Progressivity and Assignment of Income

The following table illustrates the point. It shows the income tax burden of a person whose taxable income is $210,000. Hypothetical marginal tax brackets are as noted. The total tax burden of this taxpayer is $50,000.

Taxable Income range	Marginal Tax Rate	Tax
$0 to $10,000	0%	$0
$10,000 to $60,000	10%	$5000
$60,000 to $110,000	20%	$10,000
$110,000 to $160,000	30%	$15,000
$160,000 to $210,000	40%	$20,000
Total		$50,000

Our taxpayer might try to reduce her tax burden by “assigning” some of her taxable income to persons she controls – perhaps two children. Our taxpayer might decide that she and each of the two children should receive $70,000 of the original $210,000 total. The new tax computation table would be the following:

Taxable Income range	Marginal Tax Rate	Tax
$0 to $10,000	0%	$0
$10,000 to $60,000	10%	$5000
$60,000 to $110,000	20%	$200078
Total		$7000 x 3 = $21,000

JUSTICE HOLMES delivered the opinion of the Court.

This case presents the question whether the respondent, Earl, could be taxed for the whole of the salary and attorney’s fees earned by him in the years 1920 and 1921, or should be taxed for only a half of them in view of a contract with his wife which we shall mention. The Commissioner of Internal Revenue and the Board of Tax Appeals imposed a tax upon the whole, but their decision was reversed by the circuit court of appeals. A writ of certiorari was granted by this Court.

By the contract, made in 1901, Earl and his wife agreed “that any property either of us now has or may hereafter acquire … in any way, either by earnings (including salaries, fees, etc.), or any rights by contract or otherwise, during the existence of our marriage, or which we or either of us may receive by gift, bequest, devise, or inheritance, and all the proceeds, issues, and profits of any and all such property shall be treated and considered, and hereby is declared to be received, held, taken, and owned by us as joint tenants, and not otherwise, with the right of survivorship.” The validity of the contract is not questioned, and we assume it to be unquestionable under the law of the California, in which the parties lived. Nevertheless we are of opinion that the Commissioner and Board of Tax Appeals were right.

The Revenue Act of 1918 approved February 24, 1919, c. 18, §§ 210, 211, 212(a), 213(a), 40 Stat. 1057, 1062, 1064, 1065, imposes a tax upon the net income of every individual including “income derived from salaries, wages, or compensation for personal service … of whatever kind and in whatever form paid,” § 213(a). The provisions of the Revenue Act of 1921 … are similar to those of the above. A very forcible argument is presented to the effect that the statute seeks to tax only income beneficially received, and that, taking the question more technically, the salary and fees became the joint property of Earl and his wife on the very first instant on which they were received. We well might hesitate upon the latter proposition, because, however the matter might stand between husband and wife, he was the only party to the contracts by which the salary and fees were earned, and it is somewhat hard to say that the last step in the performance of those contracts could be taken by anyone but himself alone. But this case is not to be decided by attenuated subtleties. It turns on the import and reasonable construction of the taxing act. There is no doubt that the statute could tax salaries to those who earned them, and provide that the tax could not be escaped by anticipatory arrangements and contracts, however skillfully devised, to prevent the salary when paid from vesting even for a second in the man who earned it. That seems to us the import of the statute before us, and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.

Judgment reversed.

Notes and Questions:

1. This case is the origin of the “assignment of income” doctrine, i.e., a taxpayer cannot assign her income tax liability to another by assigning income not yet earned to another.

2. The Earls entered their contract in 1901 – at a time when most people believed that a federal personal income tax was unconstitutional and fifteen years before Congress enacted the income tax statute. This “anticipatory assignment” could hardly have had as a purpose the avoidance of federal income tax liability.

• In fact, Guy Earl probably utilized the contract as an estate planning device. He was not in good health, and by this simple contract, he was able to pass half of his property – already owned or to be acquired – to his wife without need of probate. At the time, there was no right of survivorship in California community property. See Patricia A. Cain, The Story of Earl: How Echoes (and Metaphors) from the Past Continue to Shape the Assignment of Income Doctrine, in Tax Stories 305, 315 (Paul Caron, ed., 2d ed. 2009).

3. Is Mr. Earl subject to income tax in this case because he earned the income or because he exercised a right to assign its receipt prospectively?

4a. Consider: Taxpayer was a waitress at a restaurant and collected tips from customers. At the end of each shift, she would “tip out” various other restaurant employees, including busboys, bartenders, cooks, and other waitresses and waiters who assisted her during particularly busy times.

• The Commissioner argues that Taxpayer’s gross income includes all the tip income. Taxpayer may deduct as a trade or business expense what she pays other employees.

• Taxpayer argued that what she paid other employees was not even gross income to her.

• Why does one characterization rather than the other matter? Read §§ 62(a)(1), 67(a, b, g).

• What result?

• See, e.g., Brown v. Commissioner, T.C. Memo 1996-310, 1996 WL 384904 (1996).

4b. Taxpayer was a partner in a partnership. Partnerships do not pay income taxes. Rather, individual partners are liable for income tax on their individual distributive shares of partnership profits. Taxpayer and his wife entered an agreement whereby she was made a full and equal partner with him. Wife performed no services and the other partners were not a party to this agreement.

• Taxpayer argued that he should be taxed on one half of his partnership distributive share, and his wife should be taxed on one half of his distributive share. This case predates married filing jointly tax returns.

• What result?

• See Burnet v. Leininger, 285 U.S. 136, 142 (1932).

5. How useful is the tree-fruits metaphor in resolving difficult questions of assignment of income?

• Taxpayer works for Mega Corporation. Taxpayer was personally responsible for generating $1M of new business for Mega. Mega paid taxpayer his usual salary of $100,000. Next year, Mega will give taxpayer a 50% raise. On how much income should taxpayer be liable for income tax –

• in year 1?

• in year 2?

MR. JUSTICE ROBERTS delivered the opinion of the Court.

Seaborn and his wife, citizens and residents of the State of Washington, made for the year 1927 separate income tax returns as permitted by the Revenue Act of 1926, c. 27, § 223 (U.S.C.App., Title 26, § 964).

During and prior to 1927, they accumulated property comprising real estate, stocks, bonds and other personal property. While the real estate stood in his name alone, it is undisputed that all of the property, real and personal, constituted community property, and that neither owned any separate property or had any separate income.

