claim another as a dependent usually turns on the existence of a family relationship.

The definition of “marriage” is a matter of state law; states law determines who is and who is not married. State law also defines the rights that husband and wife have with respect to their property and income before, within, and after the marriage. State law governs adoptions and so is determinative of who is a “child” of the taxpayer. State (or local) law also governs the placement of foster children. State law defines the obligations that family members have towards each other – notably that parents have obligations of support for their children up to a certain age. This may affect whether one person is a dependent of a taxpayer.

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The Tax Formula:

(gross income)

MINUS § 62 deductions

EQUALS (adjusted gross income (AGI))

MINUS (standard deduction or itemized deductions)

→ MINUS (personal exemptions)

EQUALS (taxable income)

Compute income tax liability from tables in § 1 (indexed for inflation)

MINUS (credits against tax)

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We consider here the tax ramifications of marriage and family – before, during, and after.

II. Before Marriage

The Code treats a married husband and wife as a single taxpayer – although they may elect to be taxed separately. Until they are married, they remain separate taxpayers – although one might be a dependent of the other. Taxpayers may enter certain transactions with each other in contemplation of marriage., but presumptively such transactions are arm’s-length transactions.

Farid-es-Sultaneh v. Commissioner, 160 F.2d 812 (2d Cir. 1947)

CHASE, Circuit Judge.

The problem presented by this petition is to fix the cost basis to be used by the petitioner in determining the taxable gain on a sale she made in 1938 of shares of corporate stock. She contends that it is the adjusted value of the shares at the date she acquired them because her acquisition was by purchase. The Commissioner’s position is that she must use the adjusted cost basis of her transferor because her acquisition was by gift. The Tax Court agreed with the Commissioner and redetermined the deficiency accordingly.

….

The petitioner is an American citizen who filed her income tax return for the calendar year 1938 … and … reported sales during that year of 12,000 shares of the common stock of the S.S. Kresge Company at varying prices per share, for the total sum of $230,802.36 which admittedly was in excess of their cost to her. …

In December 1923 when the petitioner, then unmarried, and S.S. Kresge, then married, were contemplating their future marriage, he delivered to her 700 shares of the common stock of the S.S. Kresge Company which then had a fair market value of $290 per share. The shares … were to be held by the petitioner “for her benefit and protection in the event that the said Kresge should die prior to the contemplated marriage between the petitioner and said Kresge.” The latter was divorced from his wife on January 9, 1924, and on or about January 23, 1924 he delivered to the petitioner 1800 additional common shares of S.S. Kresge Company which were also … to be held by the petitioner for the same purposes as were the first 700 shares he had delivered to her. On April 24, 1924, and when the petitioner still retained the possession of the stock so delivered to her, she and Mr. Kresge executed a written ante-nuptial agreement wherein she acknowledged the receipt of the shares “as a gift made by the said Sebastian S. Kresge, pursuant to this indenture, and as an ante-nuptial settlement, and in consideration of said gift and said ante-nuptial settlement, in consideration of the promise of said Sebastian S. Kresge to marry her, and in further consideration of the consummation of said promised marriage” she released all dower and other marital rights, including the right to her support to which she otherwise would have been entitled as a matter of law when she became his wife. They were married in New York immediately after the ante-nuptial agreement was executed and continued to be husband and wife until the petitioner obtained a final decree of absolute divorce from him on, or about, May 18, 1928. No alimony was claimed by, or awarded to, her.

The stock so obtained by the petitioner from Mr. Kresge had a fair market value of $315 per share on April 24, 1924, and of $330 per share on, or about May 6, 1924, when it was transferred to her on the books of the corporation. She held all of it for about three years, but how much she continued to hold thereafter is not disclosed except as that may be shown by her sales in 1938. Meanwhile her holdings had been increased by a stock dividend of 50%, declared on April 1, 1925; one of 10 to 1 declared on January 19, 1926; and one of 50%, declared on March 1, 1929. Her adjusted basis for the stock she sold in 1938 was $10.66⅔ per share computed on the basis of the fair market value of the shares which she obtained from Mr. Kresge at the time of her acquisition. His adjusted basis for the shares she sold in 1938 would have been $0.159091.

When the petitioner and Mr. Kresge were married he was 57 years old with a life expectancy of 16½ years. She was then 32 years of age with a life expectancy of 33¾ years. He was then worth approximately $375,000,000 and owned real estate of the approximate value of $100,000,000.

The Commissioner determined the deficiency on the ground that the petitioner’s stock obtained as above stated was acquired by gift within the meaning of that word as used in § [102] and, as the transfer to her was after December 31, 1920, used as the basis for determining the gain on her sale of it the basis it would have had in the hands of the donor. This was correct if the just mentioned statute is applicable, and the Tax Court held it was on the authority of Wemyss v. Commissioner, 324 U.S. 303, and Merrill v. Fahs, 324 U.S. 308.

The issue here presented cannot, however, be adequately dealt with quite so summarily. The Wemyss case determined the taxability to the transferor as a gift, under [the Federal Gift Tax] … of property transferred in trust for the benefit of the prospective wife of the transferor pursuant to the terms of an ante-nuptial agreement. It was held that the transfer, being solely in consideration of her promise of marriage, and to compensate her for loss of trust income which would cease upon her marriage, was not for an adequate and full consideration in money or money’s worth … [and] was not one at arm’s length made in the ordinary course of business. But we find nothing in this decision to show that a transfer, taxable as a gift under the gift tax, is ipso facto to be treated as a gift in construing the income tax law.

In Merrill v. Fahs, supra, it was pointed out that the estate and gift tax statutes are in pari materia and are to be so construed. Estate of Sanford v. Commissioner, 308 U.S. 39, 44. The estate tax provisions in the Revenue Act of 1916 required the inclusion in a decedent’s gross estate of transfers made in contemplation of death, or intended to take effect in possession and enjoyment at or after death except when a transfer was the result of “a bona fide sale for a fair consideration in money or money’s worth.” [citation omitted]. The first gift tax became effective in 1924, and provided inter alia, that where an exchange or sale of property was for less than a fair consideration in money or money’s worth the excess should be taxed as a gift. [citation omitted]. While both taxing statutes thus provided, it was held that a release of dower rights was a fair consideration in money or money’s worth. Ferguson v. Dickson, 3 Cir., 300 F. 961, cert. denied, 266 U.S. 628; McCaughn v. Carver, 3 Cir., 19 F.2d 126. Following that, Congress in 1926 replaced the words “fair consideration” in the 1924 Act limiting the deductibility of claims against an estate with the words “adequate and full consideration in money or money’s worth” and in 1932 the gift tax statute as enacted limited consideration in the same way. Rev. Act 1932, § 503. Although Congress in 1932 also expressly provided that the release of marital rights should not be treated as a consideration in money or money’s worth in administering the estate tax law, Rev. Act of 1932, § 804, 26 U.S.C.A. …, and failed to include such a provision in the gift tax statute, it was held that the gift tax law should be construed to the same effect. Merrill v. Fahs, supra.

