Income Tax I
Bogdanski
Spring 2005
Sample Answers to Question 2
Exam No. 7162
Part 1.
The
property settlement of the cash and the partnership interest is not income
under IRC § 1041. In the
Part 2.
The issue is whether the tuition is alimony and what are the tax consequences. Under IRC § 71, the person receiving alimony (spousal support) has to put it down as gross income. Under IRC § 71(b), alimony must meet each of six factors. Part 2 of the agreement satisfies the alimony requirements because the payments are cash (tuition is the equivalent, it is not property); they are made to or benefit W, they are pursuant to the written separation document that requires money to be paid (they spent a great deal of time discussing this), there is no indication in the document that the payment is not being deemed alimony, H and W live apart (shown by visitation), and there is no obligation to make the payments after W dies.
Wendy’s tuition is alimony and the FMV of the tuition is gross income to W. This is an ordinary gain. Wendy cannot deduct this income because it is a personal expense. It does not meet the 3 part test for education deduction because the school is to become a pharmacy tech, not maintain a skill required by a current job. Also it fails test because it is training for entry level job and it qualifies W for new trade (fails all three parts). Under IRC § 25A, W may qualify for a Hope credit (first two yrs of college at $1500 per student) or a lifetime learning credit ($1000 per student). These are subject to phaseouts. Under IRC § 222, W could elect a deduction instead.
Part 3
Child support is not taxable and not income. W pays no tax on the $6000.
Part 4.
The spousal support is fishy. It is OK to give the spousal support a term of years (here 5) and to condition the spousal support on W staying single and alive. However, conditioning spousal support on the kid living is a disguised payment subject to IRC § 71(c)(2). Here, if the kid dies, the spousal support decreases. What H and W are doing is dressing up child support to look like alimony. Child support tends to be more expensive to couples if the payor (here H) is in a high tax bracket. As a couple, they would do better calling it all alimony. Because they though carefully about this, they probably made a deal to jack up the support a bit if W was willing to call it alimony. Under IRC § 71(c)(2), this scheme, the extra $3500, will be treated as child support. Therefore, W will only have $8500 income from Part 4 for the next 5 years. The $8500 spousal support (not including the dressed up child support) satisfies all of the elements of alimony, which I discussed in Part 2. The $8500 is personal income to W that is not deductible. W’s income is ordinary because it does not meet the definition of a capital gain (not actual sale or exchange).
Attorney
The attorney fees are a personal expense. Divorce is as personal as it gets. Gilmore tried to deduct divorce fees under IRC § 212 to protect his property, but lost. Similarly, W cannot deduct her divorce fees even though they are partly due to tax advice. Tax advice is deductible for a trade or business, but not in a personal matter. This is a current expenditure.
Deductions and Credits.
W, as the parent with custody, can deduct $3200 for child as a dependant. Chris is certainly a qualifying child because it is W’s child and he is a toddler (no income). The divorce decree is silent as to who can claim kid as a dependant, but W has more parenting time, so she gets the deduction. There is a phaseout, that starts at about 140k for a single parent. W could also get a child credit of $600 under IRC § 24. This is better than a deduction because a credit save $1 of tax for each $1 of credit.
Wendy’s divorce from Hollis and her grant of custody of Chris means that Wendy’s tax filing status changed from married to Single or Head of Household. Because Wendy is the custodial parent with whom Chris resides for most of the year, Code § 152 entitles her to claim Chris as an exemption on her tax returns.
Chris is just a toddler, so if Wendy is employed, she will presumably have child care expenses. Child care expenses are not deductible because they are a personal expense, but Wendy can claim a child care credit on her return, as long as the child care is incurred for employment. Child care incurred while Wendy is at school does not qualify for the child care credit.
Per Code § 1041 the property settlement of $100,000—cash and partnership--is a nontaxable event. Property transfers between spouses in a divorce are treated as gifts, which are not includible in gross income. Under Code § 1015, the basis of property received as a gift is the same as it would be in the hands of the donor; therefore, Wendy receives Hollis’s basis of $15,000 in the silent partnership. There is no basis in the cash Wendy received. However, any interest earned on the cash and any income produced by the partnership interest must be included by Wendy as ordinary income.
