If a divorce separation agreement directs part of a partner's accrued partnership income to be paid directly to his ex-wife, does he still have to report that amount as his own income for New York tax purposes?

Plain-English summary

Mitchell M. Gitin was owed $1,760,920 as his partnership share of income from his former partnership, an amount that accrued while he was still a partner and was payable in 16 equal quarterly installments. Under a 1992 separation agreement with his former wife, Rena Gitin, Rena was to receive $713,333 of that amount - 40.5% of the total - also in 16 equal quarterly installments. After adjustments for partnership expenses properly chargeable against what was owed Gitin, his ex-wife actually received $150,856 in 1992 and $131,099 in 1993, still 40.5% of what the partnership actually paid Gitin each year. These were not alimony payments, since they would have continued even if Rena had died. The separation agreement stated that Rena, not Gitin, would report these amounts as her own income for personal income tax purposes.

The Department disagreed with that characterization. New York adjusted gross income under Tax Law § 612(a) starts from federal adjusted gross income, and IRC § 61(a) taxes "all income from whatever source derived" unless specifically excluded. Gitin argued the payments were shielded by IRC § 1041(a), which defers gain or loss on property transferred between spouses incident to divorce. But Treas. Reg. § 1.1041-1T(a) makes clear § 1041 covers only transfers of property - not transfers of services or personal-service income - and Rev. Rul. 87-112 confirms that § 1041 does not shield income from recognition when that income is merely assigned to another taxpayer rather than transferred as property.

Applying the bedrock assignment-of-income principle from Lucas v. Earl - income is taxed to whoever earns it, not whoever ultimately receives it - the Department relied on Kochansky v. Commissioner (an attorney who assigned a contingent fee to his ex-wife under a property settlement still had to report it, because he performed the services that earned it) and Berger v. Commissioner (an assignment of income is disregarded unless the underlying income-producing property is also transferred, and personal-service income has no such underlying property). The Department distinguished Balding v. Commissioner, where an ex-wife's settlement payments were a buyout of her own separate community-property claim to her ex-husband's military pension, not an assignment of income he had earned. Because Gitin's ex-wife's payments were simply a redirected share of the partnership income Gitin himself earned as a partner, he had to include the full $150,856 (1992) and $131,099 (1993) in his own federal AGI and, consequently, in his New York AGI - the separation agreement's contrary reporting instruction had no legal effect.

What this means for you

Divorcing business owners and partners assigning a share of future earnings to a spouse

If a separation agreement directs part of your future compensation, partnership draw, contingent fee, or similar earned income to be paid directly to your ex-spouse, you generally cannot shift the tax liability for that income to them just because the money never passes through your hands. Under the assignment-of-income doctrine, income is taxed to whoever earned it (or whoever controls the earning of it), not whoever ultimately collects the check. This is true even if the payments would end at the ex-spouse's death (so they don't qualify as alimony) and even if the parties' agreement expressly says the recipient will report the income.

Accountants and tax professionals drafting or reviewing separation agreements involving earned income vs. property

When structuring a divorce settlement, distinguish carefully between dividing property (which can qualify for IRC § 1041(a) nonrecognition) and redirecting a share of earned, personal-service, or partnership income (which cannot). A settlement that buys out a spouse's own separate legal claim to an asset - like the military-pension buyout in Balding - can be treated differently than one that simply assigns a slice of income the other spouse personally earned, as in Kochansky, Berger, and this case. Advise clients that a reporting-allocation clause in a separation agreement does not bind the tax authorities; it only affects how the parties settle up with each other.

Common questions

Q: Why didn't IRC § 1041(a)'s divorce-transfer nonrecognition rule protect these payments?
A: Section 1041(a) only applies to transfers of property incident to divorce, per Treas. Reg. § 1.1041-1T(a). Gitin wasn't transferring property to Rena - he was directing a portion of income he had already earned as a partner to be paid to her. Rev. Rul. 87-112 makes clear § 1041 shields gain on a property sale/exchange from recognition, but does not shield income that would ordinarily be recognized upon an assignment of that income to someone else.

