As to H. For the taxable year ended June 30, 1941, H paid $3,000 none of which is deductible. For the taxable year ended June 30, 1942, H paid $6,000, of which only $3,000 is deductible by H since only that much of the $6,000 was paid in the wife's first taxable year beginning after December 31, 1941. In the taxable year ended June 30, 1943, H paid W $4,500, which, not being in excess of 10 percent of the principal sum, is deductible for such year. In his taxable year ended June 30, 1944, H paid $15,000, of which $11,700 (the sum of $4,500 and $7,200) is deductible. Clearly not an easy or intuitive result for the divorcing parties who fail to (or could not afford to) seek advice. As noted above, payments of less then ten-year duration would not qualify for the inclusion/deduction system at all if they discharged a principal sum that could be computed from the decree at the time of the execution. But, in such a case, a contingency clause inserted into the divorce agreement to increase, decrease, or terminate payments on the happening of certain events, such as death, remarriage, or a change in economic circumstances, was sufficient to make the payments sufficiently indefinite in duration to be "periodic," even if the likelihood of the contingency occurring during the payment stream was low.* 45 For example, if the decree obligated the payor to pay $900 per month for nine years, the obligation was for a principal sum paid in less than ten years and was excludable and nondeductible .... However, if the decree inserted the contingency that the payments were to continue for nine years or until the recipient's death, the payments became "periodic❞ and therefore includable, deductible. Moreover, payments under a divorce decree lacking a contingency clause would nevertheless be considered "periodic" if state law would step in and terminate or modify payments. For example, in Kent v. Commissioner, the court held that the possibility that a judge could modify an alimony award under state law if the parties' circumstances changed meant that the payment was sufficiently indefinite as to qualify as "periodic," even though the payment stream mandated by the document itself was less than 10 years and was of a principal sum. 47 48 The effect of local law on the interpretation of divorce and separation agreements meant that a divorcing couple in one state could use the very same language in their agreement as that used by a couple in another state with entirely different tax results. This lack of uniformity in the divorce tax laws caused by the dependence on state law was one reason the decisions in this area 48 Rev. Rul. 59-190, 1959-1 C.B. 23. 61 T.C. 133 (1973); see also Marshall v. Comm'r, 35 T.C.M. (CCH) 138 (1976) (ruling similarly); John Y. Taggart, Economic Consequences of Emotional Choices: Divorce and Separation under TRA 1984, 15 CUMB. L. REV. 341, 347 (1985) (citing both). have appeared so contradictory and the tax treatment of divorce settlements has been so unpredictable. 49 Requirement 3--that the payment had to discharge a legal obligation imposed because of the marital or family relationship--was another device intended to differentiate support payments from property settlements. Lifting a sentence directly from the legislative history, regulations issued in 1942 interpreted this requirement as limiting eligible payments to those made “in recognition of the general obligation to support, which is made specific by the instrument or decree."50 If the payment was not made in general recognition of the obligation to support, but rather to execute a property settlement, then it would fail to qualify as a payment made to discharge a legal obligation imposed because of the marital or family relationship and thus fail to qualify for the inclusion/deduction system, even if the payments were "periodic." This was true even if the payments were in extinguishment of such an intangible and inchoate property interest as dower or curtesy, since such amounts were not paid for support but rather for extinguishment of those intangible property rights.2 This rule caused much confusion. For example, monthly cash payments over a 121-month period (i.e., more than ten years) qualified as "periodic" (because they exceeded ten years) but were held not to be includable/deductible payments because the amount of the payments was calculated by subtracting the value of the marital property received by the payee pursuant to the divorce from the value of the marital property received by the payor. Thus, the court concluded that the payment stream was a property settlement and not made in discharge of an obligation of support. Even payments specifically designated as for "support" of the ex-wife in the divorce settlement were recharacterized as a property settlement where the payments represented the wife's interest in her former husband's partnership, which was community property under 53 49 50 Taggart, supra note 48, at 347. Reg. 103, Sec. 19.22(k)-1(a) (issued in Treasury Decision 5194, Dec. 8, 1942). The legislative history stated: "This section applies only where the legal obligation being discharged arises out of the family or marital relationship in recognition of the general obligation to support, which is made specific by the instrument or decree." H.R. REP. No. 77-2333, reprinted in 1942-2 C.B. 372, 568 (emphasis added). 