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The Tax Lawyer

The Tax Lawyer: Summer 2020

Naked Stripping for Alimony and Child-Support Tax Benefits

Steven J Willis


  • This article illustrates the unintended consequences of legislation and administrative actions of the 2017 Tax Cuts and Jobs Act.
  • The author explains how many taxpayers may be able to take advantage of the resulting loopholes and argues that the benefits should help everyone, or no one.
  • A suggestion that congressional acquiescence to the plans (per the legislative acquiescence doctrine) could expand them to help all taxpayers despite administrative or judicial action.
Naked Stripping for Alimony and Child-Support Tax Benefits
Manuel F Jimenez Rojas via Getty Images

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Despite the alimony tax deduction repeal as part of the 2017 Tax Cuts and Jobs Act (TCJA), opportunities for alimony and child-support tax benefits currently exist. Indeed, the attempted repeal actually expanded the tax benefits—even extending them to child support—contrary to the stated congressional intent. An often-praised (but ill-advised) 2002 revenue ruling, along with a long-dormant provision for preferred-stock income stripping and the poorly drafted provision of the TCJA, combine to produce these unintended consequences.

Wealthy and merely well-to-do taxpayers can easily benefit, as can many small-business owners. Indeed, the wealthy can likely receive double benefits. Unfortunately, moderate-income employed persons—those arguably most deserving of tax benefits—are at risk of having the proposed tax plans disallowed. These proposed plans involve income stripping and the assignment of income. The plans are naked because they lack any real economic substance, although they all satisfy the narrow requirements of the statutory economic substance doctrine (though not quite so clearly if used by moderate-income taxpayers).

This Article serves several purposes. First, it illustrates the unintended consequences of legislation and administrative actions. Second, it explains how many taxpayers may be able to take advantage of the resulting loopholes. Third, it argues that the benefits should help everyone, or no one. Finally, it suggests that congressional acquiescence to the plans (per the legislative acquiescence doctrine) could expand them to help all taxpayers despite administrative or judicial action.

I. Introduction

Despite the 2019 alimony-deduction repeal as part of the 2017 Tax Cuts and Jobs Act (TCJA), alimony and child-support tax-planning opportunities increased post repeal. Income-stripping strategies underlie these opportunities. Lacking real economic substance, they are effectively naked, but nevertheless realistic. This Article argues that strategies that take advantage of these opportunities lack real economic substance and thus should not work; however, they have sufficient legal substance such that they likely will work.

Let us begin with three examples and fill in the details later.

Example 1: Wealthy-Spouse (WS) and Non-Wealthy-Spouse (NWS) divorce. WS lives in a high-tax state. NWS and the children live in a low-tax state. WS pays NWS $200,000 annually for alimony and child support. WS’s combined tax bracket is 50%. NWS has sufficient income to offset the standard deduction but little more. The payments are expected to last 15 years.

The full $200,000 support payments are taxable to WS while NWS receives the support payments tax-free. Why? Because federal income tax law provides that post-2018 alimony payments are neither deductible by the payor nor includible by the recipient, and because child-support payments have never been deductible by the payor nor includible by the recipient.

But, with a little tax planning, that changed dramatically in 2019.

Example 2: Same facts as Example 1, except WS makes no payments to NWS. Instead, WS strips and assigns a sufficient interest in his/her vested nonqualified deferred compensation plan to pay NWS $325,000 annually.

WS excludes the compensation payments from gross income, and NWS includes them in gross income. As a result, the arrangement annually costs WS $162,500, a savings of $37,500. In present value terms, WS is better off by $389,237. NWS owes $87,525 income tax, netting $237,475 annually, an increase of $37,475. In present value terms, NWS is better off by $388,978. WS nominally stripped his deferred compensation plan, but otherwise changed nothing economically for himself or his ex-spouse. The spouses are collectively better off by $778,215. Uncle Sam loses the same amount.

But with a little more planning—and an arguably aggressive position—the savings are much greater.

Example 3: Same facts as Example 2, except WS purchases approximately $5,350,000 of preferred stock yielding five percent annually. WS separates (i.e., “strips”) the ownership right to dividends from the stock and transfers dividend rights to satisfy the expected 15-year alimony and child-support obligation.

NWS will annually include the resulting $267,346 dividends received, which will generate the needed $200,000 after tax. The arrangement costs WS $133,673 after tax, for an annual savings of $66,327, the present value of which is $688,454. WS then sells the stripped bonds for $2,571,956, recognizing a short-term capital loss of $2,774,956, which saves $1,387,478 in current tax, for a total present value tax savings of $2,075,932. Together, the tax savings and proceeds equal $4,647,888. WS’s net cost is about $700,000. Thus, for a cost of $700,000, WS satisfies a $2,075,932 alimony and child-support obligation. WS enjoys an immediate benefit of almost $1,375,000. Essentially, the government paid two-thirds of the alimony and child support. Consistent with Example 2, WS could alternatively purchase more preferred stock so as to share some of the tax benefit with NWS.

How can this work? The answer can be blunt, technical, skeptical, realistic, or cynical depending on one’s perspective.

The blunt answer is that the TCJA created the assignment of income loophole illustrated in the examples. Prior to 2019, WS could have assigned income to NWS; however, the tax benefits would not have occurred. Because the scheme works, Congress failed to accomplish its stated intention: removing the tax consequences of alimony payments and retaining the lack of child-support tax benefits.

The technical answer is that the loophole arose from three actions. First, a 1993 amendment to section 305 allocated the entire basis of stripped preferred stock to the stock and none to the dividends arising from that stock. Second, Revenue Ruling 2002-22 held the assignment of income doctrine inapplicable to section 1041 transfers. Third, a poorly drafted provision of the TCJA made both previously obscure loopholes usable.

The skeptical answer is that the reasoning of the Treasury Department and the Service in Revenue Ruling 2002-22, as well as that of multiple federal courts, is wrong. As a result, per the skeptical viewpoint, the loophole should not work, and taxpayers take advantage of it at their peril. Absent application of the legislative acquiescence doctrine, the Treasury Department and the Service could withdraw Revenue Ruling 2002-22, reinstate an earlier ruling from 1987, and destroy the scheme (though it would create some nightmare scenarios in the process). Realistically, I believe that this loophole will work for a great many divorced couples and will probably work for all. Revenue Ruling 2002-22 will likely stand from inertia if not because Congress effectively acquiesced to it with the enactment of the TCJA.

The cynical answer is that these schemes will likely work for the wealthy, the well-to-do, and for small-business owners; however, they may not work for the employed with modest incomes. Ultimately, I conclude they should either work for all, or they should work for none. Getting there is very technical.

The purpose of this Article is to provide assistance to overcoming such an inequitable result. Congress, the Treasury Department, and the courts should make these loopholes and planning schemes available to all or to none. The Article has four parts: (1) Background Statement of Current Law and Terminology; (2) Proposed Alimony and Child-Support Tax Planning; (3) History of Divorce Tax Rules: The Assignment of Income, Substitute-for-Ordinary Income, and Acceleration of Income Doctrines; and (4) Review of the Plans with Further Comments on Likelihood of Success.

II. Background Statement of Current Law and Terminology

A. Current Alimony and Child-Support Law

1. Alimony Payments Are Nondeductible by the Payor and Excludible by the Recipient

No Code section allows a deduction for alimony. Effective in 2019, the TCJA repealed both section 215, which had allowed a deduction for alimony payments by the payor, and section 71, which included alimony payments in the gross income of the payee. Specifically referencing the repeal of these two sections, the legislative history states: “Under the provision, alimony and separate maintenance payments are not deductible by the payor spouse.”

2. Child-Support Payments Are Nondeductible by the Payor and Excludible by the Recipient

No Code section allows a deduction for child support. Because deductions are matters of “legislative grace,” the absence of an “allowance” section precludes a deduction. The legislative history to the TCJA strongly suggests the absence of a child-support deduction.

No provision excludes the receipt of child-support payments from income for income tax purposes; however, child support has never been includible, as least by tradition. Nothing in the TCJA suggests a change to this rule.

As with child support, the nondeductibility of alimony is certain; however, as Part III illustrates, an alimony and child-support payor may create a scheme to exclude income used to satisfy alimony and child-support obligations under which the recipient is taxed on such amounts. Thus, paradoxically, what is certainly a correct statement of the law—alimony and child support are nondeductible—is also substantively incorrect: alimony and child-support payments are often excludible by the payor.

B. Current Marital and Divorce Property-Division Law

Property transfers between spouses or former spouses—if incident to divorce—are nontaxable events. Section 1041 is clear regarding the rule, though it is unclear regarding the meaning of some terms: “No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)—(1) a spouse, or (2) a former spouse, but only if the transfer is incident to the divorce.”

The term “property” has provided some confusion. Putting that issue aside for now, section 1041 resulted from Congress’s desire to make spousal and divorce transfers nontaxable. A few examples illustrate how it works generally:

Example 4: Spouse A owns separate property worth $100,000 with a $10,000 cost basis. If A sold it, A would recognize $90,000 gain. If, instead, A gave it to Spouse B, A recognizes no gain. B receives it tax-free, but with a $10,000 basis. Thus, if B later sells the property, B will recognize $90,000 gain.

Example 5: Same facts as Example 4, except A and B are divorced. If A transfers the property to B incident to divorce, the transfer is nontaxable. B receives the property with a $10,000 basis and potential for $90,000 gain upon a later sale.

Section 1041 prompts many tax-planning opportunities unaffected by the TCJA; hence, they are beyond the scope of this Article. Pre-2019, divorced spouses could disguise some property transfers as alimony, triggering a payor deduction and recipient inclusion. Effective 2019, Congress repealed the provisions intended to make the disguise difficult. Post repeal, disguising property transfers as excludible/includible alimony is much easier, as explained in Part III.

A key issue involves the definition of “property” for purposes of 1041. Part IV covers the issue in more detail. For now, a summary of the prevailing view is:

  • Section 1041 property includes the right to vested, nonqualified, nonaccrued deferred compensation.
  • Section 1041 property includes items traditionally thought to be property, such as land, buildings, corporate stock, bonds, and partnership interests.
  • Section 1041 property does not include unearned future income rights from personal services of an employee or independent contractor.
  • Whether section 1041 property includes future income rights from traditional property—such as future rents or crops—is unclear; however, stripped future income from preferred stock and bonds is very likely section 1041 property.
  • Section 1041 is irrelevant to qualified deferred compensation rights—such as those involving 401(k), 403(b), and IRA accounts—which are subject to their own special rules for spousal division.

C. Terminology

Three tax doctrines are critical for an understanding of this Article:

  1. Assignment of Income;
  2. Acceleration of Income; and
  3. Substitute-for-Ordinary Income.

Part IV contains a more in-depth explanation of each doctrine. A summary of each, excluding many details, will help the reader understand the examples in Part III.

1. The Assignment of Income Doctrine

The assignment of income doctrine has two parts. One deals with income from services and the other with income from property. Typically, the facts involve related persons because they necessarily involve gifts.

a. Service Income. A taxpayer who performs services must pay tax on the service income, regardless of who receives the funds. Consider two common examples:

Example 6: Attorney Father directs Client to pay $10,000 to his adult daughter who is not a lawyer. Although Daughter receives the $10,000, the assignment of income doctrine treats Father as having received it and paid it to her as a gift. Father must pay tax at his ostensibly high-tax bracket and is unsuccessful in assigning the income to Daughter’s low-tax bracket.

The doctrine arose early in U.S. tax history. As explained in Part IV, it has many nuances, particularly when the facts involve spouses and former spouses. Entities also create significant exceptions, as in the following example:

Example 7: Same facts as Example 6, except Daughter is also an attorney and has a partnership agreement with Father. The partnership receives the $10,000 from Client and, consistent with the partnership agreement, the partners allocate it to Daughter, rather than to Father.

This assignment will be successful: Daughter will include the income, and Father, who performed the services, will not. The details of partnership and corporate tax law are mostly beyond the scope of this Article. Although the government has weapons to reallocate income among partners and owners, a simple situation involving reasonable amounts—defined very broadly—is unlikely to be challenged.

Example 6 triggers the doctrine to the extent of the service-provider’s wages, regardless of whether s/he is an employee or independent contractor. Similarly, an author who earns income to be paid by his/her publisher must include the income, regardless of whether s/he assigns it to another. That scenario, however, triggers a significant exception.

Example 8: Mother writes two manuscripts. She wrote one at the behest of Publisher who agreed to pay royalties. She assigned those royalties to adult Son. Mother wrote the second manuscript freelance. She gave the second manuscript to adult Daughter who later marketed it to Publisher in exchange for royalties.

Mother unsuccessfully assigned income from the first manuscript because she earned it working for Publisher. It was fruit of her labors, which she controlled. In contrast, Mother successfully assigned income from the second manuscript because Daughter owned the property—the unpublished manuscript—which produced the later fruit. Importantly, she substantively controlled negotiations with Publisher. That exception leads to the next topic: income from property.

b. Property Income. A taxpayer who owns property producing income must pay tax on the income regardless of who receives it. Three common examples illustrate the basic doctrine:

Example 9: Mother owns a fruit orchard. She gives the recently picked fruit to Son who sells it to a wholesaler. Mother, rather than Son, must include the sales proceeds in her income.

This is a classic fruit-and-tree example, using the metaphor which arose in the Supreme Court’s 1930 decision in Lucas v. Earl. Justice Holmes, dealing with service income, stated:

There is no doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skilfully [sic] devised to prevent the salary when paid from vesting even for a second in the man who earned it. That seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.

But, as Example 8 illustrated, a transfer of the property itself successfully carries with it future income (or fruit) from the property. Thus, Mother could give the entire orchard—or a portion of it—to Son, who would be taxed on future fruits. Ripe fruit, however, is a different matter.

