assignment of income rules

What is “Assignment of Income” Under the Tax Law?

Gross income is taxed to the individual who earns it or to owner of property that generates the income. Under the so-called “assignment of income doctrine,” a taxpayer may not avoid tax by assigning the right to income to another.

Specifically, the assignment of income doctrine holds that a taxpayer who earns income from services that the taxpayer performs or property that the taxpayer owns generally cannot avoid liability for tax on that income by assigning it to another person or entity. The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities.

A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income. And, under the same rationale, an assignment of an interest in a lottery ticket is effective only if it occurs before the ticket is ascertained to be a winning ticket.

However, a taxpayer can shift liability for capital gains on property not yet sold by making a bona fide gift of the underlying property. In that case, the donee of a gift of securities takes the “carryover” basis of the donor.  

For example, shares now valued at $50 gifted to a donee in which the donor has a tax basis of $10, would yield a taxable gain to the donee of its eventual sale price less the $10 carryover basis. The donor escapes income tax on any of the appreciation.

For guidance on this issue, please contact our professionals at 315.242.1120 or [email protected] .

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The Assignment of Income Doctrine: A Tax Trap for the Generous but Unwary A Practitioner's Guide to the Anticipatory Assignment of Income

• Posted on May 30, 2024

Flashbacks, Squirrels, and the Assignment of Income Doctrine

Understanding the assignment of income doctrine is crucial for taxpayers who want to pass their earnings to another individual or entity before receiving the income themselves. Equally important is grasping the Federal income tax treatment of such assignments to avoid unexpected tax liabilities. This doctrine, examined by Federal courts since the early 20th century, dictates that income must be taxed to the person who earns it, regardless of any anticipatory arrangements or contracts. Simply put, the IRS is more concerned about who’s holding the purse strings than who’s pocketing the change.

The irony of the adage “even a blind squirrel finds a nut every once in a while” is not lost on you as you receive a visit from your dactylally deficient Cousin Elmer .  As you may recall from our post on the FBAR filing requirements , Cousin Elmer has seven and a half fingers, a reminder of his unsuccessful guerrilla attack on a scurry of squirrels living in his attic using what can only be described as a Vietnam-era improvised explosive device.  That Elmer has as many flashbacks of “Charlie” as he does of those poor squirrels I, you think to yourself, karma in its purest form.

For reasons unknown to you, Elmer made a small fortune in the fireworks industry.  Though he left his job as chief munitions advisor three years ago after the unfortunate sciurine incident that cost him two and a half fingers (and not a small amount of his dignity), he earns royalties on a few patents that he developed including, “The Screaming Weasel,” “The Ring of Thunder,” and his personal favorite “Click, Click, Boom!” [1]

Elmer informs you that he has more than enough money, and he is tired of paying taxes to “The Man.”  ( You’ve come to understand that The Man is anyone in a position of authority, whether it be the entire Federal government, or Billy Joe, the manager of the bait shop, who has kicked Elmer out no less than seven times over the past six months. )

As such, Elmer wants you to draft up a contract whereby the royalties, which would have gone to Elmer, instead are paid directly to his illegitimate but charming son, Cletus.

After establishing goodwill with Elmer by affirming that “we” hate Billy Joe, [2] you sit him down for another one of your much appreciated tax talks, this time about the anticipatory assignment of income doctrine.

The Doctrine in a Nutshell

From time immemorial (or at least since 1930), [3] “the first principle of income taxation [is] that income must be taxed to him who earns it.” [4]   This principle holds true even if the right to that income is assigned to another person or entity. [5]   An individual who earns income cannot escape taxation “by anticipatory arrangements and contracts however skillfully devised….” [6]   You can see that Elmer understood at least a few snippets of what you just explained, as he lets out a huge sigh of disappointment leaving him, quite literally, deflated.

The assignment of income doctrine determines who is responsible for the tax on income, focusing on who earned the income or who controls the earning of the income rather than who ultimately receives it. [7]    If the assignor retains dominion over the income-generating asset, they cannot escape taxation by assigning the income. [8]  This focus on control “preserves the principle that income should be taxed to the party who earns the income and enjoys the consequent benefits.” [9]   Because Elmer earned the royalties, and he controls the right to direct the income to Cletus or whomever scuttles Billy Joe’s bass boat, the income will be taxed to Elmer, even if he never actually receives it.

History of Anticipatory Assignments of Income

For nearly a century, [10] federal courts have held that income generated from personal services must be reported in the gross income of the individual performing such personal services. [11]  Similarly, income derived from property should be reported in the gross income of the person that maintains beneficial ownership of that property. [12]   The process of identifying the true beneficiary of income‑producing property is a matter of examining the facts and circumstances of each assignment, including which taxpayer has the authority over the property and can enjoy its economic benefits or bear its economic burdens. [13]

When any individual or entity attempts to “avoid taxation by entering into a contractual arrangement whereby that income is diverted to some other person or entity,” courts have nearly universally held that this anticipatory assignment of income is improper, and such income “must be taxed to [the person or entity] who earns it.” [14]   The Supreme Court has gone as far as to state that this doctrine is a “foundational rule” of U.S. income taxation. [15]

Nearly a century ago Justice Oliver Wendell Holmes articulated the doctrine of anticipatory assignments of income in his seminal opinion in the case of Lucas v. Earl . [16]

In Lucas , the taxpayer‑husband entered into a contract with his wife whereby she became entitled to one-half of any income he might earn in the future.  On the belief that a taxpayer was accountable only for income he actually received, the husband thereafter reported only half of his income.  Nay, nay , sayeth Justice Holmes.

The Supreme Court was unwilling to accept that tax laws permitted such easy deflection of a taxpayer’s income tax liability, and it held that the taxpayer-husband was responsible for the entire amount of his income.  Subsequent to Lucas , numerous Supreme Court and Tax Court opinions have held that such anticipatory assignments of income are ineffective as means of avoiding tax liability.  To this end, in a 2021 Tax Court decision, authored by the inestimable Judge Mark V. Holmes, [17] the Tax Court observed that “the assignment-of-income doctrine does not immunize assignments of income to…entities.” [18]

The Assignment of Income Doctrine and Trusts (Contrary Results…Sometimes)

In the Supreme Court case of Blair v. Commissioner , [19] a taxpayer assigned the income from a testamentary trust to his children.  The trustee accepted the assignment and distributed the income directly to the assignee.  The Supreme Court was faced with the question of whether an assignment of income from a trust, which income was received by the beneficiary-children, was valid.

Because there were no earnings from personal services, which would have been taxed to the individual who earned them, the court found that Lucas was not on point.  Instead, “the tax is upon income as to which…the tax liability attaches to ownership.” [20]   Stated differently, if an individual owns a beneficial interest in the trust, then that individual will be taxed on his or her income derived from the trust.

“If under the law governing the trust the beneficial interest is assignable, and if it has been assigned without reservation, the assignee, thus, becomes the beneficiary and is entitled to rights and remedies accordingly.” [21]   Instead, “[t]he one who is to receive the income” through the assignment of the beneficial interest (the assignee) rather than the initial income beneficiary (the assignor), becomes “the owner of the beneficial interest” and is responsible for paying the tax on the income distributed from the trust. [22]

The phrase “without reservation” is critical, as the taxpayer learned in Harrison v. Schaffner , [23] where the Supreme Court determined that an assignment of specific dollar amounts of trust income for one-year periods did not shift the tax burden to the assignee.  In reaching its decision, the Court distinguished Blair , where the assignment was irrevocable for the life of the taxpayer , in contrast to the one-year assignments under review, which the Court found did not create a transfer of a substantial interest “without reservation” in the property. [24]

Similarly, in Rev. Rul. 55-38, the IRS determined that a beneficiary, who periodically gave his consent to pay a certain portion of the trust income to another individual, was responsible for the tax on such income.  This arrived at this determination because the assignor had not parted with a substantial interest in property other than the specified payments of income, the right to which he could have revoked at any time.

Income from Services

If a taxpayer performs personal services for compensation, the income is includible in the taxpayer’s gross income [25] —even if the taxpayer assigns and transfers the compensation to a third party.  Even if a taxpayer redirects a payor’s check to a third party without cashing it, the taxpayer must include all income the taxpayer earned from the performance of personal services attributable to the payment. [26]

This holds true if the check is sent to a third party at the direction of the taxpayer, who never touches the check, [27] or if payment is made to the third party through other means.  The income must be included in the taxpayer’s gross income.  The same applies if the payor uses the amount to settle a debt of the taxpayer. [28] Additionally, a taxpayer may not escape assignment of income by assigning accounts receivable that arise from the taxpayer’s performance of services but remain unpaid. [29]

If a taxpayer endorses a compensation check to a third party and receives back less than the total compensation, the entire amount still must be included in their gross income. [30]   This inclusion requirement is unaffected by whether the income is paid to another person under a court order, as long as it represents compensation for services performed by the taxpayer.  However, the assignment of income doctrine does not apply if the transferor-taxpayer’s right to the income in question is contingent and subject to conditions beyond the control of the transferor. [31]

The fundamental rule that income from the performance of personal services is included in the service-provider’s income applies equally if the assignee is an entity.  Thus, in the case of Johnson v. Commissioner , [32] the taxpayer formed a Panamanian corporation to which he assigned his NBA earnings.  The NBA sent the check to the corporation rather than the taxpayer.  Nevertheless, the Tax Court held that under the contract the taxpayer was to play basketball, and in return he would earn compensation; therefore, the contract was between the team and the taxpayer, not the taxpayer’s entity.  Instead of looking at the “actual earner” of the compensation, the Tax Court turned to the inquiry of “who controls the earning of the income.” [33]

Similarly, in Leavell v. Commissioner , [34] the Tax Court held that a professional basketball player was an employee of the team for which he played even though the team had executed an employment contract with the player’s professional service corporation (“PSC”).  The Tax Court reached this conclusion by “examin[ing] all the facts and circumstances in order to determine the reality of who has control over the manner and means by which the individual service provider delivers services.” [35]

The Tax Court decided numerous cases in the 1980s, [36] in which the court held that income was not re-allocable from a PSC to the service‑provider under the assignment of income doctrine if the service-provider met both prongs of a two-prong control test evolving from case law beginning with Lucas .  Under this two-prong test, a PSC controls the service-provider, and, hence, earns the income, if: (1) the service-provider is an employee of the PSC, and the PSC has the right to direct and control him or her in a meaningful sense; and (2) the PSC and the service-recipient had “a contract or similar indicium recognizing the controlling position of the PSC.” [37]

By contrast, if a contract exists between the taxpayer’s entity and a third-party, the assignment of income doctrine historically has not been applied by the Tax Court. [38]   In the case of Laughton v. Commissioner , [39] an actor formed a corporation with which he contracted to receive a weekly payment for his exclusive services.  The corporation executed contracts with two film studios, and the corporation “loaned” the taxpayer’s services to the film studios.

The Court held the amounts paid to the corporation by the studios were not includible in the taxpayer’s gross income because those amounts were paid “under contracts between it [the actor’s corporation] and the studios,” and, as such, there was no assignment of income by the taxpayer. [40] This result is contrary to Leavell , but the Tax Court found the facts and circumstances distinguishable.  (Translation: the wind blew in a different direction for the taxpayer in Laughton than it did for the basketball player in Leavell .)

Assignment and Transfer of Income-Producing Property

As noted in the introduction, income produced by the transferred property should be reported in the gross income of the person who holds the beneficial ownership of that property. [41]   Stated differently, a taxpayer’s gross income includes income from property over which the taxpayer exercises the same degree and manner of control that the taxpayer exercised before the attempted transfer. [42]

In Commissioner v. Sunnen , [43] the taxpayer-husband assigned the underlying contracts to receive royalties on the taxpayer-husband’s patented invention to his wife in addition to giving her the right to receive the royalty payments.  It is important to note that in Sunnen , the failure of the husband to give up control over the underlying licenses (contracts) scuttled the assignment.  This retained control arose out of two separate considerations.  First, the assignment consisted of nonexclusive licenses, which were terminable by either party without liability.  Second, the licenses were held by a corporation, of which the taxpayer-husband owned 89% of the stock.

As president, director, and owner of 89% of the stock of the corporation, the taxpayer remained in a position to exercise extensive control over the license contracts after assigning them to his wife.  Thus, any assignment of the underlying contracts must not “merely involve[] a transfer of the right to receive income;” instead, the assignment must take the form of “a complete disposition of all the taxpayer’s interest in the contract and the income.” [44]

Similarly, in Schaffner the Supreme Court observed that “[e]ven though the gift of income [was] in form accomplished by the temporary disposition of the donor’s property which produces the income.” [45]    Thus, the Court found that the donor retained “every other substantial interest in it, [and the Supreme Court has] not allowed the form to obscure the reality.”

Ultimately, the Supreme Court held that the assignment of the income for the tax year of the trust of which the taxpayer was a beneficiary was not a substantial disposition of trust property so as to disrupt the taxpayer’s enjoyment of the income from the property, and the taxpayer’s power to assign the income was a benefit of the right to receive that income.  Thus, the assignment of income doctrine applied.

The assignment of income doctrine also comes into play when a taxpayer attempts, but fails, to completely transfer their property.  In such scenario, the income derived from the property must be included in the gross income of the taxpayer, not in that of the intended recipient.  Instances where this is particularly relevant include invalid gifts, where the failure to effectively shift the income to the assignees results in the income reverting to the donor.  Similarly, transactions masquerading as sales but failing to genuinely transfer ownership rights are not recognized as legitimate transfers under this doctrine.

For a property transfer to be considered valid, a fundamental shift in the economic relationship between the taxpayer and the property is necessary.  This means that if the taxpayer retains any significant rights or control over the property, such as risk of loss or full authority, the transfer is deemed ineffective.  The mere intention to transfer property at a future date does not suffice.  Conversely, if a transfer is bona fide, with the transferor relinquishing all control over the property, the assignment of income doctrine will not apply.  Likewise, if the rights retained by the transferor are negligible, the doctrine is not applicable.

The doctrine further stipulates that an agreement to allocate the income generated by a taxpayer’s property to someone else does not constitute a transfer of the property itself.  Consequently, the income remains part of the taxpayer’s gross income.  Moreover, if the property is not effectively passed to the transferee, owing to a lack of delivery effort by the taxpayer, the transfer is considered null, and the resulting income is included in the taxpayer’s gross income.

When assessing whether a transfer by purported gift is valid, several conditions must be met: (a) the donor must be competent to make the gift; (b) the recipient must be capable of accepting the gift; (c) the donor must have a clear intention to irrevocably transfer the title, dominion, and control of the property; (d) the transfer must be irrevocable; (e) there must be actual delivery of the gift or control over it; and (f) the recipient must accept the gift. Failure to meet any of these conditions results in the income from the property remaining with the original owner for tax purposes.

The assignment of income doctrine is complicated and nuanced.  There are, however, a few black letter rules that we can distill from the morass of the judicial creation:

• Income is taxed to the person who earns it, even if the right to that income is assigned to another person or entity. [46]
• An individual who earns income cannot escape taxation “by anticipatory arrangements and contracts however skillfully devised.” [47] Note: This does not mean that contracts do not play an important role—only that an individual cannot contract in anticipation of assigning income at a later date. [48]
• Income earned from the performance of personal services is included in the service‑provider’s income even if the assignee is an entity. [49]
• Income produced by the property transferred by the taxpayer is includible in the gross income of the person who holds beneficial ownership of such property. [50] Beneficial ownership is a facts and circumstances test.
• If an assignment would otherwise be effective to transfer income to a third-party assignee, the assignment must be a complete disposition of all the taxpayer’s interest in the contract and the income. [51] Retention of significant rights or control over the property—whether it be a risk of loss or full authority and discretion to dispose of the property—will nullify the transfer, and the income will be includible in the assignor’s income.

Elmer dozed off somewhere between the discussion of trusts and talk of basketball players.  ( Elmer is strictly a football and hockey aficionado, who was turned off from basketball in the early 1980s by the tiny shorts and continues to be turned off by professional wrestling for much the same reasons. )

Hope springs eternal that subconsciously he understood (a) the nuances of the anticipatory assignment of income doctrine, and (b) that you were only trying to help.  You leave him in his chair to sleep, but as you leave you could swear you heard him say something about “napalm” and “that damn bait shop.”  You make a mental note to check for napalm the next time you visit Elmer’s homestead…  

Footnotes :

[1] Though you advised Elmer to pick another name, so as not to infringe on the copyright of the band Saliva from their 2001 song of the same name, Elmer assumed that you were joking.  The band did not, and Elmer settled out of court by providing the band a lifetime supply of Screaming Weasels, which now feature prominently in their shows.  Granted, the ear-splitting fireworks are not quite Kiss level pyrotechnics, but Saliva is not quite Kiss, after all.