Hollis’s payment of Wendy’s tuition may be characterized as alimony, or spousal support. Per code § 71(b), alimony is a payment to or for the benefit of a former spouse pursuant to a written instrument where the payments are not specified as “not alimony,” the payor and payee live apart, and the obligation terminates upon the payee’s death.
Here, Wendy’s tuition payments are for her benefit, because she is gaining an education and a valuable skill as a pharmacy technician. Wendy and Hollis are divorced. There is no evidence that the settlement agreement characterizes the tuition payments as “not alimony.” Hollis’s visitation rights with Chris imply that the parties are living apart. Although the agreement does not specify that these payments will end if Wendy dies before she finishes school, presumably the school would not continue to charge tuition if Wendy were to die during the pursuit of her pharmacy technician certification. These payments are alimony, and Wendy must include them as ordinary income .
Like the property settlement to Wendy, Hollis’s payment of child support for Chris is not a taxable event. Under Code § 71(c), Wendy need not report it as income.
The $12,000 payments to Wendy are characterized as “spousal support,” but they do not meet the requirements of Code § 71(b). The five-year term is not a problem, nor is the provision that the payments terminate upon Wendy’s death or remarriage. However, $3,500 of the $12,000 annual payments will terminate upon Chris’s death. Code § 71(c )(2)(A) provides that any reduction in alimony contingent upon an event relating to the parties’ child—events like death, marriage, or graduation from school--will be treated as child support instead of spousal support. Since alimony payments to Wendy are deductible “above the line” to Hollis and child support payments are not deductible at all, Hollis is apparently attempting to disguise child support as spousal support so he can deduct it from his income. Per Code § 71(c)(2)(A), the IRS will consider $3,500 per year, the contingent portion of the payment characterized as “spousal support,” to be child support instead of alimony, and as such Wendy will not have to include it as income. She will, however, have to include the remaining annual payment of $8,500 per year which is attributable only to her support as ordinary income, in addition to any sums paid by Hollis on account of her tuition.
Attorney fees incurred for personal advice are not deductible by the taxpayer. However, legal fees incurred for tax advice are deductible. Wendy cannot deduct that portion of her attorney fees that was provided on account of her divorce, property settlement or child support, but she can deduct that portion of the legal fees she actually paid that is attributable to tax advice. Since Wendy received taxable income as a result of the settlement agreement, some portion of her attorney fees is deductible, and she should ask her attorney to apportion the $3,000 fee between tax advice and personal advice so she can take the appropriate deduction.
The deductible portion of Wendy’s attorney fees is a miscellaneous deduction under Code § 67 and is subject to a 2% floor. If Wendy itemizes deductions and if her deductible attorney fees, along with her other miscellaneous deductions, exceed 2% of her adjusted gross income, she can deduct that portion of miscellaneous deductions that exceeds 2%. There is not enough information here about Wendy’s income and deductions to reach a conclusion about whether or not she will be able to deduct that portion of her attorney fees that her lawyer allocates to tax advice.
Exam No. 7312
Pursuant to §1041 of the code, transfers between spouses or those incident to divorce are not recognized as income. The first provision of the divorce agreement provides $100,000 of income to Wendy in the form of cash and an interest in Hollis’ partnership. This will be considered incident to divorce under the presumption of §1041(c)(1), which assumes that transfers occurring within one year of a divorce are incident to a divorce. Since this first transfer took place immediately, and the transaction is pursuant to a written divorce decree, the $100,000 gain that Wendy has will not be considered income to her. Wendy will get a carry over basis of $15,000 in the partnership interest under §1041(b).
The provision for Hollis to pay for Wendy’s tuition could also arguably be incident to divorce, however, the presumption of §1041(c)(1) may not apply because it is not clear if Hollis will pay this money immediately to Wendy or whether it will be paid to her over a period of years in the future when she finally returns to school. Wendy has a good argument that the tuition is incident to divorce and therefore excluded from her gross income because it is done pursuant to written divorce agreement. However, it could be argued that this is a form of alimony or spousal support because it is not something that happened immediately after the divorce or during the marriage, but occurs in the future when Wendy returns to school. The provisions of §1041 are designed to exclude the exchange of money when dissolving the divorce, not to exclude spousal support later received pursuant to the divorce agreement. In sum, it is likely that the $6000 per year will be ordinary income to Wendy.
