Tax Consequences of Divorce and Intra-Family Transactions

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. 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 a person other than a spouse may give that other person the tax status of “dependent” and entitle taxpayer to a reduction of his tax liability. Section 151 gives (gave?) taxpayer a deduction of a fixed exemption amount for each of the taxpayer’s dependents. The Tax Cuts and Jobs Act for tax years 2018 to 2025 fixes the exemption amount at zero. § 151(d)(5)(A). However, for the same years § 24 provides credits for dependents other than spouses. We learn shortly that whether one is a dependent of taxpayer usually turns on the existence of a family relationship.

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

The Code treats a married couple as one taxpayer – although spouses 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.

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?

• Remember: the exchange 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?

2. What did taxpayer give as consideration in this case? How much did she pay for the consideration that she gave? 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?

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 an admittedly voidable contract, 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 increments of taxable income. We also know that there are such things as a “marriage bonus” and a “marriage penalty” – depending on the relative pre-marital income levels of the spouses. 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.

• 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.

Do the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax Computation: Filing Status.

C. Dependents

Section 152 defines “dependent.”

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

• 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 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).

Section 151(a) provides that a taxpayer who is an “individual” is entitled 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 and his 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).

For tax years 2018 to 2025, the exemption amount is zero. § 151(d)(5)(A). The deduction has been replaced with a doubled child tax credit (to $2000) available to taxpayers at higher income levels, a refundable tax credit of up to $1400 for taxpayers unable to take full advantage of the child tax credit, and a $500 tax credit for each “qualifying relative.” § 24(h)(2, 5, 4). Under the temporary rules, the definition of “qualifying child” and “qualifying relative” remain important.

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); OR

• 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 support during the year from his 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 the last six months of the calendar year, § 152(e)(1)(A)(iii),

• and the child is in the custody of one or both 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 will not claim the child as a dependent, § 152(e)(2)(A), and

• The noncustodial parent attaches Form 8332 to his 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 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 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 to claim a refund with his 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):

• If 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).

N.B:. Section 151 allowed (allows?) a deduction of an “exemption amount” for each of taxpayer’s “dependents.” § 151(a, b, and c). As noted, the “exemption amount” for tax years 2018 to 2025 is zero. Instead, taxpayers may be entitled to a “child tax credit” of $2000. § 24(h)(2). Prior to enactment of the Tax Cuts and Jobs Act, the credit was $1000. The conditions of the “child tax credit” are not a perfect fit with § 151(c) (dependent deduction) and § 152(c) (qualifying child). The “child tax credit” is only available until the child turns 17, § 24(a)(1), not 19 (24 in the case of a student). Moreover, the credit is not available for a child who is a resident of a country contiguous to the United States. § 24(c)(2). However, a “qualifying child” who is 17 or older may still be a dependent for which taxpayer is entitled to a $500 tax credit. § 24(h)(4)(A). The “child tax credit” is non-refundable. § 26(a). The “child tax credit” is subject to an income phaseout when a taxpayer’s modified adjusted gross income exceeds $400,000 for taxpayers married filing jointly or $200,000 for other taxpayers. § 24(h)(3), § 24(b)(1) (credit reduced by 5% of excess). Prior to enactment of the TCJA, the phaseout began at $110,000 for taxpayers married filing jointly and at $75,000 for unmarried taxpayers. § 24(b)(2).

For taxpayers whose tax liability is reduced to $0 and so cannot avail themselves of the full “child tax credit,” § 24(d) creates “an additional child tax credit” (ACTC). The ACTC is refundable to the extent a taxpayer could not use the full $2000 “child tax credit.” The TCJA caps the credit at $1400 (indexed for inflation) per qualifying child. § 24(h)(5). The ACTC is only available to a taxpayer with earned income. The refundable amount is equal to 15% of the amount by which taxpayer’s earned income exceeds $2500 or by which taxpayer’s social security taxes exceed taxpayer’s earned income credit if taxpayer has 3 or more qualifying children – WHICHEVER is greater. § 24(h)(5), § 24(d)(1)(B). The amount of the ACTC is subject to the additional condition that the “child tax credit” plus the ACTC cannot exceed $2000. § 24(d)(1)(A).

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).

• 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 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 or separate maintenance payment is not counted as payment for support of a dependent. § 152(d)(5)(A).

• 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).

N.B:. The exemption amount for tax years 2018 to 2025 is zero. The TCJA creates a $500 tax credit for dependents other than those qualifying for the “child tax credit.” § 24(h)(4)(A).

Comment: We have seen the near elimination of any marriage penalty. We have seen the exemption amount reduced to zero. We note that the Tax Cuts and Jobs Act doubled the standard deduction. But the effect of this doubling is mitigated by the suspension of many deductions, capping the SALT deductions at $10,000, and denying a deduction for personal exemptions.