[2] The use of the royal “we” is nosism at its finest.

[3] See Lucas v. Earl , 281 U.S. 111 (1930).

[4] United States v. Basye , 410 U.S. 441, 449 (1973) (quoting Commissioner v. Culbertson , 337 U.S. 733, 739-740 (1949)).

[5] Commissioner v. Culbertson , 337 U.S. 733, 739-40 (1949).

[6] Lucas , 281 U.S. at 115.

[7] Blair v. Commissioner , 300 U.S. 5 (1937); Vercio v. Commissioner , 73 T.C. 1246, 1253 (1980); Commissioner v. Banks , 543 U.S. 426, 434 (2005).

[8] Helvering v. Horst , 311 U.S. 112, 116-17 (1940).

[9] Banks , 543 U.S. at 435.

[10] N.B. , because the assignment of income doctrine developed in the courts and has not been codified by statute, “the case law has been generally unaffected by statutory changes.  Thus, many of the authorities are older than the 1954 Code but continue to be the leading cases on issues settled many years ago.”  Bloomberg BNA Portfolio 502-4th, “Gross income: Tax Benefit, Claim of Right, and Assignment of Income” (2023).

[11] Lucas , 281 U.S. at 115.

[12] Blair , 300 U.S. at 13.

[13] Hang v. Commissioner , 95 T.C. 74 (1990).

[16] 281 U.S. 111 (1930).

[17] On which Senior Tax Court Judge your dear editor may or may not have an untoward amount of admiration and utter respect for the sarcasm present in every one of his opinions…

[18] Ernest S. Ryder & Assocs., Inc., APLC v. Commissioner , T.C. Memo, 2021-88, slip op. at *118.

[19] 300 U.S. 5 (1937).

[20] Id. at 12.

[21] Id. at 13.

[23] 312 U.S. 579 (1941).

[24] Id. ; see also PLR 202047005.

[25] Tang v. Commissioner , T.C. Memo 1996-326.

[26] United States v. Allen , 551 F.2d 208 (8th Cir. 1977).

[27] Roberts v. Commissioner , T.C. Memo 1996-225.

[28] Hunt v. Commissioner , T.C. Memo 1991-566.

[29] Mensik v. Commissioner , 37 T.C. 703 (1962), aff’d , 328 F.2d 147 (7th Cir. 1964).

[30] Page v. Commissioner , T.C. Memo 1983-515.

[31] Thompson v. Commissioner , T.C. Memo 1964-198.

[32] 78 T.C. 882 (1982).

[33] Id. at 892.

[34] 104 T.C. 140 (1995).

[35] Id. at 155.

[36] Haag v. Commissioner , 88 T.C. 604, 610-614 (1987), aff’d without published opinion 855 F.2d 855 (8th Cir. 1988); Bagley v. Commissioner , 85 T.C. 663, 674-676 (1985), aff’d 806 F.2d 169 (8th Cir. 1986); Johnson , 78 T.C. at 889‑92; Pacella v. Commissioner , 78 T.C. 604, 622 (1982); and Pflug v. Commissioner , T.C. Memo. 1989-615.

[37] Leavell , 104 T.C. at 181 (Laro, J. dissenting).

[38] See, e.g. , Fox v. Commissioner , 37 B.T.A. 271 (1938).

[39] 40 B.T.A. 101 (1939).

[40] Laughton , 40 B.T.A at 106-07.

[41] Blair , 300 U.S. at 13.

[42] See Viralam v. Commissioner , 136 T.C. 151 (2011).

[43] 333 U.S. 591 (1948).

[44] Sunnen , 333 U.S. at 610.

[45] 312 U.S. at 583 (emphasis added).

[46] Commissioner v. Culbertson , 337 U.S. 733, 739-40 (1949).

[47] Lucas v. Earl , 281 U.S. 111, 115 (1930).

[48] See, e.g. , Sunnen , 333 U.S. at 610 (noting that had the taxpayer-husband given up control, the assignment of income doctrine would not have applied).

[50] Blair , 300 U.S. at 13.

[51] Sunnen , 333 U.S. at 610.

Related Posts

• Categories: All Articles , Income Tax Issues
• Tags: Anticipatory Assignment of Income Doctrine , Assignment of Income , Cousin Elmer , Income , Income Inclusion , Judge Holmes , Lucas v. Earl , Oliver Wendell Holmes , Professional Service Corporations , Scurry of Squirrels

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The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

Battling Uphill Against the Assignment of Income Doctrine: Ryder

Benjamin Alarie

Kathrin Gardhouse

Benjamin Alarie is the Osler Chair in Business Law at the University of Toronto and the CEO of Blue J Legal Inc. Kathrin Gardhouse is a legal research associate at Blue J Legal .

In this article, Alarie and Gardhouse examine the Tax Court ’s recent decision in Ryder and use machine-learning models to evaluate the strength of the legal factors that determine the outcome of assignment of income cases.

Copyright 2021 Benjamin Alarie and Kathrin Gardhouse . All rights reserved.

I. Introduction

Researching federal income tax issues demands distilling the law from the code, regulations, revenue rulings, administrative guidance, and sometimes hundreds of tax cases that may all be relevant to a particular situation. When a judicial doctrine has been developed over many decades and applied in many different types of cases, the case-based part of this research can be particularly time consuming. Despite an attorney’s best efforts, uncertainty often remains regarding how courts will decide a new set of facts, as previously decided cases are often distinguished and the exercise of judicial discretion can at times lead to surprises. To minimize surprises as well as the time and effort involved in generating tax advice, Blue J ’s machine-learning modules allow tax practitioners to assess the likely outcome of a case if it were to go to court based on the analysis of data from previous decisions using machine learning. Blue J also identifies cases with similar facts, permitting more efficient research.

In previous installments of Blue J Predicts, we examined the strengths and weaknesses of ongoing or recently decided appellate cases, yielding machine-learning-generated insights about the law and predicting the outcomes of cases. In this month’s column, we look at a Tax Court case that our predictor suggests was correctly decided (with more than 95 percent confidence). The Ryder case 1 has received significant attention from the tax community. It involved tax avoidance schemes marketed by the law firm Ernest S. Ryder & Associates Inc. (R&A) that produced more than $31 million in revenue between 2003 and 2011 and for which the firm reported zero taxable income. The IRS unmasked more than 1,000 corporate entities that R&A’s owner, Ernest S. Ryder , had created and into which he funneled the money. By exposing the functions that these entities performed, the IRS played the most difficult role in the case. Yet, there are deeper lessons that can be drawn from the litigation by subjecting it to analysis using machine learning.

In this installment of Blue J Predicts, we shine an algorithmic spotlight on the legal factors that determine the outcomes of assignment of income cases such as Ryder . For Ryder , the time for filing an appeal has elapsed and the matter is settled. Thus, we use it to examine the various factors that courts look to in this area and to show the effect those factors have in assignment of income cases. Equipped with our machine-learning module, we are able to highlight the fine line between legitimate tax planning and illegitimate tax avoidance in the context of the assignment of income doctrine.

II. Background

In its most basic iteration, the assignment of income doctrine stands for the proposition that income is taxed to the individual who earns it, even if the right to that income is assigned to someone else. 2 Courts have held that the income earner is responsible for the income tax in the overwhelming majority of cases, including Ryder . It is only in a small number of cases that courts have been willing to accept the legitimacy of an assignment and have held that the assignee is liable for the earned income. Indeed, Blue J ’s “Assigned Income From Services” predictor, which draws on a total of 242 cases and IRS rulings, includes only 10 decisions in which the assignee has been found to be liable to pay tax on the income at issue.

The wide applicability of the assignment of income doctrine was demonstrated in Ryder , in which the court applied the doctrine to several different transactions that occurred between 1996 and 2011. Ryder founded his professional law corporation R&A in 1996 and used his accounting background, law degree, and graduate degree in taxation for the benefit of his clients. R&A designed, marketed, sold, and administered six aggressive tax-saving products that promised clients the ability to “defer a much greater portion of their income than they ever dreamed possible, and, as a result, substantially reduce their tax liability.” 3 In 2003 the IRS caught on to Ryder ’s activities when his application to have 800 employee stock option plans qualified at the same time was flagged for review. A decade of investigations and audits of Ryder and his law firm spanning from 2002 to 2011 followed.

What is interesting in this case is that Ryder , through his law firm R&A, directly contracted with his clients for only three of the six tax-saving products that his firm designed, marketed, and sold (the stand-alone products). The fees collected by R&A from two of the stand-alone products were then assigned to two other entities through two quite distinct mechanisms. For the other three tax-saving products, the clients contracted — at least on paper — with other entities that Ryder created (the group-tax products). Yet, the court treated the income from all six tax-saving products identically. The differences between the six types of transactions did not affect the outcome of the case — namely, that it is R&A’s income in all six instances. Blue J ’s predictor can explain why: The factors that our predictor highlights as relevant for answering the question whether the assignment of income doctrine applies have less to do with the particular strategy that the income earner conjures up for making it look like the income belongs to someone else, and more to do with different ways of pinpointing who actually controls the products, services, and funds. In Ryder , the choices ultimately come down to whether that is R&A or the other entity.

We will begin the analysis of the case by taking a closer look at two of the six tax-saving products, paying particular attention to the flow of income from R&A’s clients to R&A and Ryder ’s assignment of income to the other entities. We have selected one of the tax-saving products in which Ryder drew up an explicit assignment agreement, and another one in which he tried to make it look like the income was directly earned by another entity he had set up. Regardless of the structures and means employed, the court, based on the IRS ’s evidence, traced this income to R&A and applied the assignment of income doctrine to treat it as R&A’s income.

This article will not cover in detail the parts of the decision in which the court reconstructs the many transactions Ryder and his wife engaged in to purchase various ranches using the income that had found its way to R& A. As the court puts it, the complexity of the revenues and flow of funds is “baroque” when R&A is concerned, and when it comes to the ranches, it becomes “ rococo .” 4 We will also not cover the fraud and penalty determinations that the court made in this case.

III. The Tax Avoidance Schemes

We will analyze two of the six schemes discussed in the case. The first is the staffing product, and the second is the American Specialty Insurance Group Ltd. (ASIG) product. Each serves as an example of different mechanisms Ryder employed to divert income tax liability away from R&A. In the case of the staffing product, Ryder assigned income explicitly to another entity. The ASIG product involved setting up another entity that Ryder argued earned the income directly itself.

A. The Staffing Product

R&A offered a product to its clients in the course of which the client could lease its services to a staffing corporation, which would in turn lease the client’s services back to the client’s operating business. The intended tax benefit lay “with the difference between the lease payment and the wages received becoming a form of compensation that was supposedly immune from current taxation.” 5 At first, the fees from the staffing product were invoiced by and paid to R&A. When the IRS started its investigation, Ryder drew up an “Agreement of Assignment and Assumption” with the intent to assign all the clients and the income from the staffing product to ESOP Legal Consultants Inc. ( ELC ). Despite the contractual terms limiting the agreement to the 2004-2006 tax years, Ryder used ELC ’s bank account until 2011 to receive fees paid by the various S corporations he had set up for his clients to make the staffing product work. R&A would then move the money from this bank account into Ryder ’s pocket in one way or another. ELC had no office space, and the only evidence of employees was six names on the letterhead of ELC indicating their positions. When testifying in front of the court, two of these employees failed to mention that they were employed by ELC , and one of them was unable to describe the work ELC was allegedly performing. Hence, the court concluded that ELC did not have any true employees of its own and did not conduct any business. Instead, it was R&A’s employees that provided any required services to the clients. 6

B. The ASIG Product

R&A sold “disability and professional liability income insurance” policies to its clients using ASIG, a Turks and Caicos corporation that was a captive insurer owned by Capital Mexicana . Ryder had created these two companies during his previous job with the help of the Turks and Caicos accounting firm Morris Cottingham Ltd. The policies Ryder sold to his clients required them to pay premiums to ASIG as consideration for the insurance. The premiums were physically mailed to R& A. Also , the clients were required to pay a 2 percent annual fee, which was deposited into ASIG’s bank account. In return, the clients received 98 percent of the policy’s cash value in the event that they became disabled, separated from employment, turned 60, or terminated the policy. 7

R&A’s involvement in these deals, aside from setting up ASIG, was to find the clients who bought the policies, assign them a policy number, draft a policy, and open a bank account for the client, as well as provide legal services for the deal as needed. It was R&A that billed the client and that ensured, with Morris Cottingham ’s help, that the fees were paid. R&A employees would record the ASIG policy fee paid by the clients, noting at times that “pymt bypassed [R&A’s] books.” 8 Quite an effort went into disguising R&A’s involvement.

First, there was no mention of R&A on the policy itself. Second, ASIG’s office was located at Morris Cottingham’s Turks and Caicos corporate services. Ryder also set up a post office box for ASIG in Las Vegas. Any mail sent to it was forwarded to Ryder . Third, to collect the fees, R&A would send a letter to Morris Cottingham for signature, receive the signed letter back, and then fax it to the financial institution where ASIG had two accounts. One of these was nominally in ASIG’s name but really for the client’s benefit, and the other account was in Ryder ’s name. The financial institution would then move the amount owed in fees from the former to the latter account. Whenever a client filed for a benefit under the policy, the client would prepare a claim package and pay a termination fee that also went into the ASIG account held in Ryder ’s name. The exchanges between the clients and ASIG indicate that these fees were to reimburse ASIG for its costs and services, as well as to allow it to derive a profit therefrom. But the court found that ASIG itself did nothing. Even the invoices sent to clients detailing these fee payments that were on ASIG letterhead were in fact prepared by R&A. In addition to the annual fees and the termination fee, clients paid legal fees on a biannual basis for services Ryder provided. These legal fees, too, were paid into the ASIG account in Ryder ’s name. 9

IV. Assignment of Income Doctrine

The assignment of income doctrine attributes income tax to the individual who earns the income, even if the right to that income is assigned to another entity. The policy rationale underlying the doctrine is to prevent high-income taxpayers from shifting their taxable income to others. 10 The doctrine is judicial and was first developed in 1930 by the Supreme Court in Lucas , a decision that involved contractual assignment of personal services income between a husband and wife. 11 The doctrine expanded significantly over the next 20 years and beyond, and it has been applied in many different types of cases involving gratuitous transfers of income or property. 12 The staffing product, as of January 2004, involved an anticipatory assignment of income to which the assignment of services income doctrine had been held to apply in Banks . 13 The doctrine is not limited to situations in which the income earner explicitly assigns the income to another entity; it also captures situations in which the actual income earner sets up another entity and makes it seem as if that entity had earned the income itself, as was the case with the ASIG product. 14

In cases in which the true income earner is in question, the courts have held that “the taxable party is the person or entity who directed and controlled the earning of the income, rather than the person or entity who received the income.” 15 Factors that the courts consider to determine who is in control of the income depend on the particular situation at issue in the case. For example, when a personal services business is involved, the court looks at the relationship between the hirer and the worker and who has the right to direct the worker’s activities. In partnership cases, the courts apply the similarity test, asking whether the services the partnership provided are similar to those the partner provided. In other cases, the courts have inquired whether an agency relationship can be established. In yet other cases the courts have taken a broad and flexible approach and consulted all the available evidence to determine who has the ultimate direction and control over the earnings. 16

V. Factors Considered in Ryder

Judge Mark V. Holmes took a flexible approach in Ryder . He found that none of the entities that Ryder papered into existence had their own office or their own employees. They were thus unable to provide the services Ryder claims they were paid for. In fact, the entities did not provide any services at all — the services were R&A’s doing. To top it off, R&A did nothing but set up the entities, market their tax benefits, and move money around once the clients signed up for the products. There was no actual business activity conducted. The court further found that the written agreements the clients entered into with the entities that purported to provide services to them were a sham and that oral contracts with R&A were in fact what established the relevant relationship, so that R&A must be considered the contracting party. In the case of the ASIG product, for example, a client testified that the fees he paid to Ryder were part of his retirement plan. Ryder had represented to him that the ASIG product was established to create an alternative way to accumulate retirement savings. 17

Regarding the staffing product in which there existed an explicit assignment of income agreement between R&A and ELC , the court found that ELC only existed on paper and in the form of bank accounts, with the effect that R&A was ultimately controlling the income even after the assignment. A further factor that the court emphasized repeatedly was that R&A, and Ryder personally as R&A’s owner, kept benefitting from the income after the assignment (for example, in the staffing product case) or, as in the case of the ASIG product, despite the income allegedly having been earned by a third party (that is, ASIG). 18

VI. Analysis

The aforementioned factors are reflected in Blue J ’s Assigned Income From Services predictor. 19 We performed predictions for the following scenarios:

the staffing product and R&A’s assignment of the income it generated to ELC with the facts as found by the court;

the staffing product and R&A’s assignment of the income it generated to ELC if Ryder ’s version of the facts were accepted;

the ASIG product and service as the court interpreted and characterized the facts; and

the ASIG product and service according to Ryder ’s narrative.

