| ||Simplifying and Rationalizing the Federal Income Tax Law Applicable to Transfers in Divorce|
Deborah A. Geier
Professor of Law, Cleveland-Marshall College of Law, Cleveland State University. © 2002 Deborah A. Geier. This article was written in my capacity as an "academic advisor" to the Joint Committee on Taxation in connection with a study of the overall state of the tax system, including recommendations with respect to possible simplification proposals, that Congress mandated in section 8022(3)(B). The opinions expressed here are, however, completely my own and should not be attributed to the Joint Committee on Taxation.
Sometimes the complexity in our tax law is defended as a necessary evil to conform the law to the underlying theory informing it. Some also say that, since ours is a complex economy and society, our tax system is necessarily complex, and those engaged in complex transactions can afford to pay for the complex tax advice necessary to navigate successfully through the system. Or so the sayings go.
One area of the tax law, however, remains needlessly complex, not because of any coherent underlying theory but because of history and a series of political compromises. Moreover, the "transaction" at issue is not one engaged in only by the savvy, well-advised, and well-to-do. The "transaction" at issue is divorce. While the tax law applicable to transfers in divorce was, on average, improved (in my view) in 1984, several fundamental incoherencies and unnecessary complexities continue to plague this area, and more recent ambiguities, dealing chiefly with redemptions of stock in closely held corporations and other transfers under the assignment-of-income doctrine, have arisen.
One of the biggest sources of complexity in the current regime is the continuing desire (though futile, in my view) to differentiate cash "alimony" from cash "child support" from cash "property settlements" in order to apply different tax rules to each transfers, depending on the label that has been applied. My bottom-line recommendation is that such labels be discarded and that the parties be explicitly empowered to determine whether cash transfers-whether denominated alimony, child support, a property settlement, an "equitable distribution" for state law purposes, or otherwise-are includable by the recipient and deductible by the payor, or excludable by the recipient and not deductible by the payor, with simple and clear default rules for taxpayers who fail to make their wishes known in their divorce, separation, or support instrument. Well-advised taxpayers already have significant freedom to decide who, between them, should be taxed on cash transfers incident to divorce, because they can structure their cash transfers in a form that will implement their agreement. Poorly-advised or unadvised taxpayers do not have the same flexibility, because they are unaware of the various transactional elections effectively available to them if they had cast their cash payments in the proper form.
The reason underlying the different tax treatment applicable to alimony and child support has never been adequately articulated, though it is often difficult to distinguish between the two. The reason underlying the different tax treatment applicable to alimony and many cash property settlements can, in contrast, be articulated as a theoretical matter, but, as Professor Malman noted in 1986, "there is no administratively practical way for the tax system to draw the alimony/property distinction." Payments that would be characterized as "alimony" for tax purposes may constitute "child support" or a "property settlement" under state law, and vice versa. Moreover, an increasing number of states are abandoning such labels altogether. Under "equitable distribution regimes," for example, the cash payment stream can be intended simply to settle all claims for support and property compensation between the parties. Continuing to make the determination of who should be taxed on cash transfers in divorce turn on what label is used to identify the payment, and then having unique tax definitions for those labels that often deviate from state law definitions, causes confusion among taxpayers and traps for the unwary, as case law litigation clearly shows.
The great fear that has driven Congress in the past is that divorcing parties will engage in inappropriate "income-shifting" if left to decide for themselves who should be taxed on cash transfers, with the joint income of the divorced couple being taxed at a lower overall rate than would have occurred absent the divorce, to the detriment of the Treasury. In response, I would argue that such tax arbitrage is built into the current system already, that people do not get divorced in order to engage in income-shifting for tax purposes, and that the income-shifting that can occur is likely a good and defensible outcome on public policy grounds in most situations in which it can occur. Such income-shifting encourages the higher-bracket spouse to transfer funds to the lower-bracket spouse (presumably the more needy spouse), often leaving the lower-bracket spouse with more after-tax income than she would otherwise have if income-shifting were disallowed. Unlike other situations in which income-shifting is deemed to be inappropriate, such as in the intact family or in the case of a closely held corporation, divorce is not a transaction that can be entered into lightly, and often, in order to shift income to another in a lower tax bracket and thus reduce overall taxes on a routine basis while retaining effective control over the shifted income. Indeed, "[f]ollowing divorce, the chances of filing bankruptcy triple." To the extent that some additional income-shifting would occur under the proposed simplifications that does not already occur under the current rules, so be it. Even if I am wrong that it would be a salutary result in most cases, it is a small price to pay for the huge simplification gains-and, I believe, the added respect for the tax system by the unfortunate parties who have to deal with these complex provisions-that would occur.
Moreover, as Professor Malman has noted, there is reason to believe that not much aggregate tax would be lost to the Treasury in any event, since every deduction is accompanied by an equal-amount inclusion. Only the rate-bracket differential between the parties, if any, results in a revenue loss, and this loss is self-limiting. As the amount paid to the payee increases, the payee ascends to higher tax brackets until further income-shifting does not produce a revenue loss. Moreover, in the context of a payor in a significantly higher tax bracket than the payee-which is the very context where it would seem that income-shifting would be at its most extreme and therefore result in the most lost revenue-any divorce "bonus" is more illusory than real. This is because the combination of one high-income spouse and one low-income spouse already receives a significant marriage bonus under current law if the couple files a joint return, and this marriage bonus is lost on the divorce. Even with income-shifting, the parties are not better off taxwise by much, if any, in the aggregate under the more onerous schedule for single filers that must apply to them after the divorce.
As mentioned above, our current system for taxing transfers in divorce is the result of history and political compromise as much as grand theory. Part I below will recount this history, for it is difficult to understand how we got to where we are today without a working knowledge of this history. Part I will also introduce the various ways to think about these transfers, as it is difficult to discuss how the law evolved without an introduction to these thoughts at the same time. Part II will continue the discussion of what works in the current system, what is fundamentally flawed, and what should be done about it and why. Part III will examine two inextricably related problems that need addressing.