After lengthy and often contentious divorce proceedings, taxpayers do not relish the thought of further tax litigation spawned by the terms of their divorce decree or settlement agreement. This article explains how reviewing Tax Court decisions since 2005 reveals that the most often litigated issue is the treatment of “alimony” payments.
Review of IRS Alimony Provisions
Section 215 of the Internal Revenue Code (“IRC”) permits a deduction for the payment of alimony during the taxable year. The taxpayer bears the burden of proving entitlement to claim the deduction.
The definition of alimony is found in IRC §71(b)(1), which provides:
(1) In general – the term “alimony or separate maintenance payment” means any payment in cash if –
(A) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument,
(B) the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under this section and not allowable as a deduction under section 215,
(C) in the case of an individual legally separated from his spouse under a decree of divorce or separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made, and
(D) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.
All four requirements must be satisfied to make payments taxable to the payee and deductible by the payor.
Additionally, IRC §71(c)(1) provides that alimony treatment “shall not apply to that part of any payment which the terms of the divorce or separation instrument fix (in terms of an amount of money or a part of the payment) as a sum which is payable for the support of children of the payor spouse.” As clarified in U.S. Tax Court decisions, amounts payable under a divorce decree will not be treated as child support unless specifically designated as such in the document.
Received Under a Divorce or Separation Instrument
IRC §71(b)(2) defines a divorce or separation instrument as (a) a decree of divorce or separation agreement written incident to such a decree, (b) a written separation agreement, or (c) a decree (not described in (a)) requiring a spouse to make payments for the support or maintenance of the other spouse.
Consider the following two examples, with differing results.
A husband and wife separated in 1999 and subsequently divorced in December 2003. At the time of separation, the parties orally agreed that Husband would pay Wife $1,250 every other week for her support. The Husband prepared an affidavit on November 10, 1999, memorializing the agreement. Wife did not sign. Husband deducted all payments as alimony. The IRS assessed deficiencies for the years 2000 through 2003, disallowing all alimony deductions. Interestingly, the Tax Court agreed with the taxpayer, finding that the payments did in fact meet the definition of deductible alimony. There is no requirement that the separation instrument be issued by a court, nor does a separation instrument need to be signed by both parties. The only requirement is that there be a meeting of the minds of the parties, as evidenced here by the affidavit that memorialized the oral agreement. (Micek v. Commissioner of Internal Revenue Service, 2011 Tax Court Summary Opinion 45)
In January 1993, Husband and Wife separated and signed an informal hand-written agreement providing that Husband would make alimony payments during their separation. The $500 was to be made from the $500 rent received from a rental property owned by Husband. Due to factors not relevant here, the property was lost to foreclosure in 1999 and the parties made an oral agreement to change their agreement. The parties were divorced in December 2005. The IRS assessed a deficiency for the 2005 tax year, disallowing Husband’s alimony deductions. The Tax Court agreed, finding that the payments were not alimony because the oral changes made to the agreement were not reduced to writing. (Williams v. Commissioner of Internal Revenue, 2010 Tax Court Summary Opinion 125)
Support of Children
As the next three examples illustrate, it is important to understand the interplay between spousal support and child support and to adequately distinguish between the two in the divorce or separation instrument.
A judgment required Father to pay monthly family support of $1,100 continuing until the youngest child attained the age of 19, both children died, when the youngest child entered into a valid marriage, or further order of the court. The judgment included language to the effect that “it is the intent of the parties that Petitioner/Father enjoy the tax exemption benefit for non-modifiable family support.” However, under IRC §71(c)(2), a payment will be treated as specifically designated as child support to the extent that the payment is reduced either on the happening of a contingency relating to a child, or at a time that can be clearly related to the contingency. And, it has been well established that the labels applied in divorce instruments are not controlling for federal tax purposes. Obviously, the payments involved contingencies related to the children and were intended for the support of the children and did not qualify as unallocated family support. Accordingly, Husband’s alimony deduction was denied. (Handy v. Commissioner of Internal Revenue, 2011 Tax Court Summary Opinion 61)
Under an order dated April 13, 2004, Father was ordered to pay $1,287 per month for the current support of his spouse and one child, which would end on the death of the mother. The parties were divorced in August 2005 and a supplemental order was entered in March 2006. Mother did not report any of the payments received in 2005 as alimony, arguing that the amounts were determined pursuant to the Pennsylvania guidelines. Under Pennsylvania statutes, the court may make an unallocated award or may separately state the amount of support allocable to the spouse and to each child. Because the order did not specifically designate the payments as child support, Wife was required to report all payments received in 2005 as taxable income. (Smith v. Commissioner of Internal Revenue, 2010 Tax Court Summary Opinion 15)
The terms of a 2004 divorce decree required Father to pay annual spousal support of $12,000, annual child support of $12,000, $2,000 annually to cure child support arrearages, and $6,022 to reimburse his ex-wife for medical expenses for the children. During 2004, the taxpayer paid $17,962.82 to his ex-wife and deducted $12,625 as alimony. The IRS assessed a deficiency, disallowing the alimony deduction in full. The deficiency was confirmed, citing IRC §71(c)(3), which states that “if any payment is less than the required child support payment specified in the relevant divorce or separation agreement, then the payment is applied first to satisfy the payor’s child support obligation.” (Haubrich v. Commissioner of Internal Revenue, 2008 Tax Court Memo 299)
No Liability to Make Payments After Death of Payee Spouse
All too often, the language in the divorce instrument inadvertently runs afoul of the requirement that the payments do not survive the death of the payee spouse. In 1986, §71(b)(1)(D) was added to specifically remove the requirement that the divorce or separation instrument specifically state that the liability to make payment terminates on the death of the payee. Where the instrument is silent or ambiguous in this regard, the Tax Court will look to state laws for guidance.