Example 10: Same facts as Example 9, except Mother transfers the entire orchard to Son, including the fruit hanging on the trees. Mother must include income from sales of the ripe fruit; however, Son will include income from all future fruit.

2. The Acceleration of Income Doctrine

The acceleration of income doctrine arose from the assignment of income doctrine. It differs in that it involves assignments for consideration rather than gifts.

Example 11: Taxpayer owns a commercial building net-leased to Tenant for five years at $40,000 per year. Taxpayer sells the lease to Buyer for its present value of $181,838.

Absent the lease sale, Taxpayer would have had annual income of $40,000 from the lease. But, by selling the income right to Buyer, Taxpayer accelerated the income into the year of sale. Because Taxpayer has no basis in the future income carved out of the ownership interest in the building, the entire amount received is ordinary income.

In some cases similar to Example 11, courts have treated the transaction as substantively a loan from the buyer to the taxpayer, paid off in installments with the lease income. Such cases prevent taxpayer use of the doctrine. As a result, the doctrine can be a trap for taxpayers who unwisely accelerate income and thus pay tax early; but, taxpayers who seek to use the doctrine for a “low-tax-year” or to offset an expiring NOL may be unsuccessful.

3. The Substitute-for-Ordinary Income Doctrine

Some items of income are ordinary, taxed at regular tax rates, and some are capital gains, potentially taxed at favorable rates. Although often the distinction is clear, sometimes it is not. Hence, the substitute-for-ordinary income doctrine arose. The doctrine tends to overlap with the acceleration of income doctrine. In Example 11, the taxpayer accelerated rental income into the present, which determines the timing of the income. Because proceeds from the sale of the lease are a “substitute” for what would have been rent, the character is ordinary.

D. Current Divorce Law Regarding the Doctrines

1. The Assignment of Income Doctrine

In Revenue Ruling 2002-22, the Treasury Department announced it would not apply the assignment of income doctrine to vested, nonaccrued stock options and nonqualified deferred compensation for cases involving spouses or former spouses incident to divorce. It made two significant statements:

The term “property” is not defined in § 1041. However, there is no indication that Congress intended “property” to have a restricted meaning under § 1041. To the contrary, Congress indicated that § 1041 should apply broadly to transfers of many types of property, including those that involve a right to receive ordinary income that has accrued in an economic sense (such as interests in trusts and annuities). Accordingly, stock options and unfunded deferred compensation rights may constitute property within the meaning of § 1041.

How far the Ruling extends the section 1041 property definition beyond stock options and vested, nonqualified deferred compensation is unclear, but the word “including” suggests some room for additional examples of a “broad” reading. Traditional property items—such as land, buildings, stocks, bonds, and partnership interests would fit within a narrow reading; hence, the use of the word “broadly” is also intriguing. Part IV covers this in more depth. In any event, for vested, earned-but-not-yet-included service income, the assignment of income doctrine does not apply in a divorce case.

The Ruling also stated:

Similarly, applying the assignment of income doctrine in divorce cases to tax the transferor spouse when the transferee spouse ultimately receives income from the property transferred in the divorce would frustrate the purpose of § 1041 with respect to divorcing spouses. That tax treatment would impose substantial burdens on marital property settlements involving such property and thwart the purpose of allowing divorcing spouses to sever their ownership interests in property with as little tax intrusion as possible. Further, there is no indication that Congress intended § 1041 to alter the principle established in the pre-1041 cases such as Meisner that the application of the assignment of income doctrine generally is inappropriate in the context of divorce.

Part IV considers the decision in Meisner v. United States and the rationale of Revenue Ruling 2002-22 in greater depth. For now, the law appears to be such that some types of income from property may be severable from the property in the divorce context and that the assignment of income doctrine will not apply. If the law only permitted the transfer of the income-producing property along with unaccrued future income, the italicized words and reference to Meisner would be superfluous.

In 2004, the Treasury Department clarified Revenue Ruling 2002-22 in Revenue Ruling 2004-60. Revenue Ruling 2004-60 reiterated the general nonapplication of the assignment of income doctrine to divorce. Its principal purpose, however, was to explain that Revenue Ruling 2002-22 applied only for income tax purposes. For employment taxes, such as Social Security and Medicare, the traditional assignment of income doctrine continues to apply.

2. The Acceleration of Income Doctrine

Apparently, the acceleration of income doctrine does not apply to situations covered by section 1041 property transfers. As further explained in Part IV, the doctrine traditionally is applied to nongift transfers of income rights. Much authority on the issue, including important rulings and cases, speaks in terms of the assignment of income doctrine and its general nonapplication in the divorce context; however, a few rulings and opinions speak of acceleration or allude to it.

Because divorce transfers are consummate nongift situations, the logical appropriate doctrine would be acceleration. At least since 1984, however, spousal property transfers have been statutorily defined as gifts. Using that classification, the acceleration of income doctrine is irrelevant; as a result, the discussion of rulings and judicial opinions consistently refer to the related assignment of income doctrine.

3. The Substitute-for-Ordinary Income Doctrine

Application—or not—of the substitute-for-ordinary income doctrine in divorce matters is not a significant issue although, as explained in Part IV, an understanding of it is important. The doctrine defines some items as ordinary income substitutes and, thus, not property for purposes of section 1221. As several courts have explained, the definition of “property” is elusive and inconsistent in tax law. Nonapplication of the assignment of income doctrine—which typically involves ordinary income assignments—would be inconsistent with the application of the substitute-for-ordinary income doctrine to remove substitutes from the definition of section 1041 property. In any event, the schemes proposed in Part III involve ordinary income items—compensation and dividends—as opposed to substitutes.

III. Proposed Alimony and Child-Support Plans

This Part proposes three plans with varying availability depending generally on income and wealth levels. Parts IV and V explain in detail why these work or may not work in some cases. Generally, the plans revolve around the two aspects of the assignment of income doctrine: service and property income. To be reliable, service-income plans must be either vested and as yet untaxed, or they must involve service income disguised as property. Property-income plans generally must involve the transfer of the property along with the income, or at least control of the property.

Other plans are conceivable; however, as explained in Part IV, nuances involving the assignment and acceleration of income doctrines, along with less-than-clear rules affecting divorce make the other plans risky. The reliable plans involve the use of:

  1. Nonqualified Deferred Compensation.
  2. Small-Business Corporations or Partnerships.
  3. Stripped Preferred Stock or Bonds.

The difficulty with each of these plans involves capital and liquidity. The wealthier and more liquid the payor, the easier to adopt a reliable plan. Unfortunately, because most people are neither wealthy nor liquid, practical problems abound.

A. Nonqualified Deferred Compensation Plans

Some payors will have an existing nonqualified plan containing sufficient vested rights. Others will need to create such a plan. Valuing the needed amounts depends on the support term and interest rates, as well as state laws regarding inflation and its impact on support obligations. Putting aside the details of such issues, I assume a four percent return on a typical plan and a 15-year support obligation. With those assumptions, for each $1,000 of monthly support required, the payor would need approximately $135,000 in vested deferred compensation.

If an existing plan permits withdrawals consistent with the support obligation, assignment is simple: the payor merely transfers all or a portion of his/her interest in the plan to the recipient. More likely, an existing plan will provide for deferred withdrawals that do not coincide with the support obligation. For example, if the support order requires $1,000 per month for 15 years, the plan may contain sufficient funds but provide only for withdrawals beginning in five or ten years. If so, the plan would require modification.

The modification of a nonqualified, deferred compensation plan is subject to section 409A. Generally, acceleration of benefits triggers current inclusion of all benefits; hence, a payor must be careful when modifying a plan. Fortunately, Treasury regulations provide a convenient exception:

A plan may provide for acceleration of the time or schedule of a payment under the plan to an individual other than the service provider, or a payment under such plan may be made to an individual other than the service provider, to the extent necessary to fulfill a domestic relations order (as defined in section 414(p)(1)(B)).

Section 414 defines a domestic relations order (DRO) as:

any judgment, decree, or order (including approval of a property settlement agreement) which—

  1. relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependent of a participant, and
  2. is made pursuant to a State domestic relations law (including a community-property law).

Significantly, neither section 409A nor the regulations requires a DRO to be a “qualified domestic relations order” (QDRO), which applies to a division of deferred compensation under a qualified plan; instead, for a nonqualified plan, the order must merely be a DRO. For a qualified plan, distributions to an alternate payee—such as an ex-spouse—cannot be earlier than they would have been for the plan participant. Nonqualified plan benefits, however, can be accelerated. Because nonqualified plans are not subject to the same restrictions as qualified plans, they may contain a “nonassignability” clause. If so, the employer need not honor the DRO; thus, such plans are unavailable for assignment unless modified.

Payors considering using nonqualified deferred compensation plans for support assignment generally fall into three categories:

  1. Those with sufficient plans as of the dissolution-filing date.
  2. Those with insufficient plans, but with sufficient income or wealth such that they can quickly accumulate sufficient vested plans.
  3. All others.

Example 12. Payor has sufficient vested nonqualified deferred compensation to satisfy the support obligation.

This example likely involves a wealthy or highly-compensated person. S/he may transfer—pursuant to a court order—an interest in the existing plan, which is then modified to permit withdrawals consistent with the court order. The employee may want to replace his/her assigned benefits with increased participation in the plan.

Example 13. Payor has insufficient existing, vested, nonqualified deferred compensation; however, s/he has sufficient income such that s/he can defer additional sufficient compensation within a year or so of the expected divorce.

Because most payors will likely lack sufficient vested rights in an existing plan, the second category will be applicable. For them, divorce counsel should negotiate either a new nonqualified plan with the payor’s employer or modifications of an existing plan. The new plan or modifications would permit transfer to another, as well as sufficient and relatively immediate accumulations to satisfy the present value of the support obligation. Payors who lack sufficient disposable income for their own needs during the accumulation period could temporarily use existing savings. Ideally, the needed accumulations would occur prior to the normal expected date of the divorce or property-division order. If necessary, counsel would need to convince the court to delay the final order until sufficient accumulations exist.

Planning for the Example 13 payor should not be difficult or risky. State courts frequently divide the divorce judgment from the property-division or support judgment. Example 13 would merely require a short-term delay of the final order until sufficient vested rights exist. Conceivably, the Service could challenge the use of such an order under the substance-over-form or step-transaction doctrine. But, considering that both Example 12 and 13 payors easily satisfy the Ruling’s vested-at-the-time-of-the-order requirement, a short-term delayed order for an Example 13 payor would seem to involve minor risk.

Example 13 payors will generally be less wealthy and less highly-paid than those in Example 12. Example 13 payors, however, will be generally well-to-do because they require sufficient income to defer and to accumulate in a relatively short period and either sufficient other income or liquidity to maintain their lifestyle during the accumulation period.

Alas, most payors will likely fit into a third category:

Example 14. Payor has little, if any, nonqualified deferred compensation, little or no available savings, and insufficient income to satisfy three requirements: (1) pay current alimony and child support, (2) defer sufficient income within a relatively short period to satisfy the present value of the support obligation, and (3) sufficient additional income or assets to maintain an adequate lifestyle during the accumulation period.

This group will likely include most eligible payors. Ineligible payors will also exist, such as those in the same tax bracket as the recipient. They will comprise a substantial portion of divorced persons; however, the Example 14 category will likely be large. They might typically be plumbers, schoolteachers, nurses, electricians, and others with comfortable incomes commonly known as those in the middle-class. Unfortunately, such persons arguably fall outside the permitted assignments of Revenue Ruling 2002-22. That is because, at the time of the expected property division—even if deferred a year or so—insufficient vested, nonqualified, deferred compensation rights exist.

Examples 12 and 13 work because they involve vested rights at the time of the property-division order. In contrast, an order dividing nonvested future income rights, while consistent with the 1998 decision of the Eighth Circuit in Meisner v. United States, is not consistent with Revenue Ruling 2002-22. Consequently, Example 14 payors would require substantially more time to accumulate the necessary amount of vested, deferred compensation rights than would the Example 13 payors. Success of the accumulation and assignment will likely be subject to a sliding scale. The easier case would be one close to, but not quite as quick as Example 13. The timeframe for a divorce varies considerably by state, but 12 to 18 months for a couple with children, property, and support issues would not seem unusual. Example 13 contemplates sufficient accumulations during that period (or perhaps a period involving an extra year), a delay which seems unlikely to raise any “red flags.” The easier Example 14 case might require three or four years for the needed accumulation. Perhaps the court would agree to the delay, or perhaps the property-division order could be split into two parts. The initial part would transfer at the typical divorce pace, whatever accumulated rights exist at that time, with an accelerated withdrawal plan for the required additional time. The court would retain jurisdiction for an additional support order which would occur soon after the additional accumulations vest.

The more difficult Example 14 case would be at the other extreme. Such facts would involve a payor who, after paying ordered support, must consume almost all remaining income. To satisfy the requirements of Revenue Ruling 2002-22, such a payor would require a series of orders, perhaps monthly or quarterly, as the accumulations stay ahead of the support obligation. As they vest, the court would order the transfer. The form of this case satisfies the Revenue Ruling because it involves an incident-to-divorce property transfer of vested, nonaccrued, nonqualified deferred compensation. Unfortunately, the substance of this case looks like an assignment of future income. As such, it would not be consistent with Revenue Ruling 2002-22 and would arguably fail. Parts IV and V explain why in greater detail.

B. Small-Business Corporations or Partnerships

Payors with ownership interests in corporations or partnerships should have no problem assigning a portion of their ownership to fulfill support obligations. Each is a property right and thus should be transferable without triggering tax consequences per section 1041. Under the assignment of income doctrine, such rights amount to a “tree with future fruit.” But, such items will present some practical problems.

