In Brief

One Question Answered But...

The tax code has become unnecessarily complex, primarily as a result of trying to be fair. A good example is IRC section 1041 that provides that no gain or loss is recognized on property transfers between spouses during a marriage and after marriage between former spouses if the transfer is part of a divorce agreement. This section led to a number of questions including the nature and characterization of interest paid or received on notes issued either to a spouse or former spouse as part of divorce.

In Seymour, the judge ruled that IRC section 1041 has no relevance to the characterization of interest on indebtedness incurred incidental to a divorce. He explained that the general rules on deductibility under IRC section 163 should be analyzed to determine the character of interest on such notes and left it up to the plaintiff and IRS to work it out and produce a stipulated settlement.

This leaves other taxpayers in the same situation of having to cope with the very complicated rules under IRC section 163. There has to be a better way.

The Internal Revenue Code of 1986, as amended to date, is ripe for reconsideration. It is a tangled web of social policy that funds our hard-earned, ever-changing democracy. It will always be complicated: The tax code reflects the world we live in; but it does not need to be as complex as it has grown. Nor does it have to be discarded in favor of an "alternative" system, be it VAT, flat, or otherwise, that surely would grow just as complex under the push/pull strains of trying to be both fair and simple. In 1986, Congress passed a two-rate, simpler, broader tax system. But over time, it seems to have failed the "fairness test." Fairness is generally achieved by targeting a tax benefit to a specific group of citizens. Complexity creeps in when you try to define the targeted group and exclude others. The solution? As former IRS Commissioner Fred Goldberg often said, perhaps a little "rough justice." If the recent partnership and discipline between lawmakers, economists, and society could produce a balanced budget legislation, then why couldn't a partnership including tax practitioners produce a simpler Internal Revenue Code? It could. The best way to understand most problems, especially complex ones, is to see a real life example. Let's take a look.

IRC Section 1041

In the early 1980s, Congress became aware of arguably unintended and certainly inconsistent tax results in domestic property transfers, principally in divorce settlements. As part of a series of domestic relations simplification provisions in the Tax Reform Act of 1984, it enacted IRC section 1041. It provides that no gain or loss is recognized on property transfers between spouses during a marriage, and, after a marriage, between former spouses if the transfer is part of a divorce agreement; fairness and simplicity in a single stroke. For the most part, a complex set of state-by-state property ownership rules that determined whether such property transfers were taxable or not was replaced by a clear rule that could be understood by most taxpayers and predictably planned for in divorces. This is where our story begins.

Considering the number of people and transactions throughout the nation affected by this type of domestic property transfer over the past 13 or so years, there has been relatively little controversy about how to comply with this tax rule. Temporary regulations were issued in August 1984, promptly after enactment, and consist of 18 straightforward questions and answers providing most of the required operational guidance. The regulation writers apparently got busy with higher priority projects. They never finalized the temporary regulations and left unanswered a few, thorny problems that generally have an effect on only the most affluent taxpayers including the:

* nature and characterization of interest paid or received on notes issued either to a spouse or to a former spouse as part of a divorce;

* tax basis of notes issued to spouses or former spouses under IRC section 1041, an especially important issue if they are not paid (i.e., do they give rise to income from debt forgiveness and are they deductible bad debts?);

* distinction between a property transfer and an assignment (or anticipatory assignment) of income; and

* interaction of gain, basis, and debt forgiveness rules in connection with transfers of partnership interests and corporate reorganizations undertaken as part of a divorce.

Guidance in these areas has been requested by many, including the AICPA. The first and most controversial of these issues, the nature of interest on spousal notes, has been resolved by the courts this year.

The Seymour Case

The Seymours appear to have had a multifaceted but otherwise typical divorce. Mrs. Seymour received nearly $925,000 as a property settlement--$300,000 in cash, and a $625,000 secured note payable over 10 years with 10% interest. She conveyed title to certain jointly owned assets, including stock in a Pepsi-Cola bottling company, title to the land and factory from which the company operates, and the marital home in Palm Beach Gardens. She also relinquished any marital rights she might have had to other property, including household furnishings, automobiles, and a 1985 tax refund. At issue was the deductibility of the interest paid by Mr. Seymour on the secured notes.

