Paul L. Caron

Monday, May 15, 2023

Lesson From The Tax Court: Allocating Between Excludable Child Support and Includable Interest

Camp (2017)As inflation rises so does interest in interest.  Certainly when my 1-year CD matures next month I will be looking for a rate better than the 2% rate that seemed so great last year!  If I get a 4.5% I will be happy ... but who knows what my dollars will be worth next year?

And that’s how we typically think of interest: it’s all about inflation, the old idea that “dollars tomorrow will be worth less than dollars today.”  But the concept of “interest” is a bit more nuanced than just being compensation for the diminished value of dollars in the future.  It is also a compensation for risk: the risk that the money will not in fact be repaid—think junk bonds.  And interest also compensates for opportunity costs: a lender is giving up the ability to use (consume or invest) that money now.  In short, interest is compensation for multiple consequences of the use or forbearance of money, similar to how rent is compensation for several different sticks of property rights given up by the lessor.

It is for these reasons that interest has always been taxed as a separate item of income, separate and apart from the underlying loan or deferred payment.  We see that lesson again today in Susan D. Rodgers v. Commissioner, T.C. Memo. 2023-56 (May 9, 2023) (Judge Gale), where the taxpayer received periodic payments from the State of Alabama in 2015 that it had collected from her ex-spouse to satisfy a court judgment for child support arrearages, plus interest.  She treated all the payments as excludable child support despite receiving a 1099-INT from Alabama that treated all the payments as interest on the arrearages.

Thus this case also presents a lesson in allocation.  How should a taxpayer decide how much of a given payment represents taxable interest or non-taxable child support?  And on that issue, dear readers, I think the Tax Court may have been misled by the State of Alabama into ignoring federal law to find that all of each payment was interest.  Details below the fold.

Law: Interest Is Different
After §61(a)’s famously circular statement that that “gross income means all income from whatever source derived,” the statute goes on to give a specific list of “items” of income.  The fourth one is “interest.”  §61(a)(4).

Courts have long emphasized that interest is indeed an “item” of income separate and apart from the payment it relates to.  In Kieselbach v. Commissioner, 317 U.S. 399 (1943), the taxpayers' property was taken by New York City in 1933, but compensation for the taking was not paid until 1937.  The payment included both the value of the property at the time of taking (agreed to be $58,000) plus an additional amount (agreed to be $15,000) which the city ordinances required.  The Court explained that the additional payment was “in addition to the value of the property fixed as of the time of the taking, to produce, when actually paid, the full equivalent of that value.”

The taxpayers argued that the entire sum of $73,000 was the compensation for the taking; it was the amount realized for calculating gain.  The additional amount of $15,000 simply reflected time value of money.  Accordingly the entire amount realized above their basis of $48,000 was long term capital gain.  The government argued that only the $58,000 was amount realized.  The interest part should be reported as ordinary income because interest is more than compensation for lost value of dollars.  Interest is a separate income item.

The Supreme Court agreed with the government.  “The sum paid these taxpayers above the award of $58,000 was paid because of the failure to put the award in the taxpayers' hands on the day, January 3, 1933, when the property was taken. *** Whether one calls it interest on the value or payments to meet the constitutional requirement of just immaterial. It is...paid to the taxpayers in lieu of what they might have earned on the sum found to be the value of the property on the day the property was taken.”  Id. at 403.  In other words, the payment was not merely an adjustment for the time value of money; you see in the last part of the quote the idea that it was also compensation for the opportunity the taxpayers lost to use or reinvest the payment on the day the property was taken.

So that was a case about what was an amount realized.  But courts have no trouble extending that reasoning to inclusion/exclusion issues.  For example, in Wheeler v. Commissioner, 58 T.C. 459 (1972), the taxpayer sued for breach of contract and obtained a $30,000 judgment, which also ordered payment of $18,000 in interest.  The taxpayer argued the entire recovery was excluded as a return of his capital investment.  Then, as now, damage recoveries which represented but a return of capital were not considered taxable income.  Here, however, the Tax Court held that only the $30,000 was awarded as compensation for breach of contract.  Only that amount could potentially qualify for the return-of-capital treatment.  The remainder of the judgment, designated as interest, was to compensate the taxpayer for the delay in receiving payment of the damages he suffered.  That additional amount had to be included in gross income.  Id. at 462.

Similarly, in Kovacs v. Commissioner, 100 T.C. 124 (1993), aff'd, 25 F.3d 1048 (6th Cir.), cert. denied, 513 U.S. 963 (1994), the taxpayer had won a wrongful death judgment against a railroad.  The railroad paid off after losing its appeals.  The final check included both the $995,000 wrongful death award plus some $1.2 million of statutorily mandated post-judgment interest.

The Tax Court agreed that the wrongful death award was properly excluded under §104(a)(2) but held that the interest was a separate item of income.  For those interested, the opinion gives a good review of the doctrinal history of why interest is treated separately from the underlying judgments, and also explains why it would not treat the payment as a structured settlement under Rev. Rul. 79-313.

Today’s lesson involves the exclusion for child support payments in a divorce that happened before December 31, 2018.  So let’s take a quick look at the divorce taxation basics for such taxpayers.