For example, the predictability of the future income stream could be problematic. A court would likely expect reasonably predictable payments for child support or, at a minimum, retain jurisdiction to modify the order if the income proved to be insufficient. A spouse owed alimony may be willing to accept the risk, or may also seek a back-up plan. Control and management authority will also likely be an issue. The main owner-spouse may not want the recipient to have significant voting, management, or even information rights. Solutions vary with entity format.

An S corporation has two options. It could restrict voting rights to some shares without running afoul of the “1 class of stock” restriction. That would limit rights to the recipient spouse, but would require corporate action and the involvement of other shareholders. An alternative would place the payor’s shares in a “qualified voting trust” with the payor or a third person acting as the voting trustee. The recipient could be the beneficial owner of the shares, but lack voting powers. Restricting the recipient’s rights to sensitive information would be a matter of contract negotiations and state laws. The spouses would also want a “buy-out” or “retransfer” agreement as part of the court order such that once the support obligation ceases, the beneficial ownership of the shares reverts to the original owner.

Example 15. Support payor owns an interest in an S corporation with a sufficiently steady income stream. Pursuant to a negotiated court order for alimony and child support, s/he transfers a sufficient number of shares to a qualified voting trust. The trustee must pay the support recipient—who is the beneficial owner—income to satisfy the support obligation consistent with the court order. Upon termination of the support order, as a child reaches the age or majority or the alimony term ends, the beneficial ownership of the trust’s shares reverts to the payor.

A partnership presents the opportunity for a limited-partnership interest created for the payor to transfer to the recipient. As a limited partner, the recipient could receive allocations of income as well as defined distributions to satisfy the support order, but would lack management rights.

Many payors without sufficient wealth or income to take advantage of the deferred compensation scheme will own shares in a small business with sufficient income to fund the support requirement. They would follow Example 15 or a limited-partnership alternative. Because they would be transferring a property interest, they would not trigger the assignment of income doctrine even if it were to apply. Prior to 2019, this scheme would have been superfluous regarding alimony because of the section 71 inclusion and section 215 deduction. It might have worked with regard to child support; however, the section 71 requirement that amounts “fixed” as child support be treated as child support could have created doubt regarding the substance of the arrangement. The TCJA repealed that particular rule; hence, that particular prior risk is gone.

Some small-business owners, however, are generally ineligible to adopt this scheme. They would include doctors, lawyers, accountants, engineers, and other “licensed professionals.” Many states restrict their ability to form a corporation, LLC, or partnership with a nonlicensed person. As a result, a nonlicensed recipient could at most receive an “assignment of ownership interest” in such an entity. Perhaps that might be viewed as a property interest for assignment of income purposes, but more likely it would appear to create a creditor-like relationship. As a result, any assigned income would be taxed to the payor, destroying the benefits of this scheme.

Such professionals will often be Example 13 payors—those with insufficient existing, nonqualified, deferred compensation plans, but with sufficient wealth and income to create such plans within a reasonable time frame. In addition, restricted professionals have options involving traditional “gift-leaseback” or family limited-partnership arrangements. This scheme would involve the payor transferring to the recipient spouse essential property—a building, computers, library, equipment, furniture, etc.—which the recipient would then lease back to the payor’s entity. The entity could deduct the lease payments and the recipient would include them, providing the equivalent of a deduction for the payor spouse with an income inclusion for the payee spouse.

Example 16. Payor is a physician with an annual support obligation of $100,000. S/he lacks sufficient nonqualified deferred compensation to satisfy Examples 12 or 13. But, Payor owns a building or medical equipment with an annual fair rental value of $100,000. S/he would transfer, pursuant to a court order, the assets to a support trust, which would then lease the assets back to the payor or his/her business entity. The trust would pay the support recipient the lease receipts to satisfy the obligation. The trust would have a term limit and reversion interest, transferring beneficial ownership back to Payor as the support obligation decreased or ended.

C. Stripped Stock and Bonds

Support payors with sufficient capital can use stripped preferred stock to generate the desired tax benefits.

Example 17. Payor with a 15-year, annual support obligation of $100,000 could purchase preferred stock which pays a five percent annual dividend. The cost would be approximately $2,000,000. S/he would strip the dividend rights and, pursuant to a court order, transfer them to the support recipient. The court order could require a retransfer as the support obligation decreased or ended.

The recipient, not the payor, would be taxed on the dividends, accomplishing the desired result, albeit with a large capital investment.

Section 305(e) deals with stripped preferred stock. It treats stripped dividends as a separate asset from the stripped principal, with all the basis being allocated to the principal. The language is cumbersome, but clear:

(e) Treatment of Purchaser of Stripped Preferred Stock.—

(1) In general.—If any person purchases after April 30, 1993, any stripped preferred stock, then such person, while holding such stock, shall include in gross income amounts equal to the amounts which would have been so includible if such stripped preferred stock were a bond issued on the purchase date and having original issue discount equal to the excess, if any, of—

(A) the redemption price for such stock, over

(B) the price at which such person purchased such stock.

The preceding sentence shall also apply in the case of any person whose basis in such stock is determined by reference to the basis in the hands of such purchaser.

(2) Basis adjustments.—Appropriate adjustments to basis shall be made for amounts includible in gross income under paragraph (1).

(3) Tax treatment of person stripping stock.—If any person strips the rights to 1 or more dividends from any stock described in paragraph (5)(B) and after April 30, 1993, disposes of such dividend rights, for purposes of paragraph (1), such person shall be treated as having purchased the stripped preferred stock on the date of such disposition for a purchase price equal to such person’s adjusted basis in such stripped preferred stock.

(4) Amounts treated as ordinary income.—Any amount included in gross income under paragraph (1) shall be treated as ordinary income.

The Example 17 payor would have a section 1012 cost basis of $2,000,000 in the stock prior to the strip. Paragraph (e)(1) would be irrelevant because the payor would be purchasing preferred stock rather than stripped preferred stock. When the payor transfers the stripped dividend rights to the support recipient, paragraph (e)(3) treats him as having purchased the retained stripped preferred stock for the $2,000,000. That paragraph effectively allocates the entire section 1012 cost basis to the principal and none to the stripped dividends. The recipient would receive the dividends and include the dividends as gross income under section 61. The payor would have no income from the retained principal.

An additional—and arguably riskier part of this scheme—would involve the payor later selling the retained stripped preferred stock. Using the facts of Example 17, the sales price would be $962,034. This would generate a $1,037,966 capital loss because the sales price would be less than the $2,000,000 basis of the stock. The loss is problematic because it is artificial: economically, the payor has suffered no loss. S/he satisfied a support obligation which has a present value of $1,037,966 and received $962,034 from the sale. Together, that amounts to the $2,000,000 cost, resulting in no economic gain or loss.

Even without the loss, the scheme accomplishes the desired result of producing tax benefits for alimony and child support; however, with the loss, the benefits are much larger. Arguably it should work. Consider a few salient points.

First, Congress allocated the basis as described, not the taxpayer. Arguably, that was unwise; however, it is clear. In particular, it dramatically differs from the similar transaction of stripping interest from bonds under section 1286, which requires a fair market value apportionment of basis among the principal and each element of the interest income stream. Section 1286 thus precludes the artificial loss by not creating an artificially high basis. Section 1286 also reduces the amount of ordinary income attributable to the stripped interest by the same amount. Wise or not, Congress clearly chose a different scheme for stripped preferred stock, one which would result in artificially high income for the owner of the stripped dividends. It also created the artificially high basis in the retained principal, justifying—at least in a literal reading of the statute—an artificial capital loss equal to the artificially high dividend income (albeit with different timing).

Second, section 305(e)(1) anticipates a purchaser buying the retained principal. Such a purchaser would have section 1272 original issue discount income equal to the $1,037,966, albeit over time. Disallowing the payor-stripper’s loss would result in a windfall for the government, which would tax a total of $2,537,966 over the hypothesized 15-year term. The stock, however, produces merely $100,000 of dividends per year. Offsetting the excess $1,037,966 with a capital loss equals out the total income, though it does so with messy timing. But, Congress wrote the timing provisions, not the payor-stripper.

Third, suppose a taxpayer outside the divorce context strips preferred stock and then sells both parts for fair market value. S/he would immediately recognize $1,037,966 of ordinary income under the acceleration of income doctrine because of the artificially low basis allocation to the dividends. Upon selling the retained principal, s/he would surely be allowed a short-term capital loss of $1,037,966 because of the artificially high basis allocation. Possibly, the loss would offset the ordinary income, producing no tax consequence. But, more likely, sections 1211 and 1212 would limit the short-term loss, offsetting them against less valuable long-term gains or against ordinary income at the rate of $3,000 per year. That appears to be the ultimate purpose of the statute: to make the stripping transaction unpalatable. Thus, Congress surely anticipated the allowed loss at least in situations involving the sale of both parts.

Fourth, if the taxpayer-stripper retains the stripped dividends, the statutory language apportioning the basis does not apply. Hence, the loss might be disallowed pursuant to long-standing authority involving stripped property other than bonds or preferred stock: the government has disallowed such losses under economic substance principles. A notable example was the 2014 decision in Principal Life Insurance Company & Subsidiaries v. United States. The case involved stripped income rights in money market funds, not preferred stock or bonds. The court applied generally applicable basis allocation rules, which effectively precluded the loss. The court distinguished cases involving stripped bonds, which have their own basis allocation provision, albeit identical to the general scheme. This could arguably occur even if the taxpayer-stripper gave them away, triggering the assignment of income doctrine, which might treat the taxpayer-stripper as effectively retaining them.

At least some commentators disagree. They rely on two significant arguments. First, the facts of Principal Life did not involve stripped preferred stock. And second, although Congress granted the Treasury Department expansive authority in 2004 to deal with artificial losses, it has not yet used the authority. In matters involving stripped bonds, Congress created a system that makes an artificial loss impossible. But with stripped preferred stock, Congress chose a system that allows the loss in at least some cases and also creates artificially high income in others. Also, disallowing the loss in cases of retained dividends arguably violates the Skelly Oil doctrine, which equitably precludes “heads I win, tails you lose” tax situations.

Fifth, section 305(e)(1), dealing with acquired stripped stock, specifically applies to an acquirer with a transferred basis, such as through a section 1015 gift or through a section 1041 divorce property division. Notably, no similar rule applies for persons who acquire stripped dividends.

Sixth, the Example 17 payor-stripper is more akin to a seller of the stripped dividends than a donor or retainer. Absent section 1041, the transfer to a former spouse would be a Davis sale. Section 1041 does not say the transfer is a gift; instead, it says the transfer is “treated as” a gift. Economically, it is a nonrecognized sale with a basis transfer. Other authorities, perhaps unwisely, preclude application of the assignment of income or acceleration of income doctrines. As the Supreme Court illustrated in the consolidated Hillsboro and Bliss Dairy case, Congress (and apparently administrators) are entitled to enact unwise statutes, rules, and regulations. The tax benefit rule exists to ameliorate court-created artificialities. If Congress creates an artificiality, it often creates a separate provision to ameliorate the benefits when undeserved; however, sometimes (as in the Hillsboro facts), it does not. If so, courts should not step in. Almost certainly, a similar rule applies to administrative artificialities: he who creates an artificiality should create a correction device for undeserved benefits; if not, do not expect the court to be a rescuer.

Outside the divorce context, section 305(e) has limited uses. Although the assignment of income doctrine would not apply to a transfer of the stripped dividends because it is “property,” the acceleration of income doctrine would apply to a transfer for consideration. Because the acceleration of income doctrine does not apply to property transfers incident to divorce, the use of stripped dividends presents an easy, albeit capital intensive, scheme to produce the desired tax benefits.

Section 1286 deals with stripped bonds. Unlike section 305, it apportions the bond’s cost basis among the various property rights: the principal and each periodic right to income. While section 1286 provides a possible vehicle for a scheme creating divorce-support benefits, it is less optimal than stripped preferred dividends. With the stripped dividends, the transferor retains all the cost basis. In contrast, with the stripped interest, the transferor must transfer a substantial portion of the basis to the recipient. As a result, all the stripped dividends produce a tax benefit, while only a portion of the stripped interest would do so.

IV. History of Divorce Tax Rules, Assignment of Income, Acceleration of Income, and Substitute-for-Ordinary Income Doctrines

To understand the potential success of the listed plans, one needs to understand the history of divorce tax as it illuminates the atmosphere surrounding both the enactment of the TCJA, as well as the issuance of Revenue Ruling 2002-22. Further, one must also understand the assignment of income, acceleration of income, and substitute-for-ordinary income doctrines, particularly regarding their application in divorce-related situations.

A. History of Divorce Tax Rules

1. Alimony

a. Early Law. Before 1942, alimony was neither deductible by the payor nor includible by the payee. Per the 1917 decision of the Supreme Court in Gould v. Gould, alimony was not income to the recipient under the existing statutory definition of income. In reaching this conclusion, the Court applied a symmetry principle not often used in tax law, stating: “The net income of the divorced husband subject to taxation was not decreased by payment of alimony under the court’s order; and, on the other hand, the sum received by the wife on account thereof cannot be regarded as income arising or accruing to her within the enactment.”

In response to Gould, practitioners began using trusts to allocate income to support recipients, coupled with an exclusion for the payor. In 1935, the Court in Douglas v. Willcuts struck down the use of such trusts using principles akin to the assignment of income doctrine:

We have held that income was received by a taxpayer, when, pursuant to a contract, a debt or other obligation was discharged by another for his benefit. The transaction was regarded as being the same in substance as if the money had been paid to the taxpayer and he had transmitted it to his creditor. . . . The creation of a trust by the taxpayer as the channel for the application of the income to the discharge of his obligation leaves the nature of the transaction unaltered.

