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Having a Love Affair Can Be Taxing

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Jul 27th 2015
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Stand-up comedienne Paula Poundstone quipped that “The wages of sin are death, but by the time taxes are taken out, it's just sort of a tired feeling.”

Contrary to the assumption of that one-liner, not all sinners get nicked for taxes. But it often proves difficult to sort out which transgressors do and which ones don't have to settle accounts with the government because the Internal Revenue Code stipulates disparate treatment for compensation and gifts. Code Section 61 clearly mandates that entrepreneurial types who seek compensation for their efforts must declare their rewards. Compare that requirement with Code Section 102, which states that those who are just chance recipients of gifts needn't count their booty as reportable income.

Given the different treatments and because of the purposely sparse wording of sections 61 and 102, the IRS and the courts have their work cut out. Section 61's mile-wide definition of income entitles the government to share in “all income from whatever source derived.” That definition includes “compensation for services,” says Section 61(a)(1). But other provisions allow many forms of income to escape taxes – partly or completely. In particular, Section 102 says that the term “income” doesn't include money or other assets received as “gifts.”

What distinguishes nontaxable gifts from taxable compensation for services rendered? According to the US Supreme Court, gifts are something given out of “detached and disinterested generosity” or “affection, respect, charity, or like impulses.” It applied this definition in 1960 in a gift-versus-income dispute involving a high-up in the Teamsters Union, who was deluged with presents at a testimonial dinner.

But in the aforementioned case, the Supreme Court was dealing with comparatively clear-cut circumstances. Other real-life situations don't always fall conveniently into place. This largely accounts for why the lower courts continually have to resolve vexing wrangles about whether cash and other items ought to be characterized as gifts or as compensation for services rendered. Not unexpectedly, that's the key issue in disputes that pit the IRS against female recipients (no male recipients in the cases decided so far) of currency, cars, dwellings, fur coats, gems, and other goodies from benefactors other than their husbands or family members.

A lawsuit underscores just how tricky the rules can be. It took only a couple of weeks after Byrnece Green met wealthy Boston businessman Maxwell Richmond for them to fall in love and become engaged. But 10 months later, Maxwell begged Byrnece to end the engagement because he had “a mental problem about marriage.” His solution: Sidestep the legal ceremony and just live together. In return for doing that, he promised to leave her “everything.”

The arrangement was a good deal for Maxwell, as Byrnece was both loyal to the nth degree and savvy. Besides holding down a job as a stockbroker, she did a daily market report on a Boston radio station owned by Maxwell and advised him on his business affairs and investments – chores that were just for starters. Byrnece also monitored his diet, cared for him during illnesses, and accompanied him on business trips and social engagements.

Maxwell somehow never got around to showing his will to Byrnece, but assured his inamorata that it provided for her. They were inseparable for nine years, until Maxwell's death. That was when she first became aware of a will that left Mr. Right's entire $7 million estate to his brother and sister.

Byrnece's understandable response was to sue his estate for the value of services she rendered to him in reliance on his promise. After a jury trial and appeal, she settled with the estate for $900,000. At tax time, her 1040 was accompanied by a note explaining that the $900,000 was a nontaxable gift or bequest from Maxwell, as all that she had performed were “wifely services.” The reply from the IRS came in the form of a bill for taxes – an assessment upheld by the Tax Court and, on appeal, the US Court of Appeals for the Second Circuit. The Tax Court's reasoning: “The taxability of the proceeds of a lawsuit depends ... upon the nature of the claim.” Byrnece based her claim on the value of her services. Hence, the $900,000 was clearly taxable income.

About the author:
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from “Julian Block's Year Round Tax Strategies,” available at julianblocktaxexpert.com.

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