Income Tax I

Bogdanski

Fall 2000

 

 

Sample Answers to Question 1

 

Exam No. 3005

 

The transfer of stock in satisfaction of Howie=s debt to the broker is a realizing event for Howie under 1001.  Howe=s basis in the stock was 10K so he not realize a gain of 90K.  This gain is a capital gain and will be taxed at lower capital gain tax rates if the property was held for over a year by Howie.  Assuming that the stock was held for over 1 year, the gain would be a LTCG.  The 10K represents Howie=s cost in the stock.  The 90K gain will be reported in Howie=s federal income taxes in 2000.  While Howie was insolvent at the time of the transfer, his insolvency does not affect the gain realized because there was no discharge of indebtedness.  Assets other than cash paid to satisfy a debt are valued at the debt relieved.  If Bigco is traded on an exchange, the 100K market value will be shown by that exchange.

 

When a married couple becomes legally separated, state law generally requires a division of property accumulated during the marriage.  In addition, one spouse may have a legal obligation to support the other spouse.  The IRC distinguishes between property divisions and support payments.

 

Alimony and separate maintenance payments may be deducted by the party who is making the payments.  IRC ' 71 states that gross income includes amounts received as alimony or SMP=s.  ' 215 will give Howie his deduction for alimony payments.  To be tax deductible, these alimony payments must meet statutory guidelines and may not be disguised child support payments.

 

Wynona receives custody of the 2 children.  Unless otherwise agreed, Wynona will claim both children as dependents upon her tax form.  Howie=s transfer of Bigco stock at time of divorce is not a recognizing event under IRC ' 1041.  ' 1041(c) states that a transfer is incident to divorce if it occurs within 1 year after the date the marriage ceases or is related to the cessation of the marriage.  Howie receives no deduction and Wynona=s basis in the appreciated stock remains $1,500.

 

Howie is also obligated to transfer 15K a year in Bigco stock over the 3 years following the divorce.  The settlement states that if Wynona dies during this time, the transfers may stop.  While any transfer within one year is treated as being incident to divorce, transfers after one year must be shown to be related to the dissolution.  The transfer is not entitled to a deduction and Howie does not recognize gain on the transfer.  When Wynona sells the stock, her basis will be $1,500.

 

Howie is required to make payments of $1,000 per month in cash to Wynona until her death, remarriage or Charlie’s 18th birthday.  Payments under agreements are classified as alimony if (1) paid in cash, (2) the agreement does not specify that the payments are not alimony, (3) payor and payee are not members of the same household at the time payments are made, and (4) there is no liability to make the payments for any period after the death of the payee.  Because the Bigco stock is not cash, it clearly is part of the property settlement.  No alimony recapture is generated for front loading because the property was non-cash, not alimony, and its FMV remained 15K for each of the 3 years.

 

Howie would like for the $1,000/month payments to be considered alimony because then the payments would be a ' 61 above the line deduction.  Unfortunately for Howie, because the payments will be reduced upon the happening of a contingency related to a child (Charlie=s 18th birthday), ' 71(c)(2) - does not allow the 1K per month payment to be considered alimony.  The $1,000 will be terminated upon Charlie reaching 18; therefore, the entire $1,000/month is child support, which is not deductible by Howie.  Howie is not allowed the deduction because the payments are made to satisfy Howie=s legal obligation to support his children.  Wynona will take the children as exemptions on her taxes while they are residing in her home unless otherwise agreed.

 

The tax code is designed to prevent individuals from disguising property settlements and child support payments as alimony to achieve tax benefits.  Here, Howie=s full-time job as an attorney will (hopefully) place him in a higher income bracket from Wynona, a stay-at-home mom.  Howie would like to be able to claim all of his payments as alimony so that he is able to take a for-AGI deduction, reducing his taxes at his higher marginal rate .  The code provides a 3-year front loading provision for disguised property settlements and requires that alimony payments not be related to a contingency of a child.  Because they are, Howie does not receive any deduction for his 1,000 monthly payments.  The transfer of property will not have a tax effect and is treated as a gift for the basis calculation.  The transfer of stock to the broker is a taxable event and will result in tax figured at the lower of Howie=s marginal rate or the capital gain rate of 25%.  Wynona will receive any ' 24 child tax credits upon her 2000-and-beyond head-of-household form.  Howie will use an unmarried form beyond year 2000 and will not take deductions for child support, or deductions for personal exemptions unless otherwise agreed.

