Divorce, American style: structuring payments to maximize income tax savings.

• Author: Stewart, C. Jean

The Code provides that alimony payments are deductible by the payor spouse and taxable to the payee spouse, (1) but child support is not alimony and is thus not deductible by the payor. (2) The application of these results in a splitting of the payor's income and of the taxability of the alimony payments. If the payments are properly structured to qualify as alimony, it is possible to achieve a net after-tax benefit for the parties.

This article will discuss what constitutes alimony, child support and property settlements; explore the income tax ramifications; and examine the tax planning options available to a divorcing couple.

Net Savings

to Divorced Taxpayers

As the following examples demonstrate, an awareness of the income tax consequences of divorce can result in a net savings to a divorcing couple. This is equally true in terms of the property settlement. By bargaining in terms of after-tax dollars, the parties gain a more realistic perception of their respective financial positions and can reach an equitable resolution more easily.

Example 1: In 1990, ex-husband H made $30,000, and W, his ex-wife, made $10,000. H paid W $5,000 in 1990, which did not qualify as alimony. Therefore, H was not entitled to a deduction and W was not required to include the payment as income.

H claimed the standard deduction for a single taxpayer and one exemption. His taxable income for 1990 was $24,700:

$30,000 - 3,250 (standard deduction) - 2,050 (personal exemption) $24,700 $24,700

H's tax liability was $4,395. Thus, his disposable income for 1990 after paying taxes and the nondeductible amounts to W was $20,605.

W claimed the standard deduction for a single taxpayer and one exemption. Her taxable income for 1990 was $4,700:

$10,000 - 3,250 (standard deduction) - 2,050 (personal exemption) $ 4,700

W's tax liability was $709 and her disposable income was $14,291.

Example 2: Assume the same facts as in Example 1, except that H gave $6,000 to W $5,000 of which qualified as alimony. H was entitled to deduct $5,000 of the payments from his gross income in determining his tax liability and W was required to report the $5,000 as income.

H's taxable income for 1990 was $19,700:

$30,000 - 5,000 (alimony paid) - 3,250 (standard deduction) - 2,050 (personal exemption) $19,700

H's tax liability was $2,995. Thus, his disposable income for 1990 after paying taxes and the amounts to W was $21,005.

W's taxable income for 1990 was $9,700:

$10,000 + 5,000 (alimony) - 3,250 (standard deduction) - 2,050 (personal exemption) $ 9,700

W's tax liability was $1,459 and her disposable income was $14,541.

Simply by having a portion of the payments qualify as alimony, both H and W increased their disposable income for the year.

Classification of

Payments as Alimony

* Sec. 71(b) requirements

A payment qualifies as alimony if it meets the seven requirements set out in Sec. 71(b).

* Payments must be in cash: The definition of "cash" is very limited and includes only cash or its equivalent, such as checks and money orders payable on demand. (3) The transfer of services or property (such as a debt instrument of a third party or an annuity contract), the execution of a debt instrument by the payor, or the use of property of the payor do not meet the "cash" requirement.

* Payments must be made to or on behalf of the payee: A cash payment to a third party may qualify as alimony if it is made on behalf of the payee. However, payments to third parties must be made pursuant to the payee spouse's written request, consent or ratification; the writing must state that the parties intend the payment to be treated as alimony; and the payor spouse must receive this written request before the filing date of the payor's tax return for the tax year in which the payment was made. (4) Qualifying payments to third parties include the cash payment of rent, tax or tuition on the payee's behalf, the cash payment or a home mortgage or expenses of maintaining a residence for the payee (so long as the property is not owned by the payor), the cash payment of life insurance premiums (so long as the payee is the owner of the policy) (5) and donations to charitable organizations. (6)

* Payments must be required by a written...