The income comprised Seaborn’s salary, interest on bank deposits and on bonds, dividends, and profits on sales of real and personal property. He and his wife each returned one-half the total community income as gross income, and each deducted one-half of the community expenses to arrive at the net income returned.

The Commissioner of Internal Revenue determined that all of the income should have been reported in the husband’s return, and made an additional assessment against him. Seaborn paid under protest, claimed a refund, and, on its rejection, brought this suit.

The district court rendered judgment for the plaintiff; the Collector appealed, and the circuit court of appeals certified to us the question whether the husband was bound to report for income tax the entire income, or whether the spouses were entitled each to return one-half thereof. This Court ordered the whole record to be sent up.

The case requires us to construe §§ 210(a) and 211(a) of the Revenue Act of 1926 (44 Stat. 21, U.S.C.App. Tit. 26, §§ 951 and 952), and apply them, as construed, to the interests of husband and wife in community property under the law of Washington. These sections lay a tax upon the net income of every individual. The Act goes no farther, and furnishes no other standard or definition of what constitutes an individual’s income. The use of the word “of” denotes ownership. It would be a strained construction, which, in the absence of further definition by Congress, should impute a broader significance to the phrase.

The Commissioner concedes that the answer to the question involved in the cause must be found in the provisions of the law of the state as to a wife’s ownership of or interest in community property. What, then, is the law of Washington as to the ownership of community property and of community income including the earnings of the husband’s and wife’s labor?

The answer is found in the statutes of the state and the decisions interpreting them.

These statutes provide that, save for property acquired by gift, bequest, devise, or inheritance, all property however acquired after marriage by either husband or wife or by both is community property. On the death of either spouse, his or her interest is subject to testamentary disposition, and, failing that, it passes to the issue of the decedent, and not to the surviving spouse. While the husband has the management and control of community personal property and like power of disposition thereof as of his separate personal property, this power is subject to restrictions which are inconsistent with denial of the wife’s interest as co owner. The wife may borrow for community purposes and bind the community property. [citation omitted]. Since the husband may not discharge his separate obligation out of community property, she may, suing alone, enjoin collection of his separate debt out of community property. [citation omitted]. She may prevent his making substantial gifts out of community property without her consent. [citation omitted]. The community property is not liable for the husband’s torts not committed in carrying on the business of the community. [citation omitted].

The books are full of expressions such as “the personal property is just as much hers as his” [citation omitted]; “her property right in it [(an automobile)] is as great as his” [citation omitted]; “the title of the spouse therein was a legal title, as well as that of the other” [citation omitted].

Without further extending this opinion, it must suffice to say that it is clear the wife has, in Washington, a vested property right in the community property equal with that of her husband, and in the income of the community, including salaries or wages of either husband or wife, or both. …

The taxpayer contends that, if the test of taxability under Sections 210 and 211 is ownership, it is clear that income of community property is owned by the community, and that husband and wife have each a present vested one-half interest therein.

The Commissioner contends, however, that we are here concerned not with mere names, nor even with mere technical legal titles; that calling the wife’s interest vested is nothing to the purpose, because the husband has such broad powers of control and alienation that, while the community lasts, he is essentially the owner of the whole community property, and ought so to be considered for the purposes of §§ 210 and 211. He points out that, as to personal property, the husband may convey it, may make contracts affecting it, may do anything with it short of committing a fraud on his wife’s rights. And though the wife must join in any sale of real estate, he asserts that the same is true, by virtue of statutes, in most states which do not have the community system. He asserts that control without accountability is indistinguishable from ownership, and that, since the husband has this, quoad community property and income, the income is that “of” the husband under §§ 210, 211 of the income tax law.

We think, in view of the law of Washington above stated, this contention is unsound. The community must act through an agent. This Court has said with respect to the community property system [citation omitted] that “property acquired during marriage with community funds became an acquêt of the community, and not the sole property of the one in whose name the property was bought, although by the law existing at the time the husband was given the management, control, and power of sale of such property. This right being vested in him not because he was the exclusive owner, but because, by law, he was created the agent of the community.”

….

The obligations of the husband as agent of the community are no less real because the policy of the state limits the wife’s right to call him to account in a court. Power is not synonymous with right. Nor is obligation coterminous with legal remedy. The law’s investiture of the husband with broad powers by no means negatives the wife’s present interest as a co-owner.

We are of opinion that, under the law of Washington, the entire property and income of the community can no more be said to be that of the husband than it could rightly be termed that of the wife.

….

The Commissioner urges that we have, in principle, decided the instant question in favor of the government. He relies on [citations omitted] and Lucas v. Earl, 281 U. S. 111.

….

In the Earl case, a husband and wife contracted that any property they had or might thereafter acquire in any way, either by earnings (including salaries, fees, etc.) or any rights by contract or otherwise, “shall be treated and considered, and hereby is declared to be received, held, taken, and owned by us as joint tenants. …” We held that assuming the validity of the contract under local law, it still remained true that the husband’s professional fees, earned in years subsequent to the date of the contract, were his individual income, “derived from salaries, wages, or compensation for personal service” under § 210, 211, 212(a) and 213 of the Revenue Act of 1918. The very assignment in that case was bottomed on the fact that the earnings would be the husband’s property, else there would have been nothing on which if could operate. That case presents quite a different question from this, because here, by law, the earnings are never the property of the husband, but that of the community.

Finally the argument is pressed upon us that the Commissioner’s ruling will work uniformity of incidence and operation of the tax in the various states, while the view urged by the taxpayer will make the tax fall unevenly upon married people. This argument cuts both ways. When it is remembered that a wife’s earnings are a part of the community property equally with her husband’s, it may well seem to those who live in states where a wife’s earnings are her own that it would not tend to promote uniformity to tax the husband on her earnings as part of his income. The answer to such argument, however, is that the constitutional requirement of uniformity is not intrinsic, but geographic. [citations omitted]. And differences of state law, which may bring a person within or without the category designated by Congress as taxable, may not be read into the Revenue Act to spell out a lack of uniformity. [citation omitted].

The district court was right in holding that the husband and wife were entitled to file separate returns, each treating one-half of the community income as his or her respective incomes, and its judgment is

Affirmed.

