To American tax lawyers used to hearing that "substance" and not "form" governs the characterization of tax transactions, it might seem odd that, while the statute announced that Congress had decided--for whatever reason--that child support should be treated differently from alimony, the law allowed what was, for all intents and purposes, disguised child support to escape characterization as “child support." Yet, what the so-called Lester Rule (as it came to be known) accomplished was the delegation to the divorcing parties of the authority to decide who, between them, should pay the tax on the amounts used to support the children. If they clearly "fixed" the amount as child support in their agreement, then the payor would pay tax on the payments; if the amount was not explicitly "fixed" but the amount paid was reduced upon the child's marriage, death, or emancipation, then the recipient would shoulder the burden. The Lester Court recognized this when it said: As we read § 22(k), the Congress was in effect giving the husband and wife the You might think that I support the outcome of the Lester Rule, since I made plain in the Introduction that I will, in Part II, explicitly argue that the parties should be able to decide for themselves who, between them, should shoulder the burden of paying tax on cash transfers. But the actual approach embodied in the Lester Rule suffers from a fundamental defect: The election was not explicit; it required the advice of a skilled tax practitioner to alert the parties to this planning device. Ill-advised (or unadvised) parties unlucky enough to call child support “child support” in their agreement were unable to shift the tax burden to the payee under the Lester Rule, even if they wished to (and the reasons they might wish to will be detailed later). Under the approach of the Lester Rule, in other words, parties were empowered to decide who should bear the tax burden only if they were aware of the magic formula. If it is true that Congress intended, as indicated by the legislative history, that the parties to be able to decide for themselves who, between them, should shoulder the burden of paying tax on amounts paid out as child support, it should have made that election explicit. Having that election effectively buried in Committee Reports and then in a Supreme Court opinion discussing what it means to “fix” an amount for child support was not defensible. Then, as now, too many people divorced without tax counsel. And even many family lawyers who were not well-versed in tax law were likely unaware of this de facto election. The de facto election under the Lester Rule was, in short, a huge trap for the unwary. There will always be parties who are unwary of the law, but the law should strive as much as possible to keep the traps to a minimum, particularly in an area, such as divorce, where people often go it alone (i.e., without good tax counsel). In sum, if Congress was serious about taxing child support differently from alimony in 1942, then the term "fix" should not have been interpreted as it was by the Lester Court. Substance should have controlled. If, on the other hand, the Lester Rule outcome was deemed desirable because it would allow the parties to decide for themselves who should bear the burden of tax on these cash payments, then the election should have been made much more explicit on 33 366 U.S. at 304. the face of the statute itself and not made contingent on including the right magic words in the divorce settlement to accomplish the same end result as would an explicit election. Amounts "fixed" as child support were not the only payments that fell outside the recipient inclusion/payor deduction system enacted in 1942. Congress intended that payments for the recipient's interest in property should not fall within the inclusion/deduction system as well and, like child support payments, should be tax neutral (i.e., neither deductible by the payor nor includable by the payee). While we were hard-pressed to come up with a reason why Congress chose to treat child support payments as falling outside the new inclusion/deduction system in 1942, it's much easier to identify the thinking behind the distinction between alimony and cash property settlements. 