Chapter 17 p.983
Taxation and the Family
The fundamental issue presented in this chapter is: Who is the proper taxpayer to report certain income for federal income tax purposes?
Why is this question important for federal income tax purposes? Because of progressive rate of income taxation. Cf., Code §1.
The fundamental tax objective in this context:
to preclude an (inappropriate) deflection or “assignment of income” to another taxpayer.
Moderating the Progressive Tax Rate
This can be achieved by “income splitting.”
Query: How is the deflection of income to another taxpayer accomplished to moderate the impact of the marginal income tax rate?
Gross income for FIT purposes can shift:
within a family unit (i.e., individuals), or
among controlled entities and owners.
Note, however, §1(g) providing for unearned income of minor children to be taxed at parents’ marginal tax rate. The “kiddie tax.” P.1025.
Tax “Common Law”
Lucas vs. Earl p.983
Services income. Before availability of joint tax return filing - could he contract with his wife for her to receive 1/2 of his income and, therefore, each spouse would separately report 1/2 of his total gross income from salary/fees?
Held: Income is taxable to that person earning the wages (and not to the “legal” owner for local property law purposes). No “anticipatory assignment” of income was permitted there.
Was this a U.S. constitutional law case? Why?
Community Property & Income Splitting p.984
Poe v. Seaborn: spouses in community property state made separate income tax returns with each reporting one-half of their total income.
IRS says this income is all his for tax reporting.
Conclusion: income allocation here is governed by state (community) property law & wife has a vested right in ˝ of the community property.
IRS asserts husband’s power of management.
Here: husband’s earnings were community property income (1/2 wife’s) from the inception.
After Poe v. Seaborn
An advantage was provided to community property jurisdictions - since splitting of the income enabled two “runs up the bracket ladder” for federal income tax purposes.
Seaborn was a statutory case, not a constitutional case, but should it have been rejected by U.S. Congress?
Should other states adopt a community property system?
After Poe v. Seaborn
Eventual result (1948):
Joint income tax return for spouses – enabling equal splitting of income and two runs up the income tax bracket ladder.
Relevance of Code §66 – treatment of community property income where spouses live apart & no joint return – all income to one spouse.
What if spouses live together but he does not disclose all his community income? Innocent spouse provision - §6015.
Gratuitous Performance of Services p.989
Should the providing of gratuitous services to another produce imputed income to the donor?
1) Parent provides investment assistance to child? And, also bookkeeping/computer record keeping assistance? And, parent prepares the child’s federal income tax return? Child-care?
2) What if free (entertainment) services directly provided by a famous entertainer at a charity event? Or, at a political event?
Enactment of the Joint Return Provision p.990
Code §1(a) – enables the filing of a joint income tax return by married individuals.
Objective: Twice the income tax on one-half of the total spousal income on the return.
This enables taxpayers in both common law and community law jurisdictions to be treated similarly for FIT purposes.
And, this enables common law states to not enact community property regimes.
Note §66 - separated community prop. spouses
Determining Marital Status p.993
Are common law (opposite sex) marriages recognized for tax purposes? What is state law relevance in this context?
Windsor case, U.S. Sup. Ct. (2013), Estate tax.
Invalidation of DOMA (violation of the equal protection clause in U.S. Constitution, 14thAm).
Same-sex marriages are recognized for Federal tax (estate tax) purposes. See Rev. Rul. 2013-17 (below) and Notice 2013-61 re over-collected FICA taxes & refunds.
Rev. Rul. 2013-17
Same sex marriages are recognized for federal tax purposes. DOMA is dead (Windsor).
Marital status is based on where the marriage was established. This status is to be recognized for federal tax purposes in other jurisdictions. The “full faith and credit” clause of U.S. Constitution (Art. 4) impacts the determination.
Marital status for tax purposes is not available for (state law) registered domestic partnerships.
(or Bonus) p.999
1948 enactment of joint return opportunity.
Twice the tax on one-half of the joint income.
But, then a “marriage penalty” for couples where each spouse had a similar amount of income – compared to non-marrieds filing.
Does this provide an incentive to two high income earners to “live in sin” for tax planning reasons? Is this a benefit for (unmarried) opposite or same sex couples where income levels are essentially equalized?
Married Filing Separate Income Tax Returns
Situations where the situation is useful for married persons to file separately:
- Separated but not divorced.
- To avoid joint & several liability on the federal income tax return. One spouse has undisclosed income - but does the “innocent spouse” provision apply? See Code §6015.
- To enable one spouse to use deductions above the floor for medical expenses (7˝% or 10%) or casualty losses (10%).
Mapes v. U.S.,
What is the “marriage penalty”?
Is the marriage penalty “constitutional” as imposed through the FIT?
Re: Equal protection and due process clauses.