We find in this decision no indication, however, that the term “gift” as used in the income tax statute should be construed to include a transfer which, if made when the gift tax were effective, would be taxable to the transferor as a gift merely because of the special provisions in the gift tax statute defining and restricting consideration for gift tax purposes. A fortiori, it would seem that limitations found in the estate tax law upon according the usual legal effect to proof that a transfer was made for a fair consideration should not be imported into the income tax law except by action of Congress.

In our opinion the income tax provisions are not to be construed as though they were in pari materia with either the estate tax law or the gift tax statutes. They are aimed at the gathering of revenue by taking for public use given percentages of what the statute fixes as net taxable income. Capital gains and losses are, to the required or permitted extent, factors in determining net taxable income. What is known as the basis for computing gain or loss on transfers of property is established by statute in those instances when the resulting gain or loss is recognized for income tax purposes and the basis for succeeding sales or exchanges will, theoretically at least, level off tax-wise any hills and valleys in the consideration passing either way on previous sales or exchanges. When Congress provided that gifts should not be treated as taxable income to the donee there was, without any correlative provisions fixing the basis of the gift to the donee, a loophole which enabled the donee to make a subsequent transfer of the property and take as the basis for computing gain or loss its value when the gift was made. Thus it was possible to exclude from taxation any increment in value during the donor’s holding and the donee might take advantage of any shrinkage in such increment after the acquisition by gift in computing gain or loss upon a subsequent sale or exchange. It was to close this loophole that Congress provided that the donee should take the donor’s basis when property was transferred by gift. Report of Ways and Means Committee (No. 350, P. 9, 67th Cong., 1st Sess.). This change in the statute affected only the statutory net taxable income. The altered statute prevented a transfer by gift from creating any change in the basis of the property in computing gain or loss on any future transfer. In any individual instance the change in the statute would but postpone taxation and presumably would have little effect on the total volume of income tax revenue derived over a long period of time and from many taxpayers. Because of this we think that a transfer which should be classed as a gift under the gift tax law is not necessarily to be treated as a gift income-tax-wise. Though such a consideration as this petitioner gave for the shares of stock she acquired from Mr. Kresge might not have relieved him from liability for a gift tax, had the present gift tax then been in effect, it was nevertheless a fair consideration which prevented her taking the shares as a gift under the income tax law since it precluded the existence of a donative intent.

Although the transfers of the stock made both in December 1923, and in the following January by Mr. Kresge to this taxpayer are called a gift in the ante-nuptial agreement later executed and were to be for the protection of his prospective bride if he died before the marriage was consummated, the “gift” was contingent upon his death before such marriage, an event that did not occur. Consequently, it would appear that no absolute gift was made before the ante-nuptial contract was executed and that she took title to the stock under its terms, viz: in consideration for her promise to marry him coupled with her promise to relinquish all rights in and to his property which she would otherwise acquire by the marriage. Her inchoate interest in the property of her affianced husband greatly exceeded the value of the stock transferred to her. It was a fair consideration under ordinary legal concepts of that term for the transfers of the stock by him. Ferguson v. Dickson, supra; McCaughn v. Carver, supra. She performed the contract under the terms of which the stock was transferred to her and held the shares not as a donee but as a purchaser for a fair consideration.

….

Decision reversed.

CLARK, Circuit Judge (dissenting) (omitted).

Notes and Questions:

1. Did the Commissioner lose out on taxing any transactions in 1923 and 1924? Which ones?

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Estate and Gift Tax: The estate and gift taxes are in pari materia with each other. Neither is in pari materia with the income tax. What does this mean?

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• Remember: the use of property whose value has appreciated or depreciated to pay for something is a recognition event. Why?

• What did the parties buy and sell in this case?

___

S.S. Kresge: Who was S.S. Kresge? What did he do to make stock in his corporation go up so much in value?

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2. What did taxpayer give as consideration in this case? What did she pay for it? When was the money that she used to pay for it subject to income tax?

• How is this contrary to the sale-of-blood cases – where the amount realized is taxed in full?

3. If there had been no ante-nuptial agreement, would the court’s holding have been the same?

• What if the parties had married and then executed a post-nuptial agreement with the same terms as the ante-nuptial agreement?

III. During Marriage

A. Tax Consequences of Support Obligations

Consider this variation of Cidis v. White, 71 Misc. 2d 481, 336 N.Y.S.2d 362 (Dist. Ct. Nassau Cty., 1972): Dependent daughter without her parents’ knowledge made an appointment with Dr. White to be fitted for contact lenses. Dr. White ordered the contact lenses, and they were of no use to anyone except for daughter Cidis. Daughter Cidis was a minor, and her contracts were voidable under state law. Father Cidis elected to void the contract. Dr. White sued for quasi-contract and restitution.

• Assume that Father Cidis has an obligation to provide Daughter Cidis with “necessaries.”

• Should Father Cidis be liable for the fmv of the contact lenses – not on the theory that there was a contract that was admittedly voidable, but because Dr. White provided his daughter with a “necessary?”

• Are contact lenses one of life’s “necessaries” if Daughter Cidis does not see very well?

• Would it matter that contact lenses are cheaper than spectacles?

• If contact lenses are a “necessary” and neither Father Cidis nor Daughter Cidis pays for the contact lenses and Dr. White finally gives up trying to collect from either, does Father Cidis have gross income? Why or why not?

B. Filing Status

We know that the “filing status” of a taxpayer determines the tax rate applicable to particular increments of income. We also know that there are such things as a “marriage bonus” and a “marriage penalty” – depending on the relative income levels of husband and wife. We have already considered the relative burdens of each of the filing statuses. Now we briefly consider the rules that place a taxpayer in one filing status or another.

Married Filing Jointly and Married Filing Separately: Section 1(a) provides that married persons who file a single tax return and certain surviving spouses must pay an income tax at the tax brackets specified. For income tax purposes, state law determines whether two persons are married.

• In United States v. Windsor, ___ U.S. ___, 133 S. Ct. 2675 (2013), the United States Supreme Court held § 3 of the Defense of Marriage to be unconstitutional. States may choose to recognize marriages between persons of the same sex. Not every state does. The IRS has issued a revenue ruling to clarify its position.

[T]he Service has determined to interpret the Code as incorporating a general rule, for Federal tax purposes, that recognizes the validity of a same-sex marriage that was valid in the state where it was entered into, regardless of the married couple’s place of domicile. …

Under this rule, individuals of the same sex will be considered to be lawfully married under the code as long as they were married in a state whose laws authorize the marriage of two individuals of the same sex, even if they are domiciled in a state that does not recognize the validity of same-sex marriages.

Rev. Rul. 2013-17. “Valid somewhere, valid everywhere.”

• Section 7703 states various rules concerning application of tax rules to marriage and separation. Read it.

• What is the rule established by § 7703(a)(1)?

• What is the rule established by § 7703(a)(2)?

• What is the rule established by § 7703(b)?

• Section 2(a) defines “surviving spouse.” Read it.

Section 1(d) provides that married persons who do not file a single tax return jointly (i.e., they are “married filing separately”) must pay an income tax at the tax brackets specified.

Head of Household: Section 1(b) provides that a “head of household” must pay an income tax at the tax brackets specified.

• Section 2(b) defines “head of household.” Read it.

• Can a married person be a “head of household?”

• Can a surviving spouse be a “head of household?”

