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Assignment of income and divorce.

In Balding, 98 TC No. 27 (1992), the Tax Court explored the relationship between Sec. 1041 and the assignment of income doctrine. California residents Hazel and Joe Balding were divorced in 1981. At that time, Mr. Balding's military retirement benefits were held to be his separate property and, therefore, not part of their property settlement. A revision in California law retroactively changed the status of the military benefits to community property. Accordingly, Mrs. Balding petitioned the divorce court to amend its judgment and award her a community property share of these retirement benefits. Before the court could act on the petition, the Baldings agreed to a settlement under which Mrs. Balding relinquished any claim against the military retirement benefits and agreed not to bring any further claims regarding marital property in exchange for Mr. Balding's promise to make three fixed payments to her.

Consistent with Letter Ruling 8813023 (issued to Mrs. Balding in 1987), the Service argued that Mrs. Balding's surrender of her community property interest in the retirement benefits was an anticipatory assignment of income and, therefore, the consideration received should be included in gross income. The court disagreed, holding instead that Sec. 1041 takes precedence over the doctrine of anticipatory assignment of income. Under Sec. 1041, gain or loss realized on transfer of property between spouses or former spouses incident to a divorce is not recognized; rather, the transfers generally are treated as gifts, resulting in the transferee taking a basis equal to the transferor's adjusted basis. The court held that the exchange between Hazel and Joe Balding should be so viewed. Accordingly, the three payments to Mrs. Balding from her former husband were held to be excluded from gross income. However, the court explicitly left open the question of whether Mrs. Balding would have to include one-half of the retirement benefits as they were paid to Mr. Balding.

For the following reasons, the authors believe that Sec. 1041 overrides not only the anticipatory assignment of income doctrine (as held by the Tax Court in Balding), but the assignment of income doctrine as well. First, Congress intended that uniform Federal income tax treatment apply to transfer between former spouses incident to a divorce (and between current spouses), regardless of state property laws. (See the General Explanation of the Deficit Reduction, Act of 1984, hereinafter, the "Blue Book," at 710-711.) If the assignment of income doctrine were applicable, this objective would be frustrated. In a common-law state, rights to pension benefits or receivables attributable to the labor of one former spouse could be 'equitably distributed" without tax consequence to that spouse, with the other former spouse receiving cash or other assets. In a community property state, on the other hand, the assignment of income doctrine would mandate that the nonworking spouse would have to recognize income (when the pension benefits were paid or when payments were made on the receivable) pursuant to the assignment of that spouse's community one-half interest.

Second, assignment of income principles, if applicable, would create a strong likelihood that the Government would be whipsawed, again in contravention of legislative intent. For example, if Mr. and Mrs. Balding were each 25 years old at the time of their divorce, it would be unrealistic to expect that Mrs. Balding would keep track of the pension benefits that her husband would receive 40 years in the future in order to include her one-half under the assignment of income doctrine. Her former husband, of course, would include only his one-half in income. The result is a no-win situation for the Government. If, however, Sec. 1041 applies, tax cost would follow cash flow, thereby increasing the likelihood of compliance and providing a much cleaner audit trail.

Third, while it is true that Sec. 1041 (a) explicitly shields from recognition only gain (or loss) that ordinarily would be recognized on a sale or exchange or property, various other provisions respect the "step into the shoes" nature of property settlements. For example, while a disposition (even by gift) of an installment obligation generally triggers recognition of deferred gain, Sec. 453B9g) mandates instead "carryover" treatment in the Sec. 1041 context (except for transfers in trust). Sec. 402(a)(9) provides that an alternate payee spouse under a qualified domestic relations order must recognize income on receipt of amounts from the plan. Sec. 72(m)(10) allocates an appropriate amount of basis to the alternate payee spouse; see, e.g., IRS Letter Ruling 9138004 (second ruling). Prop. Regs. Secs. 1.1274-1(b)(10) and 1.483-1(c)(2)(iii) exempt Sec. 1041 transfer from application of the imputed interest rules. See also IRS Letter Ruling 8645082 (a marital division of property is not the type of transaction to which Sec. 7872 was intended to apply).

Fourth, assignment of income principles have given way to other nonrecognition provisions when policy so dictates. In Hempt Bros., Inc., 490 F2d 1172 (3d Cir. 1974), the court held that a cash-basis transferee corporation was taxable on amounts it collected on accounts receivable that had been transferred to it by a cash-basis transferor in a Sec. 351 transaction. The Third Circuit stated that the anticipatory assignment of income and assignment of income doctrines "must give way in this case to the broad Congressional interest in facilitating the incorporation of ongoing businesses." Accord: Rev. Rul. 80-198.

The IRS appears to have forgotten the lessons of Hempt Bros. and Rev. Rul. 80-198 when it promulgate Rev. Rul. 87-112. The Service ruled therein that deferred accrued interest on U.S. Series E and EE savings bonds was includible under Regs. Sec. 1.454-1 by the transferor in the year the interest was transferred to his spouse in a Sec. 1041 transaction. In so ruling, the IRS stated that "[a]lthough section 1041(a) ... 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." But precisely the same could be said of Sec. 351. Yet the Service (and the Third Circuit) had no trouble in Hempt Bros. and Rev. Rul. 80-198 acknowledging that assignment of income principles should not apply in the face of well-defined policy objectives to the contrary. As indicated previously, such is the case for Sec. 1041 transfer as well.

Fifth, the purpose of the assignment of income doctrine is to protect the integrity of the progressive income tax structure in situations in which the transferor essentially retains control over transferred property. Cases decided under the law in effect prior to enactment of Sec. 1041 are split on the impact of the assignment of income doctrine on property settlements. However, given the essentially involuntary nature of a property settlement and the competing interests of the spouses in dividing up their assets, it is hard to perceive how the purpose of the assignment of income doctrine is furthered by applying it in a Sec. 1041 context. (Compare Seaborn, 282 US 101 (1930) (assignment of income doctrine does not apply when a community property regime is an "inveterate policy of the State") with Harmon, 323 US 44 (1944) (assignment of income doctrine does apply when the community system is elective).)

Sixth (and probably most importantly), the Tax Court in Balding specifically held that Sec. 1041 overrides the anticipatory assignment of income doctrine, as articulated in P.G. Lake, 356 US 260 (1958). The taxpayer in Lake conveyed to its creditor an oil payment right worth $600,000 (plus interest) in exchange for the cancellation of a $600,000 debt. In holding that the taxpayer had current ordinary income, the Court recognized that the substance of what was received was the present value of income which the taxpayer otherwise would have obtained in the future. Citing several of the landmark assignment of income cases, the Court concluded: "Here, even more clearly than there, the taxpayer is converting future income into present income." (Emphasis added.) Thus, the Supreme Court held that anticipatory assignment of income (i.e., for immediate value) presents a more compelling case for (immediate) inclusion by the transferor than the (later) inclusion under the assignment of income doctrine. Therefore, since Sec. 1041 overrides the anticipatory assignment of income doctrine (Balding), surely it should override the less compelling assignment of income doctrine.
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Author:Orbach, Kenneth N.
Publication:The Tax Adviser
Date:Sep 1, 1992
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