Douglas also emphasized that the state statutory support obligation involved in the case covered not just traditional alimony but also support for children.

In its 1940 decision in Helvering v. Fitch, the Court affirmed Douglas but explained that it would approve an alimony trust in full discharge of all the recipient spouse’s rights:

Enough has been said to show that respondent has not sustained the burden of establishing that his case falls outside the general rule expressed in Douglas v. Willcuts, supra. If we were to conclude that this case is an exception to that rule we would be acting largely on conjecture as to Iowa law. That we cannot do. For if such a result is to obtain, it must be bottomed on clear and convincing proof, and not on mere inferences and vague conjectures, that local law and the alimony trust have given the divorced husband a full discharge and leave no continuing obligation however contingent. Only in that event can income to the wife from an alimony trust be treated under the revenue acts the same as income accruing from property after a debtor has transferred that property to his creditor in full satisfaction of his obligation—unless of course Congress decides otherwise.

b. 1942 to 1984. Indeed, Congress decided otherwise in 1942. It legislatively overruled Gould, Douglas, and Fitch, by adding Code sections which:

  • Required the inclusion for alimony receipts.
  • Allowed the deduction of alimony payments.
  • Permitted the use of an alimony trust.

The 1942 statute applied to alimony under a “decree of divorce or separate maintenance.” In 1954, Congress reworded the statute and expanded its application to alimony under a “written separation agreement” or a “decree of support.” It also precluded application if the parties filed a joint return. In 1976, Congress moved the deduction to above-the-line rather than itemized status.

Curiously, the 1942 statute, as well as the 1954 amendment, included a provision that essentially codified the nonapplication of the assignment of income doctrine to alimony transfers: “such amounts received as are attributable to property so transferred shall not be includible in the gross income of such husband.” The 1954 amendment moved prior subsection 22(k) to section 71(d) and reworded it. “The husband’s gross income [in case of transferred property] does not include amounts received which, under subsection (a), are (1) includible in the gross income of the wife, and (2) attributable to transferred property.” The Ways and Means Committee report from 1942 described the rule more clearly:

Where the husband’s alimony or separate maintenance obligation is discharged through periodic payments attributable to property in trust, life insurance, annuity or endowment contracts, or to any other interest in property, the wife is required to include such payments in gross income, whether they come from income or capital. However, in the case of trusts created prior to the divorce or separation and not included thereto, the wife is required to include in gross income only the amount of the income of the trust which she is entitled to receive and which, under existing law, would be taxed to the husband. The bill excludes such amount from the gross income of the husband.

The provisions excluded from the transferor’s income amounts which otherwise would be included. For example, if a husband were to transfer the right to rental income from real property, interest income from bonds, or a partial interest in an annuity, his ex-wife would have been taxed, not him. But for the above-quoted language, the assignment of income doctrine would have provided otherwise if he retained ownership of the income-producing property.

To qualify as alimony, payments had to be “periodic” and could not be in discharge of a “specified” “principal sum” unless paid over a period greater than ten years. The periodic and principal sum requirements existed to discourage parties from disguising nondeductible (and nonincludible) property settlements as deductible and includible alimony. In addition, the new statutes specifically denied a deduction—and allowed exclusion for—amounts “fixed” as child support. Congress thus attempted to distinguish the tax treatment of the three types of divorce award: alimony, child support, and property division. Alimony had tax consequences, but child-support and property awards did not.

According to a 1984 Ways and Means Committee report, the 1942 Congress was particularly concerned with rising tax rates prompted by WWII; it feared high-bracket alimony payors would lack sufficient after-tax income to satisfy support needs of low-bracket recipients. Hence, Congress permitted high-bracket payors to deduct alimony, which was then taxed to a lower-bracket recipient. But, Congress clearly did not want similar benefits to flow for child support or property division, or at least not easily.

Given this difference in tax treatment after 1942 and before 1984, courts often needed to examine the purpose of an award to determine whether a particular payment was alimony, which was deductible and includible, or part of the property settlement or child support, which was not. This required the federal courts to resolve issues of substantive state law and delve into the construction of state decrees or settlement agreements. As the Tax Court explained in 1981, courts construed the alimony tax provisions as requiring alimony be in the nature of “support”: “The requirement that the payments be made in discharge of a legal obligation imposed ‘because of the marital or family relationship’ has been interpreted to require that the payments be in the nature of support rather than a property settlement.” Indeed, courts often lamented the need to examine the substance of divorce awards. As the Tax Court explained:

It is well settled that the determination of whether payments are in the nature of support or part of a property settlement does not turn on the labels assigned to the payments by the court in the divorce decree or by the parties in their agreement. . . . The issue is a factual one and requires an examination of all the surrounding facts and circumstances. . . . Unfortunately, because of the vexing problems which frequently arise in determining the nature and extent of a spouse’s property rights under State law, this supposedly factual inquiry has all too often taken on a metaphysical aura as the courts have struggled to classify a particular payment as either support or property settlement, when, in reality, the payment possesses a hybrid nature sharing characteristics of both. In the process, similarly situated taxpayers have occasionally been accorded disparate treatment merely because of differences in State marital property laws. For this reason, and because the confusion in this area has spawned a relentless stream of litigation, it would appear that legislative reform is warranted. As we stated in Schatz v. Commissioner, . . . some sort of safe harbor is needed so that taxpayers and divorce courts can predict with confidence the income tax consequences stemming from periodic payments occasioned by divorce. Until such legislation is enacted, however, we are left with no alternative but to plunge into the morass of the decided cases, many of them irreconcilable, and resolve this issue as best we can by applying the various factors which have been identified in prior decisions.

c. 1984 to 2017. In 1984, Congress finally adopted a more mechanical alimony definition, which largely continued until 2019. Pre-2019, alimony remained includible in gross income by the recipient and deductible by the payor. To qualify as alimony, arrangements subject to pre-2019 law had to satisfy nine factors:

  1. It must be paid in cash: property transfers do not qualify.
  2. It must be received: the accrual method is inapplicable.
  3. It must be paid to a spouse or former spouse: palimony did not qualify.
  4. It must be pursuant to a divorce or separation decree, instrument, or written agreement: verbal agreements and voluntary (noncontractual) payments do not qualify.
  5. It must not be designated as not alimony: parties may freely opt out of the section 71 and 215 tax consequences.
  6. It must not survive the death of the payee: there can be “no liability to make any such payment for any period after the death of the payee spouse.”
  7. It must not be fixed or labeled as child support, nor may it be a function of a child’s age or other significant status.
  8. The parties must not be members of the same household if they are legally separated or divorced.
  9. It must not be frontloaded; if so, it triggers recapture by the payor and deduction by the payee.

The ninth factor went through three permutations. Prior to 1984, alimony had to be “periodic,” with a period exceeding ten years being a safe harbor of periodicity. In 1984, Congress shortened the time frame to seven years and replaced the periodic requirement with complicated rules to prevent “front-loading.” A 1986 amendment further shortened the period to three years.

Alimony status conferred potential tax benefits: a high-bracket payor benefitted more from the deduction than a low-bracket payee suffered from the inclusion. Applying facts from Examples 1 and 2, if a former spouse needed $200,000 alimony after taxes, the parties had two options. First, they could opt out of sections 71 and 215. The payor spouse would then pay $200,000 annually, suffering a real economic cost of $200,000. The recipient spouse would receive the real economic benefit of $200,000.

Or, second, the payor could pay $325,000 alimony, deduct it at a 50% federal and state bracket and suffer an after-tax cost of $162,500, a lower economic cost of $37,500. The recipient—assuming that s/he is domiciled in an income-tax-free state—would receive the alimony, pay tax of $87,525, netting $237,475. The extra $75,000 was effectively “free money.”

As suggested in Part III, the TCJA makes alimony payments easily excludible by the payor (though taxable to the recipient) without the need to satisfy the pre-2019 rules. Property division disguised as alimony is similarly excludible and includible post-2018 without regard to the pre-2019 front-loading or end-on-recipient’s death requirements. Nothing in the 2017 statute suggests that that result is consistent with congressional intent; nevertheless, as with child support, it is the likely result.

2. Child Support

“Child support”—as defined for tax purposes—has never been deductible by the payor nor includible by the recipient. Since 1942, however, child support disguised as alimony has been deductible and includible, although the disguise procedures have varied from being relatively simple to horribly complex.

a. 1942 to 1984. Pre-1984, the statute provided that the alimony deduction and inclusion provisions “shall not apply to that part of any such periodic payment which the terms of the decree or written instrument fix, in terms of an amount of money or a portion of the payment, as a sum which is payable for the support of minor children of such husband.” Initially, the 1942 bill used the term “specifically designated as a sum payable for the support of minor children of the spouses.” Ultimately, the language changed to the shortened—but substantively the same—word “fix.” That word became a substantial loophole. A court could award family support without specifically labeling it “child support” and thus provide the parties with significant tax benefits.

Confusion regarding the term was common until the Supreme Court provided a resolution in its 1961 opinion in Commissioner v. Lester. In Lester, the Court concluded that Congress intended the parties to be able to disguise child support as alimony if they so wished:

As we read § 22 (k), the Congress was in effect giving the husband and wife the power to shift a portion of the tax burden from the wife to the husband by the use of a simple provision in the settlement agreement which fixed the specific portion of the periodic payment made to the wife as payable for the support of the children.

The case involved payments that were both for spousal and child support. The payments decreased if a child died, married, or reached the age of majority. The Court found such provisions insufficient to “fix” the amounts as child support. As a result, disguising child support as alimony was a simple matter. Officially, child support was not deductible or includible, but practically it was.

b. 1984 to 2018. The 1984 amendment continued the “fixed” language regarding child support, but largely overruled Lester. It added a second child-support provision:

(2) TREATMENT OF CERTAIN REDUCTIONS RELATED TO CONTINGENCIES INVOLVING CHILD.—For purposes of paragraph (1), if any amount specified in the instrument will be reduced—

(A) on the happening of a contingency specified in the instrument relating to a child (such as attaining a specified age, marrying, dying, leaving school, or a similar contingency), or

(B) at a time which can clearly be associated with a contingency of a kind specified in paragraph (1), an amount equal to the amount of such reduction will be treated as an amount fixed as payable for the support of children of the payor spouse.

Also in 1984, the Treasury Department issued a temporary regulation explaining the new child-support provision. It permitted parties to disguise child support as alimony; however, the process became far more difficult. The regulation was straightforward for matters involving one child. As was clear in the statute, the payments could not end on the happening of a contingency related to the child—“such as attaining a specified age, marrying, dying, leaving school, or a similar contingency . . . .” Also, they could not end at a time “clearly associated” with such a contingency. For this factor, the regulation provided clarity for parties with one child. It presumed a clear association if “the payments are to be reduced not more than 6 months before or after the date the child is to attain the age of 18, 21, or local age of majority.” In all other cases, the regulation provided that “reductions in payments will not be treated as clearly associated with the happening of a contingency relating to a child of the payor.”

To illustrate the pre-2019 tax-related ease with which spouses could disguise child support as alimony if only one child were involved, consider the following example:

Example 18. The spouses had one child born on July 1, 2000, and divorced on October 1, 2005. The parties and court agree that alimony of $3,000 per month and child support of $1,000 per month are appropriate.

Labeling the $1,000 per month as “child support” or ending payments within six months of July 1, 2018 (the child’s 18th birthday) would cause the payments to be non-alimony and thus not deductible or includible. The parties and court, however, could agree simply to award family support of $4,000 per month to be reduced to $1,000 if the recipient remarried and otherwise reduced to $3,000 on January 2, 2019. The latter reduction would occur when the child was 18 years, six months and one-day old; hence, it would not clearly be associated with the child. As a result, the payments would be treated as alimony, assuming they met the other eight factors.

In the example, the payor would pay an extra six months of child support to obtain over 14 years of tax benefits. Often, such a result would have been acceptable to both the payor and the payee. The payor would also have to trust the recipient not to seek child support in a later petition: child support is traditionally not waivable. The Court would also have to agree to forgo an award of child support on the record. Assuming those conditions were met, disguising child support for one child as alimony was simple.

With two or more children, the “disguise” requirements were much more difficult to apply. Indeed, they were almost incomprehensible. The regulation permitted the disguise if:

the payments are to be reduced on two or more occasions which occur not more than one year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24, inclusive. The certain age referred to in the preceding sentence must be the same for each such child, but need not be a whole number of years.

Which child was to be the “different” child was never clear. The single example provided arguably evidenced an attempt to be so confusing as to be unusable. To exacerbate the confusion, it posited an example of what would not work, rather than something that would work:

A and B are divorced on July 1, 1985, when their children, C (born July 15, 1970) and D (born September 23, 1972), are 14 and 12, respectively. Under the divorce decree, A is to make alimony payments to B of $2,000 per month. Such payments are to be reduced to $1,500 per month on January 1, 1991 and to $1,000 per month on January 1, 1995. On January 1, 1991, the date of the first reduction in payments, C will be 20 years 5 months and 17 days old. On January 1, 1995, the date of the second reduction in payments, D will be 22 years 3 months and 9 days old. Each of the reductions in payments is to occur not more than one year before or after a different child of A attains the age of 21 years and 4 months. (Actually, the reductions are to occur not more than one year before or after C and D attain any of the ages 21 years 3 months and 9 days through 21 years 5 months and 17 days.) Accordingly, the reductions will be presumed to clearly be associated with the happening of a contingency relating to C and D. Unless this presumption is rebutted, payments under the divorce decree equal to the sum of the reduction ($1,000 per month) will be treated as fixed for the support of the children of A and therefore will not qualify as alimony or separate maintenance payments.