Unmarried Individuals: Section 1(c) provides that every unmarried individual – other than a surviving spouse or head of household – must pay an income tax at the tax brackets specified.

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C. Dependents

Section 151(a) entitles a taxpayer who is an “individual” to a deduction of an “exemption amount” for each “dependent,” § 151(c). In addition, a taxpayer who files “married filing jointly” may claim a deduction of the exemption amount for both himself/herself and his/her spouse. Reg. § 1.151-1(b) (third sentence, two exemptions allowed). A taxpayer who is married but does not file a joint return may claim a deduction of the exemption amount for a spouse who has no gross income and is not the dependent of another taxpayer, § 151(b). The “exemption amount” is a fixed amount per dependent, see § 151(d)(1), indexed for inflation, § 151(d)(4). A taxpayer may not deduct an “exemption amount” for any person for whom a dependency deduction is allowable to another taxpayer, § 151(d)(2).

Section 152 defines “dependent.”

• A dependent may not claim another as a dependent. § 152(b)(1).

• A spouse who files a joint return cannot be the dependent of another taxpayer. § 152(b)(2).

• A dependent must be a citizen, national, resident of the United States, or resident of a country contiguous with the United States. § 152(b)(3)(A). This limitation does not apply to an adopted child who has the same principal place of abode as a taxpayer and is a member of the taxpayer’s household, provided that the taxpayer is a citizen or national of the United States. § 152(b)(3)(B).

• A “dependent” must be either a “qualifying child” or a “qualifying relative.” § 152(a).

Qualifying Child: A “qualifying child” is an individual who meets certain requirements of relationship, place of abode, age, support, and filing status. § 152(c)(1).

Relationship: A “qualifying child” can be –

• a child of the taxpayer, § 152(c)(1), i.e., son, daughter, stepson, stepdaughter, or a foster child placed by an authorized placement agency or under court order (§ 152(f)(1)(A and C)) or a descendant of such an individual, § 152(c)(2)(A). Taxpayer’s legal adoption of a son, daughter, stepson, or stepdaughter renders a person a child of the taxpayer by blood. § 152(f)(1)(B).

• a brother, sister, stepbrother, or stepsister or a descendant of any such relative. § 152(c)(2)(B). This includes a half-brother or half-sister. § 152(f)(4).

Abode: A “qualifying child” must have “the same principal place of abode as the taxpayer for more than one-half” of the year. § 152(c)(1)(B).

• There are special rules when the “qualifying child” is the child of divorced parents. If the “qualifying child” receives over one-half of his/her support during the year from his/her parents (including as a parent’s contribution the contribution of a new spouse, § 152(e)(6)) who either –

• are divorced, § 152(e)(1)(A)(i),

• are separated under a written separation agreement, § 152(e)(1)(A)(ii), or

• live apart for all of the last six months of the calendar year, § 152(e)(1)(A)(iii),

and the child is in the custody of one or both of the parents for more than one-half of the calendar year, then the custodial parent (i.e., the parent having custody for the greater portion of the calendar year, § 152(e)(4)(A)), may claim the child as a dependent, unless

• The custodial parent executes a Form 8332 by which the custodial parent declares that he/she will not claim the child as a dependent, § 152(e)(2)(A), and

• The noncustodial parent attaches Form 8332 to his/her tax return. § 152(e)(2)(B).

• These special rules for divorced parents do not apply to any case where the child received over one-half of his/her support under a so-called “multiple support agreement.” § 152(e)(5).

Age: A “qualifying child” must be younger than the taxpayer (§ 152(c)(3)(A)) and –

• not yet 19 years old, § 152(c)(3)(i), unless

• the individual is permanently and totally disabled at any time during the year, § 152(c)(3)(B), or

• the child is a student who is not yet 24 years old, § 152(c)(3)(A)(ii). A “student” who is an individual who is a full-time student at an educational institution or is pursuing a full-time course of institutional on-farm training. § 152(f)(2).

Support: A “qualifying child” is one who did not provide more than one-half of his/her own support. § 152(c)(1)(D). Scholarships are not taken into account. § 152(f)(5).

Filing status: A “qualifying child” may not file a joint return other than for the purpose of claiming a refund with his/her spouse. § 152(c)(1)(E).

It can happen that two or more persons can claim the same “qualifying child” as a dependent. In such a case, the “qualifying child” is treated as the “qualifying child” of –

• a parent, § 152(c)(4)(A)(i):

• In the event that more than one parent can claim the “qualifying child” and the parents do not file a joint return, § 152(c)(4)(B), the child is the “qualifying child” of –

• the parent with whom the child resided the longest during the taxable year, § 152(c)(4)(B)(i), or

• if the child resided with each parent an equal amount of time, the parent with the highest adjusted gross income. § 152(c)(4)(B)(ii).

• In the event the child is a “qualifying child” with respect to a parent but no parent claims the “qualifying child”, another taxpayer may claim the child as a dependent if that taxpayer’s adjusted gross income is higher than the highest adjusted gross income of a parent. § 152(c)(4)(C).

• If the child is not a “qualifying” child as to a parent, the taxpayer with the highest adjusted gross income for whom the individual is a “qualifying child” may claim the child as a dependent. § 152(c)(4)(A)(ii).

Qualifying Relative: A “qualifying relative” is an individual who meets certain requirements of relationship, gross income, support, and status.

Relationship: A “qualifying relative” with respect to the taxpayer may be –

• a child or descendant of a child, § 152(d)(2)(A), i.e., son, daughter, stepson, stepdaughter, or a foster child placed by an authorized placement agency or under court order (§ 152(f)(1)(A and C)) or a descendant of such an individual, § 152(c)(2)(A). Taxpayer’s legal adoption of a son, daughter, stepson, or stepdaughter renders such a person a child of the taxpayer by blood. § 152(f)(1)(B);

• a brother, sister, stepbrother, or stepsister. 152(d)(2)(B). This includes a half-brother or half-sister. § 152(f)(4);

• a father or mother or ancestor of a father or mother; § 152(d)(2)(C);

• a stepfather or stepmother, § 152(d)(2)(D);

• a son or daughter of a brother or sister (i.e., nephew or niece), § 152(d)(2)(E);

• a brother or sister of the father or mother (i.e., uncle or aunt), § 152(d)(2)(F);

• a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law, § 152(d)(2)(G);

• an individual other than one who was at any time during the taxable year a spouse who for the taxable year has the same principal place of abode as the taxpayer and is a member of the taxpayer’s household. § 152(d)(2)(H).

• An individual is not a member of taxpayer’s household if at any time during the taxable year the relationship between the individual and the taxpayer is in violation of local law. § 152(f)(3).

Gross Income: The gross income of a “qualifying relative” may not be equal to or more than the exemption amount. § 152(d)(1)(B).

• The gross income of a permanently and totally disabled individual does not include income attributable to services rendered at a charitable institution that provides special instruction or training designed to alleviate the disability, § 152(d)(4)(B), and the individual’s principal reason for his/her presence there is the availability of medical care and the income arises only from activities at the institution incident to such medical care, § 152(d)(4)(A). § 152(d)(4).

Support: Taxpayer must provide over one-half of the individual’s support for the calendar year. § 152(d)(1)(C).

• An alimony payment that the recipient includes in his/her gross income is not counted as payment for support of a dependent. § 152(d)(5).