Notation in the case: Disparities will exist no matter how the rates are structured. P.1007.
Held: Equal protection & due process clauses of U.S. constitution are not violated.
Tax rate structure held to be reasonable.
Deduction was previously enacted (§221) to provide limited relief in the marriage penalty context.
This provision was repealed in Tax Reform Act of 1986.
Substantial relief is presently accomplished indirectly through much flatter income tax rates.
Self-help & Boynter case
& Rev. Rul. 76-255 p.1013
Were the parties married for federal income tax purposes on the relevant date (i.e., year-end – Code §7703(a) –redesignated from §143(a)(1))?
Divorced (in Carribbean) at year-end (twice), and then remarried early in next calendar year.
Tax Court: Concluded home state (Md.) would not recognize foreign divorce and treated as married (and no certification to Md. high Ct.).
4th Cir.: “Sham transaction” doctrine applies.
Remanded to Tax Ct. for fact determination.
U.S. v. Harris Criminal
Convictions revd. p.1019
Tax evasion criminal convictions for two sisters receiving “gifts” from an older man. §102?
Gift tax returns filed by the man, but only for small amounts. How prove criminal intent by the recipients on their failure to report “gifts” as income for FIT purposes? What is her belief re the purpose of this payment?
Court says donor’s letters should have been permitted into evidence. Too much uncertainty for a criminal conviction here? How establish tax criminality?
Income of Minor Children
p.1025 Code §1(g)
Child has no personal exemption but a $500 standard deduction (§63(c)(5)(A)). Child must pay tax on the earned and unearned income above this minimum amount. Investment property can be shifted to children, including under TUTMA, without parent losing control.
Query: Should this property based income to the child be taxed at a lesser income tax rate?
Code §1(g) – minor child’s unearned income to be taxed at parent’s marginal income tax rate.
Income of Minor Children
Code §1(g) continued
Applies to unearned income of under 18
child (previously 14) and, in some situations, up to age 24 (where child’s earned income does not exceed ˝ of support). §1(g)(2).
Applies to all unearned income of the child,
whatever the source (not only from parent).
3) Can opt to include child’s income on the parent’s income tax return. Code §1(g)(7).
p. 1028 (& p.1094)
Prior discussion: Borrowing is not a realization event (§1001) – since no accession to wealth occurs when the borrowing proceeds are offset by the liability incurred for this debt.
Further, repayment of a debt is not a realization event and does not cause an accession to wealth (or a reduction of wealth) when the promissory note (marked “paid”) is received from the creditor in exchange for the cash delivered for payment of the note (i.e., no COD income). continued
Interest-free Gift Loans
Example: Loan from parent to child on a ten year no interest basis. Inquiry: Can the parent have no income and child receive the income?
1) Original funds transfer consists of (a) a loan
to the borrower, and (b) a note to the lender. If a term loan – measure the present value of all payments due vs. the principal amount of the loan. The excess (in the family context) will constitute a gift. A Code §102 excludible gift?
Interest-free Gift Loans
continued P. 1028
Income tax - Deemed interest payment
& receipt. The excess value will be OID to be economically realized as the debt matures. Result: OID income to the donor and accruing interest expense to donee (deductible interest?)
Timing - (a) for gift tax purposes – a gift
at commencement of transaction; §7872(d)(2); (b) for income tax - §7872(a)(2) provides for measurement of the gift amount as of the end of the current tax year.
Interest-free Gift Loans
Exceptions to OID Status
1) Small gift loan exception - §7872(c)(2) provides a $10,000 de minimis exception for gift loans between individuals. Not for loans to acquire income producing assets.
Loans not exceeding $100,000 - §7872(d).
Amount treated as transferred by the borrower to the lender at year’s end shall not exceed the borrower’s net investment income for the taxable year. Does this enable a $100,000 loan to help buy a personal residence?
Taxation within the family: A personal exemption deduction ($4,050 in 2017) is available to taxpayer, spouse and “dependents.” To be a dependent the taxpayer (e.g., parent) must provide more than one-half support for that other person.
That other person can not claim an exemption even if having income (less than ˝ of his support).
Standard deduction: $6,350 (2017) is available to the unmarried individual who does not claim itemized deductions; double for a couple. Additional amounts allowed for (1) individuals over age 65, and (2) blind individuals.
Objective of the standard deduction: eliminate income tax for a significant number of individuals. 2017 revision?
But, limitation on standard deduction amount ($500) for dependents. Code §63(c)(5).
Labor Income of the Child p. 1030
Code §73 provides that services income of a child are (for tax purposes) gross income to the child (and not to the parent).
What is the purpose of this provision?
Consider amounts to be paid to the child actor – but how paid when child is a minor?
Or, income from babysitting?
