Sidney DeLong, Taxing the Transition from Status to Contract, Part II
Taxing the Transition from Status to Contract in Family Relations, Part II
Sidney W. DeLong
This is the second of a four-part blog post. Part I introduced the relation of status and contract and introduces some basic income tax rules as they relate to intra-family wealth transfers. Today’s post shows how creating contracts with consideration between family members can convert non-taxable gifts into taxable income and capital gains into ordinary income. Part III analyzes the income tax effects of recovery under theories of promissory estoppel and restitution. Part IV shows how intrafamily contracts can lead to income splitting and double taxation, with both positive and negative tax effects. It also discusses the risk of converting non-taxable imputed income into taxable income.Consider some of the income tax implications of the following examples drawn from or inspired by classic first-year contracts cases.
Contracts for Consideration:
However, if Mother failed to do as promised and they sued her estate for breach of contract, daughter and son-in-law would be required to show that her promise was not a gift promise but was enforceable as a contract. Their services rendered in compliance with her requests constituted consideration for the promised bequest, regardless of their market value.
But recharacterizing the bequest from gift into payment for a contract performance changes the tax result. As payment for services rendered during her lifetime, the market value of the farm at Mother’s death might be fully taxable to the daughter and son-in-law as ordinary income.
The law of offer and acceptance suggests that a conditional bequest made in a will might also be construed as an offer for a unilateral contract. The following scenarios are suggested by the facts in Davis v Jacoby 34 P.2d 1026 (Cal. 1934). Suppose Uncle tells Niece, “In consideration of your caring for my wife and operating my business, I will leave you $100,000 in my will.” Whether it is construed as an offer for a unilateral or bilateral contract, and whether Niece is given the promised bequest or must recover it in a breach of contract action against Uncle’s estate, the $100,000 will not be taxed as a gift but as ordinary income. But what if the proposal appears for the first time in Uncle’s will? Does making the contract payment into a legacy make it a tax-free gift? Or does the will make an offer that Niece can accept by performing what was requested after the offeror’s death? By making the legacy into the performance of an exchange promise, Uncle might inadvertently have converted a tax-free legacy into taxable income to Niece.
If the legacy consists of appreciated capital assets, such a transaction also threatens the decedent with liability for capital gains that would otherwise have been avoided by retaining the property until death. Brackenbury and Davis each assume the form of a legacy but could easily be construed by the IRS as an inter-vivos sale of the property by the decedents to the “legatees.” The “sellers” might be liable for capital gains (measured by the value of the services received for the property) while the “buyers” will be taxed at ordinary income rates on the entire value of the farm, as compensation received for their services. This result would be avoided by simply leaving the appreciated property to the legatees as a gratuitous gift. The bad tax result stems from recasting a non-taxable gratuitous transfer as an arms’ length exchange.
But if the values are too far out of line, family promises supported by consideration may not transform a gift fully into taxable income. Consider some variations on the facts in Hamer v Sidway, 27 N.E. 256 (N.Y. 1891). Assume first that Uncle promised a “gift” of $5000 to Nephew on condition that he refrain from drinking, smoking, and playing cards for money until he was 21. If Uncle then paid $5000 to Nephew upon his fulfilling the conditions, the payment would not be taxable because it is a gift.
Now assume instead that Uncle promised Nephew that he would pay him $5000 in consideration for Nephew refraining from drinking, smoking, and playing cards for money until he was 21. If Nephew fulfilled the conditions and earned the money for his services, the payment would be taxable ordinary income to Nephew so long as the IRS construed it to be payment for services rendered by Nephew to the Uncle. Just as the services were the “price of the promise” under the doctrine of consideration, the promise was the price demanded for the services.
But Nephew might argue that the greater part of the payment was a gift, despite his having given consideration for it. Uncle characterized the payment as a “gift,” and $5000 is clearly excessive as the reasonable or arm’s length price of his abstinence. Nephew would emphasize the substance of the transaction over its form. If that argument succeeds, Nephew might owe income tax only on the “real” consideration and not on the balance. It does not matter that the law of consideration ignores the value of the consideration so long as a bargain is present. The substance-over-form argument that fails in the law of consideration succeeds in a tax law that is driven by different policies.
Brackenbury, Davis,, and Hamer illustrate one tax risk of changing status relationships into contract relationships. Non-taxable gifts can be converted into taxable income to the recipients when gift transactions are recharacterized as contracts with consideration. In other cases, if appreciated property is used to pay intrafamilial debt, what would otherwise have been taxed as capital gains is converted into ordinary income, taxed at higher rates. This risk also arises in divorce proceedings where appreciated property is divided pursuant to agreement. Family lawyers are aware of tax law and the ways to avoid these outcomes.
Performance of an unenforceable promise to pay may be considered to be “gratuitous” and a “gift” under contract law and yet not constitute a “gift” under income tax law. For example, a promise to pay a benefactor for services previously performed by the promisee is unenforceable in the absence of unjust enrichment. Restatement (Second) of the Law: Contracts § 86 (2). But if the promisor performs the promise, would the payment constitute a non-taxable gift to the promisee or would it be instead taxable compensation received by the promisee in exchange for the earlier service? In all likelihood, tax liability will not depend on whether the promise was not legally enforceable when made. Otherwise parties could evade tax liability for by recharacterizing taxable ordinary income as voluntary non-taxable gifts. Parties could avoid taxes on sales by making reciprocal gifts. The substance-over-form argument that fails in the law of consideration succeeds in tax law that is driven by different policies.