IV. ISSUES UNDER SECTION 1041 A. The Assignment-of-Income Doctrine and Section 1041 252 253 257 254 251 258 255 Under the assignment-of-income doctrine, developed in such hoary cases as Lucas v. Earl, Poe v. Seaborn, Helvering v. Horst, Blair v. Commissioner, Harrison v. Schaffner, 256 Helvering v. Clifford," Helvering v. Eubank, and others, the Supreme Court developed a common-law doctrine that prevents the shifting of income for tax purposes from one taxpayer to another in many circumstances—at least, in the absence of a nonrecognition provision that would otherwise apply. Taken together, the cases might be summarized (if somewhat simplified) to mean that an assignor cannot shift the tax burden with respect to income produced by a mechanism over which she retains control. Because services income is created by one's body, it is just about impossible to shift services income to another, since one cannot effectively give up control over one's own body; the assignor can turn the income spigot on and off at will by performing services or not. Thus, services income is essentially always taxed to the person or entity who provided the services that earned the income, whether the services income attempted to be assigned is already earned or to be earned in the future. For example, in Lucas v. Earl,259 the Supreme Court held that a contract entered into between a married couple that required the husband, who was the sole income earner, to share one-half of his earnings with his wife did not operate to shift the tax burden of those earnings to his wife. This case was decided at a time when all individuals, including married couples, were required to file individual tax returns. If the Court had held otherwise, the resulting incomesplitting would have allowed the married couple to use the lowest marginal rate brackets twice, instead of once, thus lowering the couple's aggregate tax liability. 536-37. 251 252 253 The description in the next two paragraphs was taken from Geier, supra note 24, at 281 U.S. 111 (1930). 282 U.S. 101 (1930). 260 In the same term of court, however, the Court also decided Poe v. Seaborn, which also dealt with a husband who was the sole breadwinner who attempted to split his income with his wife for tax-reporting purposes. Because the state's community-property laws in that case considered the husband's earnings to have been earned by the marital community, rather than solely by the husband, the court blessed the income-splitting in this context. Since the marital community earned the income under state law, the marital community properly reported it. Indeed, the differing treatment between married couples who could not split their income under state law and those who could eventually prompted the enactment of the joint-return option to, in essence, extend the advantages of income-splitting to those not living in community-property The Poe v. Seaborn Court also held that the couple's investment return on investment assets owned as community property should be split between them for purposes of tax reporting. That is to say, just as services income is typically taxed to the person or entity that earned it, income earned with respect to property is generally taxed to the person who owns the property (though the titleholder under state law might not be considered the owner for tax purposes). Unlike one's own body, the property owner can give up control over property producing income. Thus, assignments of income from property can be successful for tax purposes if the assignor gives up sufficient control over the property producing the income to the assignee. The disputes in this area typically center around the issue of whether sufficient control over the property producing the income was surrendered to the assignee. The possible interrelationship between the assignment-of-income doctrine and I.R.C. § 1041 has produced confusion.262 The issue typically arises when a property interest is transferred in divorce, and then cash, producing an ordinary income inclusion, is subsequently received with respect to that interest by the new owner. It also arises when compensation income already earned by one spouse but not yet received or taxed is assigned in the divorce to the other spouse. The question, as with alimony and child support, is which party must include the income, i.e., which party's marginal rate bracket will control. For the reasons described in Part II, very little revenue (if any) is at issue here, since the government is once again merely a stakeholder. If a property right is transferred and the income earned on that property is considered as having been earned after the property transfer, the new owner must include the income under the assignment-of-income doctrine, as owner of the property interest. I think that this is an uncontroversial application of the doctrine originally created in Poe v. Seaborn and not troublesome. For example, in Kenfield v. United States, H was a 50% partner in a partnership engaged in land sales, and the divorce decree provided that W was entitled to one-half of H's 263 return). 