Transfers Incident to Divorce – Issues p.1030
1) Should transfers of property (including cash) from one divorced spouse to another cause realized ordinary income to the transferee?
2) Should such a transfer enable a tax deduction to the transferor (particularly if sourced from the transferor’s current income stream)?
3) Should a transfer of appreciated property from one spouse to another be treated as (a) a sale of property, and (b) the transfer of proceeds to the other spouse (with a §1012 tax basis)?
Separation and Divorce
§71 vs. §72 p. 1030
Bernatschke v. U.S. – Are “support payments” made? Husband provided a lump sum (equivalent to 1/3 his assets) to buy annuity contracts for departing wife. This 1/3 equated to a “dower” amount. An annuity contract was purchased (to limit her spending capability?).
Held: He provided her a lump sum amount and the annuity payments were not treated as periodic payments of alimony (not paid because of a marital “support” obligation). §72 applies.
Alimony & Child Support
Certain payments (alimony) after divorce:
- Income to the recipient (§71(a)), and,
- Deduction to the payor spouse (§215) - an “above the line” deduction (§62(a)(10)).
A federal definition of “alimony” applies to determine whether the payment constitutes §61 gross income to the recipient. See §71(b).
No deduction to the payor parent for child support payments made to the other ex-spouse.
Alimony Requirements §71(b) p.1039
1) Cash payments (not property transfers).
2) Termination of this obligation occurs at the death of the payee spouse. §71(b)(1)(D).
3) No excessive front-loading. §71(f). P.1039.
4) No disguised child support. §71(c). Note the “deadbeat dad” treatment. §71(c)(3).
5) Parties are not living in the same household. §71(b)(1)(c).
Under §71(b)(1)(B) the parties can opt out of alimony tax status (and agree on no deduction).
Indirect Alimony Payments
H pays (in cash):
(1) W’s mortgage payments on her residence (paid directly to the lender bank); and,
(2) Premiums on a life insurance policy on his life (paid to the insurer) & she owns the policy.
Result: Taxable alimony to her if she owns
(1) the house and/or (2) the life insurance policy, even though she does not receive the funds.
Remember: Old Colony Trust Co. case.
Planning for Income Tax
Wife is to receive alimony (includible in her gross income) and the payment is deductible by Husband.
She wants a tax-free amount. How gross-up?
Consider the Old Colony case and the “pyramiding” problem.
But, must she still file an income tax return to reflect that alimony is includible in her gross income for tax purposes?
Child Support Obligations
Child support is (1) not deductible by the payor and (2) not gross income to payee (custodian?).
How define “child support”?
See Code §71(c)(2) concering a payment having a contingency relating to the child (e.g., reduction when reaching age 18) being treated as child support.
Transfers in Divorce
Property transfer to ex-spouse of appreciated property in divorce context (in exchange for a “release”) is a gain recognition event to the property transferor, i.e. a “sale or exchange.” How value this transaction? Are the rights given up equal to the property transferred?
What is the income tax treatment to the other party who is acquiring property? Fn.7, p.1045.
What tax basis for that property to transferee?
What did that person transfer in the exchange?
Farid es Sultaneh
Her tax basis? p.1046
He transferred appreciated shares to her in contemplation of marriage. An ante-nuptial agreement was concluded for gift (after stock transfer) where she released (any) dower rights.
What tax basis when she sells (for $19) shares transferred to her? 15 cents or $10 per share?
Held: She took the shares as a purchaser.
What did she sell? Gain treatment to her?
What did he sell? Gain treatment to him?
Dissent: He was married to another when gift.
Code §1041 p.1051
§1041 provides for: (1) no recognition to the transferor on a property transfer in divorce (or marriage); and, (2) a transferred tax basis for the property when held by the recipient.
Further, no deduction is available for the property transfer to the other (ex)spouse.
Limits on §1041 – see Rev. Rul. 87-112 re no tax-free transfer of accrued interest income.
Does the Davis case analysis survive the enactment of §1041? Yes, outside divorce.
Property Division Transfers – Example
H and W together own investment properties:
1) W receives Property One – 60x tax basis and 100x fair market value (appreciated).
2) H receives Property Two – 140x tax basis and 100x fair market value (depreciated).
Equal property division on a pre-tax basis (but not on an after-tax basis).
What happens when they sell these properties? Consider the impact of §1041.
Problem 5, p. 1053
J & M not married for federal tax purposes. Davis case analysis applies to property division.
Blackacre – 60x basis; 30x basis for each ˝.
J’s stock – 40x basis.
Stock to M; J – gets land; fmv 100x for each.
Step 1: M exchanges ˝ stock for ˝ of J’s stock & 20x gain (50x FMV & 30x basis) and then 50x basis for ˝ stock.
Step 2: J transfers remaining ˝ stock & Davis gain of 30x & M takes stock with 50x basis.