Multiple Support Agreements: If there is no taxpayer who contributed over one-half of an individual’s support, § 152(d)(3)(A),

• a taxpayer for whom the individual would otherwise have been a “qualifying individual,” § 152(d)(3)(B), and

• who contributed more than 10% of the individual’s support, § 152(d)(3)(C),

• may claim the individual as a dependent provided that all others who contributed more than 10% of the individual’s support file a declaration that they will not claim the individual as a dependent, § 152(d)(3)(D).

• The rules governing treatment of an individual whose parents are divorced that govern the individual’s abode apply as well to determinations between the parents with respect to support. § 152(e)(1).

Status: A “qualifying relative” may not be a “qualifying child” of the taxpayer or of any other taxpayer. § 152(d)(1)(D).

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• Information for Question 10: This lesson applies the law of 2008. The exemption amount in 2008 was $3500 per exemption. The phaseout of exemptions for taxpayers married filing jointly began at an AGI level of $239,950.

• Information for Question 11 The phaseout of § 68 is actually the return of a phaseout that existed prior to 2006. In tax years before 2006, the phaseout was what it is now. For tax years 2006 to 2009, Congress phased out the phaseout. First, there was a reduction of ⅓ of the phaseout and then ⅔ of the phaseout. Your answer to Question 11 should be A.

D. Intra-Family Transactions

In various sections, the Tax Code creates presumptions that the members of a family share a common interest and addresses that presumption.172

• We may choose to ignore every tax aspect of a transaction between family members. In many respects, § 1041 (discussed infra) has this effect.

• We may curtail the tax advantages of transactions where close relationships could lead to abuse.

• Read §§ 267(a)(1), 267(b)(1), 267(c)(2), 267(c)(4), 267(d).173

Consider:

1. Taxpayer owned Greenacre. Taxpayer’s adjusted basis in Greenacre was $25,000. Taxpayer sold Greenacre to his grandson for $15,000, its fmv.

• How much loss may Taxpayer deduct under § 165(a and c(2))? See §§ 267(a)(1), 267(b)(1), 267(c)(4).

• What is grandson’s basis in Greenacre? See § 1012.

• Now suppose that Grandson sold Greenacre to Clive for –

• $10,000. How much loss could Grandson deduct?

• $20,000. How much gain (loss?) must Grandson report? See § 267(d).

• $30,000. How much gain must Grandson report? See § 267(d).

• Have we seen this pattern of gain and loss recognition before?

• Would your answers be different if Taxpayer had sold Greenacre to his uncle? – grandmother? – nephew? – the daughter of his step-mother?

• Would your answers be different if Taxpayer had sold Greenacre to his wife? See § 1041.

IV. After Marriage: Tax Consequences of Divorce

Divorce renders husband and wife separate taxpayers with interests that should (at some point) no longer be presumed to be the same. Various rights and obligations may ensue, and their origins might be –

• ownership of property,

• a legal duty, or

• an agreement.

How should the source of a right or obligation affect its tax treatment?

We might suppose that the event of divorce should vest (or re-vest) each ex-spouse with property rights that can be bought and sold – with all of the tax consequences that should naturally flow from such transactions.

Should the event of divorce cause us to treat rights that can only exist between a husband and a wife as property that can be bought and sold in commercial transactions? How should we value such rights?174

United States v. Davis, 370 U.S. 65 (1962)

MR. JUSTICE CLARK delivered the opinion of the Court.

These cases involve the tax consequences of a transfer of appreciated property by Thomas Crawley Davis to his former wife pursuant to a property settlement agreement executed prior to divorce … The Court of Claims upset the Commissioner’s determination that there was taxable gain on the transfer … We granted certiorari on a conflict in the Courts of Appeals and the Court of Claims on the taxability of such transfers.175 We have decided that the taxpayer did have a taxable gain on the transfer …

In 1954, the taxpayer and his then wife made a voluntary property settlement and separation agreement calling for support payments to the wife and minor child in addition to the transfer of certain personal property to the wife. Under Delaware law, all the property transferred was that of the taxpayer, subject to certain statutory marital rights of the wife including a right of intestate succession and a right upon divorce to a share of the husband’s property. Specifically, as a “division in settlement of their property,” the taxpayer agreed to transfer to his wife, inter alia, 1000 shares of stock in the E. I. du Pont de Nemours & Co. The then Mrs. Davis agreed to accept this division “in full settlement and satisfaction of any and all claims and rights against the husband whatsoever (including but not by way of limitation, dower and all rights under the laws of testacy and intestacy). …” Pursuant to the above agreement, which had been incorporated into the divorce decree, one-half of this stock was delivered in the tax year involved, 1955, and the balance thereafter. Davis’ cost basis for the 1955 transfer was $74,775.37, and the fair market value of the 500 shares there transferred was $82,250. …

I

The determination of the income tax consequences of the stock transfer described above is basically a two-step analysis: (1) was the transaction a taxable event? (2) if so, how much taxable gain resulted therefrom? …

II

We now turn to the threshold question of whether the transfer in issue was an appropriate occasion for taxing the accretion to the stock. There can be no doubt that Congress, as evidenced by its inclusive definition of income subject to taxation, i.e., “all income from whatever source derived, including … [g]ains derived from dealings in property,” intended that the economic growth of this stock be taxed. The problem confronting us is simply when is such accretion to be taxed. Should the economic gain be presently assessed against taxpayer, or should this assessment await a subsequent transfer of the property by the wife? The controlling statutory language, which provides that gains from dealings in property are to be taxed upon “sale or other disposition,” is too general to include or exclude conclusively the transaction presently in issue. Recognizing this, the Government and the taxpayer argue by analogy with transactions more easily classified as within or without the ambient of taxable events. The taxpayer asserts that the present disposition is comparable to a nontaxable division of property between two co-owners , while the Government contends it more resembles a taxable transfer of property in exchange for the release of an independent legal obligation. Neither disputes the validity of the other’s starting point.

In support of his analogy, the taxpayer argues that to draw a distinction between a wife’s interest in the property of her husband in a common law jurisdiction such as Delaware and the property interest of a wife in a typical community property jurisdiction would commit a double sin; for such differentiation would depend upon “elusive and subtle casuistries which … possess no relevance for tax purposes,” Helvering v. Hallock, 309 U.S. 106, 309 U.S. 118 (1940), and would create disparities between common law and community property jurisdictions in contradiction to Congress’ general policy of equality between the two. The taxpayer’s analogy, however, stumbles on its own premise, for the inchoate rights granted a wife in her husband’s property by the Delaware law do not even remotely reach the dignity of co-ownership. The wife has no interest – passive or active – over the management or disposition of her husband’s personal property. Her rights are not descendable, and she must survive him to share in his intestate estate. Upon dissolution of the marriage, she shares in the property only to such extent as the court deems “reasonable.” 13 Del. Code Ann. § 1531(a). What is “reasonable” might be ascertained independently of the extent of the husband’s property by such criteria as the wife’s financial condition, her needs in relation to her accustomed station in life, her age and health, the number of children and their ages, and the earning capacity of the husband. [citation omitted].

