Income Shifting in the Happy and Fractured Family

• Author: Deborah A. Geier
• Pages: 215-257

Chapter 8: Income Shifting

in the Happy and Fractured Family

In Chapter 7, you learned that the making of a cash gift or bequest—funded from, say, wages

earned by the donor—does not succeed in shifting income tax liability from the donor to the donee.

The amount transferred by the donor is a nondeductible personal expense under § 262(a), and the

receipt by the donee is excludable from Gross Income under § 102(a). Thus, the wages earned to

fund the cash gift are effectively taxed to the donor at the donor’s tax rates (rather than to the donee

at the donee’s tax rates).

On the other hand, built-in gain (i.e., unrealized § 1001 gain) in property will be shifted to

another if the property is transferred by inter vivos gift because (1) the gift, itself, is not a realization

event for the donor and (2) § 1015 generally provides for a carryover basis in the hands of the

donee. Thus, built-in gain will effectively be shifted to the donee and taxed at the donee’s (possibly

lower) marginal rate when realized (unless, of course, the donee retains the property until death,

at which time the built-in gain will be laundered out under § 1014).1

This ability for propertied families to engage in income shifting more readily than families

whose chief source of income is from labor is a theme carried forward in this chapter, which

considers additional possibilities for income shifting or splitting in both the happy and fractured

family, as well as reactions by both Congress and the courts to such attempts.

Two reasons explain why income shifting or splitting can reduce the aggregate tax paid. First,

the income may be taxed at a lower rate if successfully shifted to a family member for whom the

income will be marginal (last) dollars in a rate bracket that is lower than the transferor’s marginal

rate bracket. Second, the ability to split income between two (or more) taxpayers for tax purposes

may mean that the lower brackets can effectively be used twice rather than only once, as would

occur if the entire amount must be included by only one taxpayer. Part A. considers income

splitting via the joint return, and Part B. considers other income-shifting possibilities.

A. Income splitting via the joint return

The place to start is Lucas v. Earl.

LUCAS v. EARL

281 U.S. 111 (1930)

MR. JUSTICE HOLMES delivered the opinion of the Court.

This case presents the question whether the respondent, Earl, could be taxed for the whole of

the salary and attorney’s fees earned by him in the years 1920 and 1921, or should be taxed for

only a half of them in view of a contract with his wife which we shall mention. The Commissioner

of Internal Revenue and the Board of Tax Appeals imposed a tax upon the whole, but their decision

1 We also saw, however, that the § 1015 basis rule for inter vivos gifts prevents built-in loss from being effectively

shifted to a donee in a higher marginal rate bracket.

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was reversed by the Circuit Court of Appeals. A writ of certiorari was granted by this Court.

By the contract, made in 1901, Earl and his wife agreed “that any property either of us now has

or may hereafter acquire … in any way, either by earnings (including salaries, fees, etc.), or any

rights by contract or otherwise, during the existence of our marriage, or which we or either of us

may receive by gift, bequest, devise, or inheritance, and all the proceeds, issues, and profits of any

and all such property shall be treated and considered and hereby is declared to be received, held,

taken, and owned by us as joint tenants, and not otherwise, with the right of survivorship.”

The validity of the contract is not questioned, and we assume it to be unquestionable under the law

of the State of California, in which the parties lived. Nevertheless we are of opinion that the

Commissioner and Board of Tax Appeals were right.

The Revenue Act of 1918 approved February 24, 1919, c. 18, §§ 210, 211, 212 (a), 213 (a), 40

Stat. 1057, 1062, 1064, 1065, imposes a tax upon the net income of every individual including

“income derived from salaries, wages, or compensation for personal service … of whatever kind

and in whatever form paid,” § 213(a). The provisions of the Revenue Act of 1921, c. 136, 42 Stat.