Q: How is this different from Balding v. Commissioner, where the ex-wife's payments weren't taxed as an assignment of income?
A: In Balding, the ex-wife received settlement payments in exchange for giving up her own separate community-property claim to her ex-husband's military retirement pay - she was being bought out of a property interest she independently held, not receiving a redirected share of income her husband earned. Here, Rena had no independent claim to the partnership income; she was simply designated to receive part of the income Gitin himself earned as a partner.

Q: Who actually owes the tax when a separation agreement says the ex-spouse will report the income?
A: The person who earned the income does, regardless of what the agreement says. The agreement's allocation of reporting responsibility has no effect on federal or New York tax liability; it can only govern the parties' private arrangements between themselves (for example, one party reimbursing the other for taxes paid).

Q: Does it matter that these payments weren't alimony?
A: The opinion notes the payments were not alimony because they would have continued even after Rena's death, but that fact wasn't what drove the outcome. The determinative issue was that the payments were an assignment of Gitin's own earned partnership income, not a property transfer - so the result would have been the same regardless of the alimony question.

Q: Would the answer differ if Gitin had transferred his partnership interest itself to his ex-wife, rather than a share of the income already accrued to him?
A: Potentially. Berger v. Commissioner suggests that transferring the underlying income-producing property (rather than just the income stream) may allow at least the nonrecognition-of-gain treatment under § 1041, though as Berger itself shows, previously deferred income tied to that property can still be triggered on the transfer. Here, however, Gitin transferred none of his partnership interest - only a share of income already accrued to him individually - so no property transfer was in play at all.

Q: Does this ruling only affect the specific dollar amounts at issue, or does it establish a broader principle?
A: It's an Advisory Opinion binding only as to Gitin's own facts, but it applies (and doesn't create) the general assignment-of-income doctrine from Lucas v. Earl, as elaborated in Kochansky and Berger: personal-service and partnership income earned by one spouse remains taxable to that spouse even when a separation agreement redirects payment of it to the other spouse.

Citations and references

• Tax Law § 612(a) - New York adjusted gross income of a resident individual means federal adjusted gross income with the modifications specified in § 612; no modification applied here
• IRC § 61(a) - gross income means all income from whatever source derived, unless otherwise excluded by law
• IRC § 1041(a) - no gain or loss recognized on a transfer of property between spouses incident to divorce
• Treas. Reg. § 1.1041-1T(a) - § 1041 governs only transfers of property (real or personal, tangible or intangible); transfers of services are not subject to § 1041
• Rev. Rul. 87-112, 1987-2 CB 207 - § 1041 shields gain on a property sale/exchange from recognition but does not shield income ordinarily recognized upon assignment of that income to another taxpayer
• Lucas v. Earl, 281 US 111 (1930) - income is taxed to the person who earns it (controls the earning of it), not whoever ultimately receives it
• Kochansky v. Commissioner, 67 TCM 2665, aff'd 92 F.3d 957 (1994) - attorney taxed on a contingent fee assigned to his ex-wife under a property settlement, because he performed the services that earned it
• Berger v. Commissioner, 71 TCM 2160 (1996) - an assignment of income is disregarded unless the underlying income-producing property is also transferred; personal-service income generally has no such underlying property
• Balding v. Commissioner, 98 TC 368 (1992) - settlement payments buying out an ex-wife's own community-property claim to a military pension were treated as nontaxable gifts, not an assignment of income

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1997.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a97_6i.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-97(6)I
Income Tax