THE CHIEF JUSTICE and MR. JUSTICE STONE took no part in the consideration or decision of this case.

Notes and Questions:

1. Is the distinction of ownership by operation of state law rather than by operation of a contract convincing? Would you expect the same resolution of the conflict to be applied to partnership allocations of income embodied in a partnership agreement, i.e., in a contract? Why the difference?

2. When taxpayer lawfully performed services for which insurance commissions were paid but which taxpayer could not legally receive, the Supreme Court held that taxpayer did not have sufficient dominion over the income to be required to include it in its gross income. Comm’r v. First Security Bank of Utah, 405 U.S. 394, 405 (1972) (“We think that fairness requires the tax to fall on the party that actually receives the premiums, rather than on the party that cannot.”).

3. Rather than assign salary income to another, can a taxpayer effectively waive her right to receive a salary? See Giannini v. Commissioner, 129 F.2d 638 (CA9 1942).

Do the CALI Lesson, Basic Federal Income Taxation: Assignment of Income: Services.

The following excerpt from a legislative report from 2001 reviews the ebb and flow of policy in the choice of tax bracket breakpoints for different filing statuses. In 2001, there was a “marriage penalty” at all income levels. Not everyone liked this. Who would prefer it? The tax brackets to which the excerpt refers have changed, but the policy considerations remain relevant.

Joint Committee on Taxation, Overview of Present Law and Economic Analysis Relating to the Marriage Tax Penalty, the Child Tax Credit, and the Alternative Minimum Tax 2-11 (March 7, 2001).

I. Marriage Tax Penalty

A. Present Law and Legislative Background

Present Law

In general

A marriage penalty exists when the sum of the tax liabilities of two unmarried individuals filing their own tax returns (either single or head of household returns) is less than their tax liability under a joint return (if the two individuals were to marry). A marriage bonus exists when the sum of the tax liabilities of the individuals is greater than their combined tax liability under a joint return.

Marriage penalties due to rate brackets and the standard deduction

Under [prior] law, the size of the standard deduction and the bracket breakpoints follow[ed] certain customary ratios across filing statuses. For taxpayers in the 15-, 28- and 31-percent marginal tax rate brackets, the bracket breakpoints and the standard deduction for single filers [were] roughly 60 percent of those for joint filers and those for head of household filers [were] about 85 percent of those for joint filers. …

With these ratios, the sum of the standard deductions two unmarried individuals would receive exceeds the standard deduction they would receive as a married couple filing a joint return. Thus, their taxable income as joint filers may exceed the sum of their taxable incomes as unmarried individuals. Furthermore, because of the way the bracket breakpoints are structured, taxpayers filing joint returns may have more of their taxable income pushed into a higher marginal tax bracket than when they were unmarried. In order for there to be no marriage penalties as a result of the rate structure and the standard deduction, the standard deduction and the bracket breakpoints for married taxpayers filing joint returns would have to be at least twice that for both single and head of household filers. Such a structure would greatly enhance marriage bonuses, however.

….

Legislative Background

….

Analysis

….

Marriage neutrality versus equal taxation of married couples with equal incomes

Any system of taxing married couples requires making a choice among three different concepts of tax equity. One concept is that the tax system should be “marriage neutral;” that is, the tax burden of a married couple should be exactly equal to the combined tax burden of two single persons where one has the same income as the husband and the other has the same income as the wife. A second concept of equity is that, because married couples frequently consume as a unit, couples with the same income should pay the same amount of tax regardless of how the income is divided between them. … A third concept of equity is that the income tax should be progressive; that is, as income rises, the tax burden should rise as a percentage of income.

Those who favor the principle of equal taxation of married couples with equal incomes argue that as long as most couples pool their income and consume as a unit, two married couples with $20,000 of income are equally well off regardless of whether their income is divided $10,000-$10,000 or $15,000-$5,000. Thus, it is argued, those two married couples should pay the same tax, as they do under present law. By contrast, a marriage-neutral system with progressive rates would involve a larger combined tax on the married couple with the unequal income division. The attractiveness of the principle of equal taxation of couples with equal incomes may depend on the extent to which married couples actually pool their incomes.

An advocate of marriage neutrality could respond that the relevant comparison is not between a two-earner married couple where the spouses have equal incomes and a two-earner married couple with an unequal income division, but rather between a two-earner married couple and a one-earner married couple with the same total income. Here, the case for equal taxation of the two couples may be weaker, because the non-earner in the one-earner married couple benefits from more time that may be used for unpaid work inside the home, other activities or leisure. …

Marriage penalty, labor supply, and economic efficiency

Most analysts discuss the marriage penalty or marriage bonus as an issue of fairness, but the marriage penalty or bonus also may create economic inefficiencies. The marriage penalty or bonus may distort taxpayer behavior. The most obvious decision that may be distorted is the decision to marry. For taxpayers for whom the marriage penalty exists, the tax system increases the “price” of marriage. For taxpayers for whom the marriage bonus exists, the tax system reduces the “price” of marriage. Most of what is offered as evidence of distorted choice is anecdotal. There is no statistical evidence that the marriage penalty or marriage bonus has altered taxpayers’ decisions to marry. Even if the marriage decision were distorted, it would be difficult to measure the cost to society of delayed or accelerated marriages or alternative family structures.

Some analysts have suggested that the marriage penalty may alter taxpayers’ decisions to work. As explained above, a marriage penalty exists when the sum of the tax liabilities of two unmarried individuals filing their own tax returns (either single or head of household returns) is less than their tax liability under a joint return (if the two individuals were to marry). This is the result of a tax system with increasing marginal tax rates. The marriage penalty not only means the total tax liability of the two formerly single taxpayers is higher after marriage than before marriage, but it also generally may result in one or both of the formerly single taxpayers being in a higher marginal tax rate bracket. That is, the additional tax on an additional dollar of income of each taxpayer is greater after marriage than it was when they were both single. Economists argue that changes in marginal tax rates may affect taxpayers’ decisions to work. Higher marginal tax rates may discourage household saving and labor supply by the newly married household. … Some have suggested that the labor supply decision of the lower earner or “secondary earner” in married households may be quite sensitive to the household’s marginal tax rate.