In a November, 1997 opinion (Seymour v. Commissioner, US TC, No. 2575-96, 109 T.C. No. 14, 11/5/97), the Honorable Robert Ruwe provided the tax community an insightful analysis of the nature of interest on spousal notes. His conclusion: IRC section 1041 has no relevance to the characterization of interest on indebtedness incurred incidental to divorce. Presumably this applies to all property transfers between spouses, until or unless some greater authority rules otherwise. Judge Ruwe explains that while section 1041 controls the tax-free transfer of various properties themselves, the general rules on deductibility under IRC section 163 should be analyzed to determine the character of interest on notes issued to acquire property from a former spouse and effectuate the transfer.

In a single stroke, Judge Ruwe provided important guidance that allows reasonable certainty of result when structuring a divorce settlement. Many tax practitioners have expressed anxiety over the sparse, inconsistent guidance in this area, especially since more often than not this involves their most significant clients. Notes are often only issued in divorces when large amounts are involved over reasonably long payout periods, for example, people like Mr. Seymour who are owners of successful privately held businesses or very wealthy persons with current liquidity issues.

Clearly, the practitioner community's concern was justified. After all, the IRS took Mr. Seymour to court over the issue; but, as Judge Ruwe pointed out, the IRS took a contrary position in several analogous situations, including a 1988 notice in advance of regulatory changes (the changed regulations are yet to be published, now nine years later) and in several private letter rulings in the late 1980s and early 1990s. In fact, the Seymour decision was in some part based on the conclusions reached five months earlier in the case of Linda Gibbs, who tried to convince the IRS that the interest she received in circumstances nearly identical to the Seymours' should not be taxable income under an extension of the principles of IRC section 1041. In that case (Gibbs v. Commissioner, TC Memo 1997-196), the IRS was successful in convincing the courts that interest paid to a former spouse was taxable income, not a gift through a section 1041 property transfer. So, why has the IRS taken such schizophrenic positions? Perhaps they wanted it both ways, that is, tax interest recipients like Mrs. Gibbs and also disallow the deduction for interest payers like Mr. Seymour. More likely, they feared tax advisors would argue the reverse. Neither taxpayers nor the IRS like to be whipsawed.

But possibly their true motivations were consciously or unconsciously based on much deeper and broader concerns. Perhaps by the early 1990s the IRS realized that resolving cases like Mr. Seymour's involved tax policy decisions that no one, not Congress, not the Treasury, and not even Judge Ruwe wants to address: How do you classify interest expense?

Interest Expense Classification

Way back in 1984, when Congress simplified domestic property transfers, lawmakers had no idea how complicated their simplification might be to implement. Complication entered the picture with the enactment of the Tax Reform Act of 1986. Prior to 1986, interest expense allocation issues were not really less theoretically difficult, but their uncertainty was controlled. Investment interest limitations enacted in 1972 had brought some added attention to these issues. The tedious task of interest expense classification and allocation involved mostly sophisticated taxpayers, either in the banking or finance industry, others with foreign connections, and some who owned tax-favored or substantial, leveraged investments. These were taxpayers accustomed to uncertainty. But in 1986 the interest classification and deduction regime was completely democratized so that nearly half of all American taxpayers would have to deal with these issues. The new law--

* made "personal" interest non-deductible for the first time since enactment of the income tax laws in 1913;

* created "passive activities" that require segregating interest relating to such activities;

* redefined residential interest to include certain medical and educational expenses and provided new limitations;

* preserved the "investment interest" deduction limitation;

* maintained the "trade or business" deductibility of interest for businesses;
and

* preserved special rules relating to sophisticated investments (tax exempts, life insurance/annuities and unregistered bonds) that require further identification and special attention.

Currently, there are eight different possible classifications of interest costs paid by an individual taxpayer and four distinctively different allocation methods suggested by statute, court case, and regulations.

What Are the Rules Today?

The basic rules to classify interest expense paid by individual taxpayers involve four basic steps as follows:

Step 1. First determine whether the interest is qualified residence interest, that is, interest generally on up to $1,100,000 of debts collateralized by a primary residence and any second residence, providing at least $1,000,000 of such debt can be successfully traced to the purchase or improvement of a
residence.

Step 2. Next, trace the use of any other borrowed funds not secured by a residence to expenditures occurring within 15 days of the receipt of the borrowings to determine the nature of the debt (and if what was bought was subsequently sold, trace again). In other words, determine whether the borrowed funds were used in a business, to acquire investment portfolio assets, to invest in a passive activity, or to pay for personal assets or expenses.

Step 3. Notwithstanding your conclusion in Steps 1 and 2, analyze all assets to determine if any special disallowance rules apply to interest paid on debt, such as the disqualification of interest incurred or maintained, directly or indirectly, to carry tax exempt investments.