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I960718D

On July 18, 1996, a Petition for Advisory Opinion was received from
Mitchell M. Gitin, c/o Peter Gold, 280 North Central Avenue, Hartsdale, New York
10530.
The issue raised by Petitioner, Mitchell M. Gitin, is whether income
assigned to his ex-wife incident to a divorce and paid to her in 1992 and 1993
must be included in Petitioner's New York adjusted gross income under Article 22
of the Tax Law for 1992 and 1993, respectively.
Petitioner submits the following facts as the basis for this Advisory
Opinion.
Pursuant to a separation agreement entered into in 1992 by Petitioner and
his former wife, Rena Gitin, Rena was to receive $713,333 in 16 equal quarterly
installments. That amount represented 40.5 percent of the $1,760,920 due to
Petitioner as his partnership share of the income of his former partnership. The
amount owed to Petitioner accrued during the time he was a partner, and was also
payable in 16 equal quarterly installments. Because of adjustments created by
the subsequent payment of partnership expenses properly chargeable against the
amount owed Petitioner, his ex-wife was paid the sum of $150,856 in 1992, and
$131,099 in 1993. These amounts represented 40.5 percent of the total amount
paid by the partnership to Petitioner in each of those years. These amounts do
not constitute alimony payments because the payment of these amounts would
continue in the event of her death. The agreement provided that Petitioner's ex­
wife was to include the payments of partnership income that she received as
income for personal income tax purposes.
Section 612(a) of the Tax Law provides: "[t]he New York adjusted gross
income of a resident individual means [the individual's] federal adjusted gross
income as defined in the laws of the United States for the taxable year, with the
modifications specified in this section." Under section 612 of the Tax Law,
there are no modifications that would affect the income at issue in this case.
When computing federal adjusted gross income pursuant to the Internal
Revenue Code ("IRC"), section 61(a) of the IRC provides that, unless otherwise
excluded by law, gross income means all income from whatever source derived.
Section 1041(a) of the IRC provides that no gain or loss will be recognized
on a transfer of property from an individual to a former spouse if the transfer
is incident to a divorce. The effect of section 1041 of the IRC is to defer the
recognition of gain or loss until the transferee disposes of the property.
Temporary regulation section 1.1041-1T(a) of the Treasury Income Tax Regulations
provides that only transfers of property (whether real or personal, tangible or
intangible) are governed by section 1041 and that transfers of services are not
subject to the rules of section 1041.

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Internal Revenue Ruling 87-112 (1987-2 CB 207), provides that although
section 1041(a) of the IRC "shields from recognition gain that would ordinarily
be recognized on a sale or exchange of property, it does not shield from
recognition income that is ordinarily recognized upon the assignment of that
income to another taxpayer."
The ruling held that the income at issue was
accrued but unrecognized interest, rather than gain, and section 1041 of the IRC
did not shield that income from recognition. Accordingly, the specific rule of
section 1.454-1(a) of the Treasury Income Tax Regulations for dispositions of
interest-deferred obligations applies to require that the transferor include the
accrued interest in income in the year of the transfer.
In Balding v. Commissioner, 98 TC 368, Dec. 48,116, (1992) it was held that
payments received by an ex-wife in settlement of her claim to a community
property share of her ex-husband's military retirement pay were to be treated as
nontaxable gifts, pursuant to sections 1041 and 102 of the IRC, and that they
were excludable from the ex-wife's gross income. The ex-wife relinquished any
claim to the ex-husband's military retirement pay (and agreed not to bring any
further claims with regard to marital property) in consideration of the ex­
husband's promise to pay to her $15,000, $14,000 and $13,000 in 1986, 1987 and
1988, respectively. These settlement payments to the ex-wife were not considered
to be an anticipatory assignment of income.
In Kochansky v Commissioner, 67 TCM 2665, Dec. 49,785(M), TC Memo. 1994­
160, affd 92 F.3d 957, an attorney who assigned his fee from a medical
malpractice case to his former wife pursuant to their property settlement was
required to include the fee in his gross income, notwithstanding that his ex­
wife's share was paid to her. Even though the fee was contingent at the time of
assignment, he provided the legal services in the case that generated the fee
and, thus, earned the income prior to the assignment. The Tax Court stated:
[w]e start with the basic proposition that income is taxed to those
who earn it. Lucas v. Earl, 281 US 111, 114,115 (1930); Helvering v.
Horst, 311 US 112, 115-117 (1940); Helvering v. Eubank, 311 US 122,
124-125 (1940). This proposition has been described as "One of the
primary principles of our system of income taxation". Vercio v.
Commissioner, 73 TC 1246, 1253 (1980). Thus, when income has been
assigned to another, "The choice of the proper taxpayer revolves
around the question of which person ... in fact controls the earning
of the income rather than the question of who ultimately receives
the income. Id. at 1253; Vnuk v. Commissioner, 621 F2d 1318, 1320
(8th Cir 1980), affg. [Dec. 36,037(M)] TC Memo. 1979-164.
In the instant case, there is no dispute as to whose efforts
produced the income here at issue....
There is nothing in the
record to suggest that the assigned income was earned by any person
other than petitioner. Nor has the petitioner even attempted to
argue otherwise. Since the assigned income was clearly earned by
petitioner, he is taxable on the assignment of it, pursuant to the
principle established in Lucas v. Earl, supra. ...

