H. The McCarty decision was subsequently overruled by statute in the Uniform Services Former Spouses' Protection Act. W moved to modify the divorce decree to recognize her interest in H's military retirement plan and then agreed to relinquish her claim in exchange for three payments by H: $15,000 in 1986, $14,000 in 1987, and $13,000 in 1988. W requested a ruling that the payments were nontaxable transfers under I.R.C. § 1041 (since they would fail to satisfy the stop-at-death requirement for includable "alimony"). The ruling concluded that, because the interest surrendered by W was a right to future income already earned under the community-property laws, the surrender constituted an impermissible assignment of income by her. The payments from H to W were thus includable in her gross income in the year received, notwithstanding that they failed to qualify as tax "alimony" under I.R.C. § 71. The ruling stated that "[W] cannot escape the taxation of ordinary income by recharacterizing her assignment of the income as a nontaxable transfer of property under section 1041(a) of the Code." The government argued, in essence, that one could never surrender the tax consequences of a community-property interest in deferred compensation. It argued that whatever one received in exchange for the interest was taxable at that time, whether or not the receipt qualified as "alimony." 276 The taxpayer then went to the Tax Court, which ruled in her favor in Balding v. Commissioner in 1992. The Tax Court concluded that the cash payments to W were "property" within the meaning of I.R.C. § 1041, and thus excludable, notwithstanding the argument made by the government that the assignment-of-income doctrine required taxation of the three payments made to W. In a footnote, the Tax Court expressly declined to rule whether W would be taxable under the assignment-of-income doctrine in future years when actual payments were made under the plan to H, but it cited Professor Asimow's article "[f]or an argument that petitioner is not required, under the Assignment of Income Doctrine, to take into income any portion of the retirement benefits ...."277 278 The government's inconsistency in this arena can be explored by examining another private ruling, which also involved a couple who lived in a community-property state and which was issued in 1989, after it issued the ruling that was litigated in Balding but before the Balding case itself was decided. The couple owned two IRAS: one for the sole benefit of H and one for the sole benefit of W. They executed a written agreement that transmuted the IRAs from community property to separate property, under which W transmuted her community-property interest in H's IRA to the separate property of H, and H transmuted his community-property interest in W's IRA, as well as some additional assets to even up the deal, to the separate property of W. The government concluded that I.R.C. § 1041 applied and prevented the recognition of any gain by either party, even though each received valuable property for their community-property interests in deferred compensation that they each surrendered. The ruling quoted the legislative history underlying I.R.C. § 1041 that emphasized that the section extends literally to all transfers between spouses. There was no mention of the assignment-of-income doctrine. 279 Not only is this ruling inconsistent with the government's position in the prior ruling that led to Balding, where it argued that whatever value is received for a surrender of a communityproperty interest in deferred compensation is taxable, notwithstanding I.R.C. § 1041, it was also inconsistent with the position taken in a yet another ruling issued just the year before in 1988. In that ruling, H proposed to transfer an undivided one-half interest in an IRA to the IRA of his spouse, W. As in the 1989 ruling described above, the transfer was not in contemplation of divorce. No mention was made regarding whether the state in which H and W resided was a community-property state. H requested a ruling that the transfer would not be considered a taxable distribution from his IRA subject to inclusion in H's gross income under I.R.C. § 408(d)(1). Section 408(d)(6) provides that a transfer of an individual's interest in an IRA to a spouse or former spouse under a divorce or separation instrument is not to be considered a taxable transfer, notwithstanding any other provision, and that the transferred interest is to be considered owned by the transferee. That provision was originally introduced as part of ERISA in 1974, a time when Davis made many such transfers taxable. The section was not repealed when I.R.C. § 1041 was introduced in 1984; in fact, a technical correction was made to it in the same act to delete a reference to the obsolete "qualified retirement bonds" repealed by the 1984 act. The government interpreted I.R.C. § 408(d)(6) as limiting nonrecognition for interspousal transfers of IRAs to the divorce context. It did so by citing the rule of statutory construction that a specific rule (I.R.C. § 408(d)(6)) controls over a general one (I.R.C. § 1041(a)) and by citing the decision by Congress to retain I.R.C. § 408(d)(6) when it enacted I.R.C. § 1041(a) as evidence that Congress intended that I.R.C. § 408(d)(6) nonrecognition be limited to the