[W]omen face longer terms of low wealth and consumption when they divorce 243 242 That John must be given a deduction to encourage him to provide Mary with more aftertax cash bothers some commentators who just don't like to see the Johns of the world reduce their taxes in this manner. But such a view reverts to a different paradigm--asking whether John, viewed independently, should be able to deduct an amount that is not made in pursuance of income--rather than the more pragmatic paradigm of deciding simply who should be taxed on these payments by looking to the side effects of the various possible decisions. I admit that I like the fact that Mary ends up with more after-tax cash here under the inclusion/deduction system, and the bald fact is that John would not be willing to provide her with more after-tax cash if he weren't better off as well, i.e., if it weren't for the tax savings that he enjoys through the deduction under his higher rate bracket. In short, this side effect is one that tends toward encouraging the higher-income spouse to provide more after-tax income to the lower-income spouse, which might be a good side effect for society in general, at a cost to the fisc that is selflimiting. 244 Finally, John's deduction would encourage him to satisfy his $1,200 per month payment obligation, rather than renege on his $1,000 per month obligation that he would otherwise agree to under an exclusion/nondeduction system, an all-too-common occurrence in the real world." The problem of nonsupport of children by their parents has become a serious one for this country.... [O]f the 8.8 million mothers with children whose fathers were not living in the home in the spring of 1986, 3.4 million, or nearly 40 percent of these mothers, had never been awarded support for their children. Fewer than one in five mothers who had never been married had been awarded support. Of those 111, 115-16 (1999). But only the degree, and not the direction, of the numbers were challenged. A later study using Ms. Weitzman's sample and records found a 27% drop in women's standard of living and 10% increase in men's after divorce. See id.; see also Margaret F. Brinig & Douglas W. Allen, "These Boots Are Made for Walking": Why Most Divorce Filers Are Women, 2 AM. J.L & ECON. 126, 127-28 (2000) (collecting other consistent studies). 242 Brinig & Allen, supra note 241, at 128. 243 244 See, e.g., Berman, supra note 232. See generally Jacqueline Pons-Bunny, Non-Custodial Fathers' Rights: States' Lack of Incentives for the Father to Remain in the Child's Life, 19 J. JUV. L. 212, 221 (1998) (noting that 65% of absent fathers do not pay alimony or child support). who had been awarded and were due support in 1986, only half received the full 245 Why don't I simply advocate that all cash payments fall within the inclusion/deduction system, with no ability on the part of the parties to agree to exclusion/nondeduction? I think that such a system would be less optimum than one preserving the effective flexibility of current law (for the well-advised). First, for parties who will not be in different tax brackets after divorcewhich may be the case more often with lower- and middle-income taxpayers who are both in the 15% bracket or both in the 28% bracket-it would be defensible to allow them to decide who should be taxed on these payments simply because no revenue is at stake. The greater flexibility to designate tax responsibility for cash payments can grease the wheels of negotiation with respect to many other matters on the table, such as who gets the car. Parties who are in different tax brackets should, if well-advised, not wish to opt out of the inclusion/deduction system in most cases, since both can usually be better off (after taxes) under that system, as illustrated in the John/Mary negotiations. But some of these parties may agree to hard numbers independent of the tax consequences. If John refuses to pay more than $1,000 per month in any event, then I think that it's good policy to provide Mary some leverage in the divorce negotiations with respect to other matters. She may agree to give up the car, in other words, if John agrees that the firm $1,000 per month that he won't budge from is excludable by her (and thus nondeductible to him). In other words, if they nevertheless wish to agree to exclusion/nondeduction in a manner that would benefit the Treasury, there is no compelling reason to prevent them, and providing taxpayers explicit authority to decide for themselves the tax status of these cash payments can help the parties negotiate other matters that aren't directly related to the tax responsibility for cash payments. Moreover, having the "tax system" interfere as little as possible (by declining to decide for the parties themselves who is responsible for the tax on the cash payments except in the absence of agreement)--when the Treasury is only a stakeholder--should increase respect for the tax system, which I also perceive as a good side effect. The flexibility allowed to the parties to decide to whom cash payments should be taxed is not the cause of confusion under current law. Rather, as illustrated by the cases discussed above, the confusion under current law arises because the flexibility provided to the parties is dependent on them knowing and understanding the various transactional forms and requirements available to