## Facts

- Cathalene Crane married Cornelius Crane in 1929; neither spouse earned employment income, and Cornelius’s wealth derived from family trusts.
- In 1940, amid divorce proceedings in Illinois, the parties negotiated a divorce agreement that did not provide for ordinary alimony.
- Under a February 20, 1940 agreement incident to divorce, Cornelius agreed to:
  - Purchase $650,000 of annuity contracts for Cathalene; and
  - Guarantee that she would receive $25,000 annually for life from annuity payments.
- The arrangement was structured as a property settlement tied to Cathalene’s marital property and dower rights, rather than as ongoing support.
- The annuity payments were payable for Cathalene’s life and were not conditioned on remarriage or other typical support contingencies.
- Cathalene remarried (to Rudolf Bernatschke) shortly after the divorce.
- For tax years 1956–1959 and 1961, the IRS treated the entire $25,000 received annually as fully taxable, characterizing the payments as divorce-related periodic payments.
- The taxpayers asserted the payments were annuity amounts governed by I.R.C. § 72, allowing exclusion of the portion treated as return of “investment in the contract.”

## Issues

1. Whether $25,000 annual payments received under annuity contracts purchased pursuant to a divorce agreement are fully includible in income as periodic divorce payments under I.R.C. § 71(a)(1).
2. Whether the payments are instead taxable under I.R.C. § 72 as annuities, permitting exclusion of the portion attributable to the recipient’s investment in the contract under § 72(b).

## Decision

- The Court of Claims entered judgment for the taxpayers and granted a refund for the years at issue, with interest as provided by law.
- The court held that I.R.C. § 72, not § 71(a)(1), governed the taxation of the annual payments.
- The court adopted in full the trial commissioner’s findings and legal conclusions.

## Legal Principles

- Divorce-related payments implemented through annuity contracts may be taxed under I.R.C. § 72 when the arrangement functions as a property settlement funded by a capital purchase of annuities, rather than as periodic support.
- I.R.C. § 71(a)(1) applies to “periodic payments” received in discharge of a divorce-related support obligation; characterization depends on the substance and structure of the obligation.
- Under I.R.C. § 72, annuity payments are includible only to the extent they exceed the excludable portion computed under § 72(b) based on the recipient’s “investment in the contract” and expected return.
- A spouse can have an “investment in the contract” in divorce-purchased annuities when marital or dower rights are exchanged as consideration for the annuity arrangement.

## Conclusion

The court treated the lifetime payments as annuity distributions arising from a property settlement, allowing taxation under § 72 with a partial exclusion for return of investment, rather than full inclusion as divorce periodic payments under § 71(a)(1).


Bernatschke v. United States, 364 F.2d 400 (Ct. Cl. 1966)