What is interesting and indicative of the benefits that machine-learning tools such as Blue J ’s predictor can provide to tax practitioners is that even if the court had found in Ryder ’s favor on all the factual issues reasonably in dispute, Ryder would still not have been able to shift the tax liability to ELC or ASIG respectively, according to our model and analysis.

The court found that R&A contracted directly with, invoiced, and received payments from its clients regarding the staffing product up until 2004, when Ryder assigned the income generated from this product explicitly to ELC . From then onward, ELC received the payments from the clients instead of R&A. Further, the court found that ELC did not have its own employees or office space and did not conduct any business activity. Our data show that the change in the recipient of the money would have made no difference regarding the likelihood of R&A’s liability for the income tax in this scenario.

According to Ryder ’s version of the facts, ELC did have its own employees, 20 even though there is no mention of a separate office space from which ELC allegedly operated. Yet, Ryder maintains that ELC was the one providing the staffing services to its clients after the assignment of the clients to the company in January 2004. Even if Ryder had been able to convince the court of his version of the facts, it would hardly have made a dent in the likelihood of the outcome that R&A would be held liable for the tax payable on the income from the staffing product.

With Ryder ’s narrative as the underlying facts, our predictor is still 94 percent confident that R&A would have been held liable for the tax. The taxation of the income in the hands of the one who earned it is not easily avoided with a simple assignment agreement, particularly if the income earner keeps benefiting from the income after the assignment and continues to provide services himself without giving up control over the services for the benefit of the assignee. The insight gained from the decision regarding the staffing product is that the court will take a careful look behind the assignment agreement and, if it is not able to spot a legitimate assignee, the assignment agreement will be disregarded.

The court made the same factual findings regarding the ASIG product as it did for the staffing product post-assignment. Ryder , however, had more to say here in support of his case. For one, he pointed to ASIG’s main office that was located at the Morris Cottingham offices. Morris Cottingham was also the one that, on paper, contracted with clients for the insurance services and the collection of fees was conducted, again on paper, in the name of Morris Cottingham . The court also refers to actual claims that the clients made under their policies. There is also a paper trail that indicates that the clients were explicitly acknowledging and in fact paying ASIG for its costs and services. From all this we can conclude that Ryder was able to argue that ASIG had its own independent office, had one or more employees providing services, and that ASIG engaged in actual business activity. However, even if these facts had been admitted as accurately reflecting the ASIG product, our data show that with a 92 percent certainty R&A would still be liable for the income tax payable on the income the ASIG product generated. It is clear that winning a case involving the assignment of income doctrine on facts such as the ones in Ryder is an uphill battle. If the person behind the scenes remains involved with the services provided without giving up control over them, and benefits from the income generated, it is a lost cause to argue that the assignment of income doctrine should be applied with the effect that the entity that provides the services on paper is liable for the income tax.

C. Ryder as ASIG’s Agent

Our data reveal that to have a more substantial shot at succeeding with his case under the assignment of income doctrine, Ryder would have had to pursue a different line of argument altogether. Had he set R&A up as ASIG’s agent rather than tried to disguise its involvement with the purported insurance business, Ryder would have been more likely to succeed in shifting the income tax liability to ASIG. For our analysis of the effect of the different factors discussed by the court in Ryder , we assume at the outset that Ryder would do everything right — that is, ASIG would have its own workers and office, and it would do something other than just moving money around (best-case scenario). We then modify each factor one by one to reveal their respective effect.

From this scenario testing, we can conclude that if R&A had had an agency agreement with ASIG, received some form of compensation for its services from ASIG, held itself out to act on ASIG’s behalf, and the client was interested in R&A’s service because of its affiliation with ASIG, Ryder would have reduced the likelihood to 73 percent of R&A being liable for the income tax. Add to these agency factors an element of monitoring by ASIG and the most likely result flips — there would be a 64 percent likelihood that ASIG would be liable for the income tax. If ASIG were to go beyond monitoring R&A’s services by controlling them too, the likelihood that ASIG would be liable for the income tax would increase to 82 percent. Let’s say Ryder had given Morris Cottingham oversight and control over R&A’s services for ASIG, then the question whether ASIG employs any workers other than R&A arguably becomes moot because there would necessarily be an ASIG employee who oversees R&A. Accordingly, there is hardly any change in the confidence level of the prediction that ASIG is liable for the income tax when the worker factor is absent.

Interestingly, this is quite different from the effect of the office factor. Keeping everything else as-is, the absence of having its own ASIG-controlled office decreases the likelihood of ASIG being liable to pay the income tax from 82 to 54 percent. Note here that our Assigned Income From Services predictor is trained on data from relatively old cases; only 14 are from the last decade. This may explain why the existence of a physical office space is predicted to play such an important role when the courts determine whether the entity that allegedly earns the income is a legitimate business. In a post-pandemic world, it may be possible that a trend will emerge that puts less emphasis on the physical office space when determining the legitimacy of a business.

The factor that stands out as the most important one in our hypothetical scenario in which R&A is the agent of ASIG is the characterization of ASIG’s own business activity. In the absence of ASIG conducting its own business, nothing can save Ryder ’s case. This makes intuitive sense because if ASIG conducts no business, it must be R&A’s services alone that generate the income; hence R&A is liable for the tax on the income. Also very important is the contracting party factor: If the client were to contract with R&A rather than ASIG in our hypothetical scenario, the likelihood that R&A would be held liable for the income tax is back up to 72 percent, all else being equal. If the client were to contract with both R&A and ASIG, it is a close case, leaning towards ASIG’s liability with 58 percent confidence. Much less significant is who receives the payment between the two. If it is R&A, ASIG remains liable for the income tax with a likelihood of 71 percent, indicating a drop in confidence by 11 percent compared with a scenario in which ASIG received the payment.

To summarize, if Ryder had pursued a line of argument in which he set up R&A as ASIG’s agent, giving ASIG’s employee(s) monitoring power and ideally control over R&A’s services for ASIG, he would have had a better chance of succeeding under the assignment of income doctrine. As we have seen, the main prerequisite for his success would have been to convince the court that it would be appropriate to characterize ASIG as conducting business. Ideally, Ryder also would have made sure that the client contracted for the services with ASIG and not with R&A. However, it is significantly less important that ASIG receives the money from the client. The historical case law also suggests that Ryder would have been well advised to set up a physical office for ASIG; however, given the new reality of working from home, this factor may no longer be as relevant as these older previously decided cases indicate.

VII. Conclusion

We have seen that R&A’s chances to shift the liability for the tax payable on the staffing and the ASIG product income was virtually nonexistent. The difficulty of this case from the perspective of the IRS certainly lay in gathering the evidence, tracing the money through the winding paths of Ryder ’s paper labyrinth, and making it comprehensible for the court. Once this had been accomplished, the IRS had a more-or-less slam-dunk case regarding the applicability of the assignment of income doctrine. As mentioned at the outset, an assignment of income case will always be an uphill battle for the taxpayer because income is generally taxable to whoever earns it.

Yet, in cases in which the disputed question is who earned the income and not whether the assignment agreement has shifted the income tax liability, the parties must lean into the factors discussed here to convince the court of the legitimacy (or the illegitimacy, in the case of the government) of the ostensibly income-earning entity and its business. Our analysis can help decide which of the factors must be present to have a plausible argument, which ones are nice to have, and which should be given little attention in determining an efficient litigation strategy.

1   Ernest S. Ryder & Associates Inc. v. Commissioner , T.C. Memo. 2021-88 .

2   Lucas v. Earl , 281 U.S. 111, 114-115 (1930).

3   Ryder , T.C. Memo. 2021-88, at 7.

4   Id. at 32.

5   Id. at 17, 19, and 111-112.

6   Id. at 51-52, 111-112, and 123-126.

7   Id. at 9-12.

8   Id. at 96.

10  CCH, Federal Taxation Comprehensive Topics, at 4201.

11   Lucas , 281 U.S. at 115.

12   See , e.g. , “familial partnership” cases — Burnet v. Leininger , 285 U.S. 136 (1932); Commissioner v. Tower , 327 U.S. 280 (1946); and Commissioner v. Culbertson , 337 U.S. 733 (1949). For an application in the commercial context, see Commissioner v. Banks , 543 U.S. 426 (2005).

13   Banks , 543 U.S. at 426.

14   See , e.g. , Johnston v. Commissioner , T.C. Memo. 2000-315 , at 487.

16   Ray v. Commissioner , T.C. Memo. 2018-160 .

17   Ryder , T.C. Memo. 2021-88, at 90-91.

18   Id. at 48, 51, and 52.

19  The predictor considered several further factors that play a greater role in other fact patterns.

20  The court mentions that ELC’s letterhead set out six employees and their respective positions with the company.

END FOOTNOTES

• Frost Brown Todd

Section 1202 Planning: When Might the Assignment of Income Doctrine Apply to a Gift of QSBS?

Jan 26, 2022

Categories:

Blogs Qualified Small Business Stock (QSBS) Tax Law Defined™ Blog

Scott W. Dolson

Section 1202 allows taxpayers to exclude gain on the sale of QSBS if all eligibility requirements are met.  Section 1202 also places a cap on the amount of gain that a stockholder is entitled to exclude with respect to a single issuer’s stock. [i]   A taxpayer has at least a $10 million per-issuer gain exclusion, but some taxpayer’s expected gain exceeds that cap.  In our article Maximizing the Section 1202 Gain Exclusion Amount , we discussed planning techniques for increasing, and in some cases multiplying, the $10 million gain exclusion cap through gifting QSBS to other taxpayers. [ii]  Increased awareness of this planning technique has contributed to a flurry of stockholders seeking last-minute tax planning help.  This article looks at whether you can “multiply” Section 1202’s gain exclusion by gifting qualified small business stock (QSBS) when a sale transaction is imminent.

This is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045.  During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice.  Much of this interest can be attributed to the reduction in the corporate rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion.  Recently proposed tax legislation sought to curb Section 1202’s benefits, but that legislation, along with the balance of President Biden’s Build Back Better bill, is currently stalled in Congress.

The Benefits of Gifting QSBS

Section 1202(h)(1) provides that if a stockholder gifts QSBS, the recipient of the gift is treated as “(A) having acquired such stock in the same manner as the transferor, and (B) having held such stock during any continuous period immediately preceding the transfer during which it was held (or treated as held under this subsection by the transferor.”  This statute literally allows a holder of $100 million of QSBS to gift $10 million worth to each of nine friends, with the result that the holder and his nine friends each having the right to claim a separate $10 million gain exclusion.  Under Section 1202, a taxpayer with $20 million in expected gain upon the sale of founder QSBS can increase the overall tax savings from approximately $2.4 million (based on no Federal income tax on $10 million of QSBS gain) to $4.8 million (based on no Federal income tax on $20 million of QSBS gain) by gifting $10 million worth of QSBS to friends and family. [iii]

A reasonable question to ask is whether it is ever too late to make a gift of QSBS for wealth transfer or Section 1202 gain exclusion cap planning?  What about when a sale process is looming but hasn’t yet commenced?  Is it too late to make a gift when a nonbinding letter of intent to sell the company has been signed?   What about the situation where a binding agreement has been signed but there are various closing conditions remaining to be satisfied, perhaps including shareholder approval?  Finally, is it too late to make a gift when a definitive agreement has been signed and all material conditions to closing have been satisfied?

Although neither Section 1202 nor any other tax authorities interpreting Section 1202 address whether there are any exceptions to Section 1202’s favorable treatment of gifts based on the timing of the gift, the IRS is not without potential weapons in its arsenal.

Application of the Assignment of Income Doctrine

If QSBS is gifted in close proximity to a sale, the IRS might claim that the donor stockholder was making an anticipatory assignment of income. [iv]

As first enunciated by the Supreme Court in 1930, the anticipatory assignment of income doctrine holds that income is taxable to the person who earns it, and that such taxes cannot be avoided through “arrangement[s] by which the fruits are attributed to a different tree from that on which they grew.” [v]   Many assignment of income cases involve stock gifted to charities immediately before a prearranged stock sale, coupled with the donor claiming a charitable deduction for full fair market value of the gifted stock.

In Revenue Ruling 78-197, the IRS concluded in the context of a charitable contribution coupled with a prearranged redemption that the assignment of income doctrine would apply only if the donee is legally bound, or can be compelled by the corporation, to surrender shares for redemption. [vi]  In the aftermath of this ruling, the Tax Court has refused to adopt a bright line test but has generally followed the ruling’s reasoning.  For example, in Estate of Applestein v. Commissioner , the taxpayer gifted to custodial accounts for his children stock in a corporation that had entered into a merger agreement with another corporation. Prior to the gift, the merger agreement was approved by the stockholders of both corporations.  Although the gift occurred before the closing of the merger transaction, the Tax Court held that the “right to the merger proceeds had virtually ripened prior to the transfer and that the transfer of the stock constituted a transfer of the merger proceeds rather than an interest in a viable corporation.” [vii]   In contrast, in Rauenhorst v. Commissioner , the Tax Court concluded that a nonbinding letter of intent would not support the IRS’ assignment of income argument because the stockholder at the time of making the gift was not legally bound nor compelled to sell his equity. [viii]

In Ferguson v. Commissioner , the Tax Court focused on whether the percentage of shares tendered pursuant to a tender offer was the functional equivalent of stockholder approval of a merger transaction, which the court viewed as converting an interest in a viable corporation to the right to receive cash before the gifting of stock to charities. [ix]   The Tax Court concluded that there was an anticipatory assignment of income in spite of the fact that there remained certain contingencies before the sale would be finalized.  The Tax Court rejected the taxpayer’s argument that the application of the assignment of income doctrine should be conditioned on the occurrence of a formal stockholder vote, noting that the reality and substance of the particular events under consideration should determine tax consequences.

Guidelines for Last-Minute Gifts

Based on the guidelines established by Revenue Ruling 78-197 and the cases discussed above, the IRS should be unsuccessful if it asserts an assignment of income argument in a situation where the gift of QSBS is made prior to the signing of a definitive sale agreement, even if the company has entered into a nonbinding letter of intent.  The IRS’ position should further weakened with the passage of time between the making of a gift and the entering into of a definitive sale agreement.  In contrast, the IRS should have a stronger argument if the gift is made after the company enters into a binding sale agreement.  And the IRS’ position should be stronger still if the gift of QSBS is made after satisfaction of most or all material closing conditions, and in particular after stockholder approval.  Stockholders should be mindful of Tax Court’s comment that the reality and substance of events determines tax consequences, and that it will often be a nuanced set of facts that ultimately determines whether the IRS would be successful arguing for application of the assignment of income doctrine.

Transfers of QSBS Incident to Divorce

The general guidelines discussed above may not apply to transfers of QSBS between former spouses “incident to divorce” that are governed by Section 1041.  Section 1041(b)(1) confirms that a transfer incident to divorce will be treated as a gift for Section 1202 purposes.  Private Letter Ruling 9046004 addressed the situation where stock was transferred incident to a divorce and the corporation immediately redeemed the stock.  In that ruling, the IRS commented that “under section 1041, Congress gave taxpayers a mechanism for determining which of the two spouses will pay the tax upon the ultimate disposition of the asset.  The spouses are thus free to negotiate between themselves whether the ‘owner’ spouse will first sell the asset, recognize the gain or loss, and then transfer to the transferee spouse the proceeds from the sale, or whether the owner spouse will first transfer the asset to the transferee spouse who will then recognize gain or loss upon its subsequent sale.”  Thus, while there are some tax cases where the assignment of income doctrine has been successfully asserted by the IRS in connection with transfers between spouses incident to divorce, Section 1041 and tax authorities interpreting its application do provide divorcing taxpayers an additional argument against application of the doctrine, perhaps even where the end result might be a multiplication of Section 1202’s gain exclusion.