divorce context. The negative implication, it argued, was that transfers during marriage are not subject to nonrecognition treatment. Thus, the government ruled against H. 280 How can these two rulings, only a year apart, be reconciled? There are several possibilities: (1) The government changed its position between the two rulings regarding whether nonrecognition can apply to IRA transfers only in divorce; (2) the authors of the two rulings did not communicate; or (3) the government believes that the two situations are substantively different because the one in which it ruled the transfer to be taxable involved the transfer of record title while the one in which it ruled the transfer not to be taxable involved only the surrender of a community-property interest to the record titleholder. That last view is the most troubling, as it reintroduces the distinction between community-property states and states with laws "similar to community property" on the one hand, and other states on the other hand—a distinction that Congress clearly intended to obliterate with the enactment of I.R.C. § 1041-as 279 280 See Priv. Ltr. Rul. 8820086 (Feb. 25, 1988). The author of the 1988 ruling was Allen Katz, chief, Employee Plans, Ruling Branch, while the author of the 1989 ruling was William A. Galanko, assistant chief counsel (Income Tax & Accounting), acting chief, Branch 6. well as lends an inordinate distinction to whether there is a transfer of record title instead of merely a surrender of an interest in community property. Perhaps more to the point, the government does not always heed that distinction, as we saw in Balding, since it argued there that the mere surrender by W of her community-property interest in exchange for cash payments resulted in taxation to W of those cash payments. 281 283 The confusion deepens further when we return to reconsider the Kochansky decision with this discussion of the impact of community-property law in mind. Recall that Kochansky was the case in which the Tax Court and Ninth Circuit held that the lawyer husband's contingent fee in a medical malpractice case, which was pending at the time of the divorce proceedings, was taxable entirely to the husband, even though the divorce decree required that he pay one-half of the fee to his ex-wife when received. As Ms. Sarah Dods noted, the taxpayers in Kochansky lived in Idaho, a community-property state, where even earned income is permissibly split by a married couple for tax purposes under Poe v. Seaborn. 282 How could Mr. Kochansky possibly be considered to have impermissibly shifted income to his ex-wife that, by definition, would have been required to be included by her under Poe v. Seaborn? In Johnson v. United States, for example, W had a vested right to one-half of her husband's income under community-property law that was earned prior to their divorce. In the divorce settlement, she assigned her community-property interest in this accrued income to H. When H collected the accrued fees after their divorce, the Johnson court held that W was taxable on one-half of them under Poe v. Seaborn. The Kochansky case is also consistent with the government's own conclusion in the private ruling described earlier, eventually litigated in Balding,284 in which the government argued that any cash received in exchange for relinquishing a community property interest is includable by the recipient, which would be Mrs. Kochansky. So how could Kochansky come out differently? 285 Perhaps the answer lies in the fact that the medical malpractice case generating the fee was not settled until after the divorce, so that the income could be considered as accruing at least partly, if not entirely, after the divorce, which would mean that the earned income was the separate property of the husband, not the community property of the marital unit. Under that scenario, Mr. Kochansky would have to include the full amount, but then the cash payment to Ms. Kochansky should be analyzed under the income-shifting system of I.R.C. §§ 71 and 215, and it was not. If (under current law) the payment obligation would not have disappeared if Ms. Kochansky had died prior to settlement of the suit and payment to her of her portion of the contingent fee, i.e., if we assume that her estate would have had the right to sue for payment if 281 See Sarah Dods, Note, Kochansky v. Commissioner: The Assignment of Income Doctrine, Community Property Law, and I.R.C. § 1041, 72 WASH. L. REV. 873 (1997). she had predeceased the payment, then the payment would not qualify as alimony under current law. Therefore the cash receipt by Ms. Kochansky would be excludable by her and not deductible by Mr. Kochansky (and thus taxable to him) in any event. But this was not the analysis undertaken by the Kochansky court. In other words, the assignment-of-income doctrine should not have been raised in any event. If, on the one hand, the income was considered earned prior to the divorce, Ms. Kochansky would properly be taxed on her one-half interest under Poe v. Seaborn and Johnson, since she would have been considered to have earned that one-half under community-property law. If, on the other hand, the income was considered earned after the divorce, so that it was the separate property of Mr. Kochansky, then it would be a plain-vanilla cash payment of