Despite the apparent ease of disguising single-child support as alimony, as a practical matter, parties likely rarely disguised child support as alimony following the enactment of the Family Support Act of 1988, which required states to adopt child-support guidelines. By 1994, each state had done so. Although denominated “guidelines,” the rules are, as a practical matter, mandatory. As a result, disguised child support post-1988 and pre-2019 required:

  • The spouses to jump through complicated regulatory hoops, which, for two or more children, were daunting.
  • The payor to trust the payee not to seek child support in a later proceeding. Because of the section 71 “fixed” provision, that trust could not be memorialized in writing.
  • The court to agree not to award child support, despite the state statute requiring it. Typically, a substantial deviation from the guidelines requires the court to list written reasons which must conform with specific statutory limitations.

To summarize, pre-1942 child-support payments had no income tax consequences. From 1942 to 1984, child-support payments could easily be disguised as alimony which could receive favorable tax treatment. From 1984 through 1988, child-support payments—if they involved one child—could easily be disguised as alimony, but payments involving more than one child could not. From 1988 through 2018, child-support payments could rarely be disguised as tax-favored alimony.

As illustrated in Part III, the post-2018 statute makes child-support payments easily excludible by the payor (although taxable to the recipient) without the need to satisfy the convoluted, pre-2018 disguise requirements. Nothing in the new statute suggests that that result is consistent with congressional intent; indeed, the legislative history strongly suggests that Congress sought no tax benefits for either alimony or child support. Nevertheless, the likely result is the opposite.

3. Property Division

Property transfers between spouses or former spouses have a long, controversial tax history. Since the 1984 enactment of section 1041, property transfers “incident to divorce” have received nonrecognition treatment. Congress thus largely—but not completely—reversed the Court’s 1962 decision in United States v. Davis, which effectively held divorce to be a tax-triggering event. To understand the evolution of section 1041 and property-division tax law, one needs to understand the assignment of income and acceleration of income doctrines, as well as nine important authorities, plus the law preceding them:

  • United States v. Davis;
  • Section 1041, enacted in 1984;
  • Revenue Ruling 87-112;
  • Kochansky v. Commissioner;
  • Meisner v. United States;
  • Revenue Ruling 2002-22;
  • Revenue Ruling 2004-60;
  • Watkins v. Commissioner;
  • Davis v. Commissioner.

Collectively, these authorities set the context that Congress faced when it enacted the TCJA in 2017. Part V.B of this Article addresses whether, in approving that legislation, Congress acquiesced in the consistent tax treatment for property divisions post-2002 as they relate to the assignment of income and acceleration of income doctrines.

a. Pre-1962 Law. Transfers of appreciated property to satisfy an obligation have long been taxable events. Two significant early cases involved testamentary trusts which satisfied specific bequests with appreciated property. Courts treated the transactions as taxable events resulting in trust gain to the extent the obligation exceed the trust’s basis in the property transferred.

Despite the existence of those decisions, the Board of Tax Appeals (BTA) twice declined to consider property transfers as taxable events in the divorce context. Each case involved a husband transferring appreciated property to his former wife who relinquished support rights. In its 1940 opinion in Mesta v. Commissioner, the Board distinguished the trust cases—which involved fixed obligations—because it could not determine the value of the rights relinquished and thus the amount realized by the transferor. The Third Circuit reversed the decision of the BTA in 1941, finding the amount realized equal to the value paid.

Five months prior to the Mesta reversal, the BTA again declined to consider a divorce transfer a taxable event in Halliwell v. Commissioner. However, that decision was also reversed in 1942 by the Second Circuit. The issue seemed settled until 1960, when, in Commissioner v. Marshman, the Sixth Circuit asserted:

A property settlement in a divorce proceeding is usually influenced and often dictated by numerous intangible, personal and practical considerations which play no part in a transaction between a willing seller and a willing buyer in the open market. The value of what is given up is no criterion of the fair market value of the “property” received.

The Claims Court followed the lead of the Sixth Circuit in 1961 in Davis v. United States, which prompted the Supreme Court to enter the discussion.

b. United States v. Davis. In United States v. Davis, pursuant to a divorce settlement, Mr. Davis transferred 500 shares of stock with a basis of $74,775.37 and a fair market value of $82,250 to Ms. Davis who, in exchange, released her state-law claims to his property. The Court faced two significant issues: (1) whether the transaction was a taxable event for Mr. Davis and (2) if so, the amount realized on the transfer. The Court held the transfer was taxable to Mr. Davis whose amount realized equaled the value of the stock transferred.

The threshold holding affirmed the by-then long-standing policy. Although the Tax Court had initially held otherwise in Mesta and Halliwell—that a transfer of property in exchange for marital rights was a nontaxable “division of property,” the Supreme Court explained that such a transfer was a taxable event:

[U]pon being reversed in quick succession by the Courts of Appeals of the Third and Second Circuits [in] Mesta [and] Halliwell, the Tax Court accepted the position of these courts and has continued to apply these views in appropriate cases since that time . . . . In Mesta and Halliwell the Courts of Appeals reasoned that the accretion to the property was “realized” by the transfer and that this gain could be measured on the assumption that the relinquished marital rights were equal in value to the property transferred. The matter was considered settled until the Court of Appeals for the Sixth Circuit, in reversing the Tax Court, ruled that, although such a transfer might be a taxable event, the gain realized thereby could not be determined because of the impossibility of evaluating the fair market value of the wife’s marital rights.

Although the Davis Court did not refer to the legislative acquiesce doctrine, it placed considerable weight on “long-standing practice”:

Our interpretation of the general statutory language is fortified by the long-standing administrative practice as sounded and formalized by the settled state of law in the lower courts. The Commissioner’s position was adopted in the early 40’s by the Second and Third Circuits and by 1947 the Tax Court had acquiesced in this view. This settled rule was not disturbed by the Court of Appeals for the Sixth Circuit in 1960 or the Court of Claims in the instant case, for these latter courts in holding the gain indeterminable assumed that the transaction was otherwise a taxable event. Such unanimity of views in support of a position representing a reasonable construction of an ambiguous statute will not lightly be put aside. It is quite possible that this notorious construction [was] relied upon by numerous taxpayers as well as the Congress itself, which not only refrained from making any changes in the statutory language during more than a score of years but re-enacted this same language in 1954.

Davis was often criticized as bad policy for several reasons. Generally, it caused many divorces to be taxable events, which commentators tended to find unwise. It also created traps for unwary or ill-advised spouses: those who transferred appreciated property incident to divorce triggered a taxable event, a result well known in the world of tax lawyers, but likely less well known among family-law practitioners. Further, it created inconsistent treatment among the states: divisions of separate property—including what is now commonly known as constituting marital assets—were typically subject to Davis, while divisions of community property were not. Significantly, several state courts have likened a spouse’s interest in the other’s property as “akin” to a vested right, not unlike rights in a community-property state. In each case, the analogy applied for purposes of tax law, although apparently not for other purposes.

c. 1984 Enactment of Section 1041. In 1984, following several years of study, Congress adopted section 1041 under which property transfers incident to dissolution do not trigger tax consequences. Instead, the basis of the property transfers from the transferor to the transferee—effectively deferring any gain or loss and assigning it to the transferee. The Ways & Means Committee expressed deep concern with the then-existing law:

The committee believes that, in general, it is inappropriate to tax transfers between spouses. This policy is already reflected in the Code rule that exempts marital gifts from the gift tax, and reflects the fact that a husband and wife are a single economic unit.

The current rules governing transfers of property between spouses or former spouses incident to divorce have not worked well and have led to much controversy and litigation. Often the rules have proved a trap for the unwary as, for example, where the parties view property acquired during marriage (even though held in one spouse’s name) as jointly owned, only to find that the equal division of the property upon divorce triggers recognition of gain.

Furthermore, in divorce cases, the government often gets whipsawed. The transferor will not report any gain on the transfer, while the recipient spouse, when he or she sells, is entitled under the Davis rule to compute his or her gain or loss by reference to a basis equal to the fair market value of the property at the time received.

The committee believes that to correct these problems, and make the tax laws as unintrusive as possible with respect to relations between spouses, the tax laws governing transfers between spouses and former spouses should be changed.

The resulting statute treated transfers between spouses or former spouses incident to divorce as gifts. While generally clear, the new rules nevertheless presented new traps for unwary spouses and new opportunities for knowledgeable but arguably unsavory spouses. Although these new traps/opportunities are themselves beyond the scope of this Article, their existence is relevant to the Article’s central point: divorce tax law is inherently complicated. Fraught with inconsistent goals and policies, no perfect system is possible: whatever Congress does will have traps and opportunities.

Consider two examples:

Example 19. Spouses—each of whom has substantial income—have three marital assets to divide:

  • $1 million cash.
  • An office building with a fair market value of $1 million but zero tax basis. A willing buyer exists such that the property can produce $1 million after all costs of sale.
  • Shares of stock with a fair market value of $1 million but a $5 million tax basis. Assume no transaction fees.

They agree that one spouse can choose one of the three, but the other spouse will receive the other two items.

The critical question involves whether a spouse—your client—wants to pick first, and if so, which item. Strategy and tax knowledge is critical. The likely after-tax value of each is paramount. Before considering the values, one must understand that the tax basis is not information automatically shared or understood in a divorce. The approximate after-tax values are:

  • $1 million
  • $750,000
  • $1.25 to $3 million.

The example is a game not unlike many divorce situations, although the pick-first-get-one is unusual; still, it illustrates the gamesmanship. Imagine one spouse is savvy with a savvy attorney, and also imagine they believe the other is unsavvy and the other’s attorney is incompetent. If so—and if the savvy spouse believes s/he will have substantial future capital gains (particularly short-term) (or perhaps plans to marry someone with substantial short-term capital loss carryovers), such a person would seek the stocks, knowing the after-tax value is at the high end. If truly manipulative, savvy spouse might even stoop to say “I’ve been such a jerk, you take the gain property—the building that guarantees a million-dollar profit. I’ll take the loss.” Or s/he might simply believe the other is unlikely to want “loss” property and thus would avoid it if picking first.

The divorce-game example can be dangerous because it relies on the other spouse and his/her attorney both being unsavvy. A more sinister game can occur during marriage—particularly if one spouse knows a divorce is on the horizon but the other does not.

Example 20. Spouse A has separate property with a zero basis but a fair market value of $1,000,000. Spouse B has separate property with a $2,000,000 basis and a fair market value of $1,000,000. Both have substantial liquid assets.

Spouse A, anticipating a divorce that B is unaware of, could offer to purchase B’s property for $1,000,000—or even a bit more. If A understands the value of the built-in loss but B does not, A will successfully obtain a loss potentially worth $500,000 plus the $1,000,000 property value for a total of $1,500,000.

A might also—if s/he believes B is sufficiently gullible—offer to sell the appreciated property to B for less than its $1,000,000 value, perhaps to “make up” for some marital infraction. Under section 1041(b), B would obtain a basis in the property of zero despite paying $900,000. As a result, if B were to sell the property for $1,000,000, B would have a taxable gain of $1,000,000 rather than the mere $100,000 an unsavvy B might expect. Unsavvy B (someone not understanding section 1041) would view the property as worth $980,000 after federal taxes, though it would actually generate only $750,000 after federal taxes if sold for $1,000,000 by either A or B. Thus, B would appear to have a potential after-tax gain of $80,000 but would actually suffer an after-tax financial loss of $150,000. A, who might appear to unsavvy B as suffering a loss (by selling the property for less than its value), would actually be making a profit.

The behavior of the Savvy Spouse in Example 19 and that of Spouse A in Example 20 is arguably reprehensible. Nevertheless, to be actionable, it ultimately requires a divorce lawyer with substantial tax law knowledge to advise unsavvy Spouse and Spouse B.

The bottom line point is unfortunate: Congress enacted section 1041 to eliminate tax traps but it arguably managed only to replace one set of traps with another.

d. Revenue Ruling 87-112. In Revenue Ruling 87-112, the Service applied the acceleration of income doctrine to an incident-to-divorce transfer, although without mentioning the doctrine by name. The Ruling posited a husband who owned Series E bonds with accrued, tax-deferred interest. He transferred the bonds in a divorce settlement. The Ruling applied the traditional rule involving such bonds: a transfer, whether by gift or for consideration, required recognition of the deferred interest. But, the Ruling more broadly stated:

Although section 1041(a) of the Code shields from recognition gain that would ordinarily be recognized on a sale or exchange of property, it does not shield from recognition income that is ordinarily recognized upon the assignment of that income to another taxpayer. Because the income at issue here is accrued but unrecognized interest, rather than gain, section 1041(a) does not shield that income from recognition. The transferred bonds in the present situation contain an interest element that has not been included in income.

The Ruling used two significant terms: “property” and “assignment of . . . income.” Section 1041 facially applies to property transfers; however, some substantial authorities question whether the definition of “property” traditionally includes income rights. The Ruling appears to agree with that analysis by distinguishing property from items which might trigger the assignment of income doctrine if transferred by gift. The Ruling thus, consistent with traditional analysis, applied the acceleration of income doctrine to “ordinary income” items. The distinction is reminiscent of both the acceleration and substitute-for-ordinary income doctrines.

Although the Ruling applied to accrued interest on Series E bonds, the language logically applied to all carve-outs of ordinary income, substitutes for ordinary income, or future income from services. Hence, under a logical extension of the Ruling, post-1987 spouses who transferred future income rights—whether accrued or not—not only suffered the relevant tax, but also accelerated it into the year of transfer.

Example 21. Author/artist spouse writes novels and paints. S/he created a character such as Tom Clancy’s “Jack Ryan” or George Rodrigue’s “Blue Dog.” During a divorce, s/he transfers a one-quarter interest in both characters, including existing licensing contracts, to his/her former spouse.