Consider the change in emphasis that the doubled “child tax credit” brings about. The indexed exemption amount for 2017 was $4050. A taxpayer in the 10% tax bracket saved $405 per exemption. The same taxpayer who benefits from a $2000 “child tax credit” would have to have $20,000 of taxable income for a deduction to yield the same amount of benefit. For a 12% taxpayer, the same figures are $486 and $16,666.67. For a 22% bracket taxpayer, the figures are $891 and $9090. What do these numbers say about the use of credits rather than deductions?

Do you see a discernible trend in Congress’s attitude about families with children? Remember, Smith and Ochs are still good law.

D. Intra-Family Transactions

• 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.

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?

• 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).

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

3. Would your answers be different if Taxpayer had sold Greenacre to his uncle? – grandmother? – nephew?

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

Divorce renders spouses 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 –

• a legal duty,

• ownership of property, or

• an agreement.

A. Alimony and Property Settlement

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 minor child.

• If a parent fails in that duty and a third person steps up and pays money to fulfill that duty, must the parent recognize 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 –

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 to such a level that many men came out below $0 when they paid alimony and the income tax on the alimony. Congress acted. It made alimony a § 62 deduction to the payor and gross income to the payee. This permitted (encouraged) divorcing spouses to characterize any payment as alimony. The source of their obligation became agreement or court order. The parties could enlarge the pie they had to split by arranging to have the ex-spouse in the lower tax bracket be liable for income tax on the alimony.

3. This has all changed. In the Tax Cuts and Jobs Act, Congress repealed all the alimony provisions of the Code. As of tax year 2019, we revert to the rule of Gould v. Gould.

4. 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.

B. Payments to Ex-Spouses to Surrender Rights

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 the tax consequences that should naturally flow from such transactions.

• The United States Supreme Court addressed these questions in United States v. Davis, 370 U.S. 65 (1962).

Note on United States v. Davis, 370 U.S. 65 (1962) and § 1041

In United States v. Davis, H transferred pursuant to a property settlement appreciated stock (basis = $74,775.37, fmv = $82,250) to W in exchange for W’s surrender of all claims against H, including dower and all rights of testacy and intestacy under Delaware state law. The Government argued that the transfer was made in exchange for an independent legal obligation. Taxpayer H argued that the transfer was comparable to a nontaxable division of property between two co-owners. The Court concluded that Delaware state law did not make W a co-owner of the stock – as might occur in community property states. Instead, H exchanged stock for W’s surrender of claims against him. In the absence of any method to value what W surrendered, the Court – by assuming that the parties engaged in an even exchange – treated H as realizing the fmv of the stock. Since that was more than his basis in the stock, the Court agreed that H’s taxable gain was the fmv of the stock minus his basis. As for W, the Court held that she acquired a basis in the stock she received equal to the amount H realized.

• The Court treated inchoate rights that can only exist in marriage as if they were property that can be bought and sold. The Court treated the parties the same way we would expect courts to treat strangers who exchanged properties. H exchanged appreciated property to pay for something; that is a recognition event.

• Giving W a tax basis equal to the fmv of what H surrendered is no more correct here than it was in Farid-es-Sultaneh.

• 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?

• Is the rule of § 1041 better than the holding of Davis?

C. Child Support

Child support payments are made to fulfill 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 (a tax credit for tax years 2018 to 2025) 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 (tax credit) in its definitions of “qualifying child” and “qualifying relative,” supra. Furthermore, receipt of child support payments is not gross income to the payee.

A parent has an obligation to support his minor children. If someone else fulfills that obligation, it seems that the parent has realized gross income. Change the facts: 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). The former spouse is left to make up the difference.

Rev. Rul. 93-27, 1993-1 C.B. 32

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

1. The basis of the Davis case 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. What should happen if H and W jointly own all 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, which was taxable at ordinary income rates. What result? See Arnes v. United States, 981 F.2d 456 (9^th Cir. 1992) and Commissioner v. Arnes, 102 T.C. 522 (1994). What is the effect of Reg. § 1.1041-2(c)?

4. Section 23 provides a capped dollar-for-dollar tax credit for various adoption expenses that is subject to an income phaseout at relatively high levels of AGI. Section 137 provides an exclusion from gross income for an employee who benefits from his employer’s adoption assistance program. In the Tax Cuts and Jobs Act, Congress doubled the child tax credit for tax years 2018 to 2025 from $1000 to $2000 and changed the deductible exemption amount for dependents other than qualifying children from (what would have been) $4150 (in 2018) to a flat $500 tax credit. From what you have learned of tax policies towards various personal choices in preceding chapters, what trends do you see in provisions such as these?

Can you explain or define –

• What it means for the federal income tax and the federal gift tax to be not in pari materia?

• How § 267 treats losses in transactions between related persons?

• What the rule of § 1041 is? How does it differ from the rule of § 1015?

• In what ways property settlements, alimony, and child support differ conceptually?