Following are three examples of the importance of state law or other authority in determining the tax treatment of payments.
Husband and Wife entered into a Settlement Agreement (“SA”) which provided, in part, that Husband was to pay Wife rehabilitative alimony of $2,250 (changed to $2,500 in 2005) per month for a period of eight (8) years and one (1) month. The duration could not be modified or terminated regardless of whether circumstances changed. In addition, Husband was required to maintain life insurance designating Wife as beneficiary for the full amount of the payments. The SA bound the parties’ successors, heirs, and assigns. Wife failed to report any of the $30,000 received in 2005 as alimony and was assessed a deficiency accordingly.
Because the SA did not specify that the payments would terminate on the death of Wife, the Tax Court looked to Florida law for guidance. Florida law defines lump sum alimony as a “fixed non-modifiable monetary payment that is immediately vested and therefore does not terminate on the death of either the payee or the payor.” Further, lump-sum payments may be paid in installments. Because the payments could not be modified or terminated, they met the definition of lump-sum alimony under Florida law and were not alimony taxable to the recipient. (Reynolds v. Commissioner of Internal Revenue, 2010 Tax Court Summary Opinion 157)
As opposed to the previous case, Husband was required to pay $5,250 monthly spousal support through October 31, 2010, the duration of which was non-modifiable. The SA also provided that the amount of support could be changed only the in case of Husband’s long-term unemployment or disability. The SA was incorporated into the judgment and was to be interpreted under the laws of California. Wife did not include the $63,000 paid to her in gross income on the basis that the payments were a guaranteed stream of payments for a fixed term payable to her or her estate. Because the judgment was silent with regard to the “death contingency,” the Tax Court looked to California law for guidance.
California law provides that “except as otherwise agreed by the parties in writing, the obligation of a party under an order for the support of the other party terminates on the death of either party or the remarriage of the other party.” Thus, the payment was alimony and the deficiency against the taxpayer was appropriate. (Johanson v. Commissioner of Internal Revenue, 2006 Tax Court Memo 105)
In yet another case, under a 1993 divorce, Husband, an active member of the U.S. Navy, was required to pay to his ex-wife, among other obligations, 25% of his disposable retirement pay pursuant to the Uniformed Services Former Spouse Protection Act (“USFSPA”). In 2002, the taxpayer paid $6,074, $2,687 of which was designated as child support. The IRS disallowed the remaining deduction of $3,387 on the basis that the SA referred to the payment of retired pay as part of the property settlement. As previously discussed, the classification in the divorce instrument did not preclude the payment from being alimony.
Because the SA was silent as to whether the payments were to terminate on the death of Wife, the Tax Court looked to the USFSPA as the underlying authority. The USFSPA states that “payments from the disposable retired pay of a member pursuant to this section shall terminate in accordance with the terms of the applicable court order, but not later than the date of death of the spouse or former spouse to whom payments are being made, whichever occurs first.” The $3,387 deduction for alimony paid was allowed. (Proctor v. Commissioner of Internal Revenue, TC 12 – Tax Court 2007)
Finally, it is not uncommon for one party to be required to pay all or part of the other party’s attorney fees incurred in connection with the divorce. As the following two cases will show, although the parties may intend the payment of the fees to be in the form of “additional support” taxable to the party on whose behalf they are paid and deductible by the payor, the requirement that the obligation to make payments must end at the death of the spouse is often violated.
Pursuant to a Superior Court of California Order, Husband was required to pay four thousand dollars ($4,000) “forthwith” toward his former spouse’s attorney fees and costs. In compliance with the order, Husband paid $3,400 toward the fees in 2006 and claimed an alimony deduction for the same amount on his 2006 tax return. The IRS denied the deduction for failing to satisfy the requirements of IRC §71(b)(1)(D). The Tax Court cited California case law in which it was held that attorney’s fees derived from a post dissolution proceeding do survive a remarriage of a payee spouse, and, further, the Ninth Circuit Court of Appeals held that the death and remarriage provisions of the California family statutes should be interpreted in a similar fashion. Based on that reasoning, the Tax Court concluded that the taxpayer’s obligation to pay his former spouse’s attorney fees would survive her death and, thus, were not deductible. (Galtfelter v. Commissioner of Internal Revenue, 2010 Tax Court Summary Opinion 2)
Similarly, a Florida taxpayer was ordered to pay his ex-wife’s attorney fees in the amount of $67,639. The taxpayer paid $15,086 to the attorney in 2007 and it is that amount which is in dispute in this case. As in most cases, the judgment was silent with regard to whether the liability for payment would end on wife’s death. The Tax Court relying on Florida cases, one of which upheld an award of attorney fees applied for before the death of the payee spouse and another which upheld an award of attorney fees even though the payee spouse died before the issuance of the divorce decree, concluded that the taxpayer’s obligation to make the payments would survive the death of the payee spouse. (Brown v. Commissioner of Internal Revenue, 2011 Tax Court Summary Opinion 114)
As illustrated in the described Tax Court cases, it is essential that parties to a divorce understand the requirements of IRC §71, the importance, or lack thereof, of the judgment or settlement agreement language, and the laws in their home state that may determine the tax treatment of certain payments for federal tax purposes.