This is not to say it would be completely illogical to consider the shearing off of the wife’s rights in her husband’s property as a division of that property, but we believe the contrary to be the more reasonable construction. Regardless of the tags, Delaware seems only to place a burden on the husband’s property, rather than to make the wife a part owner thereof. In the present context, the rights of succession and reasonable share do not differ significantly from the husband’s obligations of support and alimony. They all partake more of a personal liability of the husband than a property interest of the wife. The effectuation of these marital rights may ultimately result in the ownership of some of the husband’s property as it did here, but certainly this happenstance does not equate the transaction with a division of property by co-owners. Although admittedly such a view may permit different tax treatment among the several States, this Court in the past has not ignored the differing effects on the federal taxing scheme of substantive differences between community property and common law systems. E.g., Poe v. Seaborn, 282 U.S. 101 (1930). To be sure, Congress has seen fit to alleviate this disparity in many areas, e.g., Revenue Act of 1948, 62 Stat. 110, but in other areas the facts of life are still with us.

Our interpretation of the general statutory language is fortified by the longstanding administrative practice as sounded and formalized by the settled state of law in the lower courts. The Commissioner’s position was adopted in the early 40’s by the Second and Third Circuits, and, by 1947, the Tax Court had acquiesced in this view. This settled rule was not disturbed by the Court of Appeals for the Sixth Circuit in 1960 or the Court of Claims in the instant case, for these latter courts, in holding the gain indeterminable, assumed that the transaction was otherwise a taxable event. Such unanimity of views in support of a position representing a reasonable construction of an ambiguous statute will not lightly be put aside. It is quite possible that this notorious construction was relied upon by numerous taxpayers, as well as the Congress itself, which not only refrained from making any changes in the statutory language during more than a score of years, but reenacted this same language in 1954.

III

Having determined that the transaction was a taxable event, we now turn to the point on which the Court of Claims balked, viz., the measurement of the taxable gain realized by the taxpayer. The Code defines the taxable gain from the sale or disposition of property as being the “excess of the amount realized therefrom over the adjusted basis. …” I.R.C. § 1001(a). The “amount realized” is further defined as “the sum of any money received plus the fair market value of the property (other than money) received.” I.R.C. § 1001(b). In the instant case, the “property received” was the release of the wife’s inchoate marital rights. The Court of Claims, following the Court of Appeals for the Sixth Circuit, found that there was no way to compute the fair market value of these marital rights, and that it was thus impossible to determine the taxable gain realized by the taxpayer. We believe this conclusion was erroneous.

It must be assumed, we think, that the parties acted at arm’s length, and that they judged the marital rights to be equal in value to the property for which they were exchanged. There was no evidence to the contrary here. Absent a readily ascertainable value, it is accepted practice where property is exchanged to hold, as did the Court of Claims in Philadelphia Park Amusement Co. v. United States, 126 F. Supp. 184, 189 (1954), that the values “of the two properties exchanged in an arms-length transaction are either equal in fact or are presumed to be equal.” Accord, United States v. General Shoe Corp., 282 F.2d 9 (CA6 1960); International Freighting Corp. v. Commissioner, 135 F.2d 310 (CA 1943). To be sure, there is much to be said of the argument that such an assumption is weakened by the emotion, tension, and practical necessities involved in divorce negotiations and the property settlements arising therefrom. However, once it is recognized that the transfer was a taxable event, it is more consistent with the general purpose and scheme of the taxing statutes to make a rough approximation of the gain realized thereby than to ignore altogether its tax consequences. [citation omitted].

Moreover, if the transaction is to be considered a taxable event as to the husband, the Court of Claims’ position leaves up in the air the wife’s basis for the property received. In the context of a taxable transfer by the husband, all indicia point to a “cost” basis for this property in the hands of the wife. Yet, under the Court of Claims’ position, her cost for this property, i.e., the value of the marital rights relinquished therefor, would be indeterminable, and, on subsequent disposition of the property, she might suffer inordinately over the Commissioner’s assessment which she would have the burden of proving erroneous, Commissioner v. Hansen, 360 U.S. 446, 468 (1959). Our present holding that the value of these rights is ascertainable eliminates this problem; for the same calculation that determines the amount received by the husband fixes the amount given up by the wife, and this figure, i.e., the market value of the property transferred by the husband, will be taken by her as her tax basis for the property received.

Finally, it must be noted that here, as well as in relation to the question of whether the event is taxable, we draw support from the prior administrative practice and judicial approval of that practice. We therefore conclude that the Commissioner’s assessment of a taxable gain based upon the value of the stock at the date of its transfer has not been shown erroneous.

IV

….

Reversed in part and affirmed in part.

Notes and Questions:

1. What answer did the Court give to the question posed at the outset of this section of the text, i.e., the effect of the source of a right or obligation on its tax consequences?

2. There are some rights or interests for which there is simply no market. When a transaction entailing those rights or interests must occur, there is nowhere to look to determine the value of those rights or interests. How did the Court deal with these valuation problems?

___

Section 1041: Does § 1041 create opportunities to save divorcing spouses income taxes? What if the tax brackets of the divorcing spouses are not going to be the same?

___

3. In the second-to-last paragraph of the case, how does the Court implicitly treat the exchange that Mrs. Davis made? What should be the basis of her “inchoate marital rights?”

4. Congress responded to Davis.

• Read § 1041. The division of property between divorcing spouses is now a non-recognition event.

• How would the result in Davis have been different if § 1041 were the law at the time the case was decided?

• In what ways does § 1041 differ from § 1015?

5. The “law” imposes various duties upon persons. The source of a duty may be a relationship. For example, a parent may have a duty to provide “necessaries” for his/her minor child.

• If a parent fails in that duty and a third person steps up and pays money to fulfill that duty, does the parent realize gross income?

• If a family member has a duty to another that requires some payment of money to fulfill, should such payment give rise to a deduction?

• What answers do cases such as Flowers, Hantzis, Smith, and Ochs imply?

• Consider –

Gould v. Gould, 245 U.S. 151 (1917)

MR. JUSTICE McREYNOLDS delivered the opinion of the Court.

A decree of the Supreme Court for New York County entered in 1909 forever separated the parties to this proceeding, then and now citizens of the United States, from bed and board, and further ordered that plaintiff in error pay to Katherine C. Gould during her life the sum of $3000 every month for her support and maintenance. The question presented is whether such monthly payments during the years 1913 and 1914 constituted parts of Mrs. Gould’s income within the intendment of the act of Congress approved October 3, 1913, 38 Stat. 114, 166, and were subject as such to the tax prescribed therein. The court below answered in the negative, and we think it reached the proper conclusion.

….

In Audubon v. Shufeldt, 181 U.S. 575, 577-578, we said:

“Alimony does not arise from any business transaction, but from the relation of marriage. It is not founded on a contract, express or implied, but on the natural and legal duty of the husband to support the wife. The general obligation to support is made specific by the decree of the court of appropriate jurisdiction. … Permanent alimony is regarded rather as a portion of the husband’s estate to which the wife is equitably entitled than as strictly a debt; alimony from time to time may be regarded as a portion of his current income or earnings. …”

The net income of the divorced husband subject to taxation was not decreased by payment of alimony under the court’s order, and, on the other hand, the sum received by the wife on account thereof cannot be regarded as income arising or accruing to her within the enactment.