Under the 1987 Ruling, the transfer of future income rights from existing contracts would be both an assignment and an acceleration of income. Author/artist spouse would be taxed on the resulting income, although the ex-spouse would receive the funds. Indeed, if the contracts had a measurable value, author/artist spouse would be taxed on the date of the transfer for the present value of the expected future income transferred to the ex-spouse.

Treatment, under the Ruling, of the transfer of the future use of the characters—in books not yet written and paintings not yet painted—is less clear. Because the author/artist spouse would likely retain control of them (s/he would, after all, have to write and paint), the transfer would likely also constitute an assignment of income such that s/he would be taxed when the ex-spouse received any funds. Application of the acceleration of income doctrine would have then been less likely because the values were likely unclear, an issue faced by the Ninth Circuit in 1996.

e. Kochansky v. Commissioner. The 1996 decision by the Ninth Circuit in Kochansky v. Commissioner applied the assignment of income, but not the acceleration of income, doctrine to a transfer incident to divorce. The taxpayer—a personal injury attorney—filed a medical malpractice case in 1983 on behalf of his client. In 1985, the taxpayer and his nonattorney-spouse divorced. Pursuant to the property settlement agreement, the spouse received a one-half interest in the contingency fee (after costs). The taxpayer received the fee two years later and split it equally with his former spouse. Who would be taxed on the spouse’s share of the fee—and when he or she would be taxed—were the primary issues facing the court.

Both the Tax Court and the Ninth Circuit found the husband responsible for the tax on the former spouse’s share. Both considered the tax due for 1987—the year of receipt. The Tax Court affirmed negligence and substantial understatement penalties, but the Ninth Circuit reversed on that issue.

While the decision is compelling, the application of the assignment of income doctrine in the divorce context is often criticized. The opinions in Kochansky are troubling for several reasons:

  1. They never mentioned section 1041; hence, the courts never explained why the section did not apply. Possibly the courts considered the fees to constitute something other than “property.”
  2. They never mentioned the acceleration of income doctrine. Almost certainly, the doctrine would not have applied because the fees were not easily valued. Nevertheless, some explanation would have been helpful.
  3. Neither the Tax Court nor the Ninth Circuit cited Revenue Ruling 87-112, which was issued during the year in question and which had existed for seven and ten years by the time the courts issued their respective opinions. The Ruling is consistent with the Kochansky holding; hence, a failure to cite it—particularly by both courts—is odd.
  4. The Tax Court treated the case as a memorandum opinion and assessed penalties. These two points suggest that the Tax Court viewed the issues as very well settled. But, when did these issues become settled? The Tax Court did not say.

The matter involved community property; however, the husband failed to argue the relevance of state law, and the courts refused to allow him to amend his argument. Arguably, Idaho law, if applied, would have produced a different result: the spouse would have already owned an interest in the matter, precluding application of the assignment of income doctrine.

From 1987 until 2002, a nightmare haunted family-law tax practitioners. One spouse would transfer a stream of future income to the non-earner spouse. This might involve nonqualified deferred compensation, nonstatutory stock options, or the carve-out of income rights separate from the underlying property rights. In this nightmare, the earner/owner-spouse would be taxed on the income rather than the recipient spouse. To make matters worse, for transfers with determinable market values, the tax would arise at the time of the transfer rather than at the time of the deferred receipt—the worst possible outcome. These results flowed from Revenue Ruling 87-112 and the 1996 Kochansky decision.

The scenario was a potential catastrophe, with significant malpractice potential. What might be thought to be taxable to the recipient remained taxable to the payor. And what might be thought to be taxable in the future became taxable suddenly in the present. What might be thought to be a nonrecognition event under section 1041 became a recognition event under the assignment of income and acceleration of income doctrines. These results were controversial—but certainly worth fearing.

f. Meisner v. United States. The often-cited 1998 decision of the Eighth Circuit in Meisner v. United States—dealing with the pre-1984 enactment of section 1041—rejected application of the assignment of income doctrine to divorce transfers. At best, it muddied the waters. The court stated two reasons for its holding. First, it found the transferor retained no control over the transferred rights, which consisted of future income from intellectual property. As the court correctly explained, the assignment of income doctrine traditionally did not apply when a taxpayer transferred all of his rights and retained no control. But, the court also found the divorce context to be an important factor:

It is also significant that the transfer of rights occurred pursuant to a divorce settlement. In the context of a gift to a loved one (usually one within the donor’s nuclear family), it can be argued that “[t]he exercise of that power to procure the payment of income to another is the enjoyment and hence the realization of the income by him who exercises it.” [Helvering v.] Horst, 311 U.S. at 118 . . .; see also [Harrison v.] Schaffner, 312 U.S. at 582 … (“by the exercise of his power to command the income, [the transferor] enjoys the benefit of the income on which the tax is laid.”). The same cannot be said in the context of a divorce settlement. Nor can it be argued that a transfer pursuant to a divorce fails to “effect[] any substantial change in the taxpayer’s economic status.” See [Commissioner v.] Sunnen[, 333 U.S.] at 609-10. . . . Divorce transfers are much more akin to negotiated arms-length transactions between adversaries than to displays of generosity.

The general language regarding nonapplication of the assignment of income doctrine in the divorce context is significant. Indeed, the Court’s disinclination to apply the doctrine even during the United States v. Davis era adds heft to the opinion. Despite the confusing use of the word “property” in the 1984 statute, Congress did not appear to expand the application of the assignment of income, acceleration of income, or substitute-for-ordinary income doctrines in divorce cases by enacting section 1041. Hence, if the doctrines did not apply prior to 1984—as the Eighth Circuit suggested—they would seem unlikely to apply afterwards.

Unfortunately, the Eighth Circuit cited neither the Revenue Ruling 87-112 nor the 1996 Kochansky decision, both of which applied at least the assignment of income doctrine in a divorce matter. One is thus left to wonder whether the court neglected those authorities because it felt section 1041 changed the law or whether it was unaware of them. Neither conclusion is reassuring.

g. Revenue Ruling 2002-22. Revenue Ruling 2002-22 addressed the interplay of section 1041 with transfers of nonstatutory stock options and rights to nonqualified deferred compensation. Specifically, it asked two questions:

  1. Is a taxpayer who transfers interests in nonstatutory stock options and nonqualified deferred compensation to the taxpayer’s former spouse incident to divorce required to include an amount in gross income upon the transfer?
  2.  Is the taxpayer or the former spouse required to include an amount in gross income when the former spouse exercises the stock options or when the deferred compensation is paid or made available to the former spouse?

More bluntly, do the assignment of income, acceleration of income, and substitute-for-ordinary income doctrines override section 1041? No, held the Service. The Ruling, however, included two exceptions:

This ruling . . . does not apply to . . . future income rights to the extent such options or rights are unvested at the time of transfer or to the extent that the transferor’s rights to such income are subject to substantial contingencies at the time of the transfer.

This was a striking reversal of Revenue Ruling 87-112; as a result, spouses appeared able to freely assign vested future income incident to divorce. Several points are noteworthy.

(i) The General Exclusion of Contingent Rights to Future Income. The Ruling excluded income rights subject to substantial contingencies in the hands of the transferor. This would exclude, for example, an attorney contingent fee arrangement comparable to that in Kochansky. Hence, if an attorney were to transfer to his/her former spouse an interest in a contingent fee, the assignment of income doctrine would continue to apply. Thus, the attorney-spouse would be taxed on the income rather than the recipient spouse. Whether the acceleration of income doctrine would apply is unclear: while Revenue Ruling 87-112 applied the doctrine, the Ninth Circuit in Kochansky did not. Arguably, such a contingent fee would be sufficiently difficult to value such that deferral of recognition until collection would be appropriate.

What constitutes a “substantial” contingency—as opposed to a mere contingency—that would trigger the exclusion is not clear. Presumably, family-law practitioners should be wary of income transfers contingent on the performance of any future services by the transferor. Without a clear definition of “substantial,” the consequences of applying the assignment of income doctrine would probably not justify any such risk. Hence, divorcing spouses who “own” rights to future payments contingent on the performance of any services by them should retain those rights.

Whether the contingency exclusion applies to contingencies other than the performance of services by the transferor is also unclear. Along with this issue is the question of what constitutes a contingency and how the contingency exception relates to the vesting exception. For example, a lottery ticket for a contest not yet drawn has a value contingent on the numbers being the winning numbers. The rights, however, are fully vested and their transfer would not traditionally trigger the assignment of income doctrine. Logically, such rights would continue to constitute property for purposes of section 1041, unaffected by the contingency exclusion of Revenue Ruling 2002-22. Similarly, rights to insurance proceeds—contingent on a death or catastrophe—should be considered property for purposes of section 1041. Indeed, any contingency outside the control of the transferor should be irrelevant.

(ii) The Exclusion of Future Income Rights Contingent on the Transferee’s Behavior. The exclusion of contingent income rights literally applies only to contingencies that affect the rights of the transferor. The transferor would be the earner/owner-spouse. The exclusion does not facially apply to contingencies affecting the rights of the transferee. Hence, a spouse with vested future income rights could conditionally transfer the rights to a former spouse incident to divorce and not thereby trigger the assignment of income doctrine. A possible condition might be the death of a child or the recipient spouse seeking child support or alimony previously waived.

Such transferee-dependent contingencies are important if Revenue Ruling 2002-22 is to become a significant divorce-planning tool. For it to be effective, the technique would need to encompass income stream transfers satisfying alimony and child-support obligations as well as property obligations. This is true because, in many cases, all property will be jointly held—and thus provide no opportunity for a wealth transfer, let alone an income transfer. But, for an income stream successfully to satisfy an alimony or child-support obligation, it needs to be accompanied by a waiver of alimony or child support or both. As a rule, however, child support is not waivable, and, absent a very clear waiver, alimony tends to be modifiable. Hence, the transfer should include a reversion triggered by facts justifying a modification of support.

(iii) The Role of Vesting Is Unclear. The Ruling explicitly states that “[t]his ruling . . . does not apply to . . . future income rights to the extent such options or rights are unvested at the time of transfer . . . . That limitation includes two separate, and undefined, restrictions. What constitutes an unvested income right and what constitutes a future income right? In turn, what constitutes an unvested future income right? Although the answers are uncertain, the Ruling provides some hints; however, they are a bit inconsistent. At one point, the Ruling states:

Congress indicated that section 1041 should apply broadly to transfers of many types of property, including those that involve a right to receive ordinary income that has accrued in an economic sense (such as interests in trusts and annuities).

What constitutes an unvested future income right is mostly unclear from the Ruling. Some things, however, are clarified. For example, future income for services not yet rendered would not be vested. Presumably, future income for services not yet rendered would also be subject to substantial contingencies in the hands of the transferor and thus would not qualify under the Ruling anyway. The important question involves how this applies to future income rights from property. The analysis is tricky because the terminology is imprecise. For example, past income from property (or services) results in an asset—such as a receivable or cash. Future income represents merely a portion of the bundle of rights called property. In a civil law jurisdiction (Puerto Rico and Louisiana), these rights would be called the usus, the fructus, and the usufruct. Essentially, they correspond to various types of future interests in common law jurisdictions. Under the civil law, they are present interests. Under the common law, they are future interests. But in both cases, the rights are part of the total package of ownership known as property. They are, in other words, fully vested.

Many questions arise. For example, is future rent from a building vested? Yes, in the sense it is a property right that can be transferred separately from the building itself and recorded in public records. Does it matter whether there is an existing lessee? Probably not; however, an existing lessee makes the amount more easily measurable. But, ease of measurement is a factor in the acceleration of income doctrine, not the assignment of income doctrine.

What about future dividend or interest rights? As explained earlier, the Code treats both stripped preferred stock dividends and stripped bond interest rights as distinct assets separate from the underlying principal. The Treasury Department itself markets Separate Trading of Registered Interest and Principal of Securities (STRIPS), which include the future interest rights in treasury bonds separated from the bond. For tax purposes, they have a basis and appear to fit any definition of “property.” Similarly, futures and forward markets exist for crops, minerals, and many other items not necessarily currently existing. Also, stock appreciation rights (SARs) are commonly traded; hence, they must be “property.”

Other types of “future income rights” exist, but with a less well-developed market. For example, a writer spouse may have created and copyrighted a popular character used in a series of novels or paintings. Rights to the character are valuable property and would comprise marital assets or community property in most jurisdictions. Such rights should be fully vested under copyright laws. The development of such rights, however, requires further efforts by the creator in many, but not all, cases. For example, development of the rights to Mickey Mouse does not require any effort by the original creator. But, new novels featuring Jack Ryan probably require future efforts by the creator Tom Clancy. How Mr. Clancy might transfer partial rights in the character to a former spouse presents significant questions. Certainly he could not—under the Ruling—transfer royalties on books not yet written without triggering the assignment of income doctrine. He should, however, be able to transfer a partial, vested right to license the character. This would require him to negotiate a license with the hypothetical ex-spouse (or her transferee), which should result in income to the ex-spouse and a deduction to the transferor. This would not trigger the traditional assignment of income doctrine because it would involve the transfer of a vertically divided partial interest in property. It thus should be successful under section 1041 and Revenue Ruling 2002-22, as well.

h. Revenue Ruling 2004-60. In Revenue Ruling 2004-60, the Service considered the facts of Revenue Ruling 2002-22 in relation to employment taxes and withholding, rather than merely inclusion. The new Ruling reaffirmed Revenue Ruling 2002-22 regarding the taxable party for income tax purposes—the recipient spouse. However, Revenue Ruling 2004-60 concluded that the transferor (and his/her employer) remained responsible for FICA and FUTA taxes. Additionally, the Ruling held the employer must withhold income tax from the assigned income, with the recipient receiving credit for the amount withheld.

i. Watkins v. Commissioner. No courts have held the acceleration of income doctrine inapplicable to divorce cases; however, at least one case failed to apply the doctrine despite facts justifying its use. In 2006, the Tenth Circuit in Watkins v. Commissioner applied the acceleration of income doctrine to the 1998 third-party sale of deferred lottery winnings but not to the 1998 transfer of half the future winnings incident to divorce.