General Tax Rules For Divorces Before 2019
For divorces before December 31, 2018, federal tax law treated payments between ex-spouses as falling into one of three mutually exclusive buckets: (1) the alimony bucket; (2) the child support bucket; (3) the property settlement bucket.  I used to teach the subject that way because, for those divorces, now-repealed §215 permitted taxpayers to deduct alimony, but not child support, and now-repealed §71 required the ex-spouse to report alimony as gross income, but not child support.

So the label was important.  Divorcing couples would sometimes try to disguise child support payments as alimony so that the payor spouse could deduct the payments.  To address that, Treasury issued regulations that attempted to explain what would count as child support payments and what would not.

The big idea in the regulations was to distinguish child support payments from alimony payments.  The regulations do not attempt to distinguish child support payments from other types of payments, such as interest.  Child support payments were those that were “fixed as payable for the support of a child of the payor spouse.”  Treas. Reg. 1.71-1T(c), Q&A 15.  The regulations went on to explain that payment obligations however labeled would be treated as child support “if the payment is reduced (a) on the happening of a contingency relating to a child of the payor, or (b) at a time which can clearly be associated with such a contingency.”  Id. Q&A 16.

Under the former taxing scheme, when a payor spouse fell behind on child support and the payee spouse obtained a judgment ordering payments of the arrearages, payee spouses attempted to argue that court-ordered interest payments should be counted as child support payments as well.  The argument was that the interest constituted part and parcel of the unpaid child support payments because of time value of money principals.  They were just receiving the child support payments with inflated dollars.

Courts rejected that argument.  Interest is a separate item of income.  For example, in Fankhanel v. Commissioner, T.C. Memo.1998–403, 76 T.C.M. 809 (1998), aff’d, 205 F.3d 1333 (4th Cir. 2000), the taxpayer had obtained several judgments over the years against her ex-spouse to pay child support, plus interest.  Importantly, it appears she also appears to have been fully paid under those judgments.  She argued that the entire amounts should be viewed as child support.  The court disagreed.  It looked at the idea of “fixed” to find that “Petitioner has failed to prove that the subject payments were fixed payments made under a divorce or separation agreement. To the contrary, the payments appear to have been made as court-ordered payments of interest. Interest is includable in gross income.”  Id. at p. 815.

Let’s see how all this plays out in today’s Lesson

Ms. Rodgers divorced her ex-spouse sometime before 2011.  But in 2011 they trooped into Alabama state court over a disagreement on whether the ex-spouse was required to continue child support.  The state court agreed the ex-spouse should no longer be required to pay child support, but also found the ex-spouse was in arrears “in the sum of $18,000.”  Op. at 3.  That was in September 2011.

Well, apparently ex-spouse did not like round numbers and convinced the state court to amend its order to be more precise.  In the more precise amended order, the court found the ex-spouse “in arrears in the sum of $5,361.89 excluding interest ....”  And then the state court then found the interest owed to be $10,682.48.  That totals to roughly $16,000.  Being picky saved ex-spouse almost $2,000.  That was in April 2012.

Not that ex-spouse was, actually, paying anything.  Nope.  So the good state of Alabama started collecting from the ex-spouse, sending the amounts collected in sporadic payments to Ms. Rodgers.  Judge Gale explains that Alabama’s internal records accounted for its collections as arrearages-first, interest-last.  Op. at 3. Thus, it did not send Ms. Rodgers a Form 1099-INT for the first $5,361.89 it grabbed from the ex-spouse.  However, by 2015 the state’s internal records reflected it had finished collecting the arrearages.  So it decided it was now collecting the interest.  Thus, it sent her a 1099-INT for the $7,859.27 it collected and paid over to her in 2015.

Because Ms. Rodgers had not reported the payments she received in 2012, 2013, and 2014, she apparently saw no reason to report them in 2015 either, despite receiving a 1099-INT.  After all, in her mind it was all child support and, as we know, child support payments are not reportable as gross income.

The IRS audited and dinged her for unreported income.  She petitioned the Tax Court, pro-se.

Lesson: Child Support Is Excluded But Interest On Arrearages Is Not
Ms. Rodgers did not appear to advance any argument other than she had not received any Form 1099-INT in prior years and did not understand why what seemed to her the same payments she had received in prior years should suddenly become taxable.

Implied in her argument is an allocation issue.  As Judge Gale puts it: “The proper characterization of a payment (or a portion thereof) as alimony, child support, or interest for federal tax purposes is governed by federal law.” Op. at 5 (emphasis supplied).  Judge Gale says that the proper characterization depends on (1) the taxpayer’s admission, or not, of receiving the payments; (2) the state’s payment records; (3) the existence of a state court order splitting up payments into buckets of arrearages and interest.

Here, it was important to Judge Gale that the state court amended its first order to precisely (down to the penny!) split up the payment obligation to $5,361.89 or arrearages and $10,682.48 of interest.  Even more important to Judge Gale was that Alabama’s state records accounted for payments on an arrearage-first basis.  By 2015 the state had collected and paid over to Ms. Rodgers more than $5,361.89.  That meant that 100% of the payments in 2015 were for interest.