The possible disincentive effects of a higher marginal tax rate on the secondary worker arise in the case of couples who experience a marriage bonus as well. In the specific example above, the couple consisted of one person in the labor force and one person not in the labor force. As noted previously, such a circumstance generally results in a marriage bonus. By filing a joint return, the lower earner may become subject to the marginal tax rate of the higher earner. By creating higher marginal tax rates on secondary earners, joint filing may discourage a number of individuals from entering the work force or it may discourage those already in the labor force from working additional hours.

Eliminating or reducing the marriage penalty

….

To eliminate the marriage penalty through a change in the rate structure, the brackets for all unmarried taxpayers (both singles and heads of household) would have to be half as large as the married, filing joint brackets. … This change would exacerbate existing marriage bonuses if the rate schedule for married taxpayers filing jointly were increased. Regardless of the manner in which the rates were adjusted (i.e., by increasing bracket breakpoints for married taxpayers or reducing them for singles and heads of households), a structure with rates for married taxpayers at twice the level of single and heads of households would cause marriage bonuses. Another effect of such a step would be that single individuals and heads of household with identical incomes would find their tax liabilities nearly the same. …

Questions and comments:

1. Examine the tax brackets at the front of your Code as well as the current standard deduction for the different filing statuses. To whom and to what extent did Congress respond when it created these relationships in brackets in 2017?

2. What percentage of married filing jointly is the breakpoint for single taxpayers in the 10% bracket, the 12% bracket, the 22% bracket, the 24% bracket, the 32% bracket, the 35% bracket, and the 37% bracket?

• What would happen to the marriage penalty as the breakpoint percentage increases? What is the now the breakpoint percentage at the 37% bracket?

3. The excerpt identifies three policies that “bracketologists” might pursue. What are they? Is it possible to pursue all three policies? What policies did the Code pursue in 2001? Examine the brackets for taxpayers who are married filing jointly and for taxpayer who are single. What policies does the Code pursue after 2017?

4. Are the current (2018 through 2025) brackets marriage neutral? See 6^th footnote of the excerpt and second to last paragraph of excerpt.

Re-read Helvering v. Horst in chapter 2. Why did taxpayer Horst lose?

MR. JUSTICE STONE delivered the opinion of the Court.

This is a companion case to Helvering v. Horst, … and presents issues not distinguishable from those in that case.

Respondent, a general life insurance agent, after the termination of his agency contracts and services as agent, made assignments in 1924 and 1928, respectively, of renewal commissions to become payable to him for services which had been rendered in writing policies of insurance under two of his agency contracts. The Commissioner assessed the renewal commissions paid by the companies to the assignees in 1933 as income taxable to the assignor in that year … The Court of Appeals for the Second Circuit reversed the order of the Board of Tax Appeals sustaining the assessment. We granted certiorari.

No purpose of the assignments appears other than to confer on the assignees the power to collect the commissions, which they did in the taxable year. …

For the reasons stated at length in the opinion in the Horst case, we hold that the commissions were taxable as income of the assignor in the year when paid. The judgment below is

Reversed.

The separate opinion of MR. JUSTICE McREYNOLDS.

…

“The question presented is whether renewal commissions payable to a general agent of a life insurance company after the termination of his agency and by him assigned prior to the taxable year must be included in his income despite the assignment.”

….

The court below declared –

“In the case at bar, the petitioner owned a right to receive money for past services; no further services were required. Such a right is assignable. At the time of assignment, there was nothing contingent in the petitioner’s right, although the amount collectible in future years was still uncertain and contingent. But this may be equally true where the assignment transfers a right to income from investments, as in Blair v. Commissioner, 300 U.S. 5, and Horst v. Commissioner, 107 F.2d 906, or a right to patent royalties, as in Nelson v. Ferguson, 56 F.2d 121, cert. denied, 286 U.S. 565. By an assignment of future earnings, a taxpayer may not escape taxation upon his compensation in the year when he earns it. But when a taxpayer who makes his income tax return on a cash basis assigns a right to money payable in the future for work already performed, we believe that he transfers a property right, and the money, when received by the assignee, is not income taxable to the assignor.

Accordingly, the Board of Tax Appeals was reversed, and this, I think, is in accord with the statute and our opinions.

The assignment in question denuded the assignor of all right to commissions thereafter to accrue under the contract with the insurance company. He could do nothing further in respect of them; they were entirely beyond his control. In no proper sense were they something either earned or received by him during the taxable year. The right to collect became the absolute property of the assignee, without relation to future action by the assignor.

A mere right to collect future payments for services already performed is not presently taxable as “income derived” from such services. It is property which may be assigned. Whatever the assignor receives as consideration may be his income, but the statute does not undertake to impose liability upon him because of payments to another under a contract which he had transferred in good faith under circumstances like those here disclosed.

….

THE CHIEF JUSTICE and MR. JUSTICE ROBERTS concur in this opinion.

Notes and Questions:

1. The Court’s majority says that this case presents issues like those in Horst, supra?

• Is that accurate?

2. Should the right to collect compensation income for services performed become property simply by the passage of time, e.g., one year?

• Should the tax burden fall upon the one who earns the income only if that person receives the compensation in the same year?

3. Do you see any latent problems of horizontal equity in the opinion of Justice McReynolds? Taxpayers have endeavored from the beginning to convert compensation income from ordinary income into property. Courts are very careful not to permit this to occur.

• Why do you think that taxpayer wanted to transfer his rights to receive future renewal commissions to a corporation that he controlled? Were there tax advantages to doing this?

MR. CHIEF JUSTICE HUGHES delivered the opinion of the Court.

This case presents the question of the liability of a beneficiary of a testamentary trust for a tax upon the income which he had assigned to his children prior to the tax years and which the trustees had paid to them accordingly.

The trust was created by the will of William Blair, a resident of Illinois who died in 1899, and was of property located in that State. One-half of the net income was to be paid to the donor’s widow during her life. His son, the petitioner Edward Tyler Blair, was to receive the other one-half and, after the death of the widow, the whole of the net income during his life. In 1923, after the widow’s death, petitioner assigned to his daughter, Lucy Blair Linn, an interest amounting to $6,000 for the remainder of that calendar year, and to $9,000 in each calendar year thereafter, in the net income which the petitioner was then or might thereafter be entitled to receive during his life. At about the same time, he made like assignments of interests, amounting to $9,000 in each calendar year, in the net income of the trust to his daughter Edith Blair and to his son, Edward Seymour Blair, respectively. In later years, by similar instruments, he assigned to these children additional interests, and to his son William McCormick Blair other specified interests, in the net income. The trustees accepted the assignments and distributed the income directly to the assignees.

