Sidney DeLong, Taxing the Transition from Status to Contract, Part IV

Taxing the Transition from Status to Contract in Family Relations, Part IV

Sidney W. DeLong

This is the final installment 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. Part II hows 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. Today’s post 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.

PART IV

The risk of double taxation and the benefit of income splitting.

To the extent that the taxable judgments obtained in both Pyeatte and Watts are paid out of funds that had already been subject to federal income taxation, they also illustrate the risk of double taxation. The risk of double taxation is related to the conversion of gifts into taxable income and arises primarily in family settings. In its simplest form, A earns taxable income and, after paying taxes on it, pays part of that income to B, who takes it as income on which B must also pay tax. Both A and B have paid income tax on the same dollars. If A had simply given the money to B, it would have been taxed only once. The total tax paid by A and B will be greater than the tax paid by A.

But splitting income between A and B may lower the total tax if the amount paid by B will be deducted from A’s income. A will not pay any tax on the dollars A receives that are paid to B. If B’s marginal tax rate is less than A’s, the total tax paid by A and B will be less than the tax would have been paid by A.

Thus, whether family taxpayers will suffer from double taxation (bad) or benefit from income splitting (good) turns on whether the payment to B is deductible as a business expense by A. Here, as always, substance will dominate form. A parent who pays a fake wage to a child will create double taxation because the payment will not be deductible. A parent who pays a real wage to a child for real work done in the business that earned the parent’s income will be able to deduct the wage and reduce the family’s overall tax burden.

Double taxation and income splitting are related to the concept of imputed income. Taxpayers are not taxed on the value of the unsold benefits of their own labor. The normal contributions of family members to each other in the form of labor and other services are not taxable as they would be if they were exchanged for like services with outsiders. The value of child-care, housekeeping, maintenance, vegetable gardening, and the like are not taxable income to the recipients. The tax treatment of imputed income extends to the taxation of family businesses, including subsistence farms and restaurants, which often employ children and spouses in an enterprise whose net income will be taxable. Although such family contributions to the enterprise is non-taxable imputed income, the family may choose instead to formalize the relationship by paying a wage to the family worker. Because such wages will be deductible to the family’s taxable income, payment of family members will lower overall taxes by splitting the income between two taxpayers (the child and the primary taxpayer).  

Tax burdens usually attend the conversion of imputed into taxable income when divorce splits a family or family-like unit. Settling up may be a taxable event in which income is “recognized” by the IRS. Imputed income may be converted into ordinary income when a divorcing spouse receives compensation for housekeeping and other services as part of the settlement. Thus, in Watts and Pyeatte, the imputed income generated by years of unpaid household services was recognized and compensated in cash, but the award may have been diminished by tax liability to the recipient.

Conclusion

The movement from status to contract in family relationships is sometimes seen as empowering, as a liberation from patriarchal, tradition-bound ways of life and an emergence into the autonomy of the marketplace. But family status is currently encouraged, protected, and rewarded by American tax law, where informal sharing is tax-free. When family members renounce their family status and opt into contractual relations, they may simultaneously, if inadvertently, assume the new status of individual tax-payers with unintended tax liability.