them. It is not necessary to eliminate the flexibility available to the parties under current law in the name of simplification; rather, it is necessary only to allow the parties to exercise their flexibility explicitly, rather than indirectly, by allowing them to designate for themselves the extent to which some or all cash payments incident to divorce should be includable/deductible or excludable/nondeductible. In such a system, the only remaining issue is which default rule should govern in case of silence or a failure to reach agreement. The default rule should ideally provide the outcome that 245 William A. Klein, Tax Effects of Nonpayment of Child Support, 45 TAX L. REV. 259, 280 (1990) (quoting Senate Report, S. REP. NO. 100-377, at 2776-85 (1988), which accompanied the Family Support Act of 1988, Pub. L. No. 100-485, 102 Stat. 2343 (1988)); see also Gerzog Shaller, supra note 6, at 332-35 (collecting additional Federal statutes aimed at increasing compliance with child support obligations). the parties might have agreed to if they had thought about it, i.e., it should not be counterintuitive or surprising. I believe that the payee likely would not be surprised to find out that cash that he or she receives and controls and spends is includable. But if the payor pays a child's tuition or summer camp fees directly to a third party, with no control by or direct consumption by the payee, the payee might likely be surprised to find that such a payment is includable (absent a designation otherwise). Thus, I recommend that the default rule should be inclusion/deduction unless the payment is made to a third party on behalf of a child. Such payments should be relatively easy to distinguish. This default rule would step in, however, only in cases in which the parties fail to stipulate how their cash payments should be treated for tax purposes. For example, if the parties so choose, they could agree that payments to a third party on a behalf of a child are includable/deductible payments. At bottom, the appropriate reform analogy is the 1984 reform to the dependency exemption pertaining to the minor children of divorced spouses. Recall that, prior to 1984, the spouses often had to engage in protracted litigation to determine who provided the greater amount of support for the children in order to determine who was entitled to the dependency exemptions.246 While such an approach was surely theoretically defensible, it was impractical when applied to the real world, and it resulted in an overabundance of costly litigation for both the divorced parties and the government, while little, if any, Federal revenue was at stake. The 1984 reform simply assigned a default rule that the custodial parent gets the exemption, in the absence of an agreement by the parties that the non-custodial parent should get it. In that way, the parties could negotiate between themselves who would get the dependency exemption. This resolution might not be theoretically pure, but it was an absolutely defensible simplification that should provide the ready touchstone for simplification of the tax consequences of cash transfers in divorce. I therefore recommend that the title of I.R.C. § 71 should be changed from “alimony and separate maintenance payments" to "payments pertaining to children and former spouses.” Subsections (c) (dealing with "child support" payments) and (f) (dealing with recapture of frontloaded payments) should be repealed entirely. Subsections (a) through (c) should be amended as follows: Sec. 71. PAYMENTS PERTAINING TO CHILDREN AND FORMER SPOUSES. (a) GENERAL RULE.-Payments pertaining to children and former spouses, whether those payments constitute alimony, child support, property settlement, or an equitable distribution or apportionment under state law, shall be includable in the gross income of the payee under this section and deductible by the payor under § 215, or excludable from the gross income of the payee under this section and nondeductible by the payor under section 215, as designated by the parties in a divorce or separation instrument or support instrument. The divorce or separation instrument or support instrument may designate some payments or portions of payments as includable in the gross income of the payee and deductible by the payor and other payments or portions of payments as excludable by the payee and not deductible by the payor. (b) DEFAULT RULE.--Payments pertaining to children and former spouses that the parties fail to designate in the divorce or separation instrument or support instrument as either includable or excludable by the payee shall be includable in the gross income of the payee under this section and deductible by the payor under section 215 unless the payment is made to a third party on behalf of a child of the payor, in which case the payment shall be excludable from the gross income of the payee under this section and not deductible by the payor under § 215. (c) PAYMENTS PERTAINING TO CHILDREN AND FORMER SPOUSES DEFINED--For purposes of this section- (6) IN GENERAL.--The term "payments pertaining to children and former spouses" means any payment in cash if- such payment is received by (or on behalf of) a spouse under a divorce or separation instrument or by a parent under a support instrument, 247 the payee and the payor are not members of the same household at the time such 248 247 By these words, this section would also apply to a support decree that orders a biological father to make cash payments to the child's mother, whom he never married. 