….

… The Board [of Tax Appeals] … overruled the Commissioner’s determination as to the petitioner’s [income tax] liability. The Circuit Court of Appeals … reversed the Board. That court … decided that the income was still taxable to the petitioner upon the ground that his interest was not attached to the corpus of the estate, and that the income was not subject to his disposition until he received it.

….

… The question [is] whether, treating the assignments as valid, the assignor was still taxable upon the income under the federal income tax act. That is a federal question.

… In [Lucas v. Earl, 281 U.S. 111], the question was whether an attorney was taxable for the whole of his salary and fees earned by him in the tax years, or only upon one-half by reason of an agreement with his wife by which his earnings were to be received and owned by them jointly. We were of the opinion that the case turned upon the construction of the taxing act. We said that “the statute could tax salaries to those who earned them, and provide that the tax could not be escaped by anticipatory arrangements and contracts, however skilfully devised, to prevent the salary when paid from vesting even for a second in the man who earned it.” That was deemed to be the meaning of the statute as to compensation for personal service, and the one who earned the income was held to be subject to the tax. … [This case is] not on point. The tax here is not upon earnings which are taxed to the one who earns them. Nor is it a case of income attributable to a taxpayer by reason of the application of the income to the discharge of his obligation. Old Colony Trust Co. v. Commissioner, 279 U.S. 716; [citations omitted]. There is here no question of evasion or of giving effect to statutory provisions designed to forestall evasion; or of the taxpayer’s retention of control. Corliss v. Bowers, 281 U.S. 376; Burnet v. Guggenheim, 288 U.S. 280.

In the instant case, the tax is upon income as to which, in the general application of the revenue acts, the tax liability attaches to ownership. See Poe v. Seaborn, supra; [citation omitted].

The Government points to the provisions of the revenue acts imposing upon the beneficiary of a trust the liability for the tax upon the income distributable to the beneficiary. But the term is merely descriptive of the one entitled to the beneficial interest. These provisions cannot be taken to preclude valid assignments of the beneficial interest, or to affect the duty of the trustee to distribute income to the owner of the beneficial interest, whether he was such initially or becomes such by valid assignment. The one who is to receive the income as the owner of the beneficial interest is to pay the tax. If, under the law governing the trust, the beneficial interest is assignable, and if it has been assigned without reservation, the assignee thus becomes the beneficiary, and is entitled to rights and remedies accordingly. We find nothing in the revenue acts which denies him that status.

The decision of the Circuit Court of Appeals turned upon the effect to be ascribed to the assignments. The court held that the petitioner had no interest in the corpus of the estate, and could not dispose of the income until he received it. Hence, it was said that “the income was his,” and his assignment was merely a direction to pay over to others what was due to himself. The question was considered to involve “the date when the income became transferable.” The Government refers to the terms of the assignment – that it was of the interest in the income “which the said party of the first part now is, or may hereafter be, entitled to receive during his life from the trustees.” From this, it is urged that the assignments “dealt only with a right to receive the income,” and that “no attempt was made to assign any equitable right, title or interest in the trust itself.” This construction seems to us to be a strained one. We think it apparent that the conveyancer was not seeking to limit the assignment so as to make it anything less than a complete transfer of the specified interest of the petitioner as the life beneficiary of the trust, but that, with ample caution, he was using words to effect such a transfer. …

The will creating the trust entitled the petitioner during his life to the net income of the property held in trust. He thus became the owner of an equitable interest in the corpus of the property. Brown v. Fletcher, 235 U.S. 589, 598-599; Irwin v. Gavit, 268 U.S. 161, 167-168; Senior v. Braden, 295 U.S. 422, 432; Merchants’ Loan & Trust Co. v. Patterson, 308 Ill. 519, 530, 139 N.E. 912. By virtue of that interest, he was entitled to enforce the trust, to have a breach of trust enjoined, and to obtain redress in case of breach. The interest was present property alienable like any other, in the absence of a valid restraint upon alienation. [citations omitted]. The beneficiary may thus transfer a part of his interest, as well as the whole. See Restatement of the Law of Trusts, §§ 130, 132 et seq. The assignment of the beneficial interest is not the assignment of a chose in action, but of the “right, title, and estate in and to property.” Brown v. Fletcher, supra; Senior v. Braden, supra. See Bogert, Trusts and Trustees, vol. 1, § 183, pp. 516, 517; 17 Columbia Law Review, 269, 273, 289, 290.

We conclude that the assignments were valid, that the assignees thereby became the owners of the specified beneficial interests in the income, and that, as to these interests, they, and not the petitioner, were taxable for the tax years in question. The judgment of the Circuit Court of Appeals is reversed, and the cause is remanded with direction to affirm the decision of the Board of Tax Appeals.

It is so ordered.

Notes and Questions:

1. The Court spent several paragraphs establishing that Edward Tyler Blair had the power to dispose of his interest as he wished. Why was the exercise of this discretion sufficient in this case to shift the tax burden to the recipient when it was not sufficient in Helvering v. Horst?

2. William Blair died. Through his will, he devised part of his property to a trust. We are not told who received the remainder of his property. Edward Tyler William Blair was an income beneficiary of part of the trust. We are not told of the final disposition of the corpus of the trust. We are told that Edward had no interest in the corpus of the estate. Edward assigned fractional interests “in each calendar year thereafter, in the net income which [Edward] was then or might thereafter be entitled to receive during his life.” It appears that Edward’s entire interest was as a beneficiary of the trust. He then assigned to various sons and daughters a fraction of his entire interest.

• Exactly what interest did William Blair, Jr. retain after these dispositions?

• Compare this to what the taxpayer in Helvering v. Horst, supra, chapter 3, retained.

• Is this difference a sound basis upon which the Court may reach different results?