So 100% of the 2015 payments were interest.  And interest is a separate income item.

Comment: What About Allocation?
To me this case presents a garden-variety allocation problem.  Ms. Rodgers received a stream of payments from the state as it, sporadically, was able to grab money from her ex-spouse.  It was grabbing the money to pay both the arrearages (non-taxable) and the interest ordered by the court (taxable).

We see time and again in federal tax law the problem of how to characterize a stream of payments when part of the payments might represent non-taxable amounts and other parts of the payments represent taxable amounts.  Usually the issue arises when we are trying to figure out how much of a recurring payment represents a return of basis (not taxable) vs. a return of investment earnings or interest (taxable).

When considering the tax treatment of a stream of payments which represent a mix of non-taxable and taxable amounts, there are basically three allocation choices:  (1) treat payments as 100% allocable to the non-taxable amounts first, then treat payments as 100% recovery of taxable amounts; (2) flip it and treat the first payments as 100% taxable until that is all received, and only then treat the remaining payments as 100% non-taxable; (3) pro-rate each payment between that which is taxable and that which is not.

I think federal tax law is pretty darned consistent in going with allocation method #3, pro-ration. I’m thinking here of the §72(b) rules for annuities.  I’m also thinking of the §101(d) rules for periodic payments of death benefits to life insurance beneficiaries.  You can also see this treatment in the §453 rules for installment agreements.

This is how I see federal law usually treating the allocation issue.  It is true that all of these statutory examples deal with allocating basis and profit.  But I’m not sure I see why that would be important in deciding what portion of a payment should be allocated to an excludable amount and what portion should be allocated to an includable amount.

I thus find it more than somewhat ironic that while Judge Gale properly recognizes that the allocation issue is to be governed by federal law, he then goes right ahead and relies primarily on the state’s internal accounting records to say that 100% of the 2015 payments were interest.  Heck, that’s not even state law so far as we know.  And it’s very far from federal law.  Sure, Judge Gale recites the amended state court order splitting the obligation into arrearage and interest.  Sure, he explains that Ms. Rodgers admitted to receiving the payments in 2015.  But neither of those go to the question of allocation.  Only the state records give any such indication.  I confess I do not see why internal state court accounting system should control the federal income tax question.  I think the Court just got misled by the state records.

What do readers think?  Is not there an argument here that the proper allocation was to treat about 1/3 of  each payment received in 2015 as a return of arrearages (excludable) and the rest as interest (includable)?  Or am I missing something?  Yes, that means that Ms. Rodgers may have messed up her 2013 and 2014 returns, but that is a no-never-mind sine the year before the Court was the proper tax liability for 2015.

Bottom Line: While interest is always a separate income item, readers would be wise to never forget the potential allocation issues when you have period payments that are a mix of an excludable amount and includable interest.

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Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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I think Wayne makes an excellent point. Another reader emailed me to point out a similar idea: Because of the uncertainty of receiving the full obligation (principal and interest) Ms. Rodgers might take the position that she shouldn't be required to recognize interest income until all of the principal obligation is paid. The reader suggested this idea would be supported by Clifton Manufacturing v Comm., 137 F2d 290 (4th Cir 1943). Although that case dealt with an accrual method taxpayer and the all events test, the idea might carry over. And one sees this even in the installment sales rules when a taxpayer. Taxpayers get "basis-first" treatment when they can show both the amount and timing of the installments are indeterminate. Here, of course, the amount was not indeterminate.

Posted by: bryan | May 16, 2023 6:10:12 AM

The allocation of a portion of each payment is easy with hindsight. But as the deadbeat dad had to be forced to pay the judgment, probably through garnishment of his paychecks, the total amount to be paid was uncertain and contingent. So, if only an amount equal to or less than the child support portion was actually paid, it would be fair and reasonable to allocate 100% to the child support. Then, any excess would be allocated to interest, as was done by the state. People often quit their job or move to another state to avoid paying garnishments. I am guessing the state was well experienced in the likelihood of garnishments being fully paid and treated the payments as child support first, then interest, in the event it was actually collected. This protects the payee who is already in a poor situation. So, I would agree with the state’s reporting.

Posted by: Wayne Galloway CPA | May 15, 2023 6:26:49 PM

@Lewis: the taxpayer actually did NOT go with the 1099-INT she received. That's why she got audited. Just because someone reports a payment does not make the payment income. The concession that she received those amounts of dollars does not make them income 'cause you CAN receive dollars that are not gross income. And the math to reach what I think is the proper result---proration---is not difficult. I think if Ms. Rodgers had been represented there might have been a different outcome. But it seems to me everyone was just going with the flow without giving it much thought. I would be interested if someone could explain why pro-ration would not be the correct outcome here.

Posted by: bryan | May 15, 2023 9:00:22 AM

Taxpayer went with the 1099-INT she got from AL. "Petitioner conceded at trial that she received the amount shown on the Form 1099-INT." Judge Gale didn't decompose brain tissue on a $3K deficiency; he went with the 1099-INT and the SNOD.

Posted by: Lewis C Taishoff | May 15, 2023 6:58:13 AM