There’s a basic rule that you can’t escape tax on income that you have a right to receive by assigning it to someone else without first paying the tax on that income. The IRS labels this restriction the “fruit of the tree” principle.
It evolved out of a case in which a father tried to transfer some income to his son without first having paid tax on it. The strategy seemed a good idea because the father was taxed at a much higher rate than the son.
But the US Supreme Court ruled that “the fruit of the tree cannot fall far from the tree on which it was grown.” What the court meant was that once income has been earned, you can’t avoid tax on it by transferring it to another person.
For example, you can’t shift tax on a winning lottery or sweepstakes ticket by giving all or part of it to another person after the winning draw. To shift tax, you must be able to show that you made a valid assignment of all or part of it before it became a winning ticket.
An IRS ruling shows how a winner successfully shifted income. It seems that Rudolph and Flavia were longtime, unmarried acquaintances who lived with her parents. Rudolph’s income came from occasional manual labor; Flavia’s from Aid to Families with Dependent Children payments for two children of a prior marriage. The two of them pooled all of their meager cash by keeping it in her purse and she disbursed funds as needed.
On their lucky day, they shopped at a convenience store. Flavia gave him some money from her purse to buy food and an additional $2 to buy a lottery ticket. Rudolph bought the groceries and a ticket, which he put in his coat pocket. Later, upon becoming aware that he held a winning ticket, he gave it to Flavia, who put it in her purse for safekeeping.
Then things got complicated. To collect the prize, the back of the ticket had to be signed and sent to the State Lottery Commission. Flavia signed it and asked for the first installment to be split equally between her and Rudolph. But the couple was told that the commission’s regulations allowed the winnings to be paid to only one person.
To get around that stipulation, they signed an equal-ownership agreement, effective before the ticket’s purchase date, and designated a manager to receive and disburse the payment to each of them. That arrangement prompted the IRS to consider an arcane question: Had Rudolph, the ticket’s purchaser, become liable for gift taxes because he made a gift to Flavia either by (1) giving the winning ticket to her to keep in her purse, or (2) signing the agreement?
No, concluded the IRS, given the particular scenario. The couple always had pooled their funds to buy necessities and occasionally tickets. They saw themselves as the owners of equal interests in the winning ticket from the time Flavia gave Rudolph the $2 to buy it.
All that the two did was formalize their previous understanding when they signed the agreement; they made it because the commission’s regulations permitted payment to only one person.
Result: No gift tax liability and Rudolph shifted half of the tax from himself to Flavia (Ruling 9217004).
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