The Prepayment-of-maintenance Conundrum: Traps for the Unwary

• Publication year: 1998
• Pages: 85
• Citation: Vol. 27 No. 7 Pg. 85

27 Colo.Law. 85 Colorado Lawyer 1998.

1998, July, Pg. 85. The Prepayment-of-Maintenance Conundrum: Traps for the Unwary

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85

The CBA: A Year in Review

The Colorado Lawyer
July 1998
Vol. 27, No. 7 [Page 85]

Specialty Law Columns
Family Law Newsletter
The Prepayment-of-Maintenance Conundrum: Traps for the Unwary
by Richard I. Zuber

It has been said that "it is the curse as well as the fascination of the law that lawyers get to know more than is good for them about their fellow human beings."1 This truth is driven home daily to family law practitioners, when they learn that their former clients have ill-advisedly varied maintenance provisions contained in separation agreements or permanent orders

This article explores the potentially disastrous tax consequences that can arise to either or both former spouses resulting from a prepayment of future maintenance or a lump-sum payment of maintenance arrearages. Because a prepayment of maintenance is often embodied in a negotiated post-decree document mandating a lump-sum maintenance payment, recent developments concerning tax consequences of lump-sum maintenance also are addressed. Finally, this article discusses legally acceptable solutions formulated to eliminate or minimize the tax effects of maintenance prepayments

Prepayment of Maintenance

It is well established that, for tax purposes, alimony or separate maintenance payments are to be included in income by the payee spouse in the year received and deducted by the payor spouse in the year paid.2 With some exceptions, this general rule applies "[regardless of the method of accounting used by the taxpayer] for maintenance payments paid for the current year, payments to satisfy arrearages or with certain limitations for payments made in advance of their due date."3

The tax treatise Mertens Law of Federal Taxation warns that "it is not entirely clear to what extent advance payments of alimony are deductible in the year paid."4 One of the unstated reasons reflected in the treatise for this lack of clarity is the absence of case law and tax regulations addressing this issue

Using analogy, one reason expressed in the treatise for uncertainty includes the divergence of opinion in the tax courts concerning the deductibility of advance expense payments by cash-basis taxpayers.5 Some courts have held that advance payments of future expenses are not currently deductible on the theory that an "expense" cannot be incurred or properly deducted until there actually arises a legal obligation to pay.6 Other courts have permitted current deductibility of prepaid expenses on a limited basis, relying on what is commonly known as the twelve-month rule.7 This rule permits "an item" to be treated as a currently deductible expense "only if the paid for benefit will be exhausted completely within 12 months after the close of the taxable year."8

In addition, prepayments of maintenance may not qualify as alimony for deductibility purposes in the year paid because such payments are not being made in a manner contemplated "under" a divorce or separation instrument as required by § 71(b)(1)(A) of the Internal Revenue Code ("Code").9 This does not mean that a prepayment of maintenance will never qualify for deductibility. Rather, the amount of the deduction and the taxable year in which the deduction will be permitted should be consistent with the payment due dates and amount of the obligation as set forth in the decree and separation instrument.10

As a consequence of the foregoing uncertainties, the payor spouse may first learn, via an IRS deficiency notice, that his or her maintenance prepayment was not deductible in the tax year in which payment was made, or that the amount of the deduction in the year of payment will be limited by the twelve-month rule.

Moreover, a lesson awaits the wealthy former spouse who calculatingly decides, shortly after the divorce, that it might be advantageous from a tax planning perspective to prepay a several-hundred-thousand-dollar maintenance obligation at the end of the year. Even though, as previously noted, the payor spouse should be precluded from deducting the entire prepayment of maintenance in the year of payment, the payor may nevertheless subject himself or herself to maintenance recapture under the Code limitations on front loading of alimony payments in the first two post-separation years.11

Further, the payee spouse who unexpectedly "receives" the prepayment of maintenance may likewise find a tax trap awaiting him or her, resulting from a huge and unplanned-for tax liability.12 Mertens makes clear that this liability is not excused by the inability of the payor spouse to deduct the prepayment of maintenance. Rather, "amounts received by the payee spouse as alimony or separate maintenance payments must be included in income in the year received, even if not currently deductible by the payor spouse."13 (However, if the prepayment occurs during the first two post-separation years, an adjustment to gross income is afforded the payee spouse in the year of recapture.)

Maintenance/Alimony Arrearages

There is a general rule that "payments of back alimony are deductible in the year paid and includable in income by the payee spouse in the year received."14 It is also clear that where the parties agree to a lump-sum settlement of maintenance arrearages, "the settlement payment retains the character of the original payments for which it is substituted, and if the original payment would have qualified as alimony, the payment of the arrearage also qualifies."15

However, a circumstance frequently occurs where former spouses, in settling a dispute as to maintenance arrearages, agree to waive future maintenance obligations in consideration for payment of the arrearages. This fact pattern formed the basis of 1967 Revenue Ruling 67-11. The issue addressed by this Revenue Ruling was whether, in light of the waiver of not only past arrearages but a future alimony claim, the entire amount of the lump-sum settlement payment could be deducted in the year paid.16

The Revenue Ruling stated that the payor spouse could deduct, in the year paid, the entire lump-sum payment because it was "less than" the total amount of the arrearages.17 The Revenue Ruling, despite the explicit language of the waiver, also indicated that such payment would be considered a settlement of the arrearages and would not be treated as a prepayment of future alimony.

"Prudent attorneys are well advised to consider including provisions in the separation agreement
that address
the frequently overlooked
issue of prepayment
of...