In 1993, Mr. Watkins won $12,358,688 on a $1 lottery ticket, payable over 25 years at a rate of approximately $309,000 per year, with each payment adjusted upward by 3.7%. He was married at the time, but lived in Colorado, a separate-property-subject-to-equitable distribution state. He and Ms. Watkins divorced in 1997. Pursuant to the divorce, he transferred one-half of the future payments to Ms. Watkins, beginning in 1998. He received and reported $185,256 as his half share of the 1998 installment. Presumably, Ms. Watkins reported the other half. Tax litigation for 1998 did not question his reporting merely the one-half he received.

But in 1998, Mr. Watkins also received $2,614,744 in exchange for transferring his share of all future payments to a third party. He reported the proceeds as long-term capital gains, having apparently received shockingly bad advice regarding both the tax treatment of that sale as well as the present value of the remaining payments. The government challenged the treatment and won before both the Tax Court and the Tenth Circuit. Both the Tax Court—in 2004—and the Tenth Circuit—in 2006—correctly relied on the Supreme Court’s 1958 decision in Commissioner v. P. G. Lake as authority for treating the entire proceeds as accelerated ordinary income. Neither court discussed the transfer to Ms. Watkins, which was at least plausibly subject to both the assignment of income and acceleration of income doctrines: the winnings were vested and easily valued and thus met the basic facts required by both doctrines; indeed, the acceleration of income doctrine applied to the third-party transfer of the same winnings. But why did the doctrine not also apply to the incident-to-divorce transfer? The answer is uncertain because the courts did not discuss the issue. Presumably, the government did not assert application of either the assignment of income or the acceleration of income doctrine to the divorce transfer. That seems likely because by the date of the litigation, the Treasury Department and the Service had already issued Revenue Ruling 2002-22 which disclaimed application of the assignment of income doctrine to divorce transfers.

j. Davis v. Commissioner. In its 2013 decision in Davis v. Commissioner, the Eleventh Circuit declined to apply the acceleration of income doctrine to a divorce-related transfer of vested stock options. According to the court, section 1041 covered the transfer of the options and resulted in no taxable event to the transferring spouse. Further, the court, citing Revenue Ruling 2002-22, stated that the later exercise of the option—had it occurred—would have resulted in income to the transferee spouse, effectively eliminating application of the assignment of income doctrine. More importantly, the court relied on a private letter ruling that extended Revenue Ruling 2002-22 to nonvested stock options. Under the private letter ruling, the divorce decree ordered the future transfer of the then-unvested options. The ruling held that those, too, were property under section 1041.

B. History of the Assignment of Income Doctrine

The assignment of income doctrine dates to seven early Supreme Court cases dealing with spousal transfers. Four involved married persons attempting to assign earnings from personal services prior to legislation permitting joint returns. In its 1926 decision in United States v. Robbins, the Court upheld taxing the husband on his earnings despite his residing in California, a community-property state. The Court, construing California law, held the wife’s interest was a “mere expectancy.” In the often-cited 1930 decision in Lucas v. Earl, the Court again considered the tax liability of California spouses. The Earls signed a 1901 marital contract in which Mr. Earl assigned half of his future income to Ms. Earl. Despite the validity of the contract, the Court held Mr. Earl responsible for the taxes on the income he earned. Later in 1930, the Court reached the opposite result applying Washington community-property law. According to Poe v. Seaborne, each spouse had a vested one-half interest in the others’ earnings, rather than the community-property expectancy of California. As a result, Ms. Seaborne was taxable on the receipt of Mr. Seaborne’s earnings following a divorce. Following the Seaborne decision, some states altered their marital property laws, hoping their citizens could receive more favorable tax results. In response, in 1948, Congress allowed spouses to file joint returns, which removed much of the community/noncommunity distinctions.

In 1932, the Court rejected an attempted spousal assignment of service income using a partnership. In Burnet v. Lininger, the Court relied on partnership tax law rather than the more general assignment of income doctrine. In the famous 1940 decision in Helvering v. Clifford, the Court rejected a similar assignment using a trust.

In 1948 in Commissioner v. Sunnen, the Court revisited intrafamily service assignments in a matter involving transfers that occurred in 1937—prior to the allowance of joint returns. The Court re-affirmed Earl and held that the assignment was ineffective even though a final decision had already determined otherwise. The case is mostly known for the unusual application of res judicata to tax matters. Because, as the Court explained, each year is a separate cause of action, a final decision involving items taxed in one year are res judicata as to that item and that year, but not as to that item and a different year. Because, as the Court recognized, jurisprudence regarding income assignments and families was then evolving, the related doctrine of collateral estoppel also did not apply.

Those decisions created the assignment of income doctrine under which income from personal services is taxed to the person who performed the services. A separate, but related, line of cases applies the doctrine such that income from property is taxed to the person who owns the property. One case involved a failed attempt to assign income from property between spouses. Three other important property cases involved attempts to assign income from property to children.

The decision in Douglas v. Willcuts applied assignment of income principles in the divorce context. Mr. Douglas used a trust to hold securities, the income from which was to be paid to his former spouse in fulfillment of his support obligations. Mr. Douglas was the trust’s principal beneficiary. Not surprisingly, the Court held the existence of the trust to be ineffective in assigning the income. Congress changed this result by statute in 1942. In 1937, the Court in Blair v. Commissioner upheld a testamentary trust assignment of income to the deceased taxpayer’s children. The Court distinguished Douglas largely because of the death. In Douglas, the husband continued to equitably own the property producing the income. In contrast, in Blair, the children became, through the testamentary trust, owners of the income separate from the principal beneficiary. The Court consider the income interest to be a “property” right.

In 1940, the Court in Helvering v. Horst declined to recognize the assignment of bond interest from the bond owner to his children. Over the objection of one dissenter—who found the coupons to be property separate from the bond principal—the Court likened the interest to fruit of a tree, with the tree owner taxed on the fruit. Blair was distinguishable because there, the owner died and thus severed the “tree” from its “fruit.” In 1984, Congress enacted section 1286, which, solely for coupon bonds, adopted a rule equivalent to that of the Horst dissent, finding “stripped coupons” to be separate property from the bond itself. Finally, in Harrison v. Schaffner in 1941, the Court revisited a parent’s assignment of trust income to her children. Because the assignor remained the principal beneficiary, the Court refused to recognize the assignment for tax purposes.

What is particularly important in understanding the assignment of income doctrine is that nearly all the seminal decisions involved family members, spouses, children, and ex-spouses. Since at least 2002, the prevailing thought has been that the divorce context changes the application of the doctrine, although that was not the case in early years.

C. History of the Acceleration of Income and Substitute-for-Ordinary Income Doctrines

The acceleration of income doctrine grew out of the assignment of income doctrine. Assignments involve gratuitous transfers while accelerations involve transfers for consideration. Many commentators refer to the acceleration of income doctrine as the “substitute-for-ordinary income doctrine.” The two notions—substitute and acceleration—grew together. They are partially distinct doctrines, although related and overlapping. Both are important for this Article. Essentially, the substitute-for-ordinary income doctrine focuses on the character of income, while the acceleration of income doctrine focuses on the timing of income. The substitute-for-ordinary income doctrine will help in determining the types of items most suitable for the Part III schemes, although not exclusively. Such items would best be ordinary income items—which suffer the highest tax rate and thus underlie more effective tax planning—including ordinary income substitutes. Application of the acceleration of income doctrine, in contrast, determines whether particular schemes work, although again, not exclusively.

1. The Substitute-for-Ordinary Income Doctrine

The substitute-for-ordinary income doctrine rests on the ill-defined term “property” in the definition of a capital asset under section 1221. As a doctrine, it dates at least to the decisions in 1960 in Commissioner v. Gillette Motor Transport and in 1965 in United States v. Midland-Ross, if not to the earlier decision in 1941 in Hort v. Commissioner.

a. What is Property: Relevant Code Sections. The Code uses the term “property” frequently, but defines it inconsistently, if at all. This Article focuses on section 1041, which applies to “property” transfers incident to divorce but does not provide a definition of the term “property.” Section 1221 also uses the term “property” in defining a capital asset. Similarly, sections 1222 and 1231 rely on the meaning of a “capital asset” in their definition of capital gain or loss; hence, capital transactions inherently involve “property,” whatever that is.

(i) A Capital Asset Under Section 1221. A capital asset is “all property other than” a list of seven specific items. Much litigation, peripheral to this Article, has focused on whether the list is exhaustive or illustrative. The better conclusion is that the list is exhaustive; however, that is not quite what the Supreme Court has said. In any event, the substitute-for-ordinary income doctrine rests on certain income rights not being “property,” thus effectively side-stepping the exhaustive/illustrative issue.

(ii) Capital Gain or Loss Under Section 1222. Section 1222 states that a capital gain or loss results “from the sale or exchange of a capital asset.” Exactly what constitutes a sale or an exchange could be the subject of an article by itself. A gift, however, is neither. That is important because section 1041 treats incident-to-divorce transfers as “gifts,” at least for income tax purposes. It does not, however, quite define them as gifts, leaving the possibility they are substantively sales or exchanges of something (property?) for the release of marital rights.

(iii) Section 1231. Section 1231 applies to sales and exchanges of “property” used in a trade or business, as well as to compulsory or involuntary conversions of such property or of capital assets. After a complicated netting process, net gains from sales, exchanges, and conversions receive capital treatment, while net losses receive ordinary treatment.

b. Hort v. Commissioner. In Hort v. Commissioner, the taxpayer received a payment for the cancellation of a lease and reported it as a capital transaction. The Supreme Court disagreed:

Simply because the lease was “property” the amount received for its cancellation was not a return of capital, quite apart from the fact that “property” and “capital” are not necessarily synonymous in the Revenue Act of 1932 or in common usage. Where, as in this case, the disputed amount was essentially a substitute for rental payments which § 22(a) expressly characterizes as gross income, it must be regarded as ordinary income, and it is immaterial that for some purposes the contract creating the right to such payments may be treated as “property” or “capital.”

Finding the amount received did not constitute “property” was significant in the development of the substitute-for-ordinary income doctrine. The Court’s further statement distinguishing “property” from “capital” is particularly interesting. The analysis in Part III mostly rests on a broad definition of “property” for purposes of section 1041. In Hort, the Court dealt with whether an item was “property” under the pre-cursor to section 1221, defining a capital asset. While section 1221 refers both to “capital” and “property,” section 1041 refers only to “property.” The distinction is nuanced, but suggests that a broad reading of section 1041 property may well be more appropriate.

The Court also hinted at the notion—clarified in Gillette—that a substitute for ordinary income has no basis allocated to it from the underlying asset: “The amount received by petitioner for cancellation of the lease must be included in his gross income in its entirety.” Arguably, “entirety” refers to the lack of basis allocation. However, the taxpayer argued that it should have received a deduction for the income that it never received, a claim easily rejected by the Court.

c. Gillette Motor Transport. In 1944, Gillette drivers “struck” which caused the business operations to cease. Viewing the transport operations as essential for the war effort, the President ordered the “Office of Defense Transportation to ‘take possession and assume control’ of them.” Significantly, it left ownership and general management in the hands of Gillette. The order continued for approximately ten months.

In 1952, the government paid Gillette $122,926.21 for the temporary taking. Gillette argued the amount received should be classified as capital gain because it resulted from the involuntary conversion of property used in a trade or business. The Court held otherwise. Describing the administrative commission which award the sum, the Court

found that respondent had been deprived of property, and awarded compensation therefor. That is indeed true. But the fact that something taken by the Government is property compensable under the Fifth Amendment does not answer the entirely different question whether that thing comes within the capital-gains provisions of the Internal Revenue Code. Rather, it is necessary to determine the precise nature of the property taken. Here the Commission determined that what respondent had been deprived of, and what the Government was obligated to pay for, was the right to determine freely what use to make of its transportation facilities.

The Court also explained:

While a capital asset is defined . . . as “property held by the taxpayer,” it is evident that not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capital asset. . . . Thus the Court has held that an unexpired lease, . . . corn futures, . . . and oil payment rights . . . are not capital assets even though they are concededly “property” interests in the ordinary sense. . . .

Had the Government taken a fee in those facilities, or damaged them physically beyond the ordinary wear and tear incident to normal use, the resulting compensation would no doubt have been treated as gain from the involuntary conversion of capital assets. . . . But here the Government took only the right to determine the use to which those facilities were to be put.

That right is not something in which respondent had any investment, separate and apart from its investment in the physical assets themselves. Respondent suggests no method by which a cost basis could be assigned to the right; yet it is necessary, in determining the amount of gain realized . . . , to deduct the basis of the property sold, exchanged, or involuntarily converted from the amount received. . . . In short, the right to use is not a capital asset, but is simply an incident of the underlying physical property, the recompense for which is commonly regarded as rent.

These passages state some important fundamentals. First, things may be “property” for some legal purposes in certain transactions; but a change in structure can make that same “thing” not “property” in other transactions. Second, the right to use property differs from “property” in the capital gain context, even though such a “right” is arguably itself property in an ordinary sense. Third, any investment or basis a taxpayer has belongs to the “property,” as opposed to the right to use the property.

“Property” is not a term of art; instead, its definition varies. The schemes described in Part III of this Article mostly rely on section 1041 contemplating a broader definition of “property” than that contemplated for capital treatment. The right to use property is not itself “property” at least not in a capital gain context. This point has long roots: it was the essence of the 1791 decision in Hylton v. United States, which defined a tax on carriages as an excise on the use of property subject to uniformity rather than a direct tax on property subject to apportionment. And the third point is particularly significant: rights to use property—essentially the right to the income or the wealth the property can produce—has no basis if that right is severed from the underlying asset.