261 See generally Zelenak, supra note 10, at 344-48 (reviewing the history of the joint 262 See generally Geier, supra note 60 (generally discussing this problem). 263 783 F.2d 966 (10th Cir. 1986). partnership interest (i.e., a 25% interest in the partnership). Because valuation was difficult, the court awarded W 50% of all "future net proceeds received" by H with respect to his original partnership interest. H duly paid over the amounts every year. The issue was whether H must include the full 50% of the partnership's income on his own return or whether H need include only 25%, with W including the remaining 25%, because of the court order vesting one-half of H's partnership interest in W. ,,264 The Tenth Circuit concluded that the transfer gave W ownership of one-half of H's partnership interest, and thus W must include in her gross income the income attributable to that property that accrued after the transfer. "After the settlement, Kenfield did not own the asset that produced his ex-wife's share of the 1977 post-divorce income, i.e., his ex-wife's half of the partnership income. Kenfield thus also is not taxable on the partnership income earned by that asset. If the court had concluded as a factual matter that W did not really receive an interest in the partnership, but rather was merely compensated for her marital interest in the partnership, then the results would likely have been different, as they would have been analyzed under I.R.C. §§ 71 and 215. H would have had to include the full 50% share of the partnership's profits on his own return, and the installment payments received by W would (under current law, at least) be excludable by her and nondeductible by H if H's obligation to make the stream of payments would not terminate on W's death. (Under the proposals advanced in Part II, supra, which obliterate the distinction between cash "alimony," "child support," and "property settlements,” the parties would be free to designate whether cash payments incident to divorce or includable/deductible or excludable/nondeductible.) 265 But what if a property interest is transferred but the income subsequently received by the new property owner accrued prior to the transfer? Or what if accrued-but-not-yet-taxed compensation income is assigned to the other spouse? If the income is considered as accruing prior to the property transfer, and particularly if the income is attributable to the personal services of the transferor, then the government sometimes argues (though not consistently) that the income, even though received and consumed by the transferee spouse, must be included by the transferor spouse under the assignment-of-income doctrine, notwithstanding I.R.C. § 1041, a practice excoriated by Professor Michael Asimow in his definitive article on the topic. 266 264 Id. at 968; see also Schulze v. Comm'r, 46 T.C.M. (CCH) 143 (1983) (holding that W was taxable on one-half of the amounts collected on a claim arising from W's one-half interest in husband's law partnership received by W in divorce). 265 See, e.g., Priv. Ltr. Rul. 9123053 (March 13, 1991) (concluding that, because the divorce instrument did not give W a 50% interest in H's business but rather only required H to make cash payments to compensate W for her interest in his business, the payments were excludable by W and nondeductible by H, since W's payment rights would not terminate on her death). Accord Priv. Ltr. Rul 9143050 (July 26, 1991) (concluding that W did not receive an interest in certain patent lawsuits that H was prosecuting at the time of their divorce but rather only cash payments representing an excludable cash property settlement since her payment rights would not terminate on death). 266 Michael Asimow, The Assault on Tax-Free Divorce: Carryover Basis and Assignment of Income, 44 TAX L. REV. 65 (1988). Professor Asimow calls these "sensitive assets," and they include accounts receivable of an unincorporated, cash-basis, service business; an interest in a partnership that holds unrealized receivables or contracts to render personal services in the future: rights to royalties; and investment assets with accrued but not-yet-recognized income. For example, in Kochansky v. Commissioner,268 the government argued, and both the Tax Court and Ninth Circuit agreed, that Mr. Kochansky, a lawyer, must include in gross income the portion of a contingent fee in a medical malpractice action that was pending at the time of the divorce and that the divorce decree required to be paid to his ex-wife, because the income was earned by the personal services of Mr. Kochansky. 