248 In current I.R.C. § 71, the requirement that the payor and payee not live in the same household is required only in the case of "an individual legally separated from his spouse under a decree of divorce or of separate maintenance." I.R.C. § 71(b)(1)(C). That is to say, this requirement does not apply to individuals who simply enter into their own, private agreement, without supervision or approval of a court, when they separate for a time in the hopes of eventually reconciling. The thought is that requiring such individuals to cease living together in order to gain the advantages of the inclusion/deduction system would discourage reconciliation. See generally Paul C. Feinbert & Toni Robinson, A Household Is Not a Home: "Not Members of the Same Household" in the Tax Treatment of Alimony Payments, 6 Va. Tax Rev. 377 (1986) (generally discussing this requirement). I believe that under a system in which parties will be entitled to designate all cash payments as includable/deductible payments, without limit, this flexibility must be sacrificed in order to prevent happy couples who have no intention of actually separating from attempting to take advantage of the inclusion/deduction system on a wholesale basis while continuing to live together, filing separate returns. (Subsection (e) of I.R.C. § 71 already prevents couples filing a joint return from taking advantage of the inclusion/deduction system.) This is the one area where the abuse potential could feasibly be great. For this reason, I believe that couples should have to live apart to take advantage of the inclusion/deduction system. That would mean that couples who continue to live in the same household, even in separate bedrooms, would not be entitled to take advantage of the inclusion/deduction system for any payments made pursuant to a private agreement that they undertake together, but I believe that such a restriction is nevertheless justified in view of the larger potential for abuse. The justification for income-shifting is much less pungent in the case of a still-married couple, living in the same household. The payments made from one spouse to another would still be taxed only once; the only consequence of this (7) DIVORCE OR SEPARATION INSTRUMENT OR SUPPORT INSTRUMENT.--The term "divorce or separation instrument" or "support instrument" means- decree of divorce or written instrument incident to such a decree, a written separation agreement, payee for the payee's benefit and/or the benefit of the children of the payee and 250 The rule enacted in I.R.C. § 1041(a) that in-kind property transfers should be nonrecognition events if the transfer is incident to divorce turned out, in my view, to be an overwhelming success. Moreover, I believe that it was the right decision to resist the Task Force's tentative proposal that the nonrecognition rule be made elective. I believe that the valuation headaches that would arise if non-marketplace transfers in divorce were deemed to be realization events more than justifies a flat nonrecognition rule for such in-kind transfers. Valuation litigation would no doubt explode if parties were given this option, with transferors claiming low value for built-in gain property for purposes of measuring their gain and transferees claiming high value for purposes of their fair-market-value basis. Even if the parties were required to stipulate jointly to a single value in order to elect out of nonrecognition treatment, the government might wish to argue that the stipulated value is deflated (to generate less gain or a greater loss), particularly if the transferee does not plan on selling the property and thus would be willing to stipulate to a low value (and thus basis). In my view, this aspect of "private ordering" must give way to easy-to-administer rules in a transaction like divorce, which affects so many individuals. And after all, the reduction in flexibility is not terribly severe; if the transferor wishes recognition, he or she may sell the property to a third party, which would provide a marketplace transaction that resolves the valuation question, and then transfer the cash to the transferee spouse. While I.R.C. § 1041 has generally been a success, two serious issues nevertheless have arisen under it, both of which are addressed in the next section. The first is whether the common-law, assignment-of-income doctrine trumps this nonrecognition rule. The second is how stock redemptions in closely held corporations incident to divorce should be analyzed. rule would be that it would always be the payor that is taxed, with no ability to choose to tax the payee instead. These temporary separations should, in any event, be self-limiting in time. Either the couple will reconcile, or they will divorce, within (I assume) a year or two at most. 249 Conforming amendments would be required to be made to I.R.C. §§ 61(a)(8) and 215, as well as § 682, so that payments satisfied by the creation of a trust would effectively receive the same treatment as would apply to direct payments under I.R.C. § 71. See generally Martin J. McMahon, Jr., Tax Aspects of Divorce and Separation, 32 FAM. L.Q. 221, 243-44 (1998) (describing alimony and child support trusts). |