United States v. Davis, is a federal income tax case argued before the United States Supreme Court in 1962. It is notable (and thus appears frequently in law school casebooks) for the following holding:

• Husband's transfer of appreciated stock to his wife, pursuant to property settlement agreement executed prior to divorce, constituted a taxable event; the husband's taxable gain was measured by the stock's value at the date of its transfer.
• This applies the general rule, that a taxpayer recognizes a gain on the transfer of appreciated property in satisfaction of a legal obligation.

In 1984, "having heard criticism of the Davis/Farid rule for many years," Congress overruled the main holding: Under §1041(a), no gain or loss shall be recognized by the transferor-spouse (or former spouse, but "only if the transfer is incident to divorce"); as a corollary, §1041(b) provides that transferor's basis shall carry over into the hands of the transferee-spouse. (Thus, for transfers between spouses, §1041(b) overrules the lower-of-cost-or-market rule for determining loss on subsequent sale of a gift, in §1015.)

• While this statute overrules the specific holding of Davis, it does not change the general rule -- that "a taxpayer recognizes a gain on the transfer of appreciated property in satisfaction of a legal obligation."

Facts

Pursuant to a separation agreement, the taxpayer's (ex-)wife agreed to relinquish any potential claims

Cause of action

In the law, a cause of action is a set of facts sufficient to justify a right to sue to obtain money, property, or the enforcement of a right against another party. The term also refers to the legal theory upon which a plaintiff brings suit...

 or marital rights, in exchange for which he transferred to her 1,000 shares of stock

Stock

The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

 in DuPont

DuPont

E. I. du Pont de Nemours and Company , commonly referred to as DuPont, is an American chemical company that was founded in July 1802 as a gunpowder mill by Eleuthère Irénée du Pont. DuPont was the world's third largest chemical company based on market capitalization and ninth based on revenue in 2009...

. These shares had cost him $74,775.37, and had appreciated to $82,250 at the time of the transfer.

The government argued that the appreciation should be included in the taxpayer's gross income, viewing the transfer of property as an exchange for the release of an independent legal obligation. The taxpayer argued that the appreciation should not count as gross income

Gross income

Gross income in United States tax law is receipts and gains from all sources less cost of goods sold. Gross income is the starting point for determining Federal and state income tax of individuals, corporations, estates and trusts, whether resident or nonresident."Except as otherwise provided" by...

, since the transfer was more like a division of property between co-owners than a sale that resulted in gain.

Holding

The Supreme Court held that the $7,000 appreciation should count as gross income

Income

Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...

, as "the 'amount realized' from the exchange is the fair market value of the released marital rights, which in this case would be equal to the value of the stock transferred."

Further Reasoning

The court bolstered its position by arguing that the lower court's ruling (that the value of the released marital rights is indeterminable and therefore, not included in gross income) could prejudice the taxpayer's spouse, as her basis in the shares would not include the $7,000 appreciation, and she would have to include this in her gross income if she decided to sell the shares.

Overruled by Congress

In response to this decision, Congress enacted Internal Revenue Code

Internal Revenue Code

The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...

 § 1041. This statute provides that, generally, "no gain or loss shall be recognized on a transfer of property from an individual to...(2) a former spouse, but only if the transfer is incident to divorce."

While this statute overrules the specific holding of Davis, it does not change the general rule -- that "a taxpayer recognizes a gain on the transfer of appreciated property in satisfaction of a legal obligation."

These legislative changes were regarded by most tax specialists as overdue and welcome, because the David/Farid rule had a number of weaknesses:

• It had been a complicating factor in divorce settlements
• It resulted in better treatment for residents of community property states (since the Service had held that it would not apply Davis to an equal division of community property) that for residents of common law jurisdictions.
• It added considerably to the Treasury's enforcement burden -- the Treasury ran the risk that gain would be reported by neither spouse, unless it was prepared to audit every substantial property settlement:
• transferor-spouses sometimes seemed not to know about Davis or to find it counter-intuitive, and hence often omitted to report their taxable gain when property was transferred.
• By contrast, transferee-spouses, well aware of Farid, almost invariably computed their gain(loss) on subsequent sale by using a basis equal to fair market value at time of receipt.