Although the decision in Gillette did not use the term “substitute,” it solidified the substitute-for-ordinary income doctrine: the payment was effectively “rent”; hence, it was ordinary. Had the payment occurred in 1944 rather than 1952, the case might have also created the acceleration of income doctrine.

d. Midland-Ross. In 1965, the Court affirmed the Gillette approach, to wit: items which are property for some purposes are not property for all. The matter involved original issue discount interest accrued in years prior to the 1954 statute involving the issue. The Court stated:

Earned original issue discount serves the same function as stated interest, concededly ordinary income and not a capital asset; it is simply “compensation for the use or forbearance of money.”

Thus, amounts which were economically interest were ordinary. Unlike the decision in Gillette, the decision in Midland-Ross invoked the term “substitute”:

[T]he earning of discount to maturity is predictable and measurable, and is “essentially a substitute for . . . payments which § 22(a) expressly characterizes as gross income[; thus] it must be regarded as ordinary income, and it is immaterial that for some purposes the contract creating the right to such payments may be treated as ‘property’ or ‘capital.’”

In any event, both doctrines have family-law consequences. This Article focuses on the acceleration of income doctrine, which grew from assignment of income cases. Situations involving the substitute-for-ordinary income doctrine essentially become acceleration matters if they involve a nongift or death transfer. For tax purposes, the two doctrines reach the same consequence from different fact patterns: the substitute-for-ordinary income doctrine focuses on the character of income, and the acceleration of income doctrine focuses on the timing of what would otherwise be future income. For divorce transfer purposes, both doctrines partially produce the same result: ordinary income for the person taxed. Acceleration, however, changes which person is taxed, when, and by how much. Thus, for this Article, it is the more significant element of the overlapping doctrines.

2. The Acceleration of Income Doctrine

The acceleration of income doctrine involves the carve-out, or separation, of an income right from the underlying property right—such as the right to rents, interest, or dividends being sold despite retention of the building or securities.

In its 1958 decision in Commissioner v. P. G. Lake, Inc., the Court relied on its earlier decisions in Schaffner, Clifford, and Horst concerning the assignment of income. Lake involved the sale of mineral income with the seller retaining the underlying property. Referring to the stripped coupons at issue in Horst, the Court explained:

There the taxpayer detached interest coupons from negotiable bonds and presented them as a gift to his son. The interest when paid was held taxable to the father. Here, even more clearly than there, the taxpayer is converting future income into present income.

In 1962 in Commissioner v. Ferrer, the Sixth Circuit similarly applied the acceleration of income doctrine to a taxpayer who sold movie production rights for a play, but retained the play. The Sixth Circuit expanded its application of the doctrine in 1973 in Estate of Stranahan v. Commissioner, permitting a taxpayer to invoke the acceleration of income doctrine. Prior to his death, Mr. Stranahan paid $754,815.72 in interest in settlement of a tax controversy. His 1964 income, however, was insufficient to absorb the full interest deduction. He thus sold to his son the right to future dividends on stock he continued to own. Mr. Stranahan reported the proceeds as ordinary income, consistent with P. G. Lake and Ferrer. He excluded the dividends which his son later received, and his son included them in future years upon receipt. The government effectively sought to treat the transaction as a mere loan; however, the court disagreed. It held that taxpayers are free to arrange their affairs as they wish and that the transaction was substantively a sale of future income. Presumably, a sale of the right to rents separate from the building or land should also trigger this doctrine, although academic discussion of the acceleration of income doctrine has varied.

V. Review of the Plans with Further Comments on Likelihood of Success

Part III suggested three plans, each with subcategories:

1. Stripped Nonqualified Deferred Compensation.

(a) Category 1: Very wealthy payors.

(b) Category 2: Well-to-do payors.

(c) Category 3: Middle-class payors.

2. Small-Business Corporations or Partnerships.

(a) Nonprofessional service.

(b) Professional service.

3. Stripped Preferred Stock or Bonds

(a) Dividend strip.

(b) Loss on sale of remainder.

Each has a realistic chance of success, absent a statutory, judicial, or regulatory change. Plans 1(c) and 3(b) are the most-risky, although they are defensible.

A. Plan 1: Stripped Nonqualified Deferred Compensation

Plan 1(a)—vested, pre-existing, nonqualified deferred compensation (NQDC) stripped by a wealthy payor—precisely fits the requirements of Revenue Ruling 2002-22. Thus, absent a regulatory change (e.g., withdrawal of the Ruling), it will work because it will not be challenged. If the government were to withdraw the Ruling, the plan would continue to have judicial and academic support. The risk of judicial, as well as regulatory, change is tempered by the legislative acquiescence doctrine, discussed below.

Plan 1(b)—Plan 1(a) with some added vested-during-normal-divorce-time-frame NQDC—has a strong likelihood of success. It extends the facts of Revenue Ruling 2002-22 but not its holding. Although the plan contemplates some vesting during the divorce process, it still involves the transfer of vested rights as described by the Ruling. A short-term delay during the divorce process, or immediately preceding the process, does not appear particularly worrisome, as it is but a minor deviation from the Ruling’s facts. As many courts have said, a taxpayer is entitled to plan his affairs to minimize tax.

Plan 1(c) is problematic because it involves a series of section 1041 transfers as vesting occurs in a NQDC plan woefully inadequate or nonexisting but for the divorce planning. Facially, this differs from Plan 1(b) only in the built-in time delay; however, it unquestionably resembles a traditional assignment of future service income disguised as a Plan 1(a) transfer. One can easily imagine the government distinguishing it using a step-transaction or substance-over-form argument. Admittedly, it differs substantially from Plans 1(a) and (b) with regard to the timing and the number of steps involved. Nevertheless, at least one court has suggested that the step-transaction doctrine can apply to extend, but not to restrict section 1041.

The fact that Plan 1(c) closely resembles a traditional assignment of service income may also be its defense. Indeed, that is why this Article is entitled “naked” stripping. Plan 1(c) is an assignment of income, but then, so are Plans 1(a) and (b). They have no real substance distinguishing them from a naked assignment. They work because they work: because Revenue Ruling 2002-22, encouraged by academics and the courts who do not want divorce to be a taxable event, exists, not because of any traditional tax theory.

Traditionally, Plan 1(a) would not have worked because NQDC is not “property”; instead, it is a substitute for ordinary income. But, academics, courts, and, most significantly, the government disagree. In my opinion, Revenue Ruling 2002-22 is incorrect. Nevertheless, it has existed for 17 years. Limiting its use to the wealthy or well-to-do is regressive. It benefits the wealthy over the average taxpayer. “Fairness” is not the strongest argument for a taxpayer to rely on, but “fairness” coupled with literal compliance with a ruling is not a bad argument either. Readers can judge the likelihood of success. This author judges it as more-likely-than-not. “Fairness”—whatever that is and however it is measured—demands that all three versions of Plan 1 should work, or none should work. Personally, I think none should work; however, 17 years in which Plan 1(a) has worked is a compelling argument that all should work.

B. Aside on Legislative Acquiescence

A key to whether Plan 1 works involves the continued existence of Revenue Rulings 2002-22 and 2004-60. The Treasury Department and the Service could withdraw them and thus revert back to Revenue Ruling 87-112, which applied the assignment of income doctrine to section 1041 transfers. Plan 2(a), on the other hand, relies mostly on the continued existence of the voting trust regulations, while Plan 2(b) relies on the continued court approval of the gift-leaseback game. Plan 3, alternatively, rests on section 305(e). Arguably, the government could withdraw Revenue Rulings 2002-22 and 2004-60 and then assert application of the assignment of income doctrine to stripped preferred stock; however, because the strip as well as the basis allocation has statutory support, that result appears unlikely. Plans 2 and 3, however, are available for only a portion of taxpayers. Thus, the relative ease with which Plan 1’s support could evaporate is significant.

Generally, the Treasury Department and the Service are free to withdraw or amend a revenue ruling, as it is merely the an opinion of the agency. That, however, has not always been the case. The legislative acquiescence doctrine casts some doubt on the commissioner’s ability to alter the 2002/2004 rulings, as well as the courts’ ability to alter cases consistent with them, such as the Meisner and Davis decisions. Under the doctrine, if Congress amends a statute which courts and agencies have consistently construed, but does not address or alter that construction, then Congress has acquiesced to it. As a result, the consistent construction rises to the level of law, which only Congress can amend. At least two tax cases are significant in determining whether the doctrine applies.

In its 1962 decision in Davis, the Court relied on long-standing judicial support for—and taxpayer reliance on—divorce transfers being taxable events:

Such unanimity of views in support of a position representing a reasonable construction of an ambiguous statute will not lightly be put aside. It is quite possible that this notorious construction was relied upon by numerous taxpayers as well as the Congress itself, which not only refrained from making any changes in the statutory language during more than a score of years but re-enacted this same language in 1954.

Indeed, in 1984, Congress ultimately toppled the Davis rule with the enactment of section 1041.

Perhaps more significantly, in its 1983 decision in Bob Jones University v. United States, the Court relied on legislative acquiescence of Revenue Ruling 71-447. Of significance, the Treasury Department attempted to withdraw the Ruling, but was effectively enjoined from doing so. While the issues of racial discrimination and tax-exempt status in Bob Jones University vary substantially from the issues involving the taxation of property transfers in the divorce context, the two are nevertheless each of substantial national interest. Both were the subject of considerable debate spanning many years, and both saw reversals in Treasury Department policy. Also, in each case the critical ruling—Revenue Ruling 71-447 in Bob Jones University and Revenue Ruling 2002-22 herein—had circuit court support and broad academic support, as well as many years of existence and reliance.

A problem with any reliance on the notion of legislative acquiescence of Revenue Ruling 2002-22 is the lack of a post-2002 amendment to section 1041. But, the essential issue involves tax benefits for alimony and child support, which were the province of section 71 and 215, each of which regulated the benefits, or not, as well as attempts at disguising child support as alimony or either child support or alimony as a division of property. Congress repealed those restrictions in 2017, effective in 2019, in the atmosphere described above: consistent rulings, judicial opinions, and academic commentary against the application of the assignment of income doctrine to transfers under section 1041. That nonapplication is intertwined with the opportunity for parties to disguise alimony or child support as something it is not—an opportunity clearly permitted prior to the 2017 repeal, however cumbersome the process to take advantage of the opportunity may have been. The repeal of sections 71 and 215, along with the absence of comment or change regarding a broad reading of section 1041, arguably amounts to legislative acquiesce of Revenue Ruling 2002-22, as well as the decisions in Meisner and Davis.

C. Plan 2: Transfer of Small-Business Interests.

Plan 2(a)—transfer of a small-business corporate or partnership interest—should work without any significant problems. As explained in relation to Example 15, the transferor would likely want transferred stock to either have restricted voting rights or be placed in a voting trust. A transferred partnership interest should similarly be limited. Such restrictions would maintain control by the transferor. For the plan to work, the business would require sufficiently predictable income to satisfy the alimony recipient as well as the court in relation to any child-support obligations.

Although Plan 2(a) will not work for professional corporations in most states—because of state ownership restrictions—Plan 2(b) provides a workable solution. It involves a gift-leaseback of valuable property. The transferor could distribute the property from the entity to him/herself and then transfer it per section 1041 to the recipient, who would lease it back to the entity. Transferors would need to ensure the distribution itself was not taxable. Or, consistent with the 1996 decision in Berger v. Commissioner, the entity might transfer the property on behalf of the payor directly to the recipient.

As a caution, this author has argued against the use of gift-leasebacks. They lack real substance, as no one would use such a scheme without the leaseback portion. Though courts mostly require some formalities—such as control by the recipient such that s/he might not lease the property back—such requirements are difficult to support. That said, courts have allowed them, albeit with varying levels of complexity. Thus, the scheme will likely work, even though it should not work.

D. Plan 3: Stripped Preferred Stock

Plan 3(a) will work. Section 305 treats the stripped dividend rights as an asset with a zero basis, but nevertheless a separate asset from the underlying shares. Section 1286, dealing with stripped bonds, has a different basis allocation method, but it, too, treats the stripped interest as a separate asset with its own basis. Such treatment should be sufficient to remove the respective assets from the assignment of income doctrine. In any event, Revenue Ruling 2002-22, along with the 1998 decision in Meisner and the 2013 decision in Davis, effectively removes section 1041 property transfers from challenge by an assertion of the assignment of income doctrine.

Application of the substitute-for-ordinary income doctrine is arguably less clear as to stripped dividends, but also irrelevant. Absent an amazingly broad reading of section 1222, collection of the dividends would not be a sale or exchange; hence, the dividend receipts would be ordinary in the hands of the recipient, as they would have been by the transferor. The acceleration of income doctrine should apply, but almost certainly will not, again because of a broad reading of “property” as well as the nonapplication of the assignment of income doctrine. Not applying the assignment of income doctrine, but applying the acceleration of income doctrine would not make much sense, and no authorities suggest otherwise. Indeed, not applying the acceleration of income doctrine is stronger than not applying the assignment of income doctrine because of the section 1041 imputed gift treatment.

VI. Final Thoughts and Conclusion

Congress should clarify its messy attempted repeal of the alimony deduction. It should also clarify the meaning of section 1041 property. Absent any congressional clarification, courts should not apply the assignment of income or acceleration of income doctrines to divorce or other spousal transfers, at least to the extent of vested rights, even if those rights vest seriatim and the section 1041 transfers are numerous.

The author thanks Karen Burke, Dennis Calfee, and Grayson McCouch for helpful comments. Any errors are those of the author.