More Resources 

In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS planning. Venture capitalists, founders and investors who want to learn more about QSBS planning opportunities are directed to several articles on the Frost Brown Todd website:

• Planning for the Potential Reduction in Section 1202’s Gain Exclusion
• Section 1202 Qualification Checklist and Planning Pointers
• A Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
• Maximizing the Section 1202 Gain Exclusion Amount
• Advanced Section 1045 Planning
• Recapitalizations Involving Qualified Small Business Stock
• Section 1202 and S Corporations
• The 21% Corporate Rate Breathes New Life into IRC § 1202
• View all QSBS Resources

Contact  Scott Dolson  or  Melanie McCoy  (QSBS estate and trust planning) if you want to discuss any QSBS issues by telephone or video conference.

[i] References to “Section” are to sections of the Internal Revenue Code.

[ii] The planning technique of gifting QSBS recently came under heavy criticism in an article written by two investigative reporters.  See Jesse Drucker and Maureen Farrell, The Peanut Butter Secret: A Lavish Tax Dodge for the Ultrawealthy.  New York Times , December 28, 2021.

[iii] But in our opinion, in order to avoid a definite grey area in Section 1202 law, the donee should not be the stockholder’s spouse.  The universe of donees includes nongrantor trusts, including Delaware and Nevada asset protection trusts.

[iv] This article assumes that the holder of the stock doesn’t have sufficient tax basis in the QSBS to take advantage of the 10X gain exclusion cap – for example, the stock might be founder shares with a basis of .0001 per share.

[v]   Lucas v. Earl , 281 U.S. 111 (1930).  The US Supreme Court later summarized the assignment of income doctrine as follows:  “A person cannot escape taxation by anticipatory assignments, however skillfully devised, where the right to receive income has vested.”  Harrison v. Schaffner , 312 U.S. 579, 582 (1941).

[vi] Revenue Ruling 78-197, 1978-1 CB 83.

[vii] Estate of Applestein v. Commissioner , 80 T.C. 331, 346 (1983).

[viii] Gerald A. Rauenhorst v. Commissioner , 119 T.C. 157 (2002).

[ix] Ferguson v. Commissioner , 108 T.C. 244 (1997).

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Assignment of Income Lawyers

(This may not be the same place you live)

  What Happens if you Assign your Income?

There are some instances when a person may choose to assign a portion of their income to another individual. You may be able to do this by asking your employer to send your paycheck directly to a third party.

It should be noted, however, that if you choose to assign your income to a third party, then this does not mean that you will be able to avoid paying taxes on that income. In other words, you will still be responsible for paying taxes on that income regardless of whether you decide to assign your income to a third party or not. This guideline is known as the “assignment of income doctrine.”

The primary purpose of the “assignment of income doctrine” is to ensure that a person does not simply assign their income to a third party to avoid having to pay taxes. If they do, then they can be charged and convicted of committing tax evasion .

One other important thing to bear in mind about income assignments is that they are often confused with the concept of wage garnishments. However, income or wage assignments are different from wage garnishments. In a situation that involves wage garnishment, a person’s paycheck is involuntarily withheld from them to pay off a debt like outstanding child support payments and is typically ordered by a court.

In contrast, an income or wage assignment is when a person voluntarily agrees to assign their income to someone else through a contract or a similar type of agreement.

How is Assigned Income Taxed?

Are there any exceptions, should i consult with an attorney.

As previously discussed, a taxpayer will still be required to pay taxes on any income that is assigned to a third party. The person who earns the income is the one who will be responsible for paying taxes on the income, not the person to whom it is assigned. The same rule applies to income that a person receives from property or assets.

For example, if a person earns money through a source of what is considered to be a passive stream of income, such as from stock dividends, the person who owns these assets will be the one responsible for paying taxes on the income they receive from it. The reason for this is because income is generally taxed to the person who owns any income-generating property under the law.

If a person chooses to give away their income-generating property and/or assets as a gift to a family member, then they will no longer be taxed on any income that is earned from those property or assets. This rule will be triggered the moment that the owner has given up their complete control and rights over the property in question.

In order to demonstrate how this might work, consider the following example:

• Instead, the person to whom the apartment building was transferred will now be liable for paying taxes on any income they receive from tenants paying rent to live in the building since they are the new owner.

There is one exception to the rule provided by the assignment of income doctrine and that is when income is assigned in a scenario that involves a principal-agent relationship . For example, if an agent receives income from a third-party that is intended to be paid to the principal, then this income is usually not taxable to the agent. Instead, it will be taxable to the principal in this relationship.

Briefly, an agent is a person who acts on behalf of another (i.e., the principal) in certain situations or in regard to specific transactions. On the other hand, a principal is someone who authorizes another person (i.e., the agent) to act on their behalf and represent their interests under particular circumstances.

For example, imagine a sales representative that is employed by a large corporation. When the sales representative sells the corporation’s product or service to a customer, they will receive money from the customer in exchange for that service or product. Although the sales representative is the one being paid in the transaction, the money actually belongs to the corporation. Thus, it is the corporation who would be liable for paying taxes on the income.

In other words, despite the fact that this income may appear to have been earned by the corporation’s agent (i.e., the sales representation in this scenario), the corporation (i.e., the principal) will still be taxed on the income since the sales representative is acting on behalf of the corporation to generate income for them.

One other exception that may apply here is known as a “kiddie tax.” A kiddie tax is unearned or investment-related income that belongs to a child, but must be paid by the earning child’s parent and at the tax rate assigned to adults (as opposed to children). This is also to help prevent parents from abusing the tax system by using their child’s lower tax rate to shift over assets or earned income and take advantage of their child’s lower tax bracket rate.

So, even though a parent has assigned money or assets to a child that could be considered their earned income, the money will still have to be paid by the parent and taxed at a rate that is reserved for adults. The child will not need to pay any taxes on this earned income until it reaches a certain amount.

In general, the tax rules that exist under the assignment of income doctrine can be confusing. There are several exceptions to these rules and many of them require knowing how to properly apply them to the specific facts of each individual case.

Therefore, if you have any questions about taxable income streams or are involved in a dispute over taxable income with the IRS, then it may be in your best interest to contact an accountant or a local tax attorney to provide further guidance on the matter. An experienced tax attorney can help you to avoid incurring extra tax penalties and can assist you in resolving your income tax issue in an efficient manner.

Your attorney will also be able to explain the situation and can recommend various options to settle the assignment of income issue or any related concerns. In addition, your attorney will be able to communicate with the IRS on your behalf and can provide legal representation if you need to appear in court.

Lastly, if you think you are not liable for paying taxes on income that has been assigned to you by someone else, then your lawyer can review the facts of your claim and can find out whether you may be able to avoid having to pay taxes on that income.

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The Assignment of Income Doctrine

Tax Court ruling of special interest to church treasurers.

Ferguson v. Commissioner, 108 T.C. 244 (1997)

Background. Donors occasionally attempt to “assign” their right to receive income to a church, assuming that they are avoiding any receipt of taxable income.

Example. Rev. T is senior pastor of First Church. He conducts a service at Second Church, and is offered compensation of $500. Rev. T refuses to accept any compensation, and asks the pastor of Second Church to put the $500 in the church’s building fund. Rev. T, and the treasurer at Second Church, assume that there is no income to report. Unfortunately, they may be wrong.

The United States Supreme Court addressed this issue in a landmark ruling in 1940. Helvering v. Horst, 311 U.S. 112 (1940). The Horst case addressed the question of whether or not a father could avoid taxation on bond interest coupons that he transferred to his son prior to the maturity date. The Supreme Court ruled that the father had to pay tax on the interest income even though he assigned all of his interest in the income to his son. It observed: “The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment and hence the realization of the income by him who exercises it.” The Supreme Court reached the same conclusion in two other landmark cases. Helvering v. Eubank, 311 U.S. 122 (1940), Lucas v. Earl, 281 U.S. 111 (1930).

Example. A taxpayer earned an honorarium of $2,500 for speaking at a convention. He requested that the honorarium be distributed to a college. This request was honored, and the taxpayer assumed that he did not have to report the $2,500 as taxable income since he never received it. The IRS ruled that the taxpayer should have reported the $2,500 as taxable income. It noted that “the amount of the honorarium transferred to the educational institution at the taxpayer’s request … is includible in the taxpayer’s gross income [for tax purposes]. However, the taxpayer is entitled to a charitable contribution deduction ….” The IRS further noted that “the Supreme Court of the United States has held that a taxpayer who assigns or transfers compensation for personal services to another individual or entity fails to be relieved of federal income tax liability, regardless of the motivation behind the transfer” (citing the Horst case discussed above). Revenue Ruling 79 121.

A recent Tax Court ruling. The Tax Court has issued an important ruling addressing the assignment of income to a church. Don owned several shares of stock in Company A. On July 28, Company A agreed to merge with Company B. Pursuant to the merger agreement, Company B offered to purchase all outstanding shares of Company A for $22.50 per share (an 1,100% increase over book value). On August 15, Don informed his stockbroker that he wanted to donate 30,000 shares of Company A to his church. On September 8 Don deposited 30,000 shares in his brokerage account and on September 9 signed an authorization directing his broker to transfer the shares to his church. A few days later the church issued Don a receipt acknowledging the contribution. The receipt listed the “date of donation” as September 9. The church sold all of the shares to Company B for $22.50 per share. Don claimed a charitable contribution deduction for $675,000 (30,000 shares at $22.50 per share). He did not report any taxable income in connection with the transaction..

The IRS audited Don, and conceded that a gift of stock had been made to the church. It insisted, however, that Don should have reported the “gain” in the value of his stock that was transferred to the church. Not so, said Don. After all, he never realized or “enjoyed” the gain, but rather transferred the shares to the church to enjoy.

The IRS asserted that Don had a legal right to redeem his Company A shares at $22.50 per share at the time he transferred the shares to the church. As a result, Don had “assigned income” to the church, and could not avoid being taxed on it.

The Tax Court agreed with the IRS. It began its opinion by addressing the date of Don’s gift. Did the gift to the church occur before he had a legal right to receive $22.50 per share for his Company A stock? If so, there was no income that had been assigned and no tax to be paid. Or, did Don’s gift occur after he had a legal right to receive $22.50 per share? If so, Don had “assigned income” to the church and he would have to pay tax on the gain. The court concluded that Don’s gift occurred after he had a legal right to receive $22.50 per share. It quoted the following income tax regulation addressing the timing of gifts of stock:

Ordinarily, a contribution is made at the time delivery is effected …. If a taxpayer unconditionally delivers or mails a properly endorsed stock certificate to a charitable donee or the donee’s agent, the gift is completed on the date of delivery or, if such certificate is received in the ordinary course of the mails, on the date of mailing. If the donor delivers the stock certificate to his bank or broker as the donor’s agent, or to the issuing corporation or its agent, for transfer into the name of the donee, the gift is completed on the date the stock is transferred on the books of the corporation.

The critical issue was whether Don’s broker was acting as Don’s agent or the church’s agent in handling the transaction. The court concluded that the broker had acted as Don’s agent. The broker “facilitated” Don’s gift of stock to the church, and was acting on the basis of Don’s instructions. The court concluded:

[Don has] failed to persuade us that depositing stock in his brokerage account with instructions to [the stockbroker] to transfer some of the stock to the [church] constituted the unconditional delivery of stock to a charitable donee’s agent …. [Don] has failed to persuade us that depositing stock in [his] brokerage account with instructions to [his stockbroker] to transfer some of the stock to the [church] constituted the unconditional delivery of stock to a charitable donee’s agent pursuant to [the regulations] …. Based on the circumstances surrounding the gift … we believe that [the stockbroker] acted as [Don’s] agent in the transfer of the stock and that [he] relinquished control of the stock on September 9 when the letters of authorization were executed, and we so find. The gift to the [church], therefore, was complete on September 9.

The court concluded that on the date of the gift (September 9) Don had a legal right to receive $22.50 per share for all his shares of Company A, and therefore his gift to the church was a fully taxable “assignment of income.” The court observed:

It is a well-established principle of the tax law that the person who earns or otherwise creates the right to receive income is taxed. When ]the right to income has matured at the time of a transfer of property, the transferor will be taxed despite the technical transfer of that property …. An examination of the cases that discuss the anticipatory assignment of income doctrine reveals settled principles. A transfer of property that is a fixed right to income does not shift the incidence of taxation to the transferee …. [T]he ultimate question is whether the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in the property at the time of transfer.

The court concluded that Don did have a “fixed right to income” at the time he donated the 30,000 shares to his church. According to the terms of the merger agreement between Company A and Company B, each outstanding share of Company A was “converted” into a right to receive $22.50 per share in cash. In essence, the stock in Company A “was converted from an interest in a viable corporation to a fixed right to receive cash.”

Conclusions. Here are a few principles for church treasurers to consider:

* Charitable contribution reporting. Note that the “assignment of income” doctrine does not bar recognition of a charitable contribution. Both the Tax Court and IRS conceded that Don was eligible for a charitable contribution deduction as a result of his gift of stock.

* Timing of a gift of stock. This case will provide helpful guidance to church treasurers in determining the date of a gift of stock. The income tax regulations (quoted above) contain the following three rules:

(1) Hand delivery. if a donor unconditionally delivers an endorsed stock certificate to a charity or an agent of a charity, the gift is completed on the date of delivery

(2) Mail. if a donor mails an endorsed stock certificate to a charity or an agent of a charity, the gift is completed on the date of mailing

(3) Delivery to an agent. if a donor delivers a stock certificate to his or her bank or stockbroker as the donor’s agent (or to the issuing corporation or its agent) for transfer into the name of a charity, the gift is completed on the date the stock is transferred on the books of the corporation

* Notification of income consequences. While certainly not required, church treasurers may want to inform some donors about the assignment of income doctrine. It often comes as a shock to donors (such as Don) to discover that their charitable contribution is “offset” by the taxable income recognized under the assignment of income doctrine. Assignments of income most often occur in connection with donations of stock rights or compensation for services already performed.

* Gifts of appreciated stock not affected. Many donors give stock that has appreciated in value to their church. Such transactions are not affected by the court’s ruling or by the assignment of income doctrine because the donor ordinarily has no “fixed right to income” at the time of transfer. Don’s case was much different. He had a contractual right to receive $22.50 per share for all of his shares of Company A stock as a result of the merger.

Key point. Persons who donate stock often can deduct the fair market value of the stock as a charitable contribution (there are some important limitations to this rule) and they have no “assigned income” to report.

Example. Jill is employed by a local business. Her company declares a $1,000 Christmas bonus. Jill asks her supervisor to send the bonus directly to her church. The supervisor does so. The church treasurer should be aware of the following: (1) Jill will be taxed on the bonus under the assignment of income doctrine. The church treasurer may want to point this out to Jill, although this is not required. There is no need for the church to report this income, or issue Jill a W-2 or 1099. (2) Jill should be given credit for a charitable contribution in the amount of the bonus. Since the bonus was in excess of $250 the receipt issued by the church should comply with the charitable contribution substantiation rules that apply to contributions of $250 or more.

This content is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. "From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations." Due to the nature of the U.S. legal system, laws and regulations constantly change. The editors encourage readers to carefully search the site for all content related to the topic of interest and consult qualified local counsel to verify the status of specific statutes, laws, regulations, and precedential court holdings.

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Hoensheid: assignment of income and gift substantiation.

It is fairly common to make charitable gifts of property prior to a sale transaction. Often, those gifts are of real property or closely-held business interests. This is for good reason. Structured properly, not only do donors generally receive a charitable income tax deduction equal to the fair market value of the donated property, they also avoid any capital gains on the sale of that property. [1] The double benefit of both avoiding capital gain and receiving a full fair market value deduction can be quite powerful. [2]

As stated above, however, the gift must be structured properly in order to obtain these benefits. Two of the important areas in this regard are: (1) avoidance of an assignment of income; and (2) proper gift substantiation. We have previously written about cases where these issues have arisen. [3]   A recent Tax Court opinion once again addresses these issues, [4] this time possibly contradicting IRS guidance [5] and a previous binding opinion of the full Tax Court. [6]

Commercial Steel Treating Corp. (“CTSC”) was owned by three brothers. After one of the brothers announced his plans to retire in the Fall of 2014, the three brothers decided to solicit bids for a sale of the company. In so doing, they engaged a financial advisory firm which began the process in early 2015.