Step 4. If the result in Step 1 is not favorable (for example, if the debt exceeds $1,100,000 and interest costs are not deductible), consider making a once per loan, generally irrevocable, election to use tracing in Step 2 to determine if some of the funds borrowed collateralized by residences might produce interest deductions, for example, if they were used to operate a business or invest in income producing assets.

Perhaps it sounds simple. In real life, it is anything but simple. These rules often produce dozens and sometimes hundreds of different, arguably correct, tax calculations with the same facts. The lack of certainty and finality of a self-assessed and calculated tax is nerve-rackingly troublesome to many.

IRS Guidance

The IRS knows how hard interest is for both its agents and taxpayers. They
have even issued sympathetic, broadly defined rules attempting to allow reasonable discretion in the "tracing regime" that is the backbone of their temporary fix to this mess.

These rules, largely embodied in temporary regulations and administrative notices, illustrate the conundrum Congress has provided the tax community, including the IRS, tax advisors, and, of course ultimately, taxpayers. For example, the IRS allows taxpayers to use "any reasonable method" of allocation with respect to pass-through entities, such as partnerships, and then goes on to offer three alternatives to consider, each of which would almost surely produce a different tax based on identical facts from taxpayer to taxpayer and from year to year.

In fact, in regulating this area, the IRS repeats the phrase "any reasonable method" often, and for good reason. Congress has asked the IRS to perform a very unpopular task: promulgate rules to classify interest in a fair and objective way that will protect Congress's revenue raising intentions. Any reasonable method in this context is the tax code's equivalent to defining pornography as recognizable when you see it. In other words, when millions of subtle, different fact patterns are possible across a broad range of American taxpayers, this job may be impossible, especially considering the additional mandate given to the IRS--be fair, clear, and objective in applying the law. Sensing this to be a problem with no solution, the IRS has been notably quiet for most of the last 11 years. Who can blame them for not wanting to tackle this thankless task?

Judge Ruwe similarly recognized the black hole of possibilities and simply told the IRS and Mr. Seymour to work it out and produce a "stipulated settlement." While his wise choice of kindergarten justice (you two kids know the basic rules: work it out and get along or we'll send you to the principal) works under the watchful eye of the Tax Court, the lack of objective guidance can be an unbearable burden at the basic taxpayer compliance and field audit levels.
The supervision, direction, or will to
settle at lower levels is often an insufficient motivator.

Today's State of Affairs

No doubt Congress had laudable public policy and tax fairness issues in mind when they enacted the matrix of interest expense rules in 1986. But, if the rules cannot be understood or followed by either those responsible to enforce the law, or those responsible to comply with it, they only bring disrespect for the otherwise noble principles they attempt to promulgate. No doubt a simpler delivery system, objective and easier to understand, can be formulated to produce a nearly equivalent public policy result. To do so may require some compromises and a cooperative effort among lawmakers, law enforcers, and law compliers--Congress, the IRS, and the tax practitioner community.

In practice, most tax advisors long ago learned to live with the complexity and uncertainty prevalent in the area of interest deductions. But, it may be very unhealthy to accept the status quo. While neither the IRS nor the public currently has the will, resources, or inclination to pursue the current state of uncertainty, interest complexity is a systemic disaster waiting to happen. How many of us can afford to go to Judge Ruwe to narrow the issues and work it out? How long can taxpayers and the IRS continue to play cat and mouse?

Interest expense simplicity is one of about a half dozen areas that could be tackled to make the Internal Revenue Code manageable. When tax uncertainties involve a few, wealthy, divorcing taxpayers, customized advice and risk assessment is the norm. Determining the characterization of interest on notes in marital settlements to resolve the tension between section 1041 and other aspects of the code is a detail the tax system can handle reasonably efficiently either by regulation (when the IRS has the time and resources) or by the judicial system. It is a by-product of the advanced economy and society we live in and a necessary component of tax planning in such an environment.

On the other hand, interest expense classification has become one of the unnecessarily complex cornerstones of our current tax system. It makes too many people's lives too uncertain. Complexity that leads to fairness is generally tolerated. Pensions, IRAs, and other saving incentives are good examples of tolerable complexity. Foreign investing is another. Complexity that creates uncertainty breeds revolt, especially if the complexity affects a lot of people, in this case about half those who file tax returns.
This same group pays over 95% of all individual taxes.

Our current system has been described by some as mind-numbingly complicated. It doesn't have to be. Whether by implementing rough justice, a redefinition of benefits targeted to the interest-bearing taxpaying sector, or through a simple reality check, any society wise enough to make things so complex should be able to simplify the system too. *