35 As a simple example, assume that John and Mary owned Blackacre, worth $100,000, as joint tenants when they divorced. John wished to own 100% of Blackacre outright, and he thus agreed to pay Mary $50,000 for her share of Blackacre, either out of his own previously earned funds or in installments from his future earnings. In each of these scenarios, this $50,000 payment should not (as a matter of theory, at least) fall within the inclusion/deduction scheme, if we respect the payment as a purchase of property. Viewed from John's perspective alone, an outlay made to purchase property is properly a nondeductible "capital expenditure."34 Allowing John a deduction for his outlay to purchase property violates the fundamental structure of a tax on "income," effectively garnering John consumption-tax treatment, instead. Another way to view it (again, from John's perspective alone) would be to say that if John were allowed to deduct his purchase price of $50,000 for Mary's interest in Blackacre, the Treasury would actually be funding a portion of his purchase price (equal to John's tax savings). On the other hand, we must remember that Mary would be fully taxed on the cash receipt if John gets to deduct it, so the revenue loss to the Treasury by treating this payment under the inclusion/deduction scheme (rather than as a tax neutral payment) would equal only the difference (if any) between John's marginal rate bracket (the tax lost to the Treasury) and Mary's (the tax gained). Viewed from Mary's perspective alone, if this payment were respected as a payment for her share of Blackacre, she would measure her realized gain or loss under I.R.C. § 1001 by comparing the $50,000 received for her half interest with her basis in the half interest. Only if her basis were zero would the gain realized equal the entire $50,000 that would be included if the payment were instead treated under the inclusion/deduction system, and even then the gain might be lower-taxed capital gain (instead of the ordinary income that arises under the 34 35 See supra note 18. Under a consumption tax, all outlays--even those that would constitute nondeductible capital expenditures under an income tax--are deductible so long as the outlay does not buy personal consumption. Thus, additions to savings, such as John's purchase of $50,000 worth of Blackacre, would be deductible under a cash-flow consumption tax, even though it would be nondeductible under an income tax. See generally Dodge, Fleming, & Geier, supra note 10, at 472-83. inclusion/deduction system) or might not be recognized at all.36 The transaction might also produce a loss if Mary's basis for her half share of Blackacre were higher than $50,000. In short, in theory at least, only the portion of a shared income stream earned by the payor after the divorce and paid to the recipient for support (and not for her share of property or inchoate property rights accrued during the marriage) should be eligible for the inclusion/deduction system. The 1942 legislation attempted to codify this idea in new § 22(k) with the following language: In the case of a wife who is divorced or legally separated from her husband under such taxable year is received during such taxable year, the aggregate of such 37 installment payments) does not exceed 10 per centum of such principal sum. subpart. 36 Whether Mary's realized gain or loss would be recognized is discussed in the next 37 I.R.C. § 22(k) (1942). The language referring to a transfer “attributable to property transferred (in trust or otherwise) in discharge of” a legal obligation ensured that if a payor satisfied his alimony obligation by creating a trust or purchasing a life insurance or annuity contract, etc., with the payments from the trust or insurance company payable to the payee, then that income stream was also includable by the payee. The later language that the amounts "received as are attributable to property so transferred shall not be includable in the gross income of the husband" rendered a deduction unnecessary to the husband to shift the income tax obligation to the payee. The income shifting was accomplished via different means (an exclusion for the husband rather than a deduction) but was nevertheless successfully accomplished. Regulations issued in 1942 give this example. "For example, if in order to meet an alimony obligation of $500 a month, the husband purchases or assigns for the benefit of his former wife a commercial annuity contract paying such amount, the full $500 a month received by the wife is includable in her income, and no part of such amount is includable in the husband's income or deductible by him." Reg. 103, Sec. 19.22(k)-1(b) (issued in Treasury The statute provided the payor a deduction in § 23(u) for all amounts includable by the recipient. 