Question

Hank Moody, an executive for a healthcare company in Dallas, TX, has approached our firm, The Comet Group, due to recent interaction with the IRS. Over the past few years, Hank acquired and renovated several properties in the Dallas area, ultimately intending to lease them for use by various tenants. Hank is the sole owner of these properties. Hank’s daughter, Becca, began her freshman year at the University of Texas at Dallas in the Fall of 2018. Hank hopes to use the income from these properties to pay for Becca’s college tuition, as well as her living expenses.  

In December 2017, Hank successfully leased his first property. The lease began on January 1, 2018, and the tenants made their first rental payment that same day. The contract stated that the lease is for one year (i.e., it ends on December 31, 2018) and specified that the tenants would pay rent of $1,000 on the first day of each month. Thus, the total rent collected from the tenants for 2018 was $12,000. The tenants paid their rent each month on time.

Hank had discussed his intentions to use the income from the rental property to fund Becca’s education with his friends. One of them suggested that Hank have the tenants pay rent directly to Becca so that she, rather than Hank, would earn the income and be responsible for paying tax on it. His friend reasoned that, because Becca only has a part-time job, she would pay tax on the rental income at a lower rate than Hank, which would allow the income to cover more of the cost of her education. Hank was delighted to receive this advice from his friend, and he implemented it. The rental contract specified that the tenants send their payments directly to Becca Moody. The tenants complied with the terms of the contract, and Becca cashed their checks each month and used the money to pay for her education expenses. Becca reported $12,000 of rental income on her 2018 tax return and paid the appropriate tax.   

After examining Hank’s 2018 tax return, the IRS issued a deficiency assessment claiming that the $12,000 of rental income reported by Becca constituted income to Hank, and thus, should be included in Hank’s income under I.R.C. Section 61(a)(5). Hank has requested our assistance because he disagrees with the IRS’s position and believes that he is not required to include the income in his gross income given that the rental payments were paid directly to Becca. How should we advise Hank?

Assignment:

1) Look up and review the following authorities:

I.R.C. Section 61(a)

Treas. Reg. Section 1.61-1(a)

Lucas v. Earl, 281 U.S. 11 (1930)

1. State the primary issue or issues that the clients wants analyzed and answered?

2. Summerize the law and provide an analysis of the law as it appears to the facts of the case. (hint: summarize the relevant legal authorities that may pertain to the issue and analyze the clients facts in the light of the guidence you provide.)

Answer 1

Primary Issue :- Rental Income for the year 2018 from the property owned by Mr Hank was considered as income of his daughter Ms Becca in IRS return of the year 2018.So IRS is claiming that Mr Hank has transfer his income ($12,000) in his daughter return to avoid paying high tax as tax on his return will be at higher percentage compare to his daughter tax liability.

Answer to the issue:- As property belongs to Mr Hank currently, so income derived from that property will be taxed in the hands of Mr Hank. Rental Income cannot be transferred and tax in another person

hands by just effecting another person name in rent agreement under payment clause.

As per IRS section 61(a) Gross income means all income earned by whatever sources. Section specially mentioned Rent income as a part of Gross income. Section also excludes some points but it is not relevant to our case.

As Treasury Regulation 1.61-1(a) also says Gross income includes all income unless excluded by law.And Rent Income is not excluded from gross income under any law.

As per Supreme court judgement in the case Lucas v. Earl 281 U.S. 111(1930), tax could not be escaped by anticipatory arrangements and contract. So in our current case Mr Hank wanted to take advantage and avoid paying high tax which is incorrect as only arrangement in rent agreement under payment clause can't change the tax implication.

Advice:- 1) Mr Hank should accept IRS claim and explain them his intention was just to avoid paying high rate and not of tax evasion, as he has showed all his income but some of his income under his daughter return as her tax rate will be less than him.

2) For the coming year if he want take advantage of Tax rate, he can sale the property to his daughter for certain sum by vesting proper sale agreement. And rent agreement should be made between his daughter and tenant once property belongs to her.