3. Think of the ownership of “property” as the ownership of a “bundle of sticks.” Each stick represents a particular right. For example, a holder of a bond may own several sticks, e.g., the right to receive an interest payment in each of ten consecutive years might be ten sticks, the right to sell the bond might be another stick, the right to the proceeds upon maturity might be another stick. Imagine that we lay the sticks comprising a bond, one on top of the other. Then we slice off a piece of the property. We might slice horizontally – and thereby take all or a portion of only one or a few sticks. Or we might slice vertically – and thereby take an identically proportional piece of every stick.

Consider the accompanying diagrams of Horst and Blair. Do they suggest an analytical model in “assignment of income derived from property” cases?

• Slice vertically rather than horizontally?

4. Taxpayer was the life beneficiary of a testamentary trust. In December 1929, she assigned a specified number of dollars from the income of the trust to certain of her children for 1930. The trustee paid the specified children as per Taxpayer’s instructions.

• Exactly what interest did Taxpayer retain after these dispositions?

• Should Taxpayer-life beneficiary or the children that she named to receive money in 1930 be subject to income tax on the trust income paid over to the children? See Harrison v. Schaffner, 312 U.S. 579, 582-83 (1941).

5. Taxpayer established a trust with himself as trustee and his wife as beneficiary. The trust was to last for five years unless either Taxpayer or his wife died earlier. Taxpayer placed securities that he owned in the trust. The trust’s net income was to be held for Taxpayer’s wife. Upon termination of the trust, the corpus was to revert to Taxpayer and any accumulated income was to be paid to his wife.

• Exactly what interest did Taxpayer retain after these dispositions?

• Should Taxpayer-settlor-trustee or his wife be subject to income tax on the trust income paid over to Taxpayer’s wife? See Helvering v. Clifford, 309 U.S. 331, 335 (1940).

5a. Now suppose that Taxpayer placed property in trust, the income from which was to be paid to his wife until she died and then to their children. Taxpayer “reserved power ‘to modify or alter in any manner, or revoke in whole or in part, this indenture and the trusts then existing, and the estates and interests in property hereby created[.]?’” Taxpayer did not in fact exercise this power, and the trustee paid income to Taxpayer’s wife.

• Exactly what interest did Taxpayer retain after this disposition?

• Should the trust income be taxable income to Taxpayer or to his wife?

• See Corliss v. Bowers, 281 U.S. 376, 378 (1930).

6. Again: is the tree-fruits analogy useful in difficult cases? Consider what happens when the fruit of labor is property from which income may be derived.

Before SWAN and MOORE, Circuit Judges, and KAUFMAN, District Judge.

SWAN, Circuit Judge.

This litigation involves income taxes of Lewis R. Heim, for the years 1943 through 1946. On audit of the taxpayer’s returns, the Commissioner of Internal Revenue determined that his taxable income in each of said years should be increased by adding thereto patent royalty payments received by his wife, his son and his daughter. The resulting deficiencies were paid under protest to defendant Fitzpatrick, Collector of Internal Revenue for the District of Connecticut. Thereafter claims for refund were filed and rejected. The present action was timely commenced … It was heard upon an agreed statement of facts and supplemental affidavits. Each party moved for summary judgment. The plaintiff’s motion was denied and the defendant’s granted. …

In August 1943 plaintiff assigned to his wife ‘an undivided interest of 25 per cent in said agreement with The Heim Company dated July 29, 1943, and in all his inventions and patent rights, past and future, referred to therein and in all rights and benefits of the First Party (plaintiff) thereunder * * *.’ A similar assignment was given to his son and another to his daughter. Plaintiff paid gift taxes on the assignments. The Company was notified of them and thereafter it made all royalty payments accordingly. As additional types of bearings were put into production from time to time the royalties on them were fixed by agreement between the Company and the plaintiff and his three assignees.

The Commissioner of Internal Revenue decided that all of the royalties paid by the Company to plaintiff’s wife and children during the taxable years in suit were taxable to him. This resulted in a deficiency which the plaintiff paid …

The appellant contends that the assignments to his wife and children transferred to them income-producing property and consequently the royalty payments were taxable to his donees, as held in Blair v. Commissioner, 300 U.S. 5. . Judge Anderson, however, was of opinion that (151 F. Supp. 576):

‘The income-producing property, i.e., the patents, had been assigned by the taxpayer to the corporation. What he had left was a right to a portion of the income which the patents produced. He had the power to dispose of and divert the stream of this income as he saw fit.’

Consequently he ruled that the principles applied by the Supreme Court in Helvering v. Horst, 311 U.S. 112 and Helvering v. Eubank, 311 U.S. 122 required all the royalty payments to be treated as income of plaintiff.

The question is not free from doubt, but the court believes that the transfers in this case were gifts of income-producing property and that neither Horst nor Eubank requires the contrary view. In the Horst case the taxpayer detached interest coupons from negotiable bonds, which he retained, and made a gift of the coupons, shortly before their due date, to his son who collected them in the same year at maturity. Lucas v. Earl, 281 U.S. 111, which held that an assignment of unearned future income for personal services is taxable to the assignor, was extended to cover the assignment in Horst, the court saying,

‘Nor is it perceived that there is any adequate basis for distinguishing between the gift of interest coupons here and a gift of salary or commissions.’

In the present case more than a bare right to receive future royalties was assigned by plaintiff to his donees. Under the terms of his contract with The Heim Company he retained the power to bargain for the fixing of royalties on new types of bearings, i.e., bearings other than the 12 products on which royalties were specified. This power was assigned and the assignees exercised it as to new products. Plaintiff also retained a reversionary interest in his invention and patents by reason of his option to cancel the agreement if certain conditions were not fulfilled. This interest was also assigned. The fact that the option was not exercised in 1945, when it could have been, is irrelevant so far as concerns the existence of the reversionary interest. We think that the rights retained by plaintiff and assigned to his wife and children were sufficiently substantial to justify the view that they were given income-producing property.

