Background. Employees sometimes “assign” part of their income to another person or to a charity thinking that they can avoid paying tax on the assigned amount since they never received it. For example, a guest speaker at a church instructs the church treasurer to deposit his compensation into the church’s missions fund. Or, a pastor assigns a Christmas gift from the church to the church’s building fund. It is perfectly natural for both the guest speaker and the pastor to assume that the assigned income is not taxable. A recent Tax Court case demonstrates that this is usually an incorrect assumption.
A recent case. A taxpayer (Bill) earned $100,000 that he had deposited in the bank account of a third party. Bill did not report the $100,000 as taxable income on his tax return since he never received it. The IRS audited Bill, and claimed that the $100,000 was taxable income as a result of the “assignment of income” doctrine. In a landmark tax case, the Supreme Court ruled that “the power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment and hence the realization of the income by him who exercises it.” Lucas v. Earl, 281 U.S. 111 (1930).
The Tax Court agreed with the IRS that Bill should have reported the $100,000 as taxable income since his transfer of the income to the third party was “a classic assignment of income.” Further, “because such assignments are ineffective for federal income tax purposes [Bill] remained the party taxable on the income generated by his services.” The court explained,
One of the primary principles of the federal income tax is that income must be taxed to the one who earns it. The Supreme Court has referred to this assignment of income rule as “the first principle of income taxation” and as “a cornerstone of our graduated income tax system.” Attempts to subvert this principle by deflecting income away from its true earner to another entity by means of contractual arrangements, however cleverly drafted, are not recognized as dispositive for federal income tax purposes …. The assignment of income rule applies with particular force to personal service income. In the landmark case of Lucas v. Earl Mr. Earl and his wife entered into a contract providing that any property acquired by either of them, including salary and fees, would be considered joint property. The Supreme Court assumed that the contract was valid under state law, but held that Mr. Earl was still taxable on his entire salary and professional fees, stating, “There is no doubt that [salaries are taxed] to those who earned them and … tax cannot be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it” …. In cases similar to the case at hand, we have held that the taxable party is the person or entity who directed and controlled the earning of the income, rather than the person or entity who received the income.
Relevance to church treasurers. Church treasurers should be familiar with the assignment of income rule, and should carefully scrutinize attempts by staff members and others to avoid taxation on earned income by assigning it to another person or entity. If in doubt, contact a tax attorney or CPA for clarification. Johnston v. Commissioner, T.C. Memo. 2000-315 (2000).
This content originally appeared in Church Treasurer Alert, April 2001.