227, in sections bearing the same numbers are similar to those of the above. A very forcible

argument is presented to the effect that the statute seeks to tax only income beneficially received,

and that taking the question more technically the salary and fees became the joint property of Earl

and his wife on the very first instant on which they were received. We well might hesitate upon

the latter proposition, because however the matter might stand between husband and wife he was

the only party to the contracts by which the salary and fees were earned, and it is somewhat hard

to say that the last step in the performance of those contracts could be taken by anyone but himself

alone. But this case is not to be decided by attenuated subtleties. It turns on the import and

reasonable construction of the taxing act. There is no doubt that the statute could tax salaries to

those who earned them and provide that the tax could not be escaped by anticipatory arrangements

and contracts however skillfully devised to prevent the salary when paid from vesting even for a

second in the man who earned it. That seems to us the import of the statute before us and we think

that no distinction can be taken according to the motives leading to the arrangement by which the

fruits are attributed to a different tree from that on which they grew.

Judgment reversed. _________________________________

At the time of Lucas v. Earl, there was only one Federal income tax rate schedule that was used

by all taxpayers, including married individuals, who filed separate tax returns. If the attempted

assignment of income from Mr. Earl to Mrs. Earl of one-half of his wages had been successful for

income tax purposes, why would the aggregate tax paid between them have been lower than if, as

held, the attempted assignment of income had no effect for tax purposes?

While I sometimes edit opinions to make them shorter for student digestion, I did not edit Justice

Holmes’s opinion at all. Can you figure out why, precisely, Mr. Earl’s assignment of income to

his wife—while assumed to be valid under state contract law—did not shift the Federal income

tax burden on that assigned income to his wife? Could Guy Earl and his wife have executed the

contract with the intent of reducing their aggregate Federal income liability? When was this

contract signed? Recall from Chapter 3 that the 16th amendment was ratified in 1913 and that the

first income tax was enacted in the same year.

Lucas v. Earl and Poe v. Seaborn, though decided in the very same term of Court, came to very

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different outcomes. Why?

POE v. SEABORN

282 U.S. 101 (1930)

MR.JUSTICE ROGERTS delivered the opinion of the Court.

Seaborn and his wife, citizens and residents of the State of Washington, made for the year 1927

separate income tax returns. During and prior to 1927 they accumulated property comprising real

estate, stocks, bonds and other personal property. While the real estate stood in his name alone, it

is undisputed that all of the property real and personal constituted community property and that

neither owned any separate property or had any separate income.

The income comprised Seaborn’s salary, interest on bank deposits and on bonds, dividends, and

profits on sales of real and personal property. He and his wife each returned one-half the total

community income as Gross Income and each deducted one-half of the community expenses to

arrive at the net income returned.

The Commissioner of Internal Revenue determined that all of the income should have been

reported on the husband’s return, and made an additional assessment against him. Seaborn paid

under protest, claimed a refund, and on its rejection, brought this suit. The District Court rendered

judgment for the plaintiff; the Collector appealed, and the Circuit Court of Appeals certified to us

the question whether the husband was bound to report for income tax the entire income, or whether

the spouses were entitled each to return one-half thereof. This Court ordered the whole record to

be sent up.

The case requires us to construe Sections 210(a) and 211(a) of the Revenue Act of 1926 [the

predecessor to current § 1] and apply them, as construed, to the interests of husband and wife in

community property under the law of Washington. These sections lay a tax upon the net income

of every individual. The Act goes no farther, and furnishes no other standard or definition of what

constitutes an individual’s income. The use of the word “of” denotes ownership. It would be a

strained construction, which, in the absence of further definition by Congress, should impute a

broader significance to the phrase.

The Commissioner concedes that the answer to the question involved in the cause must be found

in the provisions of the law of the State, as to a wife’s ownership of or interest in community

property. What, then, is the law of Washington as to the ownership of community property and of

community income, including the earnings of the husband’s and wife’s labor?

The answer is found in the statutes of the State, and the decisions interpreting them. These

statutes provide that, save for property acquired by gift, bequest, devise or inheritance, all property

however acquired after marriage, by either husband or wife, or by both, is community property.

On the death of either spouse his or her interest is subject to testamentary disposition, and failing

that, it passes to the issue of the decedent and not to the surviving spouse. While the husband has

the management and control of community personal property and like power of disposition thereof

as of his separate personal property, this power is subject to restrictions which are inconsistent

with denial of the wife’s interest as co-owner. The wife may borrow for community purposes and

bind the community property (Fielding v. Ketler, 86 Wash. 194). Since the husband may not

discharge his separate obligation out of community property, she may, suing alone, enjoin