Once that process started, the following sequence of events unfolded:

• April 1, 2015: HCI Equity Partners (“HCI”) submitted a draft Letter of Intent (“LOI”) to acquire CTSC.
• Mid April 2015: Mr. Hoensheid, one of the owner/brothers and the taxpayer in this case, begins discussing the possibility of establishing a donor advised fund (“DAF”) to make a charitable contribution of CTSC stock prior to the anticipated sale to take advantage of the type of planning described above (i.e. double benefit of fair market value charitable deduction and avoidance of capital gains on the donated shares).
• April 16, 2015: Mr. Hoensheid’s attorney emailed that “the transfer would have to take place before there is a definitive agreement in place.” [7]
• April 23, 2015: LOI between HCI and CTSC was executed.
• May 22, 2015: CTSC executed an Affidavit of Acquired Person for the Federal Trade Commission representing that CTSC had “a good faith intention of completing the transaction.”
• Valuation date of CTSC submitted in substantiation of charitable deduction.
• Hoensheid emailed his attorney that “I do not want to transfer the stock until we are 99% sure we are closing.”
• Shareholders and Directors meetings ratifying sale of all stock of CTSC to HCI.
• CTSC submitted to the Michigan Department of Licensing and Regulatory Affairs an amendment to its Articles of Incorporation per request from HCI.
• Stock Purchase Agreement submitted by Mr. Hoensheid’s attorney to Fidelity Charitable for execution (dated effective June 15, 2015).
• Shareholders approve Mr. Hoensheid’s transfer of an unspecified number of CTSC shares to Fidelity.
• June 12, 2015: HCI’s investment committee and managing partners approved acquisition of CTSC.
• HCI formed a new Delaware corporation to serve as the acquirer of CTSC.
• Hoensheid sends an email that he is “not totally sure of the shares being transferred to the charitable fund yet.”
• July 7: CTSC determined to distribute payments to employees pursuant to a Change of Control Bonus Plan and almost all remaining cash to its shareholders.
• Email from Mr. Hoensheid’s financial advisor that “it looks like Scott has arrived at 1380 shares.”
• Hoensheid delivered the stock certificate transferring shares in CTSC to his attorney.
• Revised draft Stock Purchase Agreement circulated with missing date upon which Mr. Hoensheid transferred shares to Fidelity Charitable.
• CTSC paid bonuses to employees under Change of Control Bonus plan.
• Redline draft of Stock Purchase Agreement circulated indicating acceptance of all substantive changes.
• Printout list of CTSC shareholders indicating gift to Fidelity Charitable from Mr. Hoensheid on July 10, 2015.
• PDF stock certificate submitted by email to Fidelity Charitable showing the stock transfer from Mr. Hoensheid to Fidelity Charitable.
• July 14: CTSC distributed almost all remaining cash to its shareholders.
• July 15, 2015: Transaction closing and funding.

There was some dispute between the taxpayers and the IRS about the date of the charitable gift. The taxpayers argued the stock was gifted on July 10, 2015, the date upon which Mr. Hoensheid decided to transfer 1380 shares of CTSC to Fidelity Charitable, executed a stock certificate to that effect, and delivered the stock certificate to his attorney. However, the IRS argued, and the Tax Court agreed, that the transfer did not occur until July 13, 2015. The reason was that, citing to Michigan law [8] , there was no deliver of the gift to the charity until the PDF stock certificate was sent [9] and no acceptance of the gift until Fidelity Charitable’s email on July 13, 2015, acknowledging same. [10] As a result, for purposes of the tax dispute, July 13, 2015, was the date of the charitable donation.

Assignment of Income

The assignment of income doctrine recognizes income as taxed “to those who earn or otherwise create the right to receive it.” [11] Particularly in the charitable donation context, a donor will be deemed “to have effectively realized income and then assigned that income to another when the donor has an already fixed or vested right to the unpaid income.” [12] This analysis looks “to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities.” [13] The form of a charitable donation will not be respected if the donor does not: (1) give the appreciated property away absolutely and divest of title (2) before the property gives rise to income by way of a sale. [14]

Before analyzing Mr. Hoensheid’s donation through the relevant tests for assignment of income, the Tax Court addressed arguments raised by Mr. Hoensheid regarding existing guidance. In addition to other sources, this is particularly important in citing to Rev. Rul. 78-197 and Rauenhorst [15] . In Rev. Rul. 78-197 the IRS acquiesced in the Palmer [16] decision where a donor transferred shares in a closely-held corporation he controlled to a private foundation he also controlled, followed by a redemption of those shares by the corporation. The IRS argued the substance of the transaction was a redemption followed by a cash contribution since the taxpayer had a “prearranged plan” of redeeming the shares at the time of the contribution. After the Tax Court ruled in favor of the taxpayer, the IRS issued Rev. Rul. 78-197 stating that “the Service will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donor only if the donee is legally bound, or can be compelled by the corporation to surrender the shares for redemption ” (emphasis added). Certainly, regardless of any other facts, there was nothing to legally compel a closing of the sale of CTSC stock to HCI, or otherwise compel such closing, at the date of Mr. Hoensheid’s charitable gift.

In Palmer , the Tax Court held that certain charitable gifts made after a redemption of stock was “imminent” did not constitute an assignment of income. In Rauenhorst , the Tax Court noted that the IRS attempted to “devise a ‘bright-line’ test which focuses on the donee’s control over the disposition of the appreciated property” by adopting Rev. Rul. 78-197. Although Revenue Rulings do not bind the Tax Court, they do bind the IRS. When there was an LOI, but no binding obligation to sell, therefore, the IRS was precluded in Rauenhorst from arguing there as an assignment of income when the facts in the case were not distinguishable from those in Rev. Rul. 78-197. The facts in Rauenhorst bear similarities to those in Hoensheid . In Rauenhorst , there was a signed LOI, a resolution authorizing executing an agreement of sale, and a valuation report indicating there was little chance the transaction would not close.

However, in Rauenhorst , and cited in Hoensheid , the Tax Court noted “we have indicated our reluctance to elevate the question of donee control to a talisman for resolving anticipatory assignment of income” and that the donee’s power to reverse the transaction is “only one factor to be considered in ascertaining the ‘realities and substance’ of the transaction.” In Rauenhorst and Hoensheid , the Tax Court stated that “the ultimate question is whether the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in property at the time of the transfer.” [17] As such, notwithstanding that the Tax Court in Rauenhorst held the IRS to its position in Rev. Rul. 78-197, the court stated that “in the appropriate case we could disregard a ruling or rulings as inconsistent with our interpretation of the law.” As such, while Hoensheid could be seen as inconsistent with Rauenhorst , it also could be seen as consistent insofar as the Tax Court kept the door open for the Hoensheid result in the opinion it issued in Rauenhorst . [18]

In making that determination the Tax Court in Hoensheid looked at factors including: (1) “any legal obligation to sell by the donee”, (2) “the actions already taken by the parties to effect the transaction”, (3) “the remaining unresolved transactional contingencies”, and (4) “the status of the corporate formalities required to finalize the transaction.”

Applying these factors, while conceding that there was no obligation of Fidelity Charitable to sell shares at the time of contribution, the Tax Court found there to be an assignment of income. The court cited to the number of acts which had taken place at the time of the donation which rendered the transaction a “foregone conclusion.” Relevant facts included that, on the date of the charitable donation, corporate formalities of approving the transaction had occurred, bonuses payable to employees resulting from the transaction had been paid, dividends had been paid to such an extent that CTSC no longer remained a viable going concern, and all substantive terms of the transaction had been fully negotiated. Ultimately, the court stated that, by July 13, 2015, “the transaction had simply ‘proceeded too far down the road to enable petitioners to escape taxation on the gain attributable to the donated shares.’”

Substantiation

Although the scope of this writing is to address the concept of anticipatory assignment of income and the Hoensheid opinion, particularly as it relates to prior authorities and guidance, it is important to note the substantiation issues which ultimately cost the taxpayers any charitable deduction. Even finding an assignment of income, the taxpayers would be entitled to charitable donation equal to the fair market value of the shares gifted. They merely would be forced to recognized their share of gain from the sale transaction. However, having failed to satisfy the charitable donation substantiation requirements, the taxpayers lost the deduction in full.

Relevant in Hoensheid , gifts of property of more than $500,000 require taxpayers to obtain a qualified appraisal from a qualified appraiser to attach to the taxpayer’s income tax return for the year of the gift. [19] Although the scope of what constitutes a “qualified appraisal” from a “qualified appraiser” is beyond the scope of this writing, in Hoensheid , the taxpayer failed primarily as a result of obtaining an appraisal from someone unqualified to render valuations for purposes of substantiating charitable gifts.

The Tax Court notes that the requirement for the appraiser to be qualified is “the most important requirement” of the regulations. [20] The appraiser in Hoensheid only infrequently performed valuations, did not hold himself out as an appraiser, and held no certifications from any professional appraiser organization. Based on these and other factors, it was clear that the appraiser in Hoensheid was not a “qualified appraiser” as contemplated by the applicable statute and regulations. By all accounts, he was used because he charged no fee for the valuation, instead offering to perform the valuation under the fees paid to the financial advisory firm handling the sale transaction which is where he was employed. In addition to the appraiser lacking the proper qualifications, the valuation report contained a number of deficiencies which rendered it not to constitute a “qualified appraisal” either. One of such problems was using a June 1, 2015, valuation date when intervening events between that date and the date of the gift, including the substantial bonus and dividend distributions, should have caused the value of CSTC to materially change.

Although “substantial compliance” can be sufficient in satisfying regulatory substantiation requirements [21] , the Tax Court found that Mr. Hoensheid failed to substantially comply due to his failure to engage a qualified professional to complete the valuation along with the numerous errors could not be concluded to satisfy the requirements of substantial compliance. However, as a silver lining, in avoiding a 20% underpayment penalty [22] , Mr. Hoensheid was held to have reasonably relied on his attorney’s advice that the deadline for the charitable donation was the date a definitive agreement is executed.

Here, Mr. Hoensheid made a couple of fatal choices. First, he chose to wait until the transaction was 99% sure to close before making the charitable gift. Second, he cut corners by using a free and unqualified appraiser rather than simply paying for a qualified valuation professional. Sure, Mr. Hoensheid’s professional advisors led him to believe he may have had until the closing (the date the purchase agreement would be signed) in order to make the gift. Further, his attorney may have been justified in believing that to constitute the law given Rauenhorst and Rev. Rul. 78-197. However, his own attorney said “any tax lawyer worth [her] fees would not have recommended that a donor make a gift of appreciated stock” so close to the closing.

It is understandable that taxpayers desire to wait until they are confident a sale will close before donating equity interests. We encounter that frequently. There is no clear, bright-line date on which the tests as discussed in Hoensheid may apply (as opposed to Rauenhorst and Rev. Rul. 78-197). As such, taxpayers and their planners should look to the timeline in this case and the Tax Court’s discussion in determining when to make charitable gifts in anticipation of a sale. In many cases, closing and purchase agreement execution occur simultaneously as opposed to transactions where a purchase agreement is signed with a number of contingencies and before much of the due diligence or other pre-closing details have been finalized. Extra care is likely needed when there is a contemporaneous execution and closing, as in  Hoensheid . While no legally binding document may have been executed, the deal may be a “foregone conclusion” at some point along the spectrum.

Of course, beyond the assignment of income issues, we continue to see taxpayers trip up on charitable gift substantiation. [23] Sometimes it is a mere mistake; other times taxpayers try to cut corners and/or save money by not engaging the proper professionals. When large gifts are being made, real value is being donated. The donor will never get those funds back and the costs of complying with the substantiation requirements is typically much less than the value of the deduction, especially when gifts are made in advance of a liquidity event.

[1] This presumes a donation of long-term capital gain property to a public charity, generally subject to a limitation on the deduction of 30% of the donor’s adjusted gross income. IRC § 170(b)(1)(C).

[2] As an example, a top bracket taxpayer (37% ordinary income tax bracket and 20% capital gains bracket) who donates a $1 million asset with a $200,000 cost basis stands to obtain both an $1M income tax deduction for a benefit of $370,000 and also avoid $800,000 of capital gains for a benefit of $160,000, yielding a combined tax benefit of $530,000. This means the true cost of the $1 million charitable gift was only $470,000. The savings may be more to the extent the net investment income tax and/or state income tax applies.

[3] Allen, Charles J., “IRS Continues Aggressive Stance on Charitable Contributions,” Oct. 23, 2018, https://esapllc.com/chrem-case/ ; and Sage, Joshua W., “Gifting Appreciated Stock Before Redemption – Dickinson,” Oct. 6, 2020, https://www.esapllc.com/dickinson-redemption2020/ .

[4] Estate of Scott Hoensheid, et ux. v. Commissioner , T.C. Memo 2023-34.

[5] Rev. Rul. 78-197.

[6] Rauenhorst v. Commissioner , 119 T.C. 157 (2002).

[7] These statements were repeated in an email from the taxpayer’s financial advisor on April 20, 2015, and the taxpayer’s attorney on April 21, 2015.

[8] Michigan law requires a showing of: (1) donor intent to make a gift; (2) actual or constructive delivery of the subject matter of the gift; and (3) donee acceptance. See Davidson v. Bugbee , 575 N.W.2d 574, 576 (Mich. Ct. App. 1997).

[9] Although the stock ledger showing an earlier transfer date could have possibly substantiated delivery, that printout was dated July 13, 2015, meaning the Tax Court could not determine an earlier date upon which CTSC acknowledged the transfer.

[10] Again, here, there were communications with Fidelity Charitable showing a July 11, 2015, transfer date but the documentary proof provided to the Tax Court by the taxpayers bore a July 15, 2015, date rather than a production of the earlier original. As such, absent proper proof, the Tax Court could not conclude a July 11, 2015, acceptance date occurred.

[11] Helvering v. Horst , 311 U.C. 112, 119 (1940).

[12] Cold Metal Process Co. v. Commissioner , 247 F.2d 864, 872-73 (6th Cir. 1957).

[13] Jones v. U.S. , 531 F.2d 1343, 1345 (6th Cir. 1976); and Allen v. Commissioner , 66 T.C. 340, 346 (1976).

[14] Humacid Co. v. Commissioner , 42 T.C. 894, 913 (1964).

[15] See supra Note 6.

[16] Palmer v. Commissioner , 62 T.C. 684 (1974),

[17] Citing Ferguson v. Commissioner , 108 T.C. 244 (1997).

[18] Note also the Ninth Circuit’s opinion in Ferguson v. Commissioner , 174 F.3d 997 (9th Cir. 1999), whereby assignment of income was found where a threshold of a tender of 85% of corporate shares was required prior to any binding obligations to sell when only more than 50% had been transferred at the time of the gift, the court finding there was enough “momentum” to the transaction to make the merger “most unlikely” to fail. This extension of the assignment of income doctrine was specifically refused to be followed by the U.S. District Court in Keefer v. U.S. , 2022 WL 2473369, particularly given that the case was appealable to the Fifth Circuit Court of Appeals.

[19] IRC §170(f)(11)(D) and (E), and Treas. Reg. § 1.170A-13.

[20] Citing Mohamed v. Commissioner , T.C. Memo 2012-152.

[21] We have discussed substantial compliance in other writings including, Gray Edmondson, “RERI Revisited on Appeal, $33M Deduction Denial Upheld,” June 5, 2019, https://esapllc.com/reri-appeal/ ; and Devin Mills, “Private Jet Deduction Fails for Lack of Substantiation,” July 26, 2022, https://esapllc.com/izen-jet-2022/ .

[22] IRC § 6662 based on any underpayment of tax required to be shown on a return that is attributable to negligence, disregard of rules or regulations, or a substantial understatement of income tax.

[23] For a recent article discussing charitable gift substantiation, including substantial compliance, see Sholk, Steven H., “A Guide to the Substantiation Rules for Deductible Charitable Contributions,” 137 J. Tax’n 03 (Dec. 2022).

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Gross Income: Tax Benefit, Claim of Right and Assignment of Income (Portfolio 502)

James Maule

Professor of Law, Emeritus

Villanova University School of Law

At a glance

I. Introduction II. Tax Benefit Doctrine III. Claim of Right Doctrine IV. Assignment of Income

The Bloomberg Tax Portfolio, Gross Income: Tax Benefit, Claim of Right and Assignment of Income, No. 502, addresses three areas of gross income that are substantially judicial in origin and nature. It analyzes in depth the nature, concept, scope, and application of the tax benefit doctrine, the claim of right doctrine, and the assignment of income doctrine.

The tax benefit doctrine excludes from a taxpayer's gross income any recovery or refund of an amount deducted in a prior taxable year to the extent the deduction did not reduce tax liability. Under the claim of right doctrine, a taxpayer must include in gross income for the year of receipt any income received under a claim of right free of restrictions.