51 See Taggart, supra note 48, at 346. Moreover, a voluntary payment would fail to qualify, since such a payment would not be made "in discharge of a legal obligation." See, e.g., Moore v. United States, 449 F. Supp. 163 (N.D. Tex. 1978). See generally John W. Harris, The Federal Income Tax Treatment of Alimony Payments--The "Support" Requirement of the Regulations, 22 HASTINGS L.J. 53 (1970) (generally examining the development and then-current contours of the "support" requirement). 52 See Swindle v. Comm'r, 35 T.C.M. (CCH) 1 (1976). 53 Adam v. U.S., 429 F. Supp. 38 (D. Wyo. 1977); accord Gammill v. Comm'r, 710 F.2d 607 (10th Cir. 1982); Crouser v. Comm'r, 73 T.C. 1113 (1980). 54 California law. Conversely, payments specifically found by a state court to be a "property settlement" were held to be "alimony" for federal tax purposes since the Tax Court found that the wife did not relinquish anything of value when she transferred her joint tenancy interest in a house to her former husband." In that case, the Tax Court went so far as to say that "the labels given to the payments by the parties or by the [state court decree] do not govern their characterization for tax purposes. ,,56 A further taste of the confused state of the law in trying to differentiate "support" payments from "property settlements" under this standard was given by one commentator, as follows: The courts were often inconsistent in these recharacterizations. In Ryker v. 57 When Congress recodified the income tax law in 1954, this treatment of alimony and child support (as well as their definitions) was continued in I.R.C. §§ 71 (alimony includable, child support excludable) and 215 (amounts includable under I.R.C. § 71 are deductible). As this quick perusal of the law makes clear, the law between 1942 and 1984 with respect to alimony and child support was complex, ambiguous, not uniform from state to state, and 54 55 56 Westbrook v. Comm'r, 74 T.C. 1357 (1980). Graham v. Comm'r, 43 T.C.M. (CCH) 15 (1981). Id.; accord Widmer v. Comm'r, 75 T.C. 405 (1980) (holding that a state court's characterization of payments under a divorce decree as alimony was not controlling for tax purposes and that since the payments were not contingent and the wife was required to assign a stock interest to her husband the payments were correctly determined to be a property settlement). 57 Mattei, supra note 40, at 186 n.72 (case citations omitted) (citing Stanley M. Grossbard, Comment, Taxation of Divorce Settlements and the Property/Support Distinction, 55 S. CAL. L. REV. 939 (1977) and John W. Harris, The Federal Income Tax Treatment of Alimony Payments--The "Support Requirement" of the Regulations, 22 HASTINGS L.J. 53 (1970)). contained a large number of traps for the unwary. Advice of a lawyer well-versed in the tax law was crucial, and even then, labels attached to payments in the agreements and state divorce decrees often were recharacterized by the courts in the ensuing tax litigation. “Couples were making significant financial decisions which might bind them for many years, yet were sometimes unable to predict the tax consequences of their decisions with any certainty."58 The not infrequent need to resort to litigation to deal with some of these complexities and ambiguities also made the task of complying with the law all the more expensive. And it's difficult to believe that all of this confusion could be justified by any argument that the complexity was required in order to get it “right.” The law characterized an absolute obligation to pay $10,000 per year for 9 years (a total of $90,000) as an excludable/nondeductible property settlement in full, period, regardless of whether this conclusion was fairly justified by the underlying facts. No judge had the power to make an inquiry into the underlying facts with such terms. At the same time, an absolute obligation to pay $10,000 per year for 9 years and $1,000 per year in years 10 and 11 was characterized as “alimony" to the extent of $9,200 of each of the payments in years 1 through 9 and the full $1,000 payments in years 10 and 11, with only the remaining $7,200 characterized as "not alimony"--unless the underlying facts convinced a judge that the payment stream really was meant to compensate the recipient for her interest in marital property so that the payment was not made in discharge of an obligation for "support." I think it would be almost mere happenstance if these tax conclusions reliably labelled the status of these payment streams "correctly." 