In addition to Judge Anderson’s ground of decision appellee advances a further argument in support of the judgment, namely, that the plaintiff retained sufficient control over the invention and the royalties to make it reasonable to treat him as owner of that income for tax purposes. Commissioner v. Sunnen, 333 U.S. 591 is relied upon. There a patent was licensed under a royalty contract with a corporation in which the taxpayer-inventor held 89% of the stock. An assignment of the royalty contract to the taxpayer’s wife was held ineffective to shift the tax, since the taxpayer retained control over the royalty payments to his wife by virtue of his control of the corporation, which could cancel the contract at any time. The argument is that, although plaintiff himself owned only 1% of The Heim Company stock, his wife and daughter together owned 68% and it is reasonable to infer from depositions introduced by the Commissioner that they would follow the plaintiff’s advice. Judge Anderson did not find it necessary to pass on this contention. But we are satisfied that the record would not support a finding that plaintiff controlled the corporation whose active heads were the son and son-in-law. No inference can reasonably be drawn that the daughter would be likely to follow her father’s advice rather than her husband’s or brother’s with respect to action by the corporation.

….

For the foregoing reasons we hold that the judgment should be reversed and the cause remanded with directions to grant plaintiff’s motion for summary judgment.

So ordered.

Notes and Questions:

1. Eubank involved labor that created an identifiable and assignable right to receive income in the future. How does Heim v. Fitzpatrick differ from Eubank? After all, a patent is the embodiment of (considerable) work.

2. A patent is no longer, (§ 1221(a)(3)(A)) a capital asset to the taxpayer whose personal efforts created it. Otherwise it is a capital asset that the holder has presumptively held for more than one year. § 1235(a), (b)(1). However, this rule does not apply to transfers between related persons as defined in §§ 267(b, c) or 707(b) and modified by § 1235(c)(1, 2).

• In Heim, to whom would § 1235 matter?

Do the CALI Lesson, Basic Federal Income Taxation: Assignment of Income: Property.

Consider these scenarios:

• Father has a large savings account, and daughter is 18 years old. Daughter is enrolled at Private University and in need of tuition money. Father and mother have planned for many years for this day and saved an ample amount to pay for Daughter’s tuition. They now have $1M saved, and the annual interest income on this amount is $80,000. Father and mother are in the 37% marginal income tax bracket. Daughter is in the 0% marginal income tax bracket. An income of $80,000 would place Daughter in the 22% marginal tax bracket – although some of that income would not be subject to any tax, some would be subject to 10% tax, and some would be subject to 12% tax. Father and mother decide to loan Daughter $1M interest free. Daughter would deposit the money in an interest-bearing account and use the interest income to pay her tuition and other expenses for four years. With diploma in hand, Daughter will repay the loan.

• Are there any income tax problems with this?

• Read § 7872(a)(1), (c)(1)(A), (e), (f)(2), (f)(3).

• [By the way, § 7872 applies both to the income tax and to the gift tax.]

• What result under these provisions.

• Corporation very much wants to hire Star Employee and has made a generous salary offer. To sweeten the deal, Corporation offers to loan $1M to Star Employee interest free so that Star Employee can purchase a house in an otherwise expensive housing market. Star Employee will repay the loan at the rate of $40,000 per year for the next 25 years. Star Employee must pay the full principal of the loan if she stops working for corporation. Star Employee may not transfer her interest in the loan.

• Are there any income tax problems with this?

• Read § 7872(a), (c)(1)(B), (e), (f)(2), (f)(5).

• What result under these provisions?

• Closely-held Corporation is owned by four shareholders. If the corporation pays dividends to shareholders, the dividend income is subject to income tax for the shareholders. The payments are not deductible to Corporation. Closely-held Corporation loans each shareholder $100,000 interest free. Shareholders will repay the loans at the rate of $1000 per year for the next 100 years.

• Are there any income tax problems with this?

• Read § 7872(b), (c)(1)(C), (e), (f)(1), (f)(2), (f)(6).

• What result under these provisions?

The “Kiddie” Tax

Read 1(j)(4); 1(g); 1(h); 1(j)(4). What do they mean?

Cases such as Helvering v. Horst, 311 U.S. 112 (1940), supra chapter 2, illustrate taxpayers’ efforts to shift income to persons that a taxpayer controls and whose income is subject to income tax at a rate lower than that of the taxpayer. Congress and the IRS have addressed some of these efforts. Cf. § 704(e) (gifts of partnership interests and intra-family purchases of partnership interests); Commissioner v. Culbertson, 337 U.S. 733 (1949) (developing test for recognition of family partnership). More recently, Congress enacted § 1(g) of the Code, which states income tax rules applicable to the “net unearned income” of a minor child. Congress subjected such income – minus a standard deduction for dependents – to the parents’ income tax rate. The Tax Cuts and Jobs Act changes these rules for tax years 2018 to 2025. Consider two hypothetical cases:

Hypothetical 1: Taxpayer is three years old and the dependent of H and W. Taxpayer has interest income of $8000.

• Consider the indexed standard deduction applicable to a taxpayer who may be claimed as a dependent of another under § 63(c)(5)(A) to be $1050. Consider the indexed amount under § 63(c)(5)(B) to be $350.

• Consider the tax tables to be those at § 1(j)(2) as of tax year 2018, i.e., as enacted in TCJA in 2017.

• Obviously, these figures would need updating.

What is Taxpayer’s income tax liability?

Hypothetical 2: Taxpayer is twelve years old and the dependent of H and W. Taxpayer has earned income of $7000 derived as compensation for services, long-term capital gains of $5000, and interest income of $8000.

• What is Taxpayer’s income tax liability?

The Tax Cuts and Jobs Act (2017) ostensibly simplified the rules governing income taxation of children with unearned income for tax years 2018 to 2025. The TCJA added § 1(j)(4) to the Code, which states new rules applicable to the income taxation of the income of a minor child. The parents’ income and their tax bracket(s) play no part in determining the income tax liability of a child. All minor children with taxable income will be taxed the same. Once again, Congress stated rules with a web of definitions. Some of the definitions are taken from the old § 1(g), and some are new.

• Section 1(j)(4)(A): “[A] child to whom subsection (g) applies” is defined at § 1(g)(2) to be –

• a child who is 17 years old or less,

• a student who is 23 years old or less, OR

• a dependent who is permanently and totally disabled.

• Section 1(j)(4)(D) defines “earned taxable income” of a child to be the child’s “taxable income” minus the child’s “net unearned taxable income.”

• Section 63(a, b) defines “taxable income” to be “gross income minus itemized deductions” or gross income minus the standard deduction. “Taxable income” does not include the deduction provided by § 199A.

