Income Shifting in the Happy and Fractured Family

Author:Deborah A. Geier
Pages:215-257
 
FREE EXCERPT
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 attorneys 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 wifewhile assumed to be valid under state contract lawdid 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 wifes 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

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