The judgment of the court below is

Affirmed.

Notes and Questions:

1. What basis of the obligation to pay alimony does the Court recognize?

2. The holding in Gould was the rule until World War II. At that time, tax brackets increased so much that many men came out below $0 when they paid alimony and the income tax on the alimony. Congress acted.

3. Read § 61(a)(8), § 71, § 215, and § 62(a)(10).

• Does it not seem – at least implicitly – that the source of a duty to pay alimony is no longer law or morals but rather agreement (or quasi-agreement)?

A. Alimony and Property Settlement

A property settlement divides marital property – assets as well as debts. Presumably, the spouses purchased assets with after-tax dollars and so its allocation to one spouse or the other should not be the occasion for another layer of income tax.

• What role does § 1041 play in a property settlement?

• Does the rule of § 1041 suggest how parties might agree to divide property in which there is unrealized loss? – unrealized gain?

Alimony is an allowance that one party pays the other for maintenance and support. The Code treats alimony as income to the recipient and deductible to the payor. It is income that only one ex-spouse receives and so pays income tax on, the marital union having been dissolved. When the tax brackets of the parties are different, there is an opportunity to “enlarge the pie.” If the pie is larger, then each can have a bigger slice.

Consider: H’s tax bracket is (going to be) 35%. W’s tax bracket is (going to be 10%). W wants to receive $100 that is not subject to tax.

• To satisfy W’s wishes, how much before-tax income will this cost H?

• If W is willing to pay the income tax on some amount so long as she is left with $100, what is the minimum amount she could accept?

• What is the range within which the parties should settle, assuming that H can deduct whatever payment he makes, and W must include that amount in her gross income?

You should see that characterization of transfers between divorcing spouses presents an opportunity to “enlarge the pie” at the expense of the Treasury. Divorcing spouses may agree between themselves to require payments that they label “alimony” that in fact more accurately represent a division of marital property. And of course, the ex-spouse who makes a payment may simply wish to claim a deduction – irrespective of the source of his/her obligation to make the payment. For these reasons, Congress enacted § 71 to set the parameters of what is and what is not “alimony.”

Section 71(b) sets forth the elements of “alimony.” They are –

• a payment in cash

• received by or on behalf of a spouse under a divorce or separation instrument

• that does not designate a payment as not includible in the gross income of the recipient and not allowable as a deduction for the payor.

• An individual legally separated from his spouse under a decree of divorce or separate maintenance cannot together with his spouse be members of the same household at the time of making a payment.

• There can be no liability to make any payment (or a substitute for payment) after the death of the payee spouse.

If any one of these elements is not present, a payment is not “alimony.” The tone of § 71(b) seems strict, but in fact the parties have considerable discretion to label a payment “alimony” or not. The third condition enables them to designate in the divorce or separation instrument whether a payment is alimony.

Excess front-loading is a characteristic of what parties may label as alimony that is in fact a property settlement. It refers to the phenomenon of an obligor undertaking to meet most of a property settlement obligation over a very few years. Alimony does not have the characteristic of terminating after only a few years.

• Performance of obligations under a property settlement would usually occur relatively quickly after the divorce.

• An alimony obligation, on the other hand, may last a long time.

• If a divorce or separation agreement requires very high payments for a short period followed by greatly reduced payments, it is likely that the parties are trying to make a property settlement appear to be alimony.

• The phrase for this phenomenon is “excess front-loading of alimony payments.”

The Code adopts a mechanical176 approach to identifying whether payments are alimony or property settlements. § 71(f). The Code takes a “wait-and-see” approach, allowing the parties to characterize payments as “alimony” for three tax years and requiring “recapture” only if “excess front-loading” actually occurred.

Section 71(f)(1)(A) states that if there are excess alimony payments, the payor spouse must include such excess in the third post-separation year and the payee spouse may deduct such excess from his/her adjusted gross income. § 71(f)(1). Section 71(f)(2) defines “excess alimony payments” to be “excess payments” for the first post-separation year plus “excess payments” for the second post-separation year.

• The first post-separation years” means the first calendar year in which the payor spouse actually paid to the payee spouse alimony or separate maintenance payments. § 71(f)(6). The second and third post-separation years are the first and second succeeding years. Id.

• Computation of the excess payments for the first post-separation year requires that taxpayer know what the excess payment is for the second post-separation year. See § 71(f)(3).

Excess alimony payments for the second post-separation year: Excess alimony payments for the second post-separation year are (§ 71(f)(4)) –

(alimony or separate maintenance paid during 2nd post-separation year) MINUS [(alimony or separate maintenance paid during 3rd post-separation year) + $15,000]

Excess alimony payments for the first post-separation year: Excess alimony payments for the first post-separation year are (§ 71(f)(3)) –

(alimony or separate maintenance payments paid during 1st post-separation year) MINUS [(alimony or separate maintenance paid during 2nd post-separation year) MINUS (excess payment for 2nd post-separation year) PLUS (alimony or separate maintenance paid during 3rd post-separation year)/2 + $15,000]

• There are no “excess alimony payments” if either spouse dies before the close of the third post-separation year or if the payee spouse remarries before the close of the third post-separation year and the payments cease by reason of such death or remarriage. § 71(f)(5)(A).

• The term “alimony” for purposes of these calculations does not include any payment to the extent it is made pursuant to a continuing liability over not less than three years to pay a fixed portion of income from a business, property, or compensation (whether as employee or as self-employer). § 71(f)(5)(C).

• Payments made pursuant a decree requiring payments for support or maintenance, but not pursuant to a decree of divorce or separate maintenance or incident to such a decree, are not “alimony or separate maintenance” for purposes of these calculations. § 71(f)(5)(B) (referencing § 71(b)(2)(C)).

Section 71(f) focuses on how precipitously alimony or separate maintenance payments decline from the first post-separation year to the second post-separation year and from the second post-separation year to the third post-separation year. Some other matters to notice or consider:

• Excess front-loading only occurs with respect to alimony payments that the payor actually makes, not those that s/he may owe.

• The definition of first “post-separation years” is the first calendar year “in which the payor spouse paid to the payee spouse[.]” § 71(f)(6). If payment obligations are monthly and the payor spouse makes the first payment late in the year, the first year payment may in fact be quite small.

• The numbers work out so that if the decrease from the first to second post-separation years is $7500 or less and the decrease from the second post-separation to the third post-separation years is $15,000 or less, there is no excess front-loading problem.

• There will always be an excess front-loading problem if the decrease from the second to the third post-separation year is more than $15,000.

• For every $1 difference between the first and second post-separation years in excess of $7500, the difference between the second and third post-separation year must be reduced by $2 to avoid an excess front loading recapture income/deduction problem.

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Do the CALI Lesson Basic Federal Income Taxation: Gross Income: Alimony and Alimony Recapture

B. Child Support

Child support represents the fulfillment of a parental obligation. Both parents have this obligation. Fulfillment of this obligation does not create any right to a deduction, but only to a dependent deduction of the exemption amount. The same is true after dissolution of the marriage. The Code has some special rules for allocation of the dependent deduction in its definitions of “qualifying child” and “qualifying relative,” supra. Furthermore, receipt of child support payments is not gross income to the payee. See § 71(c)(1).