Under the assignment of income doctrine, gross income from personal services must be included in the gross income of the person who rendered the services. In addition, under that doctrine, gross income from property must be included in the gross income of the person who beneficially owns the property.

The Worksheets include relevant legislative history for provisions discussed in detail and for which regulations have not yet been issued.

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FAQ: What Is the Assignment of Income?

Assignment of income allows you to assign part of your income directly to another person. While there are several valid reasons to assign your income to someone else, many taxpayers mistakenly believe that it can help lower their taxable income. While assignment of income allows you to divert income, you cannot divert taxes.

In this article, we’ll provide some examples of failed attempts at avoiding income taxes through the assignment of income and the valid reasons someone might want to assign income to someone else.

RELATED: Tax Evasion Vs. Tax Avoidance: The Difference and Why It Matters

You Can’t Use Assignment of Income to Avoid Paying Taxes

The assignment of income doctrine states that the taxpayer who earns the income must pay the tax on that income, even if he gave the right to collect the income to another person.

The doctrine is quite clear: taxpayers must pay their own taxes. However, that doesn’t stop many people from thinking they can avoid paying taxes or minimize their taxable income through the assignment of income.

Here are a few scenarios we commonly see.

• High-Earning Individuals: In an attempt to avoid having to pay the higher tax rates on their substantial income, high-earning individuals sometimes try to divert income to a lower-income family member in a significantly lower tax bracket. The assignment of income doctrine prevents this scheme from working.
• Charitable Donating : Even if a taxpayer assigns part of their income to a charitable organization, they will still have to pay the taxes. However, they might be eligible to claim a deduction for donations to charity while building some good karma by helping others in need.
• Owning Multiple Businesses: A taxpayer who controls multiple businesses might try to divert income from one business to another, especially if one has the potential to receive a tax benefit but requires a higher income to do so. Not only is this illegal, but it also will not lower the taxable income of the business.

You Can Use Assignment of Income to… Assign Your Income

The assignment of income doctrine does not stop you from diverting part of your income to someone else. In fact, that’s the whole point! Maybe you’re helping to support an elderly family member, or you consistently donate to the same charity every month or year. Whatever the case, you can assign the desired amount of your income to go to another person or organization.

While there are no tax benefits involved in assigning income versus making traditional payments or donations, it can be a more convenient option if you’re making regular payments throughout the year.

S.H. Block Tax Services Provides Clear Answers For Complicated Questions

If you have any questions about how to go about assigning part of your income to a family member in need or a separate business entity, please contact S.H. Block Tax Services today. We can answer all of your questions and address all of your concerns regarding the assignment of income and provide suggestions on valid and legal ways to save on your taxes.

Please call us today at  (410) 872-8376  or complete  this brief contact form  to get started on the path toward tax compliance and financial freedom.

The content provided here is for informational purposes only and should not be construed as legal advice on any subject.

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• Tax Planning

What Is Income Shifting?

Income Shifting Explained

How Does Income Shifting Work?

Types of income shifting.

• Disadvantages and Restrictions

Frequently Asked Questions (FAQs)

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Income shifting is the practice of moving unearned income from one taxpayer to another. Ideally, it moves to someone in a lower tax bracket so the tax bite taken out of the money isn’t as great.

Key Takeaways

• Income shifting is a tactic of moving unearned income out of the ownership of one taxpayer and into that of a taxpayer in a lower tax bracket.
• Income shifting is commonly employed among family members because you’re technically giving away income or income-producing assets.
• The practice is perfectly legal, but the Internal Revenue Code imposes many rules and regulations for doing it correctly.
• You could be hit with a gift tax or your child could be liable for the Kiddie Tax if the asset you give away is very valuable.

Income shifting involves redirecting a stream of income, such as from an investment or a business. It moves from you to another individual who will not pay a high tax rate on it. You’re actually giving them your income, so the practice is most common among family members. Income shifting is sometimes also called income splitting.

Income shifting doesn’t work with earned income , that which is paid to you by an employer or as an independent contractor. Those payments are tagged with your Social Security or tax ID number from the onset. They’re reported to the IRS as your income on Form W-2 or Form 1099-NEC. You’re free to give the money away, of course, but it will first be taxed at your own tax rate.

Only unearned income can be shifted.

Example of Income Shifting

The top dollar of your income might put you in the highest tax bracket , which for 2022 is 37%. You’re expecting to receive income from an investment at year’s end, or maybe you’re self-employed and having a banner year. In any case, you’d have to give 37 cents of every dollar of that money to the IRS because of your tax rate.

Meanwhile, your elderly mother is in the 12% tax bracket, and she’s unable to make ends meet on her own. Income shifting involves transferring that income-producing investment into her name so it’s only taxed at 12 cents on the dollar. You normally help her out financially anyway, but you won’t have to share that income with the federal government as well if you use this method of generosity.

Corporations and multinational companies may also engage in a form of income shifting by moving income from countries with high taxes to countries with lower taxation.

You can shift income a few ways. They all involve giving someone else a portion of your money in a documented way that establishes it as their own.

Hire a Family Member

You can hire your child or children to work for you if you have your own business. Rather than keep that money and be taxed on it at your own rate, you can pay it to them and claim a business deduction for their wages or salary. This also reduces your income for purposes of the self-employment tax if you’re a sole proprietor. Children under age 18 who are employed by their parent’s sole proprietorship or partnership aren’t subject to FICA taxes , either—Social Security and Medicare taxes.

This option isn’t reserved only for your kids. You can hire a parent or a sibling, too. Income you pay to any employee is technically shifted from you to them, but you can keep it in the family when you pay a family member.

Transfer Income-Producing Assets

You can also transfer ownership of an income-producing asset such as company stock to another taxpayer. This might be an investment account or even a rental property. They would report the income on their own tax return and pay their own, lower, tax rate on it. Of course, it no longer adds to your net worth, either—another reason why this tactic is typically used among family members.

You might consider transferring the asset into a trust for the benefit of your child if they are still a minor. This would have the same income-shifting effect because the trust, not you, now owns it.

Defer Bonuses and Income

This strategy doesn't involve giving money away. It's a matter of delaying it. Taxpayers can do this by shifting income from one tax year to the next.

This can be advantageous if you’re in a particularly high tax bracket this year but you expect your income will be less next year. You’ll also pay less of a tax percentage on the money if you delay taking year-end bonuses from your employer until January.

You can employ a similar tactic if you’re self-employed. You might delay invoicing or collecting income from a client in November or December and do so in January instead. Or you might pay tax-deductible expenses in December rather than in January, which would also reduce your taxable income in the current year.

You’re actually shifting income to yourself when you delay or defer bonuses and income, rather than shifting it to someone else.

Disadvantages and Restrictions When Shifting Income

Numerous tax rules and regulations restrict these income-shifting measures to some extent.

The ‘Kiddie Tax’

You might still end up paying a tax on income-producing assets that are transferred to your children under some circumstances. So your income-shifting efforts could turn out to be for naught. Congress put the “ Kiddie Tax ” in place to prevent the transfer of particularly lucrative assets in this way. You won’t get the tax bill for the investment—your child will—but they’ll be taxed on it at your highest tax rate, not their own.

You’ll dodge the Kiddie Tax if you employ your child because the tax only applies to unearned income.

Limits apply to the Kiddie Tax rule, however. The tax only applies to unearned income over a certain amount: $2,300 for the 2022 tax year if your child is any of the following:

• Younger than age 18
• 18 years old at the end of the tax year and you did not have earned income that was more than 50% of the child’s support needs
• Age 19 through age 23 and the child didn’t have earned income equal to more than half of their support needs

The Uniform Transfers to Minors Act (UTMA)

This rule doesn’t apply at the federal level, but some states impose it. UTMA and the Uniform Gifts to Minors Act (UGMA) prohibit securities from being registered in the name of a minor child. You’d have to gift your child this type of asset under UTMA or UGMA rules, or place it into a trust for their benefit.

Placing it into a trust can be tricky as well. The trust’s income still is taxed to you if the trust is a revocable grantor trust . The only way to remove yourself from the ownership and tax equation is to place the asset in an irrevocable trust.

The Gift Tax

You might additionally be hit with a federal gift tax if you transfer an asset to your child—or to anyone else, for that matter. The IRS imposes a tax on gifts exceeding $16,000 per person per year, as of the 2022 tax year. You would owe a gift tax on $4,000 if you give your child or other family member an asset valued at $20,000. The donor is responsible for paying this tax, not the recipient.

You can defer this tax to be payable by your estate at the time of your death if you believe that the total value of your estate will fall below that year’s gift and estate tax exemption . The exemption is set at $12.06 million for individuals as of tax year 2022.

Your Child's Job

Income shifting won’t work unless you legitimately hire your child or family member for a bona fide job opening. In other words, they must honestly perform work for your business in some reasonable capacity. It’s recommended that you have them fill out a time card and other appropriate employment-related documentation. Avoid the temptation to pay them $75 an hour to sweep your floor. Your child’s wages or salary must be on par with what anyone else would receive for performing the same job.

Your Method of Accounting

The option of delaying income into the next year or accelerating tax-deductible expenses only works for self-employed persons who use the cash method of accounting . This method assigns income and deductions to the year in which money is received or expenses are paid. Otherwise, it’s assigned to the year in which you contracted the job or incurred an expense, if you use the accrual method.

What is the 'assignment of income' doctrine?

According to the assignment of income doctrine, gains should be taxed to those who earn them. Further, it states that a taxpayer cannot make an arrangement to assign the gains, and therefore the tax, to another entity before the gain is accrued. While assignment of income limits income shifting, taxpayers can engage in income-shifting of unearned income, the gains and therefore the tax from which have not been realized.

IRS. " IRS provides tax inflation adjustments for tax year 2022 ."

University of North Carolina, Kenan Institute of Private Enterprise. " Tax Income Shifting ."

IRS. " Family Help ."

Henssler Financial. " Tax Planning for the Self-Employed: Shifting Income/Timing Income ."

IRS. " Instructions for Form 8615 ."

Fidelity. " What to know about the kiddie tax ."

IRS. " Topic No. 553 Tax on a Child's Investment and Other Unearned Income (Kiddie Tax) ."

American Bar Association. “ Young Lawyers Network: Tax and Non-Tax Considerations When Drafting Irrevocable Trusts .”

IRS. “ Frequently Asked Questions on Gift Taxes .”

IRS. " Estate Tax ."

IRS. " Internal Revenue Bulletin: 2005-15 ."

Grossman St. Amour. " What is “Assignment of Income” Under the Tax Law? "

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You can receive income in the form of money, property, or services. This section discusses many kinds of income that are taxable or nontaxable. It includes discussions on employee wages and fringe benefits, and income from bartering, partnerships, S corporations, and royalties. The information on this page should not be construed as all-inclusive. Other steps may be appropriate for your specific type of business.

Generally, an amount included in your income is taxable unless it is specifically exempted by law. Income that is taxable must be reported on your return and is subject to tax. Income that is nontaxable may have to be shown on your tax return but is not taxable. A list is available in Publication 525, Taxable and Nontaxable Income .

Constructively-received income. You are generally taxed on income that is available to you, regardless of whether it is actually in your possession.

A valid check that you received or that was made available to you before the end of the tax year is considered income constructively received in that year, even if you do not cash the check or deposit it to your account until the next year.  For example, if the postal service tries to deliver a check to you on the last day of the tax year but you are not at home to receive it, you must include the amount in your income for that tax year.  If the check was mailed so that it could not possibly reach you until after the end of the tax year, and you could not otherwise get the funds before the end of the year, you include the amount in your income for the next year. 

Assignment of income.   Income received by an agent for you is income you constructively received in the year the agent received it.  If you agree by contract that a third party is to receive income for you, you must include the amount in your income when the party receives it. 

Example. You and your employer agree that part of your salary is to be paid directly to your former spouse.  You must include that amount in your income when your former spouse receives it. 

Prepaid income.   Prepaid income, such as compensation for future services, is generally included in your income in the year you receive it.  However, if you use an accrual method of accounting, you can defer prepaid income you receive for services to be performed before the end of the next tax year.  In this case, you include the payment in your income as you earn it by performing the services. 

Employee Compensation

Generally, you must include in gross income everything you receive in payment for personal services. In addition to wages, salaries, commissions, fees, and tips, this includes other forms of compensation such as fringe benefits and stock options. 

You should receive a Form W-2, Wage and Tax Statement, from your employer showing the pay you received for your services. 

Childcare providers.   If you provide child care, either in the child's home or in your home or other place of business, the pay you receive must be included in your income.  If you are not an employee, you are probably self-employed and must include payments for your services on Schedule C (Form 1040 or 1040-SR), Profit or Loss From Business. You generally are not an employee unless you are subject to the will and control of the person who employs you as to what you are to do and how you are to do it. 

Babysitting.   If you babysit for relatives or neighborhood children, whether on a regular basis or only periodically, the rules for childcare providers apply to you.

Fringe Benefits

Fringe benefits you receive in connection with the performance of your services are included in your income as compensation unless you pay fair market value for them or they are specifically excluded by law.  Abstaining from the performance of services (for example, under a covenant not to compete) is treated as the performance of services for purposes of these rules. 

Recipient of fringe benefit.   You are the recipient of a fringe benefit if you perform the services for which the fringe benefit is provided.  You are considered to be the recipient even if it is given to another person, such as a member of your family.  An example is a car your employer gives to your spouse for services you perform.  The car is considered to have been provided to you and not your spouse. 

You do not have to be an employee of the provider to be a recipient of a fringe benefit. If you are a partner, director, or independent contractor, you can also be the recipient of a fringe benefit. 

Business and Investment Income

Rents from personal property. If you rent out personal property, such as equipment or vehicles, how you report your income and expenses is generally determined by:

• Whether or not the rental activity is a business, and
• Whether or not the rental activity is conducted for profit.

Generally, if your primary purpose is income or profit and you are involved in the rental activity with continuity and regularity, your rental activity is a business.  See Publication 535, Business Expenses , for details on deducting expenses for both business and not-for-profit activities.

Partnership Income

A partnership generally is not a taxable entity. The income, gains, losses, deductions, and credits of a partnership are passed through to the partners based on each partner's distributive share of these items. For more information, refer to Publication 541 .

Partner's distributive share.   Your distributive share of partnership income, gains, losses, deductions, or credits generally is based on the partnership agreement. You must report your distributive share of these items on your return whether or not they actually are distributed to you. However, your distributive share of the partnership losses is limited to the adjusted basis of your partnership interest at the end of the partnership year in which the losses took place.

Partnership return. Although a partnership generally pays no tax, it must file an information return on Form 1065, U.S. Return of Partnership Income. This shows the result of the partnership's operations for its tax year and the items that must be passed through to the partners.

S Corporation Income

In general, an S corporation does not pay tax on its income. Instead, the income, losses, deductions, and credits of the corporation are passed through to the shareholders based on each shareholder's pro rata share. You must report your share of these items on your return. Generally, the items passed through to you will increase or decrease the basis of your S corporation stock as appropriate.

S corporation return.  An S corporation must file a return on Form 1120-S, U.S. Income Tax Return for an S Corporation. This shows the results of the corporation's operations for its tax year and the items of income, losses, deductions, or credits that affect the shareholders' individual income tax returns. For additional information, see the Instructions for Form 1120-S PDF .

Royalties from copyrights, patents, and oil, gas and mineral properties are taxable as ordinary income. 

You generally report royalties in Part I of Schedule E (Form 1040 or Form 1040-SR), Supplemental Income and Loss.  However, if you hold an operating oil, gas, or mineral interest or are in business as a self-employed writer, inventor, artist, etc., report your income and expenses on Schedule C.

For additional information, refer to Publication 525, Taxable and Nontaxable Income .

Virtual Currencies

The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability. This guidance applies to individuals and businesses that use virtual currencies .

Bartering 

Bartering is the exchange of goods or services. Usually there's no exchange of cash. An example of bartering is a plumber exchanging plumbing services for the dental services of a dentist. Bartering doesn't include arrangements that provide solely for the informal exchange of similar services on a noncommercial basis (for example, a babysitting cooperative run by neighborhood parents). You must include in your income, at the time received, the fair market value of property or services you receive in bartering. For additional information, refer to Tax Topic 420, Bartering Income .

