Sidney DeLong, Taxing the Transition from Status to Contract, Part I
Taxing the Transition from Status to Contract in Family Relations
Sidney W. DeLong
PART I
Transformation of informal family relationships and transactions into formalized, contractual relationships and transactions can jeopardize the favorable treatment enjoyed by families under the Internal Revenue Code. Many of the cases appearing in contracts casebooks in which family members enter into contracts with each other may inadvertently incur income tax liabilities. Even first year law students should be warned that tax advice is always wise when they’re contemplating intrafamilial wealth transfer’s and similar contracts.
In the Nineteenth Century, legal historian Henry Maine famously observed that the progress of modern societies was from status to contract. Maine had in mind the replacement of feudal relationships with contractual employment relationships. But the modern world recognizes status primarily in the law relating to family relationships. As Maine might have foreseen, the Twentieth Century has seen a continuous progress from status to contract in the legal relationships between spouses and between parents and children. Viewed cynically, family law has become only a set of default rules that can be displaced by different agreements that reflect the relative bargaining power of spouses and other family members.
These agreements usually affect property ownership or wealth transfers. Contract cases demonstrate that, e.g., caregiving may be secured by promises by which wealthy relatives procure the services of younger ones, family property may be transferred by contract rather than by inheritance, and spousal obligations of support may be formalized in pre- and post-nuptial agreements. These formalized family arrangements remain largely invisible to the courts, however, until the underlying relationships come apart, the promises are breached, and a legal dispute arises. Cases in the Contracts canon show that death or divorce will often occasion a day of reckoning in which unfulfilled promises made in informal settings become the basis of legal claims against decedents’ estates and separating spouses.
Oddly, the legal domain in which “status” continues to have the most material significance in the lives of family members is tax law. Many features of tax law are designed to preserve the intact family from the vicissitudes of the marketplace. Tax law sharply divides activities into non-taxable status behavior and taxable contractual exchanges. Wealth transfers that would be taxable under the Tax Code are often tax free if they are between parties to filial and spousal relationships, as intra-familial gifts are shielded from the taxes that would be assessed against market transactions. However, this status-based protection may be inadvertently lost as a result of intra-family contract litigation based on the consideration doctrine, promissory estoppel, or restitution.
Moving from status to contract by creating intra-familial contracts can subject the parties to several income tax risks: the conversion of non-taxable gifts into taxable income; the double-taxation of income that has already been taxed; the conversion of non-taxable “imputed income” into taxable income; and the conversion of capital gains into ordinary income taxable at higher rates.
The following discussion is designedly non-technical and is intended only to be suggestive. It does not constitute tax advice and should not be relied upon for any purpose. Caveat lector.
Some tax basics. As a general rule . . . .
Money received in exchange for services or for the sale of most property is taxable to the recipient as ordinary income. If the recipient receives property other than money, it is taxable as ordinary income at its fair market value. Money that a taxpayer expends in order to earn such ordinary income is usually deductible from income, so that the recipient is taxed only on net income received. A business that expended $125,000 in order to generate $100,000 in receipts has no taxable income for that year.
Accessions to wealth that do not arise from transactions with other persons but that are generated by the taxpayer’s own labor do not constitute taxable income. However, if the products of one’s labor are sold or exchanged, the proceeds will be taxable. Examples of imputed income are given below.
Money or property received in exchange for property that has been held for a long time is usually taxable to the recipient at the lower tax rates applied to capital gains and even then, only to the extent that the value of the receipts exceeds the recipient’s cost. If I buy an acre of land for $10,000 and sell it for $15,000 after holding it for six years, I will owe capital gains tax of 15% on $5,000 worth of capital gains, not on the full $15,000.
Money or property received as a gift or a bequest is not taxable to the recipient. (The donor or estate may owe a tax on the value of the property transferred, but this post does not concern gift or estate tax liability.) In determining whether money is received as income or as a gift, tax liability will depend on the substance rather than the form of the transaction. A purported bequest that is actually payment for services may be taxable to the recipient as ordinary income and may be deductible by the payer. Conversely, a purported payment for services that is actually a gift may not be taxable to the recipient and may not be deductible as a business expense by the donor.
Property that has increased in value and that is sold during the lifetime of the owner subjects the seller to capital gains tax on increase in value (sales price minus seller’s “basis”). The buyer of appreciated property is not taxed but takes a basis in the property equal to what it paid, for purposes of computing its own capital gains on later resale.
By contrast, appreciated property that is given away during the lifetime of the owner is not taxable to either party at the time of the gift. However, the donee takes the donor’s basis for purposes of computing its own capital gains on later resale.
Finally, and most importantly, appreciated property that is held at the death of the owner and inherited by a legatee is taxed to neither the estate nor the transferee. It escapes capital gains tax altogether. The legatee takes a “stepped-up” basis in the property equal to its value at the time of the inheritance.
To illustrate these principles, consider this example. Owner buys a farm for $50,000. During owner’s lifetime, the farm appreciates to the value of $750,000. Owner then dies, leaving the farm by to Legatee, who immediately sells the property for $750,000. Legatee owes no income tax on the $750,000 of the farm upon its receipt. Neither Owner’s estate nor Legatee owes capital gains tax on the $700,000 appreciation.
By contrast, if Owner had given the farm to Legatee during Owner’s lifetime and Legatee had then sold the farm, Legatee would owe no income tax on the gift, but would owe capital gains tax on the $700,000 because it would have taken the donor’s basis.
Finally, in the worst case scenario, if during Owner’s lifetime, Owner exchanged the farm for money, goods, or services provided by the Legatee, Owner would owe capital gains on the amount by which value of the consideration received exceeded the Owner’s cost basis in the farm. Legatee would owe ordinary income tax on $750,000, less any deductions it can show.