If the tuition money is considered income to Wendy it will be ordinary income. She does not qualify for a deduction for the tuition money (or the money received that she uses towards tuition), because the only way that she could deduct the tuition would be as a business expense. Wendy will want to argue that it is a business expense because it is preparing her for a career in a new field. However, this argument will fail because tuition that prepares a taxpayer for work in a new field is not deductible as a business expense (reg. §1.162-5(b)(2)). In addition, the education would have to be required by her employer or to improve her current business skills. Since neither of these apply, she will be allowed to deduction for her education as a business expense. Wendy may be able to take a life time learning credit. In sum, the tuition payments to Wendy are likely to be considered ordinary income that will be taxed.
Child support is considered a nothing for tax purposes, and Wendy would not have to include this as income when it is received from Hollis (number three in the divorce agreement).
Regarding provision 4, Wendy could make an argument that this is child support, and therefore not income. She could use the Alimony provisions in her favor to argue this. For example, the alimony provisions provide that alimony is income to the spouse who receives it (payee), §71. But the alimony provisions do not apply to payments received that look like a property settlement or child support (for example, provisions that are contingent upon the age of the child). Since these payments are contingent upon the age of the child, Wendy could argue that they are more like child support and therefore excluded as income. This argument is likely to prevail as to $3500 of the $12000 per year that she receives (since the 12,000 will be reduced to $8500 if Chris dies, the difference is presumably child support), since this is contingent upon Chris and therefore looks more like child support. Since there is an extra amount clearly defined in the agreement that is not related to the support of the Child, the rest of the payment could easily be defined as ordinary income to Wendy ($8500).
Wendy could also argue that since the payments last only five years, they are incident to the divorce and therefore excluded as income. These payments are more likely to be defined as alimony or separate maintenance payments, however. Alimony is defined as amounts received in cash, for the benefit of the payor’s ex spouse, made pursuant to a written divorce agreement, there cannot be any liability to make payments after the payee spouse’s death and the payee and payor cannot be members of the same household. §71(b)(1). All of these requirements are satisfied. In addition, the amount of $8500 per year is not contingent on the support of Chris. Furthermore, the one year presumption that the amounts are incident to divorce does not apply. §1041(c)(1). All of these things weigh in favor of treating the payments in section four as alimony, and therefore regular income to Wendy.
The fee paid to her attorney for divorce and tax advice could be partially deducted by Wendy. §212(3) allows a deduction to the taxpayer for expenses incurred in connection with the determination, collection or refund of any tax. Since part of the services that her attorney provided to her were tax related, they could be deducted under this provision.
As far as the support of Chris, Wendy may be able to take a deduction for Chris as a dependant. To take a deduction for a dependant under §151, the dependant must be your child, who lives with you, who does not provide more than half of their own support. Since Chris has no way of providing his own support (he is a toddler), he lives with Wendy, and he is under the age limits, Wendy can take a $3200 deduction for him, below the line, on her tax return. Hollis may be able to argue here that he provides more than have of Chris’ support and therefore should have the deduction, but the tie breaker provisions provide that the custodial spouse gets the deduction. If Wendy foregoes itemized deductions, she could also take a standard deduction for Chris because he is her dependant. This deduction would be $800 (since it is the greater of $800 or $250 plus the child’s earned income). In addition to these, Wendy could take a child credit under §24 of $1000, because Chris is her dependant and he is not yet 17. Finally, if the costs of Chris’ child care eventually allow her to go to work, she could take a child care credit. This credit, under §21 would depend on her income and would be reduced by 2% for every $2,000 over the limit that she is.
Exam No. 7985 – See .pdf file here.
Created
by: <bojack@lclark.edu>
Update: 01 Jun 05
Expires: 31 Aug 06