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• GAINS & LOSSES

Taxing the Transfer of Debts Between Debtors and Creditors

• C Corporation Income Taxation
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T he frequent transfer of cash between closely held businesses and their owners is very common. If the owner works in the business, the transfer is likely to be either a salary to a shareholder/employee or a Sec. 707(c) guaranteed payment to a partner. Alternatively, the transfer may be a loan. As long as the true substance of the transaction is a loan, it will be respected for tax purposes. 1

The cash flow is not exclusively from the businesses to the owner. Many owners prefer to capitalize their closely held business with a combination of equity and debt. Once again, these loans will be respected and not reclassified as equity if they are bona fide loans.

In the normal course of business, these loans are repaid. The receipt of the repayment will be tax free except to the extent it is interest. However, in difficult economic conditions, many of these loans are not repaid. To the extent that the creditor cancels the obligation, the debtor has cancellation of debt (COD) income under Sec. 61(a)(12). This income is taxable unless the taxpayer qualifies for an exclusion under Sec. 108. In other cases, the debt is transferred between the parties either as an independent transaction or part of a larger one. This article reviews these transactions.

Two basic types of transfers have created significant tax issues. In the first, the debtor transfers the debt to the creditor. If the debtor is the owner of a business and the business is a creditor, the transfer appears to be a contribution. If the business is the debtor and the owner is the creditor, the transfer can be a distribution, liquidation, or reorganization. The other type of transfer is from the creditor to the debtor. Again, the transaction can take the form of a contribution if the creditor is the owner, or it can take the form of a distribution, liquidation, or reorganization if the creditor is the business.

Debtor-to-Creditor Transfers

Corporations.

The two seminal cases that established the framework for analyzing the transfer of a debt obligation from a debtor to a creditor are Kniffen 2 and Edwards Motor Transit Co. 3 Arthur Kniffen ran a sole proprietorship and owned a corporation. The sole proprietorship borrowed money from the corporation. For valid business reasons, Kniffen transferred the assets and liabili ties of the proprietorship to the corporation in exchange for stock of the corporation, thereby transferring a debt from the debtor to the creditor. The transaction met the requirements of Sec. 351.

The government argued that the transfer of the debt to the creditor was in fact a discharge or cancellation of the debt (a single step), which should have been treated as the receipt of boot under Sec. 351(b) and taxed currently. The taxpayer argued that the transfer was an assumption of the debt and, based on Sec. 357(a), should not be treated as boot.

The Tax Court acknowledged that the debt was canceled by operation of law. However, it did not accept the government’s argument as to the structure of the transaction. Instead, it determined that two separate steps occurred. First, the corporation assumed the debt. This assumption was covered by Sec. 357(a). After the assumption, the interests of the debtor and creditor merged and the debt was extinguished. Since the transfer was not for tax avoidance purposes, Sec. 357(b) did not apply. The result was a tax-free Sec. 351 transaction, except to the extent that the assumed debt exceeded the bases of the assets transferred, resulting in gain under Sec. 357(c). This decision established the separation of the debt transfer from its extinguishment.

Edwards Motor Transit Co. cites, and is considered to have adopted, the approach in Kniffen . For valid business reasons, the owners of Edwards created The Susquehanna Co., a holding company, and transferred Edwards’ stock to it under Sec. 351. Susquehanna borrowed money from Edwards to meet certain financial obligations. To eliminate problems that arose from having a holding company owning the stock of an operating company, the owners merged Susquehanna into Edwards under Sec. 368(a)(1)(A). The government acknowledged that the basic transaction was a nontaxable merger. However, the government wanted the company to recognize income as a result of the cancellation or forgiveness of the debt. The Tax Court ruled for the taxpayer, on the grounds that the debt transfer (from debtor to creditor) was not a cancellation of the debt. The ruling cited Kniffen as authority for this conclusion.

On its surface, Edwards Motor Transit affirmed the decision and reasoning in Kniffen . The Tax Court stated, “The transfer by the parent corporation of its assets to Edwards [its subsidiary] . . . constituted payment of the outstanding liabilities . . . just as surely as if Susquehanna had made payment in cash.” This statement relied on both Kniffen and Estate of Gilmore. 4 In Gilmore , a liquidating corporation transferred a receivable to its shareholder who happened to be the debtor. In that case, the court ruled the transaction was an asset transfer and not a forgiveness of debt. The court based its conclusion in large part on the fact that no actual cancellation of the debt occurred.

The statement in Edwards Motor Transit quoted above, however, is inapposite to the conclusion in Kniffen . A payment is not a transfer and assumption of a liability. Since Susquehanna was deemed to have used assets to repay the debt, the Tax Court should have required Susquehanna to recognize gain to the extent that the value of the assets used to repay the debt exceeded their bases. The conclusions in Kniffen and Edwards are consistent only in their holdings that these debt transfers were not cancellations of debts that would result in COD income. In Kniffen, the court ruled that the debt was assumed and then extinguished. In Edwards, the court ruled that the extinguishment of the debt constituted repayment.

It is possible that the Tax Court reached the correct outcome in Edwards Motor Transit but for the wrong reason. In Rev. Rul 72-464, 5 a debtor corporation merged into the creditor corporation in a tax-free A reorganization under Sec. 368(a)(1)(A). The ruling concluded that the debtor corporation did not recognize any gain or loss on the extinguishment of the debt within the acquiring corporation. General Counsel Memorandum (GCM) 34902 6 provided the detailed analysis behind the conclusion.

The GCM cited both Kniffen and Edwards 7 and adopted their underlying rationale. Specifically, it concluded that the basic transaction (the reorganization) results in a transfer of the debt to the acquiring corporation. It is after the transfer that the debt is extinguished by the statutory merger of interests. The transfer is an assumption of debt, which is nontaxable under Sec. 357(a). Therefore, the transferor (debtor corporation) recognizes no gain or loss.

This is exactly what happened in Ed wards . The debt was assumed, not repaid. Therefore, the Tax Court should have reached the conclusion that the transaction was nontaxable under Sec. 357(a) and not have relied on the questionable authority of Estate of Gilmore 8 or concluded that the debt was repaid.

Liquidations

The transactions discussed up to this point have been either tax-free corporate formations (Sec. 351) or tax-free reorganizations (Sec. 361). In a different transaction that is likely to occur, the creditor/shareholder liquidates the debtor corporation.

If the transaction is not between a parent and its subsidiary, taxability is determined by Secs. 331 and 336. Prior to 1986, the outcome might have been determined by Kniffen and Edwards . With the repeal that year of the General Utilities 9 doctrine (tax-free corporate property distributions) and the enactment of current Sec. 336, the outcome is straightforward. Under Sec. 336, the debtor corporation that is liquidated recognizes its gains and losses. Whether the liquidated corporation is treated as using assets to satisfy a debt requiring the recognition of gain or is treated as distributing assets in a taxable transaction under Sec. 336, all the gains and losses are recognized.

The taxation of the shareholder is a little more complex. First, the shareholder must determine how much it received in exchange for the stock. The most reasonable answer is that the shareholder received the value of the assets minus any debt assumed and minus the face amount of the debt owed to it by the liquidated corporation. This amount is used to determine the gain or loss that results from the hypothetical sale of stock under Sec. 331. Second, the shareholder must determine what was received for the debt, whether assets or the debt itself. The amount received in payment of the liquidated corporation’s debt is a nontaxable return of capital. If the shareholder is deemed to have received the debt itself, then the debt is merged out of existence. The basis of all the assets received should be their fair market value (FMV) under either Sec. 334(a) or general basis rules.

If the liquidated corporation is a subsidiary of the creditor/shareholder, the results change. Under Sec. 337, a subsidiary recognizes neither gain nor loss on the transfer of its assets in liquidation to an 80% distributee (parent). Sec. 337(b) expands this rule to include distributions in payment of debts owed to the parent corporation. Therefore, the subsidiary/debtor does not recognize any gain or loss.

The parent corporation (creditor) recognizes no gain or loss on the liquidation of its subsidiary under Sec. 332. The basis of the transferred property in the hands of the parent is carryover basis. 10 This carry­over basis rule also applies to property received as payment of debt if the subsidiary does not recognize gain or loss on the repayment. 11 In other words, the gain or loss is postponed until the assets are disposed of by the parent corporation.

One important exception to the nonrecognition rule is applied to the parent corporation. Under Regs. Sec. 1.332-7, if the parent’s basis in the debt is different from the face amount of the debt, the parent recognizes the realized gain or loss (face amount minus basis) that results from the repayment. Since this regulation does not mention any exception to the rules of Sec. 334(b)(1), the parent corporation is required to use carryover basis for all the assets received without adjustment for any gain or loss recognized on the debt.

This discussion of liquidations assumes that the liquidated corporation is solvent. If it is insolvent, the answer changes. The transaction cannot qualify under Secs. 332 and 337. The shareholder is not treated as receiving any property in exchange for stock; therefore, a loss is allowed under Sec. 165(g). The taxation of the debt depends on the amount, if any, received by the shareholder as a result of the debt.

Partnerships

The taxation of debt transfers involving partnerships is determined, in large part, by Secs. 731, 752, and 707(a)(2)(B). Specifically, the taxation of transfers by debtor partners to the creditor/partnership is determined by the disguised sale rules of Sec. 707(a)(2)(B), whereas transfers by debtor partnerships to a creditor/partner fall under Secs. 731 and 752.

Sec. 707(a)(2)(B) provides that a transfer of property by a partner to a partnership and a related transfer of cash or property to the partner is treated as a sale of property. The regulations specify the extent to which the partnership’s assumption of liabilities from the partner is treated as the distribution of the sale price.

Regs. Sec. 1.707-5 divides assumed liabilities into either qualified liabilities or unqualified liabilities. A qualified liability 12 is one that:

• Was incurred more than two years before the assumption;
• Was incurred within two years of the assumption, but was not incurred in anticipation of the assumption;
• Was allocated to a capital expenditure related to the property transferred to the partnership under Temp. Regs. Sec. 1.163-8T; or
• Was incurred in the ordinary course of business in which it was used, but only if all the material assets of that trade or business are transferred to the partnership.

The amount of qualified recourse liabilities is limited to the FMV of the transferred property reduced by senior liabilities. Any additional recourse liabilities are treated as nonqualified debt.

If a transfer of property is not otherwise treated as part of a sale, the partnership’s assumption of a qualified liability in connection with a transfer of property is not treated as part of a sale. The assumption of nonqualified liabilities is treated as sale proceeds to the extent that the assumed liability exceeds the transferring partner’s share of that liability (as determined under Sec. 752) immediately after the partnership assumes the liability. If no money or other consideration is transferred to the partner by the partnership in the transaction, the assumption of qualified liabilities in a transaction treated as a sale is also treated as sales proceeds to the extent of the transferring partner’s share of that liability immediately after the partnership assumes the liability. 13 Following the assumption of the liability, the interests of the debtor and creditor merge, thereby extinguishing the debt. The result is that generally the full amount of these assumed liabilities are part of the sale proceeds. 14

The assumed liabilities that are not treated as sale proceeds still fall under Sec. 752. Since the transaction results in a reduction of the transferor’s personal liabilities, the taxpayer is deemed to have received a cash distribution equal to the amount of the debt assumed under Sec. 752(b). Given that the debt is immediately extinguished, no amount is allocated to any partner. The end result is that the transferor must recognize gain if the liability transferred exceeds the transferor’s outside basis before the transaction, increased by the basis of any asset transferred to the partnership as part of the transaction.

A partnership may have borrowed money from a partner and then engaged in a transaction that transfers the debt to the creditor/partner. The first question is whether the initial transaction is a loan or capital contribution. Sec. 707(a) permits loans by partners to partnerships. The evaluation of the transaction is similar to one to determine whether a shareholder has loaned money to a corporation or made a capital contribution. The factors laid out in Sec. 385 and Notice 94-47 15 should be considered in this analysis.

Assuming the debt is real and it alone is transferred to the creditor/partner, the outcome is straightforward. The partner is treated as having made a cash contribution to the partnership under Sec. 752(a) to the extent that the amount of debt exceeds the amount allocated to the partner under the Sec. 752 regulations. If part of the debt is allocated to other partners, these other partners are treated as receiving a deemed cash distribution.

If the transfer is part of a larger transaction, then the analysis is a little more complex. The transfer of the other assets is governed by Secs. 737, 731, and 751. Sec. 737 requires a partner to recognize gain if, during the prior seven years, the partner had contributed property with built-in gain to the partnership and the current FMV of the distributed property exceeds the partner’s outside basis. The partner is treated as recognizing gain in an amount equal to the lesser of (1) the excess (if any) of the FMV of property (other than money) received in the distribution over the adjusted basis of such partner’s interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution, or (2) the net precontribution gain of the partner. The outside basis is increased by the amount of the deemed contribution because the partner assumed a partnership liability. After any gain under Sec. 737 is determined, the general distribution rules of Secs. 731 and 751(b) apply to the transaction. In effect, the transfer to a creditor/partner of a partnership debt owed to the partner is treated the same as any liability assumed by the partner. The extinguishment of the debt should not result in additional tax consequences.

Creditor-to-Debtor Transfers

In addition to debtor-to-creditor transfers, there are creditor-to-debtor transfers. The outcome of these transactions is determined by the two-step analysis in Kniffen . The creditor is treated as having transferred an asset to the debtor/owner. After the transfer, the interests of the debtor and creditor merge, resulting in the extinguishment of the debt. This extinguishment is generally nontaxable since the basis of the debt and the face amount are equal. 16 The result changes if the basis in the hands of the creditor and the adjusted issue price of the debtor are not equal. 17

One of the initial pieces of guidance that addressed this question was Rev. Rul. 72-464. 18 In this ruling, the debt was transferred in a nontaxable transaction. Consequently, the recipient (the debtor) had a carryover basis in the debt. Since this basis was less than the face amount, gain equal to the difference was recognized. This ruling did not explain the reasoning behind the gain recognition or the potential impact if the value of the debt was different from its basis. 19 These items were addressed in Rev. Rul. 93-7. 20

Rev. Rul. 93-7 analyzed a transaction between a partnership and a partner, here designated P and A , respectively. A was a 50% partner. This percentage allowed A to not be a related party to P under Sec. 707(b). P also had no Sec. 751 assets, and A had no share of P ’s liabilities under Sec. 752. These were excluded because they did not affect the reasoning behind the taxation of debt transfers. A issued a debt with a face amount of $100 for $100. P acquired the debt for $100. When the debt was worth $90, it was distributed to A in complete redemption of its interest, which had an FMV of $90 and outside basis of $25. In other words, a creditor/partnership distributed debt to the debtor/partner.

The debt was an asset, a receivable, in the hands of P . When it was distributed to A , P determined its taxation under Sec. 731(b), which provides that no gain or loss is recognized by a partnership on the distribution of property. The application of Sec. 731(b) in this transaction followed directly from Kniffen , which treated the transfer of a debt as a separate transaction from any extinguishment that follows the transfer. Under Sec. 732, A ’s basis in the transferred debt was $25. 21

The basis rules of Sec. 732 assume that a built-in gain or loss on distributed property is realized and recognized when the recipient disposes of the property. In this situation, the distributed debt was extinguished, and therefore no future event would generate taxable gain or loss. Consequently, this extinguishment became a taxable event. In this specific case, A recognized gain of $65 ($90 FMV – $25 basis) and COD income of $10 ($100 face − $90 FMV.) The ruling did not spell out the reasoning for the recognition of both gain and COD income. It is the correct outcome based on Regs. Sec. 1.1001-2. Under that regulation, when property is used to satisfy a recourse obligation, the debtor has gain equal to the difference between the value of the property and its basis, and COD income equal to the difference between the amount of debt and the value of the property used as settlement. The distributed debt is property at the time of the distribution, and the rules of Regs. Sec. 1.1001-2 should apply.

In Rev. Rul. 93-7, the value of the debt was less than the face amount. A debt’s value could exceed its face amount. In that case, the revenue ruling indicated, a deduction for the excess value may be available to the partner as a result of the deemed merger. In Letter Ruling 201105016, 22 the IRS ruled that a taxpayer was entitled to a deduction when it reacquired its debt at a premium as part of a restructuring plan. Rev. Rul. 93-7 cited Regs. Sec. 1.163-4(c)(1), and Letter Ruling 201105016 cited Regs. Sec. 1.163-7(c). Both regulations state that the reacquisition of debt at a premium results in deductible interest expense equal to the repurchase amount minus the adjusted issue price. Regs. Sec. 1.163-4(c)(1) applies to corporate taxpayers, while Regs. Sec. 1.163-7(c) expanded this treatment to all taxpayers. Based on these regulations and the treatment of the distribution as an acquisition of a debt, an interest expense deduction should be permitted when the value exceeds the amount of debt, whereas COD income is recognized when the value is less than the amount of the debt.

