earned income. Hence, Row 4 of Table 1 shows that zero is the Social Security tax threshold for all family units. Finally, Row 5 of Table 1 shows the combined income and Social Security tax threshold (i.e., net federal tax threshold) for various family units. These thresholds occur at the income level at which a taxpayer's preliminary income plus Social Security tax liabilities minus earned income and child tax credits equals zero. For example, a typical married couple with two children will not actually have a net federal tax liability for 2001 unless its income exceeds $23,562.26 Similarly, Table 2 compares the 2000 federal tax thresholds and poverty income guidelines for heads of household with one to four children. 26 Algebraically, each computation in Row 5 involved determining the appropriate equation for computing each family unit's combined income and Social Security tax liability after its earned income and child tax credits and solving for the income level at which that tax liability is equal to zero. For example, for 2001, for a married couple with two children with income (I) in excess of its $19,200 simple income tax threshold but less than the $32,121 level at which its earned income credit is fully phased out, the couple's combined income and Social Security tax liability (T) can be determined by the following formula: T=.15 x (I- $19,200) + .0765 x I - ($4,008 - .2106 x [I- $13,090]) minus the lesser of ([2 x $500] or [.15 x {I- $19,200}]). Setting T equal to zero and solving for I in the above manner shows that the couple's combined income and Social Security tax threshold after the earned income and child tax credits is $23,562. TABLE 2. POVERTY LEVELS AND NET FEDERAL TAX THRESHOLDS AFTER TAX CREDITS IN 2001, BY FAMILY SIZE, HEADS OF HOUSEHOLD B. Simplifying and Rationalizing the Federal Income Tax Law Applicable to Transfers in Divorce By Deborah A. Geier Sometimes the complexity in our tax law is defended as a necessary evil in order to conform the law to the underlying theory informing it. Some also say that, since ours is a complex economy and society, our tax system is necessarily complex, and those engaged in complex transactions can afford to pay for the complex tax advice necessary to successfully navigate through the system. Or so the sayings go. One area of the tax law, however, remains needlessly complex not because of any coherent underlying theory but because of history and a series of political compromises. Moreover, the "transaction" at issue is not one engaged in only by the savvy, well-advised, and well-to-do. The "transaction" at issue is divorce. While the tax law applicable to transfers in divorce was, on average, improved in 1984 (in my view), several fundamental incoherencies and unnecessary complexities continue to plague this area, and more recent ambiguities (dealing chiefly with redemptions of stock in closely held corporations and other transfers under the assignment-of-income doctrine) have arisen. One of the biggest sources of complexity in the current regime is the continuing desire-though futile, in my view--to differentiate cash "alimony" from cash "child support" from cash "property settlements" in order to apply different tax rules to such transfers, depending on the Professor of Law, Cleveland-Marshall College of Law, Cleveland State University. O Deborah A. Geier 2001. This article was written in my capacity as an "academic advisor" to the Joint Committee on Taxation in connection with a study of the overall state of the tax system, including recommendations with respect to possible simplification proposals, that Congress mandated in I.R.C. § 8022(3)(B). The opinions expressed here are, however, completely my own and should not be attributed to the Joint Committee on Taxation. 1 The specifics of current law will be discussed in more detail later in this article. Briefly stated, cash payments satisfying the federal definition of "alimony" in I.R.C. § 71(b) (regardless of what the payments are called for state law purposes) are includable in gross income by the recipient and deductible by the payor directly from gross income (unhampered by the inability to itemize deductions). See I.R.C. §§ 71, 215, & 62(a)(10). Thus, the tax burden on these cash payments is, at least nominally, borne by the recipient. Cash payments constituting "child support" within the meaning of § 71(c) are neither includable by the recipient nor deductible by the payor. See I.R.C. § 71(c). Thus, the tax burden on these cash payments is, at least nominally, borne by the payor. 2 As described supra note 1, payments qualifying as “alimony" under I.R.C. § 71(b) are includable by the recipient and deductible by the payor. Cash payments not satisfying the requirements of I.R.C. § 71(b) are neither includable nor deductible. Notice that payments label that has been applied. My bottom-line recommendation is that such labels be discarded and that the parties be explicitly empowered to determine whether cash transfers--whether denominated alimony, child support, a property settlement, an "equitable distribution" for state law purposes, etc.