2. In-Kind Property Transfers 59 Notice that the definition of includable/deductible "alimony" enacted in 1942 contained no requirement that the payment be made in cash. Thus, a $500 alimony obligation could be discharged with the transfer to the alimony recipient of property worth $500. Moreover, property settlements often required the transfer of property in kind from one spouse to the other. How were these in-kind property transfers treated for tax purposes? One result was already described: If the transfer otherwise qualified as "alimony" under the requirements described in subpart 1, above, then the recipient had to include the value of the property in gross income and the transferor could deduct it. Conversely, if the transfer failed to qualify as "alimony," then the recipient would exclude the receipt and the transferor would not be permitted to deduct it. But with an in-kind property transfer, a second question arises in both instances: Is the transfer a realization and recognition event, so that any built-in gain or loss is taken into account for tax purposes? Disagreements surrounding the answer to this question led the Supreme Court to consider it in Davis v. Commissioner in 1962. 58 60 Deborah E. Behr, Note, Tax Planning in Divorce: Both Spouses Benefit from the Tax Reform Act of 1984, 21 WILLAMETTE L. REV. 767, 773 (1985). 59 See supra text accompanying note 37. 60 370 U.S. 65 (1962). The following paragraphs describing Davis and the evolution of the law in the years following are taken from Deborah A. Geier, Form, Substance, and Section 1041, 60 TAX NOTES 519, 520-21 (1993). In 1955 and pursuant to a divorce decree, H transferred to his former spouse, W, shares of E.I. du Pont de Nemours & Co. that had a cost basis in H's hands of approximately $75,000 and a fair market value at the time of transfer of approximately $82,250. In return, W released H from all claims, including dower and any rights under the laws of testacy and intestacy. Concluding that "the inchoate rights granted a wife in her husband's property by Delaware law do not even remotely reach the dignity of co-ownership," the Supreme Court applied the marketplace rule that the transfer of property owned by one taxpayer to another taxpayer in exchange for the release of an independent legal obligation is a realization event. Assuming that the value of the release of the inchoate marital rights equalled the value of the stock, the Court concluded that H realized a gain of approximately $7,250 on the transfer and that W took a cost basis of $82,250 in the stock. The Court noted in a footnote the "administrative practice" of not taxing W on the release of marital rights." 63 64 62 Had W possessed some sort of ownership interest in the stock at the time of the divorce, as in a community property state, the outcome might have been different. The transaction might have been viewed instead as a division of jointly owned property, which was not considered a realization event. The Court acknowledged, but apparently was not overly troubled by, the disparities that its decision would create between residents of community-property states--in which no "transfer" might be deemed to occur on the division of marital property--and residents of common-law states. As described below, the post-Davis era was one of confusion and uncertainty and certainly one full of traps for the unwary. It was also an era that witnessed state legislation that had as its goal the frustration of a federal tax case, the Davis case, while maintaining a commonlaw property regime in other respects. 65 The government conceded that approximately equal divisions of community property or property in states where the law is "similar to community property law" were not taxable; the transferee took a carryover basis and tacked holding period in the property. Similarly, the Service ruled that approximately equal divisions of property owned in joint tenancy or property held as tenants in common were nontaxable divisions of property, even though ownership wasn't 62 Id. at 68-70. Cf. International Freighting Corp. v. Comm'r, 135 F.2d 310 (2d Cir. 1943) (transfer of appreciated property to employee in payment for services rendered is a realization event for transferor). 63 370 U.S. at 71-74. See Philadelphia Park Amusement Co. v. U.S., 126 F. Supp. 184 (Ct. Cl. 1954) (basis of property received in taxable exchange is fair market value of the property received). |