WHOSE INCOME IS IT?
General:
Issues arise b/c of progressive taxation –people want to push income to low bracket taxpayers
Much of law in this area is case law or administrative (Rev. Rulings) not statute
It is difficult to shift income without giving up the property
You cannot shift income received from services received under same agreement.
The one area where income can be shifted, is divorce or separation (alimony).
I – THE TAXABLE UNIT:
I-A. TAXATION OF THE FAMILY:
Marriage penalty:
“Marriage penalty” is a tax penalty on 2-earner married couples by taxing them at a higher rate than unmarried individuals earning the same amount.
Policy that a married couple must file a joint return unless they elect to file separately (limitations apply with MFS)
Difficult if not impossible to treat everyone alike with progressive system that requires married individuals to combine their incomes – therefore the tax system is adjusted to make it more or less advantageous to being married vs. unmarried
Assumption under IRS is that married individuals share their income, 2 people earn together less [474].
2001 Tax Relief Act – attempt to relive “marriage penalty” starting in 2005 and completely eliminated in 2008 or 2009
DRUKER [467] (1982)
Marriage penalty does NOT constitute a direct legal obstacle on decision to marry therefore it does not violate the Constitution.
Facts:
Assistant US attorney challenged the constitutionality of rate structure that gives disadvantage to marriage
D computed their tax based on MFS even though they were married
D claimed that marriage penalty is unconstitutional b/c it unfairly discriminates against working married couples in violation of the Equal Protection Clause of the 14th Amendment
Analysis:
Right to marry is considered “fundamental,” but reasonable regulations that do not SIGNIFICANTLY INTERFERE with the decision to marry may be imposed
Marriage penalty is not a direct legal obstacle therefore does not significantly interfere
Kiddie Tax: I.R.C. §1(g) [477]
Children under 14 are taxed on “net unearned income” at the parent’s top marginal rate (e.g. interest, dividends).
Designed to eliminate a perceived abuse – that parents would put assets in names of children and therefore income would be taxed at children’s rate or not at all if under standard deduction and personal exemption
Represents a major step toward taxation based on family income
Amount taxed is that in excess of $650 reduced by greater of $650 or amount of allowable deductions that are directly connected with the production of the unearned income.
Summary:
Minimum of $1,300 of child’s unearned income is NOT subject to the kiddie tax and is taxed at the child’s marginal rate
Anything over $1,300 is taxed at parent’s marginal rate
“unearned income” is interest, dividends etc.
Note: If child’s income is between $500 and $5,000, parent can choose to report child’s income on return but rate structure is different then under kiddie tax. First $650 is not taxed, next $650 is taxed at 15% and anything over is at the parent’s marginal rate. The advantage is that the children do not have to file returns if this is their only income.
Assignment (shifting) of Income Principles:
3 divisions of income:
(1) Income from services:
Can K for compensation be changed to shift income to another?
NO, per Lucas v. Earl- income from services is taxed to the person who earns it
TP that earned income is taxed even if transferred to TP #2
(2) Income from income producing property
Eg: Dividends, interest, rent
Can income from income producing property be shifted?
NO, per Horst – income from income producing property is taxed to the OWNER of the property. Cannot separate the fruit from the tree. Does not matter who receives the income “in fact.”
(3) Disposition of income producing property
Can G/L from disposition be shifted?
NO, the OWNER of the property must report the G/L
Per Salvatore one issue is who is the owner at the time of the sale.
I-B. DISSOLUTION OF THE FAMILY:
General Rule: taxpayers cannot by private agreement allocate tax consequences
EXCEPTION: Agreements made by divorce or separation agreements re: shifting of income via alimony are effective for tax purposes.
REV. RULING 76-255: [478]
Determines “who is married”
Legal status of divorce is that no marriage ever existed.