38 The relevant qualifications for an includable/deductible payment could be distilled, therefore, as follows: (1) The payment had to be "periodic," but a payment could be periodic even if not made at regular intervals. (2) (3) (4) (5) It had to be made pursuant to a decree of divorce or of separate maintenance. It had to discharge a legal obligation imposed on the payor because of the marital or family relationship. It could not be an amount "fixed" for child support. If the payment was an installment payment that discharged a principal sum stipulated in the divorce decree, then the payment qualified only if the installment period exceeded ten years from the date of the decree and, even then, the installment payment in any one year could qualify only to the extent that it did not exceed ten percent of the principal sum designated in the decree. Requirement 2 is straightforward, and I have already discussed requirement 4. ,,39 40 The implicit assumption underlying requirement 1 that the payment be "periodic" was that a lump-sum obligation (even if paid in installments) looks much more like a property settlement than a support payment out of new earnings of the payor that have not yet been taxed. But while the general idea is fairly easy to grasp, the provision generated much litigation in search of the precise meaning of the term "periodic.' The cases generally concluded that, to be periodic, the payments had to be either for an indefinite amount or an indefinite period. Moreover, as requirement 5 indicates, if the payment was part of an installment stream that discharged a principal sum stipulated in the divorce decree, the payment stream had to exceed ten years to overcome the underlying presumption that it otherwise constituted a payment for the recipient's interest in marital property. A payment was considered to be in discharge of a principal sum if "the final sum to be paid could be definitely determined at the time the decree Decision 5194, Dec. 8, 1942). This sentence was lifted directly from the legislative history. See H.R. REP. NO. 77-2333, reprinted in 1942-2 C.B. 372, 568. 39 See, e.g., Warnack v. Comm'r, 71 T.C. 541 (1979); Bishop v. Comm'r, 55 T.C. 720 (1971); Van Orman v. Comm'r, 418 F.2d 170 (7th Cir. 1969). 40 177, 185. Barb Mattei, Note, 1984 Deficit Reduction Act: Divorce Taxation, 1986 WIS. L. REV. was executed."41 Even if the ten-year period was met, no more than ten percent of the principal sum could qualify as deductible alimony in any one year. An example taken from the 1942 regulations illustrates the operation of this rule. A divorce decree in 1940 provides that H is to pay W $20,000 each year for the next 5 years, beginning with the date of the decree, and then $5,000 each year for the next 10 years. Assuming the wife makes her returns on the calendar year basis, each payment received in 1942 [the first year in which the new rules became effective] 1943 and 1944 is a periodic payment under section 22(k), but only to the extent of 10 percent of the principal sum of $150,000. Thus for such taxable years, only $15,000 of the $20,000 received is includable under section 22(k) in the wife's income and is deductible by the husband under section 23(u). For the years 19451954, inclusive, the full $5,000 received each year by the wife is includable in her income and is deductible from the husband's income.' This ten percent rule, in short, discouraged front-loaded payments that might look as though they consisted more of a property settlement than a support payment. Matters could get quite complicated, however. The regulations provided that “[t]his 10 percent limitation applies to installment payments made in advance but does not apply to delinquent installment payments for a prior taxable year of the wife made during her taxable year. » 43 The interrelationship between the ten-year rule, the ten-percent rule, and the rules for advance and delinquent payments was illustrated by the following sticky example. Under the terms of a separation agreement incident to divorce granted in December 1940, H agrees to pay W $500 on the first day of each month, beginning with the month after the decree, for 12 years. W makes her income tax returns on the calendar year basis while H makes his returns on the basis of the fiscal year ending June 30. H makes the promised payments in 1941 and 1942 and, in addition, on December 31, 1942, pays W $1,500 as an advance payment of installments for the next three months. In the calendar year 1943, H makes no payments at all because of financial straits. On January 1, 1944, H inherits $15,000, which he immediately pays to W in satisfaction of not only his back alimony installments for the last 9 months of 1943 but also his alimony installments for the next 21 months. The results as to H and W are as follows: As to W. In the calendar year 1941, W received $6,000, none of which is includable in her gross income. In the calendar year 1942, W received $7,500. Since 10 percent of $72,000 (the principal sum) is $7,200, only $7,200 of the $7,500 so received is includable in her income for 1942. For 1943, nothing is includable in her income under section 22(k). In 1944, W received $15,000. Of this amount, $4,500 is in payment of back installments and, therefore, is includable without limitation in her income for 1944. Of the balance of $10,500, only $7,200 is includable in her income for 1944. 41 Id. 42 43 Reg. 103, Sec. 19.22(k)-1(c), Ex. 2 (issued in Treasury Decision 5194, Dec. 8, 1942). Reg. 103, Sec. 19.22(k)-1(c) (issued in Treasury Decision 5194, Dec. 8, 1942). |