Category: Individuals Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayers are divorcing spouses. Taxpayers own rental property which is treated as community property under local law. Per the terms of the divorce agreement, the husband will report all the income from the rental property. The year in question is a married-filing-separately year preceding finalization of the divorce. I am strongly of the opinion that the taxpayer's reporting agreement will not be respected for tax purposes. There is a judicially created addendum to IRC Section 61 called the assignment of income doctrine. In essence, this principle states that income must be taxed to its beneficial owner. It is irrelevant that the owner transfers cash or other property representing the income to another party (or directs that cash or other property be given directly to the other party). In the landmark case, Lucas v. Earl, 281 U.S. at 111 (at 115), 2 USTC ¶496 (S. Ct., 1930), the Supreme Court held as follows. ...income is taxable to the person who earns it, and that such taxes cannot be avoided through arrangement[s] by which the fruits are attributed to a different tree from that on which they grew.
I can find no reason that a divorce proceeding changes the general principle. Consider Schulze v. Comr., T.C. Memo 1983-263; and Kochansky v. Comr., T.C. Memo 1994-160--both cases predate Section 1041 (see below)where the Tax Court held that a contingent fee from a lawsuit paid part to the taxpayer, a lawyer, and part to his ex-wife pursuant to their divorce agreement, was entirely taxable to the taxpayer. The taxpayer had agreed to the contingent fee with his client and had filed the lawsuit, but the suit had not yet been settled when the taxpayer and his wife divorced. On appeal, the Ninth Circuit affirmed the Tax Court's decision that the contingent fee was includable in full in the taxpayer's gross income, noting that the taxpayer remained in control of his own services, but reversed the Tax Court's imposition of negligence penalties. Kochansky v. Comr., 96-2 USTC Para.50,431 (9th Cir. 1996). There is an issue as to whether Section 1041--which allows tax free transfers of property between spouses or former spouses--would allow accrued income items such as accrued rent or interest to be transferred without imposition of tax on the transferring spouse. In other words, which rule dominates, the assignment of income doctrine or Section 1041? This is an evolving area. Revenue Ruling 87-112, 1987-2 CB 207, holds that the assignment of income doctrine controls while Balding v. Comr., 98 TC 368 (1992) suggests otherwise (although not very definitively). In my view, neither Rev. Rul. 87-112 nor Balding is controlling over these facts. These precedents deal with a matured right to receive income: Rev. Rul. 87-112 deals with accrued interest and Balding deals with vested pension benefits. Both these income rights, accrued interest and vested pension benefits, would be considered property by virtually any standard one could imagine. Clearly, Section 1041, which concerns itself with transfers of property, could arguably apply to such items. In our case, however, we are dealing with a naked, contractual allocation of the tax consequences of a transaction. We are not dealing with an item of accrued (but as yet unreceived) income in the context of a property settlement. I think this is different entirely. I think this situation clearly falls within the grasp of the assignment of income doctrine. |