IRC §143(a)(1) provides that determination of whether an individual is married shall be made at the close of the taxable year (ie. 12/31)
However, if never an intention to be unmarried then divorce will not be recognized for tax purposes – i.e. take “vacation” together = “sham”
IRC §6013 permits husband wife to file joint return
Reg. 1.143-1(a) and 1.6013-4(a) provide that an individual shall be considered married even though living apart from spouse unless legally separated under a decree of divorce or separate maintenance.
Estate of Borax [480]
In the 2nd Circuit an ex parte divorce not valid in state of residence will be recognized for purpose of determining deductible alimony payments. (Superceded by Rev. Rul. 67-442, below)
Facts: Couple were separated in 1965 and entered into a separation agreement. Husband obtained an ex parte divorce in Mexico. Wife was served in CT but never appeared in Mexico. Husband remarried. Ex-parte divorce in Mexico was ruled invalid. Husband continued to live with wife #2 and make separation payments to wife #1 under the agreement.
Issue: Are payments recognized as payments incident to a divorce?
Held: Yes. 2nd Circuit held that the payments were deductible as payments “incident to… a decree of divorce” even though the divorce was held invalid.
Rev. Rul. 67-442: [479]
Divorce will be held invalid if not recognized by state court.
1967. IRS will not allow a deduction when a state court with jurisdiction declares a prior divorce to be invalid. Couple is considered still married.
This view was upheld in 9th Circuit and 2nd Circuit has limited the Borax finding to the alimony issue alone.
Davis[483]
Facts: TP had property with AB of 60k and FMV of 100k. TP transferred property pursuant to a divorce decree for 100k.
Issue: Is this a realization transaction?
If so, then he has $40k of gain. Remember tax results depending on what state you live in and what way you hold the property.
It depends on
sent child support – if not fixed then not considered child support
Note: § 71(c)(2) was added after Lester: if it is clear from agreement that payment declines when child reaches age, dies, marries, leaves school then this is sufficient to signify what portion is for child support. Trap for the unwary.
I-C. ANTENUPTIAL AGREEMENTS:
FARID–ES–SULTANEH [486]
CONSIDERATION will be found in a promise to marry and relinquishment of dower rights therefore transaction is NOT a gift but rather a purchase for BASIS purposes (i.e. basis is COST, not donor’s basis).
Facts:
Before divorcing his 1st wife, he gave Farid (2d wife) Kresge stock and again before marriage he gave her more
Per antenuptial agreement, in exchange for stock, Farid agreed to release her dower and other marital rights
Married for 4 years then divorced.
Farid did not receive any alimony and began to sell off the Kresge stock
Issue: On sale of stock how much gain does she have? What is her BASIS?
Analysis:
If by GIFT then basis under 1015 is donor’s basis – which was a basis of 16 cents per share
If by PURCHASE then her basis is “cost” under 1012 which was $10.67 (i.e. FMV at time she received the shares)
FMV of stock was almost $300 per share
To be considered a PURCHASE there must be BARGAINED FOR CONSIDERATION
Court found there was consideration for the stock via her DOWER RIGHTS and promise to marry, therefore it was a “purchase” and 1012 applies and basis is cost – i.e. $10.67 per share.
Court reasons that b/c there was consideration then it cannot be a gift – regardless if agreement labeled it as such. It would only have been a gift if he had died before marriage.
Dissent: Farid was not married when she received the first block of stock and nor were they then entering into the agreement (therefore did not have dower rights to bargain with)
If it was a purchase to Farid, it must have been a sale to Kresge (or at least a disposition)
Kresge was not a party to this litigation and therefore court did not address
Equity says Kresge should’ve recognized gain when stock was transferred.
NOTE: Farid did not realize any gain on the transfer of her marital rights in exchange for the stock. Per Rev. Ruling 67-221 [478](passed 20 years after this case) there is no gain when marital rights are relinquished. The service gave no rationale for this position in this ruling.
NOTE: Unmarried cohabitants [478]: No special provisions to govern the tax treatment of support payment or property settlements upon separation of unmarried cohabitants.