Taxpayer may try to exploit the treatment of alimony and so characterize child support payments as alimony. The Code has some rules for identifying a portion of payments the parties may label as alimony that are in fact child support. § 71(c)(2) (carryout ¶). A characteristic of child support is that its amount should decrease (or disappear) on certain occasions in the child’s life, notably attaining a certain age. Thus –

• if the divorce instrument specifies that payments will be decreased on the happening of a contingency relating to the child (e.g., attaining a certain age, marrying, dying, leaving school (as well as leaving the spouse’s household or gaining employment, Reg. § 1.71-1T(c) (Q&A 17)), then the amount of the decrease will be treated as child support. § 71(c)(2)(A).

• if the divorce instrument specifies that payments will be decreased at a time “which can clearly be associated with a contingency” of the sort just noted, then the amount of the decrease will be treated as child support. § 71(c)(2)(B).

• Reg. § 1.71-1T(c) (Q&A 18) creates presumptions about whether a reduction occurs “at a time which can clearly be associated with the happening of a contingency relating to a child of the payor[.]” Rebuttal of either presumption may occur “by showing that the time at which the payments are to be reduced was determined independently of any contingencies relating to the children of the payor.” For example, a presumption may be rebutted “by showing that alimony payments are to be made for a period customarily provided in the local jurisdiction, such as a period equal to one-half the duration of the marriage.”

• Payments that are to be reduced not more than six months before or after attaining the age of 18, 21, or the local age of majority are presumptively “clearly associated with the happening of a contingency relating to a child of the payor.”

• This presumption is conclusively rebutted by showing that the “reduction is a complete cessation of alimony or separate maintenance payments during the sixth post-separation year … or upon the expiration of a 72-month period.” Id.

• Payments that are to be reduced on two or more occasions which occur not more than one year before or after a different child of payor spouse attains an age between 18 and 24 are presumptively “clearly associated with the happening of a contingency relating to a child of the payor.”

When reading the following case and revenue ruling, consider whether you feel the issues are resolved correctly – and why.

Faber v. Commissioner, 264 F.2d 127 (3rd Cir. 1959)

BIGGS, Chief Judge.

This case comes before us on a petition to review a decision of the Tax Court, 1958, 29 T.C. 1095. The issue presented is: Is the taxpayer, Faber, entitled to deduct under § 23(u) [now §§ 215/62(a)(10)], Internal Revenue Code of 1939, a portion of an annual $5,000 payment, made to his divorced wife, Ada, namely $2,700, designated in the separation agreement incorporated in the divorce decree for the support of his divorced wife’s son?

The taxpayer and his wife, Ada, were divorced in 1952. The former Ada Faber had been previously married and had a son by this former marriage, William Black, who adopted his stepfather’s surname but was never legally adopted by his stepfather. The taxpayer and his wife entered into a separation agreement which was made part of the final decree of divorce. The agreement provided in pertinent part:

‘The Husband covenants and agrees to pay to the Wife in settlement of her property rights and the obligation of the Husband for her future care, support and maintenance, and for the care of the Wife’s child, William, the sum of Fifty-five thousand dollars ($55,000), payable Five thousand dollars ($5,000) annually, beginning the first day of January, 1952, to and including the first day of July, 1962, or for a period of eleven years. * * * …

‘Said payment or payments are to be allocated Two thousand three hundred dollars ($2,300) annually for the Wife, and Two thousand seven hundred dollars $(2,700) annually for the support and care of his Wife’s son, William.

‘In the event that the Wife or her son die before all payments have been made, then the allocated part of the payment, as above set forth, shall cease, and the future payments reduced, and the estate of the one so dying shall have no claim against the Husband for future ‘payments’.’ .

The taxpayer paid Ada $5,000 in 1952. He deducted the $5,000 as an alimony payment in his individual tax return for that calendar year. The Commissioner allowed $2,300 but disallowed the remaining $2,700 as a deduction on the ground that this amount represented ‘payment for care, support and maintenance of William Faber, under § 23(u) of the Internal Revenue Act of 1939.’

The pertinent statutory provisions of the Internal Revenue Code of 1939 are set out in the footnote.177

Whether the taxpayer may deduct, under § 23(u), the amount of any payment to his wife depends on whether the payment is properly includible in the wife’s income under § 22(k) [now § 61(a)(8)]. Eisinger v. C.I.R., 9 Cir., 1957, 250 F.2d 303, cert. denied, 1958, 356 U.S. 913.

The taxpayer contends that the second sentence of § 22(k) is exclusionary in effect and meaning and that William Faber is not within the classification of ‘minor child.’ We agree. William was a stepchild of the taxpayer and was not the taxpayer’s child.178 But it does not follow, as the taxpayer contends, relying on our decision in Feinberg v. C.I.R., 3 Cir., 1952, 198 F.2d 260, that since the exception contained in the second sentence of § 22(k) does not apply, the full amount of $5,000 automatically must be included in the wife’s income and hence must be deducted from the husband’s. The Feinberg decision does not support the taxpayer’s view for if the whole payment is to be considered as income to the wife the requirements of the first sentence of § 22(k) must be satisfied independently. The Feinberg decision does not hold that those requirements do not have to be met. The second sentence of § 22(k) deals only with one specific type of payment which is not includible in the wife’s income.

It remains to be determined whether under the first sentence of 22(k) the entire $5,000 should constitute income to Ada Faber. The Tax Court has concluded that ‘the amounts paid to William were purely voluntary on the part of the petitioner so far as this record shows, and therefore not within the intendment of Subsection 22(k).’ With this conclusion we cannot agree.

Suppose that in this case it was clear that Ada had the legal obligation to support William179 and the agreement had recited that the amount for William’s care was for and in Ada’s behalf. It would then be apparent that $2,700 would have been includible in Ada’s income and deductible from the taxpayer’s. Robert Lehman, 1951, 17 T.C. 652.180 Here, a recital to such effect is missing but the mere absence of the appropriate language from the agreement does not resolve the issue and it becomes pertinent to inquire whether the payment of the $2,700 was made for and in behalf of Ada. Relevant to this inquiry is the answer to the question whether Ada acquired an economic benefit of such nature that the payment may be said to be for and in her behalf. In Mandel v. C.I.R., 7 Cir., 1956, 229 F.2d 382, the taxpayer-husband agreed to pay his wife $18,000 a year, the separation agreement further providing that should she remarry, the payment would be reduced to … $10,000 a year, and that if a child, there being two children of the marriage, should marry, or on reaching 21 live apart from the wife, the husband could elect to pay directly to the child … $5,000 per year.

Before the tax years in question, Mandel’s wife remarried, and the two children of Mandel had married and were living apart from their mother, the wife. Mandel paid to his former wife amounts as specified in the separation agreement which she in turn paid to the two children. The court did not allow the taxpayer to deduct the amounts so paid, since the amounts were not income to the wife. The court stressed the point that, by the terms of the agreement and under the circumstances, the wife had received no economic or personal benefit from the payments made to her after her remarriage and the emancipation of the two children. ‘No legal obligation to support the children after they arrived at their majority was imposed upon Edna.’ 229 F.2d at 387. In the case at bar the existence of a legal obligation of the wife to support her son has been assumed by us to be present. Under this assumption aid in the satisfaction of Ada’s obligation by the payments of the separation agreement was for her benefit and hence was ‘for and in behalf of’ Ada. Lehman, supra, 17 T.C. at 653. That the payment also benefits another person, William, does not remove it from the ambiency of § 22(k). This payment was made in discharge of a legal obligation, which because of the ‘marital or family relationship,’ was incurred by the taxpayer. Lehman, supra. Cf. Treasury Regulations 118, 39.22(k)-1(a)(5). Accordingly, under this assumption, the entire $5,000 would be includible in Ada’s income.