postdivorce earnings that should be analyzed under I.R.C. §§ 71 and 215, where income-shifting is clearly permissible and contemplated, so long as the requirements for tax "alimony" are satisfied. Recall that the "labels" applied to such cash payments for state law purposes (whether "alimony" or "property settlement") are irrelevant for purposes of the Federal income tax analysis applicable to such cash payments. But even if this analysis is correct, this reasoning once again reintroduces the very distinction between community-property states and common-law states that was clearly intended to be obliterated by the 1984 amendments, since the outcome under community-property law if the income is considered as accruing prior to the divorce can be different, under assignment-ofincome norms, than under noncommunity-property law. Moreover, it would require, in community-property states, an analysis in situations like that in Kochansky of how much of the contingent free was earned prior to the divorce (and thus was community property taxable in part to Mrs. Kochansky) and how much was earned after (and thus would be the separate property of Mr. Kochansky). When Congress expressed a desire to make the tax laws "as unintrusive as 286 Finally, Ms. Dods noted that this Tax Court decision (as well as the Ninth Circuit decision affirming it), accepting the government's argument that the assignment-of-income doctrine trumps I.R.C. § 1041, is inconsistent with other Tax Court decisions, such as Balding, rejecting it. She also argued that the doctrine is, in any event, inconsistent with the purposes underlying I.R.C. § 1041. She is right. 287 286 Id. at 898. 287 For example, she described the Tax Court decision in Schulze v. Commissioner, 46 T.C.M. (CCH) 143 (1983), in which a couple agreed to split any proceeds resulting from a pending legal claim of the husband. The Tax Court held that the husband was not taxable on the portion of the proceeds received with respect to the claim that were paid to his ex-wife pursuant The latest foray by the IRS into this morass is found in a field service advice 288 that deals with the transfer of nonqualified stock options in divorce. Although the ruling provided no numbers, let me use some simple ones for illustration. Assume that the corporation for which H works transfers to him, as part of his compensation package, stock options at no charge. Assume further that H is not taxed on the receipt of the options under I.R.C. § 83, because the options do not have a “readily ascertainable fair market value” at that time.29 H thus would take a zero basis in the options. If H were to exercise the options for a strike price that is less than the fair market value of the stock, he would include, as ordinary compensation income, the spread. For example, if H were able to exercise the options for $100 at a time when the stock had a fair market value of $150, H would include $50 of ordinary compensation income at that time under LR.C. § 83(a).2 If H were instead to sell the options for cash in an arm's-length transaction, the difference between H's zero basis in the options and the sales price would produce ordinary compensation income for H, and he would realize no further tax consequences when the option buyer exercised the option.291 Thus, for example, if H sold the options in an arm’s-length transaction for $50 (because the strike price was $100 and the fair market value of the stock was $150), he would similarly include $50 of ordinary compensation income at the time of sale. He would realize no further tax consequences if the buyer were able to exercise the option for $100 at a time when the stock had a fair market value of, say, $175. What happens if H and W divorce and their divorce decree requires H to transfer these unexercised stock options to W at a time when the strike price is $100 and the fair market value of the stock is $150? In the field service advice, the IRS concluded that H realizes $50 of consideration on the transfer under the Davis approach of assuming that the release of marital rights by W has a value to H equal to the value of the options transferred to W. The ruling concludes that the $50 of cash deemed received by H results in $50 of ordinary income to H under I.R.C. § 83 at the time of the transfer. W would take a $50 basis in the options. If she were to exercise the options for $100, she would take a $150 basis in the stock, and H would realize no tax consequences at the time of exercise. In other words, the IRS determined that the same rules that would apply to H if he were to sell the options to an unrelated third party for $50 cash apply when H transfers the options to W pursuant to a divorce decree. to the divorce agreement. See Dods, supra note 281, at 879. See also id. at 888-89 (discussing other inconsistent Tax Court opinions). 288 289 IRS FSA 200005006 (Feb. 4, 2000), 1999 FSA LEXIS 270. Few stock options are taxed on receipt, as the standards for determining whether stock options have a “readily ascertainable fair market value” are quite stringent. Options that are not actively traded on an established market are deemed not to have a "readily ascertainable fair market value" on receipt "unless its fair market value can otherwise be measured with reasonable accuracy." Treas. Reg. § 1.83-7(b)(2). |