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Petitioner ... assigned compensation earned through the performance
of his services as an attorney.
The fact that his stake in the
lawsuit was contingent on the outcome of future events does not make
it any less compensatory. Cf. Wilkinson v. United States 157 Ct.
Cl. 847, 304 F2d 469, 473-474, 477 (1962).... In short, petitioner
transferred personal service income and not income producing
property to his ex-wife....
In Berger v Commissioner, 71 TCM 2160, Dec. 51,179(M), 1996-76, the Tax
Court held that the nonrecognition rule in section 1041 of the IRC did not bar
application of the clear reflection of income rule where property with
economically accrued income elements was transferred.
In the case, which
involved the transfer by a husband to his wife of his share of a cemetery
business, the court held that although the husband recognized no gain on the
transfer under the nonrecognition rule, the transfer triggered the accrual of the
husband's share of the income from crypt sales that had been previously deferred
and that would not have been otherwise includable in income until the completion
of the mausoleum. The Tax Court stated that:
[a]n assignment of income is generally disregarded unless the
underlying income-producing property is also transferred.
See
generally, 3 Bittker & Lokken, Federal Taxation of Income, Estates
and Gifts, ch.75 (2d ed. 1991 & Supp. 1995). Usually there is no
property underlying personal service income so that assignment of
personal service income is disregarded, and the taxpayer who earned
the income is taxed on it under Lucas v Earl, [supra]....
In the instant case, Petitioner was due $1,760,920 as his partnership share
of the income of his former partnership. The amount owed Petitioner accrued
during the time he was a partner, and was payable in 16 equal quarterly
installments.
Pursuant to a separation agreement entered into in 1992 by
Petitioner and his former wife, she was to receive $713,333 in 16 equal quarterly
installments, which was 40.5 percent of Petitioner's partnership income. After
the adjustments properly chargeable against the amount owed Petitioner for
partnership expenses, Petitioner's ex-wife was paid $150,856 in 1992, and
$131,099 in 1993, representing 40.5 percent of the amount received by Petitioner.
Pursuant to temporary regulation section 1.1041-1T(a) of the Treasury
Income Tax Regulations, transfers of services are not subject to the rules of
section 1041 of the IRC. As explained in Rev Rul 87-112, supra, Ltr Rul 8820086,
Kochansky, supra, and Berger, supra, section 1041 of the IRC does not shield from
recognition income that is ordinarily recognized upon the assignment of that
income to another taxpayer. Usually there is no property underlying personal
service income and that the assignment of personal service income is disregarded
and the taxpayer who earned the income is taxed on it.
These cases are
distinguished from Balding, supra, where the settlement payments received by the
ex-wife in return for the ex-wife's relinquishment of her claim to the ex­
husband's military retirement pay were not considered to be an assignment of the
ex-husband's military retirement pay.

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Accordingly, in the instant case, the amounts paid to Petitioner's ex-wife
in 1992 and 1993 pursuant to the separation agreement constitute the assignment
of the income owed to Petitioner as his share of partnership income that accrued
during the time he was a partner of the former partnership. Since these amounts
were earned by the Petitioner, the Petitioner recognizes the income upon the
assignment of it. Therefore, when computing Petitioner's New York adjusted gross
income under section 612 of the Tax Law, these amounts should be included in
Petitioner's starting point, federal adjusted gross income computed pursuant to
section 61 of the IRC for those years.

DATED: August 6, 1997

NOTE:

/s/
John W. Bartlett
Deputy Director
Technical Services Bureau

The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.