 

 

Exam No. 3044

 

The transfer of the stock to the stockbroker, a transfer of property in compensation for services under ' 83, is a realizing event for Howie.  That the transfer was to satisfy a debt does not change this.  Howie trades property he paid $10,000 for to satisfy a $100,000 debt.  Howie=s basis was $10,000, the amount realized was $100,000 (the value of the debt), leaving Howie with a gain of $90,000.  The $90,000 gain is an undeniable accession to wealth, clearly realized, over which the taxpayer has complete dominion.  Glenshaw Glass.  The $90,000 is a long term capital gain, taxable in the year of the transfer.  The property is not excluded by § 1221(a) and was held for more than one year.  This is not discharge of indebtedness income, as the transfer of the stock satisfied the entire debt.  Because this was not DOI income, Howie’s insolvent status ($60,000 excess of liabilities over FMV of assets) is of no consequence.

 

The $15,000 stock transfer is not alimony.  Although it was received under a written divorce settlement, constant for the first three years and terminable upon Wynona’s death, it is not a payment in cash, as required by § 71(b)(1).  While it is unclear, Howie and Wynona presumably do not live together any more and did not elect to have the payments be other than alimony.  § 71(b)(1)(B-C).  However, all five of the criteria set forth in 71(b) must be satisfied to make this alimony.  Because the payments are not alimony, Howie does not get a deduction and Wynona need not include them in her gross income.

 

Thus, the transfers of stock are controlled by 1041.  Because they are not alimony, they are properly regarded as transfers of property between spouses, in this case, incident to divorce.  These transfers are incident to divorce, meaning, in the case of the first transfer, within one year of divorce, and regarding the others, because they are related to the cessation of the marriage.  § 1041(c).  A transfer is related to cessation of marriage if it is pursuant to a divorce decree and not more than 6 years after date of divorce.  Reg § 1.1041-1T(a).  Because the transfers are incident to divorce, no gain or loss is recognized.  This property is simply treated as being acquired by gift, which is not a realizing event.  Accordingly, Wynona will have a carryover basis.

 

The $1,000 monthly payments look suspiciously like child support trying to pass as alimony.  The provision for termination upon Wynona’s death or remarriage smell like alimony, but the termination upon Charlie’s 18th birthday smells like child support.  Wynona has custody of the children and Charlie is the youngest.  When he is 18, both will be of legal age and presumably not in need of Wynona’s care.  Additionally, the $1000 amount is relatively low.  Once again, because this looks like child support and not alimony, Howie does not get a deduction for the $1,000 monthly payments he so faithfully made.

 

 

Exam No. 3135

 

The transfer of the stock to the broker is simply transferring property to satisfy a debt.  So, it is treat as a sale of the property with the amount realized as the cost of the debt.  Howie has a $90,000 gain on the stock.

 

100K amount realized

-10K basis                

  90K capital gain

 

This is a capital gain, so it will be taxed at the lower capital gain rate.

 

The fact that Howie is insolvent at the time of the transaction does not matter, because this is not a discharge of indebtedness (no debt is being forgiven) and it is not covered by § 108.

 

The divorce settlement is structured to look like alimony, because the payments are spread out over three years evenly (15K per year), it is a written obligation and it ceases if Wynona dies.  There is no mention of opting out of alimony in the agreement, but this does not qualify as alimony, because the payments are not in cash; § 215 requires the payment to be in cash.  The Bigco stock must be treated as a property settlement.  As such, it is treated the same as a gift from husband to wife and there are no tax consequences for Howie.  He does not get a deduction and his ex-wife gets his low basis in the stock.  If it were alimony, Howie would get a deduction at a higher rate, and his ex-wife would count it as income at her lower rate.  But as it is, this is just a gift-type transfer.  It is a valid settlement under § 1041, because it is transferred incident to divorce and is related to the divorce.

 

The other provision of the $1,000 a month is also structured similar to alimony, but it fails because it includes a contingency that relates to the children.  So this is child support, despite the fact that it is cash and ends if Wynona dies or remarries.  It is tied to the child’s 18th birthday, so it does not qualify as alimony.  The result is that there are no tax consequences due to the child support.  Howie does not get a deduction, because this is a family living expense.

 

The fact that Wynona has custody of the children is significant, because this means she gets to claim the dependent deductions ($2800 for each child), even though Howie is paying child support.  If Wynona is willing to give up the deduction, she can elect to pass it to Howie by sending in an election with her tax return.  This would allow Howie to take the dependent deduction, if together they are providing one-half of the kids’ support.

 

 

 

 

 

Created by:  bojack@lclark.edu

Updated: 02 Sep 04

Expires: 31 Aug 05