Negotiable bonds pay off in
two ways. First, once the due date of the bond comes, they can be cashed
in for the principle amount of the bond. Second, they also come with
some 'interest coupons' that can be cashed in at regular intervals for an
interest payment.
So say you had a negotiable
bond worth $100 in a year and paying 12%. That means you'd get 12
coupons that you could cash in one per month for $1 each, and at the end
of the year you could cash in the bond for $100.
Horst earned a lot of money
and realized that due to progressive tax rates, the last dollar a person
earns in a year is taxed at a significantly higher tax rate than the first
dollar they earn. So he came up with an idea to give all of his interest
coupons to his son (who otherwise had an income of $0). That way the
family could pay less in taxes overall because the son would get taxed on
the income at a lower rate than Horst would.
When Horst filed his taxes, he
did not include the income from the interest coupons in his gross
income. The IRS disagreed.
Horst argued that since the
son was the legal owner of the interest coupons, they should be included
in his son's taxes.
The IRS argued that Horst
was the real owner of the interest coupons, and needed to pay taxes on
them, regardless of his machinations.
That's the Assignment of
Interest Doctrine from Lucas v.
Earl (281 U.S. 111 (1930)).
The Tax Court found for the
IRS. Horst appealed.
The Appellate Court reversed.
The IRS appealed.
The US Supreme Court reversed
and found for the IRS.
The US Supreme Court found
that the power to dispose of income is the equivalent to ownership of
that income.
The Court found that Horst
could not attribute the 'fruit' (aka the interest coupon) to his son
while retaining the 'tree' (the negotiable bond itself).
The Court noted that if
Horst had given the entire bond to his son, then it would have been
taxable to the son.
Note that Horst could have
gotten around this problem if he had done things differently. 26
U.S.C. §102 says that a gift
is excludable as income. But §102(b)
says that gifts of income derived from property are not
excludable. Therefore the interest coupons (which represent income
derived from the bond) are not excludable as gifts. But if Horst had
instead given his son the bond instead of the interest coupons, then the
bond would have been excludable as a gift to the son.