• Section 1(g)(4) defines “net unearned taxable income” to be taxpayer’s “adjusted gross income” not attributable to earned income minus the standard deduction provided in § 63(c)(5) minus [the greater of the standard deduction provided in § 63(c)(5) or itemized deductions directly attributable to taxpayer’s adjusted gross income].

• Taxpayer’s “net unearned income” may not exceed his taxable income. § 1(g)(4)(B).

• “Adjusted gross income” is a taxpayer’s gross income minus the deductions listed in § 62.

• Notice: § 1(j) and § 1(g) have established four identifiable incomes: “taxable income,” “adjusted gross income,” “net unearned income,” and “earned taxable income.”

• Section 1(j)(4)(B) provides a residual rule that taxes the income of a child as it otherwise would be taxed with the certain modifications. To determine the applicable tax, we must follow certain steps:

• Determine “earned taxable income” (§ 1(j)(4)(D): Notice: Since the taxpayer’s “net unearned income” – because of the reductions that § 1(g)(4) prescribes – will be less than taxpayer’s unearned income, taxpayer’s “earned taxable income” will be more than the income taxpayer actually worked for.

• Taxpayer will pay income tax on his “earned taxable income” according to rates otherwise applicable. § 1(j)(4)(B). The taxpayer would be treated as an unmarried individual who is another taxpayer’s dependent. In our hypotheticals, taxpayer would have a standard deduction of the greater of $1050 or [$350 + his earned income].

• Taxpayer will pay income tax on his “net unearned income” as per the rules of §§ 1(j)(4)(B)(i, ii, and iii) and 1(j)(4)(C).

• First, taxpayer backs out “net capital gain” subject to tax rates of 0%, 15%, and 20%, as per § 1(h).

• The “maximum zero bracket amount” is “earned taxable income” plus $2600. §§ 1(j)(4)(C)(i), 1(j)(5)(i)(IV) (indexed for inflation). The “maximum 15-percent rate amount” is “earned taxable income” plus $12,700. §§ 1(j)(4)(C)(ii)), 1(j)(5)(ii)(IV) (indexed for inflation).

• The balance of “net unearned income” is subject to income taxation according to the tax brackets applicable to estates and trusts. § 1(j)(2)(E). There are four brackets applicable to estates and trusts, i.e., 10%, 24%, 35%, and 37%. They are steeply progressive.

• The maximum amount of income subject to a 24% rate of tax is taxpayer’s “earned taxable income” plus the minimum taxable income for the 24% bracket in the rate schedule for estates and trusts. § 1(j))(4)(B)(i).

• The maximum amount of income subject to a 35% rate of tax is taxpayer’s “earned taxable income” plus the minimum taxable income for the 35% bracket in the rate schedule for estates and trusts. § 1(j))(4)(B)(ii).

• The maximum amount of income subject to a 24% rate of tax is taxpayer’s “earned taxable income” plus the minimum taxable income for the 37% bracket in the rate schedule for estates and trusts. § 1(j)(4)(B)(iii).

Hypothetical 1 (the simple case): Taxpayer’s taxable income is $8000. All of it is unearned income. Taxpayer’s “net unearned income” is $8000 minus $1050 minus $1050, or $5900.

• The tax on this amount is $255 plus 24% of ($5900 – $2550), i.e., $255 + $804 = $1059.

Hypothetical 2 (the more complex case): Taxpayer has taxable income of $20,000.

• Taxpayer’s “net unearned income” is $13,000 minus $1050 minus $1050 = $10,900.

• Hence, taxpayer’s “earned taxable income” is $20,000 minus $10,900 = $9100. Reduce this by taxpayer’s standard deduction, i.e., $350 + $7000 = $7350. $9100 – $7350 = $1750. The tax on $1750 of income as per the schedule at § 1(j)(2)(C) (unmarried individuals) is $175.

• Taxpayer has “net unearned income” of $10,900. Back out the LTCG of $5000. This leaves $5900. The tax on this amount as per the schedule at § 1(j)(2)(E) is $255 plus 24% of ($5900 minus $2550), i.e., $255 plus $804 = $1059.

• Taxpayer’s tax on $5000 of LTCG: Since taxpayer’s “taxable income” other than LTCG is $15,000, all of the LTCG is subject to a tax rate of 20% because taxpayer’s maximum 15% rate amount is $12,700. 20% of $5000 = $1000.

• Total: $175 + $1059 + $1000 = $2234.

See Samuel D. Brunson, Meet the New ‘Kiddie’ Tax: Simpler and Less Effective, Tax Notes 1367 (Sept. 3, 2018).

By making the income tax on a dependent minor child’s investment income independent of parental income, Congress provides an equal (dis)incentive to all parents to shift investment income to their children. Obviously, some parents will not be able to respond to the incentive while wealthier parents can exploit the rules to reduce the overall tax burden on a family unit.

Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Below Market Loans.

• Note: Learn the points made in questions 1-2, but keep in mind that we are concerned with income tax, not gift tax. Read § 7872(d)(2) carefully.

2. At what point does it not pay to spend money to gain income that will not be subject to federal income tax?

3. When the IRS in its enforcement mission must come up with an interest rate, it turns to the “applicable Federal rate.” When § 7872 is applicable, what might be wrong with reliance on such a uniform rate?

4. Congress has made the tax burden on the combined income of taxpayers who file married filing jointly exactly twice the tax burden on single persons with half the income of the couple. This arrangement applies to those taxpayers whose taxable income places them in all but the 35% or 37% tax brackets. This reduced the tax bracket on married persons from what it was before Congress enacted this change. Is that preferable to giving relief only to those couples where both spouses work, as was the case when the Code provided for a credit based on the amount of income earned by the spouse who earned less?

5. Comment on the following rough outline of a flat tax: Remove all deductions, exclusions, and credits from the Code. Retain only those associated with the production of income so that the income tax is a tax only on “net” income. All taxpayers would be entitled to a $40,000 exemption. The tax would be a flat rate on all taxpayers to the extent their gross income exceeds $40,000.

Can you explain or define –

• What is income splitting?

• What is the marriage penalty? What is the marriage bonus?

• What is the assignment-of-income doctrine? How does it apply to income derived from services? How does it apply to income derived from property?

• In what way is a below-market loan an assignment of income?