Alimony reductions: avoiding the trap.

• Author: Sweeney, James P.

CPAs are often called on to assist divorcing clients and their attorneys in structuring marital separation agreements that ultimately become part of the final divorce decrees. For most marriages, child support and alimony may be issues. Practitioners not only drafting agreements, but also assisting in the review of such agreements, must use extra caution.

A trap for the unwary is present in situations in which final marital separation agreements not only call for child support payments, but also modifiable alimony payments on a reduction schedule for the future (Temp. Regs. Sec. 1.71-1T(c)). Modifiable alimony may operate to provide the recipient of such alimony payments with larger payments immediately after a divorce, and smaller payments in the future. The reduction schedule for modifiable alimony payments must be carefully constructed not only to make good economic sense for the client, but also to avoid possible adverse tax treatment in the event of an IRS inquiry.

Prior to 1984, one could easily include a "Lester clause" in a final agreement and avoid alimony payments being reclassified as nondeductible child support. The Supreme Court, in Lester, 366 US 299 (1961), ruled that if alimony was modified or reduced, based on a contingency related to a child, such a reduction did not fix that part of the payment as being of the character of child support unless the agreement explicitly stated it. In order for child support to be treated as child support for tax purposes, the payment (or any part of such payment) was required to be fixed by the divorce decree as being payable for the support of the child (or children) of the payor spouse.

The Tax Reform Act of 1984 (TRA) completely reversed the Supreme Court's decision in Lester. Currently, a payment will be treated as nondeductible child support if any of three conditions exist:

1. The decree specifically states the payment to be for child support.

2. A payment, usually called modifiable alimony, is reduced on the occurrence of a contingency related to a child (with the corresponding reduction being classified for tax purposes as child support).

3. The reduction of the payment takes place at a time "clearly associated" with a contingency related to a child (Sec. 71(c)).

Temp. Regs. Sec. 1.71-1T(c) provides that a contingency relates to a child of a payor spouse if that contingency associates itself with any event relating to that child, regardless of whether the event is certain or likely...