--should be includable by the recipient and deductible by the payor, or excludable by the recipient and not deductible by the payor, with simple and clear default rules for taxpayers who fail to make their wishes known in their divorce, separation, or support instrument. Well-advised taxpayers already have significant freedom to decide who, between them, should be taxed on cash transfers incident to divorce, since they can structure their cash transfers in the form that will implement their agreement. Poorly advised or unadvised taxpayers are not provided similar flexibility, since they are unaware of the various transactional elections effectively available to them if they had cast their cash payments in the proper form. 3 The reason underlying the different tax treatment applicable to alimony and child support has never been adequately articulated, and it is often difficult to distinguish between the two in any event. The reason underlying the different tax treatment applicable to alimony and many cash property settlements can, in contrast, be articulated as a theoretical matter, but, as Professor Malman noted in 1986, “there is no administratively practical way for the tax system to draw the alimony/property distinction."4 Payments that would be characterized as "alimony" for tax purposes may constitute "child support" or a "property settlement" under state law, and vice versa. Moreover, an increasing number of states are abandoning such labels altogether. Under "equitable distribution regimes," for example, the cash payment stream can be intended simply to settle all claims for support and property compensation between the parties. Continuing to make the determination of who should be taxed on cash transfers in divorce turn on what label is used to identify the payment, and then having unique tax definitions for those labels that often subject to the inclusion/deduction scheme may not actually constitute "alimony" under state law, so long as the payment satisfies the federal tax definition of “alimony” in § 71(b). That is to say, a cash payment constituting a property settlement under state law or upon examination of the particular facts can nevertheless qualify as an includable/deductible payment so long as the federal requirements for "alimony" are satisfied. For example, payments qualifying as tax alimony (and thus subject to the inclusion/deduction system) can be intended to compensate the recipient for her share of vested or inchoate property rights that either go to the payor on the divorce (such as a piece of real estate that was co-owned by the spouses prior to the divorce) or are extinguished on the divorce (such as dower and curtesy rights or statutory share provisions created under some state intestacy laws). Some cash payments will not satisfy the federal definition of "alimony” or “child support" and thus are considered tax-neutral "property settlements" by default. 3 Cf. Marci Kelly, Calling a Spade a Club: The Failure of Matrimonial Tax Reform, 44 TAX. LAW. 787, 811-12 (1991) (reaching the same conclusion). Laurie L. Malman, Unfinished Reform: The Tax Consequences of Divorce, 61 N.Y.U. LAW REV. 363, 367 (1986). deviate from state law definitions, causes confusion among taxpayers and traps for the unwary, as case law litigation clearly shows. The great fear that has driven Congress in the past in this area is that divorcing parties will engage in inappropriate "income-shifting" if left to decide for themselves who should be taxed on cash transfers, with the joint income of the divorced couple being taxed at a lower overall rate than would have occurred absent the divorce, to the detriment of the Treasury. In response, I would argue that such tax arbitrage is built into the current system already, that people do not get divorced in order to engage in income-shifting for tax purposes, and that the income-shifting that can occur is likely a good and defensible outcome on public policy grounds in most situations in which it can occur, since it encourages the higher-bracket spouse to transfer funds to the lower-bracket spouse (presumably the more needy spouse), often leaving the lowerbracket spouse with more after-tax income than she would otherwise have if income-shifting were disallowed.' Unlike other situations in which income-shifting is deemed to be inappropriate, such as in the intact family or in the case of a closely held corporation, divorce is not a transaction that can be entered into lightly, and often, in order to shift income to another in a lower tax bracket and thus reduce overall taxes on a routine basis while retaining effective control over the shifted income. Indeed, "[f]ollowing divorce, the chances of filing bankruptcy triple ..........” To the extent that some additional income-shifting would occur under the proposed simplifications that does not already occur under the current rules, so be it. Even if I am wrong that it would be a salutary result in most cases, it is a small price to pay for the huge simplification gains--and, I believe, added respect for the tax system by the unfortunate parties that have to deal with these complex provisions--that would occur. Moreover, as Professor Malman noted, there is reason to believe that not much aggregate tax would be lost to the Treasury in any event, since every deduction is accompanied by an 5 See infra notes 173-230 and accompanying text (surveying some cases). 6 Cf. Wendy Gerzog Shaller, On Public Policy Grounds, A Limited Tax Credit for Child Support and Alimony, 11 AM. J. TAX POL'Y 321, 321 (1994) (also referring to the "abuse of income-shifting" in this context). put it, 7 See infra note 240 and accompanying text (providing example). As Professor Hjorth I am not unduly concerned by the specter of a "divorce bonus." For every case of Roland L. Hjorth, Divorce, Taxes, and the 1984 Tax Reform Act: An Inadequate Response to an Old Problem, 61 Wash. L. Rev. 151, 190 (1986). David Kay Johnston, Bankruptcy Borne of Misfortune, Not Excess, N.Y. TIMES, Sept. 3, 2000, § 3, at 7. 71-870 2001 - 2 |