269 Probably the most common type of accrued income subject to assignment-of-income arguments is deferred compensation income, such as retirement savings, that is not subject to a “qualified domestic relations order,” or QDRO. There is no question about who gets taxed on pension benefits that are covered by a valid QDRO, which was created in I.R.C. § 414(p) as part of the Retirement Equity Act of 1984. Prior to creation of the QDRO, it was possible to split pension assets in a divorce, but the court order was directed at the spouse with the pension, rather than at the pension plan itself. For example, H might have been ordered by the court to pay onehalf of his monthly pension payments to W when he begins to receive them—perhaps twenty years in the future. If H died before retirement, W received nothing. Under I.R.C. § 414(p), in contrast, the pension plan administrator is the subject of the court order, and W receives vested rights. The administrator is ordered to treat W in our scenario just as if she were a plan participant. While the primary purpose of the QDRO was to recognize these pension assignments270 and to protect W's interest in the plan, even if H should predecease W, the provisions also ensure that W, as the "alternate payee” under a QDRO, is taxed on the payments when ultimately paid by the pension, not H.271 QDROS can apply only to defined benefit and defined contribution plans such as 401(k) and profit-sharing plans. They cannot apply to individual retirement accounts (IRAs) or other kinds of deferred compensation arrangements, though I.R.C. § 408(d)(6) provides similar treatment for IRA transfers in divorce. It is with respect to other, so-called nonqualified arrangements that the government has argued, albeit inconsistently, that transfers of rights to receive income (or surrenders of community property interests in such income) cannot shift the burden of including the income that has already accrued. That is to say, in our situation in which H transfers to W rights to future payments that represent H's accrued interest in deferred 267 See, e.g., Rev. Rul. 87-112, 1987-2 C.B. 207 (holding that accrued interest on U.S. savings bonds was taxed to the transferor notwithstanding I.R.C. § 1041). 268 269 270 271 92 F.3d 957 (9th Cir. 1996), aff'g 67 T.C.M. (CCH) 2665 (1994). P.L. 98-397, § 204, 98 Stat. 1445 (1984). See infra note 300 and accompanying text. See, e.g., Priv. Ltr. Rul. 8837013 (June 7, 1988). See generally Notice 97-11, 1997-2 I.R.B. 49 (sample QDRO text and detailed instructions and explanations of the use of QDROs). compensation that cannot qualify for a QDRO (considered owned solely by him in a commonlaw state), the government might argue that, even though W receives the cash, H is taxed when W receives the cash years later. 272 For example, in Darby v. Commissioner," a case pre-dating adoption of the QDRO, the divorce court ordered Mr. Darby to assign to his ex-wife a $75,000 portion of his vested interest in a qualified plan that could today qualify for a QDRO, a profit-sharing fund of his employer. The $75,000 amount was one-half of the estimated value of Mr. Darby's interest in the plan at the time of the divorce. The court ordered that the $75,000 payment should be made as follows: $60 per week until Mr. Darby died or retired, the balance due paid in a lump sum at that time. The decree also provided that Mr. Darby "shall notify said Fund of the above Assignment, and the Assignment, or this Judgment in lieu thereof, may be recorded in the County Register of Deeds or appropriate office, wherein the Fund is located so as to give notice of the same. Mr. Darby complied by submitting a document to the plan informing the plan administrators of the court-ordered assignment and attaching a copy of the court's order. Mr. Darby paid a total of $22,030 in installments toward the $75,000 total before he retired, and the profit-sharing plan paid him a lump sum of more than $182,000 at that time. A few days later, he wrote a check to Ms. Darby for the $52,970 that represented her remaining interest in the plan. ,,273 While Mr. Darby did not deduct the prior $60 weekly payments as "alimony," he did not include $75,000 of the lump-sum distribution that he received upon his retirement, arguing that the divorce decree and court order resulted in a legal transfer of $75,000 of his interest in the profit-sharing plan to his ex-wife. The government made both a statutory argument and an argument under the common-law assignment-of-income doctrine in concluding that Mr. Darby was not entitled to exclude $75,000. The statutory argument was that only Mr. Darby could qualify as a "distributee" within the meaning of I.R.C. § 402(a)(1), who is the person required to include in gross income amounts deferred under a qualified pension plan. The government further argued that, even if the plan had paid the $75,000 directly to Ms. Darby, "the payment was compensation for services rendered by petitioner and, as such, is taxable to him under the assignment of income doctrine." The Tax Court agreed on both counts. 274 Another instance in which the government raised the assignment-of-income doctrine, but this time eventually lost before the Tax Court, began as a private letter ruling request in 1987.2 W's marriage was dissolved in a community-property state in December of 981. At that time, the Supreme Court's ruling in McCarty v. McCarty275 was in effect, which held that a military spouse's retirement benefit was that spouse's separate property in community-property states and thus not subject to division as part of the community property. Pursuant to the McCarty decision, the divorce decree stated that H's military retirement plan was the separate property of |