Assignment of Income

The assignment of income doctrine, as outlined by , is a very ambitious doctrine, a doctrine that attempts to answer two elemental questions in federal income tax law: (1) the “who” (the person or entity to be taxed) and (2) the “what,” that is, the character of the income received (i.e., or ).

In the famous Supreme Court case, , the Court held invalid the contract between the taxpayer-attorney and his wife wherein all the couple’s acquisitions (including income from his personal services as an attorney) were to be shared equally: the “fruits” from the attorney’s “tree” cannot be attributed to the wife’s “tree.” In other words, despite the legal form of the couple’s contract, the Court looked to the substance of the contract and deemed it tax avoidance. From this decision emerges the general rule that taxes on income from personal services are attributable (assignable) to the person performing the services. In this case, the obvious answers to the “who” and “what” questions are the taxpayer-attorney is taxable and the character of the income received is ordinary (compensation for services).

The assignment of income doctrine also helps to differentiate between transfers of and associated with, or attached to, that property. The basic principle is that in an effective, substantial transfer of the entire underlying property, the , not , is taxed on future income from the property. In short, the assignment of income doctrine does not apply.

However, if the property is transferred with income attached (e.g., any interest accrued on a will be taxable to the assignor in the year he or she transfers the interest-bearing security) or the assignor transfers only the right to receive income yet retains the income-producing property, the assignment of income doctrine will apply even if the form of the transfer is gratuitous (a gift). Put differently, to avoid classification as a and be effective for federal income tax purposes, the transfer must be real and effective for state law purposes and the donor must not retain excessive controls over the income-producing property transferred.

And this brings us to another important distinction: gratuitous assignments versus assignments for . The key issue in gratuitous assignments is the “who” question, that is, the person or entity taxable. In assignments of income for consideration, the pressing issue is the character of the consideration received or the “what” question, namely, the classification of consideration received as capital gain or ordinary income. As a general rule, if the assignor receives bona fide consideration for transferring a right to income, the tax burden falls on the assignee and one must look to the character of the right transferred to determine whether it will produce capital gain or ordinary income.

For example, in the Supreme Court Case , the lessee paid the lessor a lump-sum payment in order to cancel a lease. Looking to the character of the payment received in consideration for cancellation of the lease, the Court reached a conclusion contrary to the lessor-taxpayer’s claim that the payment be recognized as capital gain. Instead, the Court ruled that the character of the amount received by the lessor was in substance ordinary income since it was a substitute for rent.

For additional information on the assignment of income doctrine, please consult the following resources:

Many happy returns, Roger

Tax Benefit Rule

The tax benefit rule provides an exception to the general rule that a deduction (or credit) taken in a prior year must be included in gross income in the year of recovery. If and to the extent the earlier deduction (or credit) does not reduce taxes, under the , the recovery is excluded from the current year’s . Although it would be logical to go back and restate the original transaction, the IRS prefers certainty, closure, and “administrative convenience”: to go back and monkey with a prior year’s transaction would run counter to the Service’s long standing principle that a tax year is a closed and separate event.

For example, assume that amounts paid and deducted for medical expenses in, say, 2007, are reimbursed by the taxpayer’s insurance carrier in 2008. To the extent that the 2007 deduction bolsters the taxpayer’s so that they exceed the applicable amount (no mean feat given that are deductible only to the extent they exceed 7.5% of ), a tax benefit results and the taxpayer would have to include in gross income the lesser of the insurance reimbursement or the amount by which the total for 2007 itemized deductions listed on (pdf file) exceeds the standard deduction amount. There is nothing special about the standard deduction amount and the taxpayer who chooses this option receives no tax benefit for the year in question (provided, of course, that the taxpayer doesn’t have any other deductions or credits subject to recovery in later years, e.g., in 2007 for (pdf file) that are reimbursed by the taxpayer’s employer in 2008). Therefore, in calculating the (pdf file) the taxpayer includes in gross income, we must first determine the amount of the 2007 tax benefit (i.e., the amount by which itemized deductions exceed the standard deduction amount) and then include in gross income the lesser of the insurance recovery or the excess of itemized deductions over the standard deduction. The topic of (pdf file) is another area where the tax benefit rule is commonly applied.

One more comment: The tax benefit rule focuses on the previous year’s deduction, not the actual tax paid. Put differently, it does not consider the the taxpayer’s ; the taxpayer comes out even only if the he or she stays in the same bracket. But if you move up to a higher bracket then you must include the recovery in income at a higher and therefore lose out in the deal.

Other useful articles about the tax benefit rule are listed below:

Many happy returns, Roger

Tax Avoidance

A concept appearing time and again in leading tax resources is the idea of “tax avoidance,” and I illustrate this key concept using the example of a clever and complicated .

In my research, whether reading law school textbooks on federal income taxation or one of many helpful practitioner guides, the concept of substance over form explains decisions made in many important court cases and serves as a standard to guide practice. In a word, the lay person and the practitioner must understand the “meat” or substance of controversial tax issues in order to structure transactions so they meet not only the letter but also the spirit of the law. If a transaction serves no other purpose than that of you can expect the Commissioner of the and courts of law to reject your claim for favorable tax treatment.

One area where the doctrine of substance over form is commonly applied is litigation examining the economic substance and business purpose of tax shelters (and the very label of “tax shelter” is a clue that the writer of the opinion or law school textbook is a most unsympathetic critic of the taxpayer’s argument).

For example, in ACM Partnership v. Commissioner, a case in the Third Circuit of Appeals (1998), Colgate-Palmolive sells (in 1988) a wholly-owned subsidiary for a of approximately $104 million. In order to create a to offset its large gain, Colgate enters into partnership with ACM (owned 94% by Colgate) and makes an of property to a nontaxable foreign entity. In the first year of the installment sales contract, the foreign entity has a large interest in the partnership and reports a large nontaxable gain, “owning” over 90% of that gain. In year two, after adjustment of ownership interests so that ACM now owns most of the partnership with the foreign entity, the property is sold at a loss, and presto!, ACM (i.e., Colgate) is the beneficiary of a large tax loss it uses to offset Colgate’s $104 million gain.

In the majority opinion, the court looks to the (pdf file) of this complicated transaction and finds little substantial economic effect other than the conjuring up of a tax loss to offset Colgate’s earlier taxable gain. Moreover, it finds a glaring absence of a sound and rules the real purpose of the transaction is a scheme to avoid federal income taxes.

Here are some additional resources on tax avoidance:

Many happy returns, Roger