In Rev. Rul. 93-7, the partnership was the creditor, and the debt was transferred to a debtor/partner. The reverse transaction can occur, in which a creditor/partner transfers debt to the debtor/partnership in exchange for a capital or profits interest. Sec. 721 applies to the creditor/partner. Therefore, no gain or loss is recognized. However, Sec. 108(e)(8)(B) applies to the debtor/partnership. Sec. 108(e)(8)(B) provides that the partnership recognizes COD income equal to the excess of the debt canceled over the value of the interest received by the creditor. This income is allocated to the partners that owned interests immediately before the transfer. The partnership does not recognize gain or loss (other than the COD income) as a result of this transaction. 23 The value of the interest generally is determined by the liquidation value of the interest received. 24 If the creditor receives a profits interest, the liquidation value is zero, and therefore the partnership recognizes COD income equal to the amount of debt transferred.

Corporate Transactions

Debt transfers between corporations and shareholders are just as likely as transfers between partners and partnerships. If the transferor is a shareholder or becomes a shareholder as a result of the transaction, Secs. 1032, 118, and 351 provide basic nontaxability. However, Sec. 108 overrules these sections in certain cases.

If the shareholder transfers the debt to the corporation as a contribution to capital, Sec. 108(e)(6) may result in the recognition of COD income by the corporation. Under Sec. 108(e)(6), the corporation is treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness. Therefore, the corporation has COD income amount equal to the excess of the face amount of the debt over the transferor’s basis in the debt immediately prior to the transfer. In most cases, the face and basis are equal, and no COD income is recognized. If the transfer is in exchange for stock, Sec. 108(e)(8)(A) provides that the corporation is treated as having satisfied the indebtedness with an amount of money equal to the FMV of the stock. Therefore, the corporation recognizes COD income equal to the excess of the face value of the debt over the value of the stock received. In many cases, the value of the stock is less than the debt canceled, and therefore COD income is recognized. Sec. 351 provides that 80% creditor/shareholders recognize neither gain nor loss if the debt is evidenced by a security. If Sec. 351 does not apply, the creditor/shareholder may be able to claim a loss or bad-debt deduction.

Rev. Rul. 2004-79 25 provides a detailed analysis of the transfer of debt from a creditor corporation to a debtor shareholder. The analysis is similar to the one for partnership distributions covered by Rev. Rul. 93-7, discussed previously.

Modifying the facts of Rev. Rul. 2004-79, assume that a shareholder borrows money from his corporation. The face amount of the debt is $1,000, and the issue price is $920. The original issue discount (OID) of $80 is amortized by both the corporation and the shareholder. At a time when the adjusted issue price and basis are $950 but the FMV is only $925, the corporation distributes the debt to the shareholder as a dividend.

From the corporation’s point of view, this is a property dividend. Rev. Rul. 2004- 79 cites Rev. Rul. 93-7, but it could just as easily have cited Kniffen . As a property dividend, the transaction’s taxa tion to the corporation is governed by Sec. 311. Since the value in the revenue ruling was less than the basis, the corporation recognized no gain or loss. If the value had appreciated, the corporation would have recognized gain equal to the appreciation.

The shareholder receives a taxable dividend equal to the value of the debt; consequently, the debt has a basis equal to its FMV of $925. Since the debt is automatically extinguished, the shareholder is treated as having satisfied an obligation in the amount of $950 with a payment of $925. Therefore, the shareholder must recognize $25 of COD income.

A second fact pattern in the revenue ruling is the same, except the value of the distributed debt is $1,005. Under these facts, the shareholder would be entitled to an interest expense deduction under Regs. Sec. 1.163-4 or 1.163-7 in the amount of $55 ($1,005 − $950). In other words, the shareholder is deemed to have reacquired its own debt for a payment equal to the basis that the distributed debt obtains in the transaction.

The conclusions of Rev. Rul. 2004-79 are consistent with those in Rev. Rul. 93-7. They follow the reasoning of Kniffen .

Another transaction that could occur involving shareholder debt is a liquidation of the corporation, resulting in a distribution of the debt to the debtor/shareholder. The results should be similar to those in Rev. Rul. 2004-79. The corporation that distributes the debt is taxed under Sec. 336. Therefore, the corporation recognizes gain or loss depending on the basis of the debt and its FMV. This is the same result as in the dividend case, except that the loss is recognized under Sec. 336 instead of being denied under Sec. 311. The shareholder’s basis in the debt is its FMV under Sec. 334(a). The shareholder recognizes COD income or interest expense, depending on whether the basis is less than or greater than the adjusted issue price of the debt. These results flow from the regulations under Secs. 61 and 163 and are consistent with the conclusions in the above revenue rulings.

The results change slightly if the liquidation qualifies under Secs. 332 and 337. The IRS discussed these results in Chief Counsel Advice 200040009. 26 Sec. 332 shields the parent from recognition of income on the receipt of the debt. Sec. 337 shields the liquidating corporation from recognizing gain or loss on the transfer of the debt to its parent corporation. The basis is carryover basis under Sec. 334(b). Then, because the debt is extinguished, the parent recognizes either COD income or interest expense on the extinguishment of the debt. As in the prior revenue rulings and Kniffen , the extinguishment has to be a taxable event because the elimination of the carryover basis prevents the parent corporation from having a taxable transaction in the future involving this debt. These results are consistent with prior decisions.

The results discussed for a parent/subsidiary liquidation should also apply if the debtor/corporation acquires a corporation that owns its debt in a nontaxable asset reorganization. In this case, Sec. 361 replaces Secs. 332 and 337. The extinguishment of the debt is a separate transaction that should result in recognition of income or expense.

Acquired Debt

So far, this article has discussed transactions between the debtor and creditor. Now it turns to how the holder of the debt acquired it. In many cases, the holder acquired the debt directly from the debtor, and the acquisition is nontaxable. In other situations, the debt is outstanding and in the hands of an unrelated party. The holder acquires the debt from this unrelated party. In these cases, Sec. 108(e)(4) may create COD income.

Under Sec. 61, if a debtor reacquires its debt for less than its adjusted issue price, the debtor has COD income. Sec. 108(e)(4) expands on this rule: If a party related to the debtor acquires the debt, the debtor is treated as acquiring the debt, with the resulting COD income recognized. Related parties are defined in Secs. 267(b) and 707(b)(1).

The regulations provide that the acquisition can be either direct or indirect. A direct acquisition is one by a person related to the debtor at the time the debt is acquired. 27 An indirect acquisition occurs when the debtor acquires the holder of the debt instrument, where the holder of the debt acquired it in anticipation of becoming related to the debtor. 28 The determination of whether the holder acquired the debt in anticipation of becoming related is based on all the facts and circumstances. 29 However, if the holder acquires the debt within six months before the holder becomes related to the debtor, the acquisition by the holder is deemed to be in anticipation of becoming related to the debtor. 30

In the case of a direct acquisition, the amount of COD income is equal to the adjusted issue price minus the basis of the debt in the hands of the related party. In the case of indirect acquisitions, the calculation depends on whether the debt is acquired within six months of being acquired. 31 If the holder acquired the debt within six months of being acquired, the COD income is calculated as if it were a direct acquisition. If the holder acquired the debt more than six months before being acquired, the COD income is equal to the adjusted issue price minus the FMV of the debt instrument on the date that the holder is acquired.

When a debtor reacquires its own debt, in addition to reporting COD income, the debtor has the debt extinguished as a result of the merger of interests. When a related party acquires the debt, the debtor has COD income, but the debt remains outstanding. In these cases, the debtor is treated as issuing a new debt instrument immediately following the recognition of the COD income for an amount equal to the amount used to calculate the COD income (adjusted basis or FMV 32 ). If this issue price is less than the stated redemption price at maturity of the debt (as defined in Sec. 1273(a)(2), the difference is OID that is subject to the amortization rules of Sec. 1272.

Rev. Rul. 2004-79 provides a simple example of this transaction. In the ruling, a parent corporation, P , issued $10 million of debt for $10 million. After issuance, S , a subsidiary of P , purchased the debt for $9.5 million. Under Regs. Sec. 1.108-2(f), P had to recognize $500,000 of COD income ($10 million face − $9.5 million basis to S ). After this recognition, P was treated as having issued the debt to S for $9.5 million. Therefore, $500,000 of OID was amortizable by P and S . If S later transfers the debt to P , the previously discussed rules determine the taxation of the transfer using S ’s basis ($9.5 million + amortized OID).

Secs. 61 and 108(e)(4) apply only if the debt is acquired for less than the adjusted issue price. If the acquisition price is greater than the adjusted issue price, the acquiring party treats this excess as premium and amortizes it, thereby reducing the amount of interest income recognized by the holder.

Installment Obligations

An installment obligation differs from other obligations in that the holder recognizes income when cash is collected in payment of the obligation. The rules describing the taxation of installment obligations were rewritten as part of the Installment Sales Revision Act of 1980, P.L. 96-471. Under old Sec. 453(d) (new Sec. 453B(a)), if the holder of an installment obligation distributes, transmits, or disposes of the obligation, the taxpayer is required to recognize gain or loss equal to the difference between the basis in the obligation and the FMV of the obligation. There is an exception to this rule for distributions in liquidation of a subsidiary that are exempt from taxation under Sec. 337.

Prior to the Code revision, the regulations permitted the transfer of installment obligations without gain recognition if the transaction was covered by either Sec. 721 or 351. 33 Although the regulations have not been revised for the Code change, the IRS continues to treat Secs. 721 and 351 as overriding the gain recognition provision. 34

If the transaction results in transfer of the obligation either from the creditor to the debtor or from the debtor to the creditor, the tax result changes. The seminal case is Jack Ammann Photogrammetric Engineers, Inc. 35 In it, the taxpayer created a corporation to which he contributed $100,000 in return for 78% of the corporation’s stock. He then sold his photogrammetry business to the corporation for $817,031. He received $100,000 cash and a note for $717,031. He reported the sale under the installment method. When he was still owed $540,223 on the note, he transferred it to the corporation for stock of the corporation worth $540,223. He reported this as a disposition under Sec. 453(d) and recognized the deferred gain. Later, he filed a claim for refund, arguing that Sec. 351 prevented recognition of the deferred gain. After allowing the refund, the IRS assessed a deficiency against the corporation, arguing that the corporation came under Sec. 453(d). The corporation argued that, under Sec. 1032, it was not taxable. The Tax Court ruled for the IRS.

The Fifth Circuit reversed the decision. The underlying reasoning was that the disposition by the shareholder and the extinguishment of the debt in the hands of the corporation were separate transactions. The extinguishment did not fall under Sec. 453(d). The court indicated that the IRS should have assessed the tax against the shareholder.

Following this case, the IRS issued Rev. Rul. 73-423. 36 In this ruling, a shareholder transferred an installment obligation from Corporation X back to the corporation in a transaction described in Sec. 351. The ruling concluded that the transfer was a satisfaction of the installment agreement at other than face value under Sec. 453(d)(1)(A) and that the shareholder was required to recognize gain without regard to Sec. 351. The corporation had no gain or loss under Sec. 1032 and Ammann .

Sec. 453(d) is now Sec. 453B(a), and the rule has not changed. Therefore, if a creditor transfers an installment obligation to the debtor in an otherwise tax-free transaction, the obligation is treated as satisfied at other than its face value, and the creditor is required to recognize gain or loss as discussed in Rev. Rul. 73-423. 37

New Sec. 453B(f) covers transactions in which installment obligations become unenforceable. This section covers the extinguishment of an installment debt through a merger of the rights of a debtor and creditor. The Code treats these transactions as dispositions of the obligation with gain or loss recognized. When the debtor and creditor are related, the disposition is at FMV but no less than the face amount.

If the debtor of an installment obligation engages in a transaction in which the creditor assumes the debt, the results are consistent with those of transactions involving obligations other than installment notes. The debtor is deemed to have received cash equal to the amount of the debt. This is fully taxable unless exempted by Sec. 357, 721, or a similar provision. The creditor falls under Sec. 453B(f), with the extinguishment treated as a taxable disposition of the obligation for its FMV (which for related parties is no less than the face amount).

Business entities often incur debts to their owners, and, conversely, the owners incur liabilities to their business entities. In numerous transactions these obligations are canceled for consideration other than simple repayment of the debt. Based on Kniffen , these transactions are treated as a transfer of consideration followed by an extinguishment of the debt. If a shareholder’s debt to his or her controlled corporation is transferred to that corporation along with assets, the transaction may be tax free under Secs. 351 and 357(a). If a shareholder/creditor receives the related corporate debt in a distribution or liquidation, Sec. 311 or 336 determines the corporation’s taxation.

The cancellation of a partner’s debt to the partnership is generally governed by the distribution rules, including the constructive sale or compensation rules of Sec. 707(a)(2). When a partner cancels the partnership’s debt, the partner has made a contribution to capital. This can have consequences to all partners since the total liabilities are decreased and the partners’ bases are decreased under Sec. 752.

In most cases the merger of debtor and creditor interests is nontaxable. However, if the basis of the debt or receivable does not equal the face amount of the debt, income or loss is recognized. The exact amount and character of the income or loss depends on factors discussed in this article. It is important for the tax adviser to identify those cases in which the debt transfer is not tax free.

1 Invalid loans to shareholders have been reclassified as dividends.

2 Kniffen , 39 T.C. 553 (1962).

3 Edwards Motor Transit Co. , T.C. Memo. 1964-317.

4 Estate of Gilmore , 40 B.T.A. 945 (1939).

5 Rev. Rul. 72-464, 1972-2 C.B. 214.

6 GCM 34902 (6/8/72). The GCM also refers to Sec. 332, which will be dis cussed later.

7 As the GCM points out, by using Sec. 357(a), taxpayers could achieve the same outcome in C reorganizations.

8 See Chief Counsel Advice 200040009 (10/6/00), which suggests Estate of Gilmore ’s requirement of a formal cancellation of debt before COD income is recognized may no longer be valid.

9 General Utilities & Operating Co. v. Helvering , 296 U.S. 200 (1935).

10 Sec. 334(b)(1).

12 Regs. Sec. 1.707-5(a)(6).

13 If the partnership transfers money or other consideration in the transaction, the amount treated as sales proceeds may be limited under Regs. Sec. 1.707-5(a)(5)(i)(B).

14 Under Regs. Sec. 1.707-5(a)(3)(ii), a partner’s share of liabilities is reduced by liabilities assumed that are anticipated to be reduced. Based on Kniffen and Edwards , the reduction will be anticipated.

15 Notice 94-47, 1994-1 C.B. 357.

16 See, e.g., IRS Letter Ruling 8825048 (3/23/88).

17 The transaction that gives rise to the difference and the taxation that results are discussed later.

18 Rev. Rul. 72-464, 1972-2 C.B. 214. Although this is a debtor-to-creditor transfer, the result is the same.

19 See GCM 34902 (6/8/72).

20 Rev. Rul. 93-7, 1993-1 C.B. 125.

21 If the partnership makes a Sec. 754 election, the partnership has a Sec. 734 adjustment of $75 ($100 inside basis – $25 basis after distribution).

22 IRS Letter Ruling 201105016 (2/4/11).

23 Regs. Sec. 1.108-8, effective Nov. 17, 2011.

24 See the Regs. Sec. 1.108-8(b)(2) safe-harbor rule.

25 Rev. Rul. 2004-79, 2004-2 C.B. 106.

26 CCA 200040009 (10/6/00).

27 Regs. Sec. 1.108-2(b).

28 Regs. Sec. 1.108-2(c)(1).

29 Regs. Sec. 1.108-2(c)(2).

30 Regs. Sec. 1.108-2(c)(3).

31 Regs. Secs. 1.108-2(f)(1) and (2).

32 Regs. Sec. 1.108-2(g).

33 Regs. Sec. 1.453-9(c)(2).

34 See IRS Letter Rulings 8824044 (3/22/88) and 8425042 (3/19/84).

35 Jack Ammann Photogrammetric Engineers, Inc. , 341 F.2d 466 (5th Cir. 1965), rev’g 39 T.C. 500 (1962).

36 Rev. Rul. 73-423, 1973-2 C.B. 161.

37 Although this revenue ruling involved a corporation, the IRS believes the same rule applies to partnerships. Treasury is currently working on a revision of the regulations to clarify the results. See the preamble to Regs. Sec. 1.108-8, T.D. 9557 (11/17/11).

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