….

Merely because Ada’s obligation, if it exists, may be limited to the providing of necessaries for William, it does not follow that only the amount required for necessaries is to be includible in her income. The provisions of § 22(k) do not limit includible alimony payments to the wife to necessaries and we cannot say that payments to another person on her behalf should be so limited. While Ada may not be legally responsible for more than necessaries, it may still be to her economic advantage to have funds supplied which exceed the legally required amount. We cannot say that the payment is so large that it becomes unrelated to the economic advantage which is Ada’s by virtue of the payment of $2,700 made for William.

….181

Accordingly, the decision of the Tax Court will be vacated and the case remanded in order to determine whether Ada had, in the Tax year in question, an obligation to support her son William. If it be found to be a fact that Ada had such an obligation, the Tax Court should enter its decision in favor of the taxpayer. If it be found that Ada had no such obligation the Tax Court should again enter its decision in favor of the Commissioner. [citations omitted].

Notes and Questions:

1. A parent has some obligation to support his/her minor children. If someone else fulfills that obligation, it seems that the parent has realized gross income. When that “someone” is a former spouse, the former spouse may treat it as alimony – provided all of the other elements of alimony are present.

2. What were the distinguishing facts in Mandel that made the result in that case different?

3. Change the facts of Faber: instead of a person with no parental obligation making payments, it is a person with a parental obligation who fails to make payments (an all-too-frequent occurrence). It is the former spouse who must make up the difference.

Rev. Rul. 93-27
ISSUE

Is a taxpayer entitled to a nonbusiness bad debt deduction under § 166(a)(1) of the Code for the amount of the taxpayer’s own payment in support of the taxpayer’s children caused by an arrearage in court-ordered child support payments owed by a former spouse?

FACTS

The taxpayer, A, was divorced in 1989 from B and was granted custody of their two minor children. Pursuant to a property settlement and support agreement that was incorporated into the divorce decree, B agreed to pay to A $500 per month for child support. During 1991, B failed to pay $5,000 of this obligation. Because of B’s arrearage, A had to spend $5,000 of A’s own funds in support of A’s children.

LAW AND ANALYSIS

Section 166(a)(1) of the Code allows as a deduction any debt that becomes worthless within the taxable year.

Section 166(b) of the Code provides that for purposes of § 166(a), the amount of the deduction for any worthless debt is the adjusted basis provided in § 1011 for determining the loss from the sale or other disposition of property.

Section 1011 of the Code generally provides that the adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, is the basis as determined under § 1012.

Section 1012 of the Code provides that the basis of property is the cost of the property.

In Swenson v. Commissioner, 43 T.C. 897 (1965), the taxpayer claimed a bad debt deduction under § 166(a)(1) of the Code for an uncollectible arrearage in child support payments from a former spouse. The Tax Court denied the deduction on the ground that § 166(b) precluded any deduction because the taxpayer had no basis in the debt created by the child support obligation. The taxpayer had argued that her basis consisted of the expenditures for child support she was forced to make from her own funds as a result of the father’s failure to make his required payments. The court pointed out, however, that the father’s obligation to make the payments had been imposed by the divorce court and was not contingent on the taxpayer’s support expenditures. It stated that those expenditures neither created the arrearage nor constituted its cost to the taxpayer. Swenson, at 899.

The Tax Court has followed the decision in Swenson on similar facts in Perry v. Commissioner, 92 T.C. 470 (1989); Meyer v. Commissioner, T.C.M. 1984-487; Pierson v. Commissioner, T.C.M. 1984-452; and Diez-Arguellos v. Commissioner, T.C.M. 1984-356.

In the present case, as in those above, B’s obligation to make the child support payments to A was imposed directly by the court. A’s own child support expenditures did not create or affect B’s obligation to A under the divorce decree. Accordingly, A did not have any basis in B’s obligation to pay child support, and A may not claim a bad debt deduction under § 166(a)(1) of the Code with regard to an arrearage in those payments.

….

HOLDING

A taxpayer is not entitled to a bad debt deduction under § 166(a)(1) of the Code for the amount of the taxpayer’s own payment in support of the taxpayer’s children caused by an arrearage in court-ordered child support payments owed by a former spouse.

Notes and Questions:

1. A problem for “A” is that she wants a deduction but no other taxpayer realizes an equal amount of gross income.

• If the Commissioner determined that B should include $5000 in his gross income, should a court uphold the Commissioner’s position?

2. Aside from the technical requirements of § 71(f), is there any way that “A” could argue that she has paid “B” alimony by paying to support his children? If so, could the parties draft a sufficiently limited decree (“contingent alimony?”) that called for such treatment in the event he does not pay?

3. Could taxpayer or the Commissioner invoke the principles of § 7872(a)(1) and hypothesize a transfer from B to A and a retransfer from A to B?

• The transfer from B to A would be non-deductible child support.

• The retransfer from A to B would be a payment of alimony, deductible to A and taxable income to B.

4. Should the failure of one ex-spouse to make child support payments to other ex-spouse be a matter for the IRS? One suspects that IRS involvement might lead to fewer child support arrearages.

Wrap-Up Questions for Chapter 8

1. The basis of Davis was that taxpayer’s wife’s interest partook “more of a personal liability of the husband than a property interest of the wife.” Hence, taxpayer merely fulfilled his obligation by giving up appreciated property – a recognition event. Was Congress right to reverse the holding?

2. Mr. Davis would have benefited from § 1041. Exactly how does § 1041 affect Mrs. Davis’s basis in her inchoate marital rights?

3. Dissolution of marriage is a matter of state law. Often, the Code yields to state law in such matters as status, property ownership, and legal duties. Why should the Code (so forcefully) intervene in determining whether payments between ex-spouses are alimony, child support, or property settlement?

4. Can you argue that the holding of Revenue Ruling 93-27 is incorrect?

5. What should happen if H and W jointly own all of the stock of a corporation that owns a McDonald’s franchise. They divorce. McDonald’s does not allow divorced spouses to own jointly a franchise. As part of their property settlement, H and W agree that the corporation will redeem W’s stock. For this, W must pay tax on the gain. In reaching this agreement, the parties carefully considered its tax consequences. Specifically, a large chunk of cash would go to W, and she would pay income tax at the capital gains rate – much lower than the tax rate on ordinary income. W decides not to pay the tax on the gain and to argue in court that the corporation, a third party, was paying the property settlement obligation of H. Hence, he should be subject to income tax on dividend income. What result? See Arnes v. United States, 981 F.2d 456 (9th Cir. 1992) and Commissioner v. Arnes, 102 T.C. 522 (1994). What is the effect of Reg. § 1.1041-2(c)?


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