Need-To-Know Divorce Tax Law for Legal Assistance Officers

• Author: Lieutenant Colonel Craig D. Bell, Usar
• Pages: 08

2003] DIVORCE TAX LAW 213

NEED-TO-KNOW DIVORCE TAX LAW FOR LEGAL ASSISTANCE OFFICERS

LIEUTENANT COLONEL CRAIG D. BELL, USAR1

1. Introduction

   On two occasions during the 1980s, Congress passed comprehensive tax legislation that dramatically changed the principles of divorce and se

   aration taxation. The first major enactment occurred when the Tax Reform Act of 1984 (TRA 1984)2 was signed into law on 18 July 1984. The TRA 1984 completely overhauled the tax treatment of property transfers between spouses and between former spouses when the transfer is "incident to a divorce."3 In addition, while preserving the fundamental precept of alimony deductibility by the payor spouse, TRA 1984 redefined alimony and created "front-loading" anti-abuse rules designed to prevent a payor from transferring property as deductible alimony.4 The TRA 1984 also changed the eligibility requirements for several tax credits (namely, the child care credit and earned income credit), the child dependency exemption, and other related rules.5

   Soon after attorneys, IRS auditors, and the judiciary mastered these new rules, Congress passed the Tax Reform Act of 1986 (TRA 1986).6 The TRA 1986 revised the anti-front-loading rules to permit a larger dollar-amount fluctuation in alimony payments, shorten the period subject to recapture of "excessive" alimony payments, and make additional changes to the alimony provisions.7 The 1986 overhaul of the marginal tax brackets,8 the addition of a phase-out of personal and dependent exemptions through a surtax,9 the repeal of the capital gains sixty percent deduction,10 and other fundamental changes11 have all had a major impact on how attorneys must approach settlement negotiations and the structuring of the parties' obligations in separation agreements or divorce proceedings. The attorney who understands these rules is in a strong position to provide his client with valuable tax advice and the opportunity for significant tax savings.

2. Alimony

   1. Overview of General Rules Before 1985

      Alimony or maintenance payments have been considered as taxable ordinary income to the receiving spouse and deductible by the paying spouse since 1942.12 Under prior law, for a payment to be considered as alimony it had to meet the following four requirements: (1) the payment had to be "periodic;" (2) the payment had to be in discharge of a legal obligation of support imposed as a result of the family relationship; (3) the payment must have been made subsequent to the entry of a divorce decree or the execution of a separation agreement; and (4) the payment must have been required by the divorce decree or separation agreement.13 Any amounts paid in excess of that required by the divorce decree or separation instrument were not considered deductible alimony payments.14 This definition of alimony led to inconsistent results when determining whether alimony existed for federal tax purposes. State law determined whether a payment was "periodic" or whether the payment was based upon an obligation of support that originated out of the family relationship.15 The inconsistent treatment among the states led to divergent results among taxpayers who were otherwise similarly situated. The TRA 1984 sought to eliminate this disparate treatment.16

   2. Tax Reform Act of 1984 Overhauls Alimony Definition

      The TRA 1984's substantial changes to the alimony provisions were the result of a conscious effort by Congress to reduce the importance of state law differences that caused similarly situated taxpayers to receive different tax consequences.17 Alimony payments continued to remain deductible by the payor spouse and includable in the income of the payee

      spouse.18 The TRA 1984 definition of alimony can be broken into five components:

      minate within the six-year period if one of the following three events occurred: (1) death of the payor spouse; (2) death of the payee spouse; or

      (3) remarriage of the payee spouse.27 The purpose of the minimum-term rule was to ensure that deductible payments were only for purposes of support and not a mechanism to effect property settlements.28

      In addition, if during any one of the first six post-separation calendar years the total of alimony payments made during the calendar decreases by more than $10,000 from any preceding year within the six post-separation calendar years, the difference in excess of $10,000 was "recaptured." The recapture provisions required the payor spouse to add this difference to his or her gross income. The payee spouse was then entitled to a corresponding deduction of the "recapture amount" from his or her gross income, because the amount recaptured had already been included in gross income during an earlier year as alimony income.29 The purpose of the recapture provisions was to discourage "front-end loading" of alimony payments.

   3. Tax Reform Act of 1986 Revised Alimony Provisions

      The Tax Reform Act of 1986 made three changes to the alimony rules. First, Congress repealed the requirement that a divorce or separation instrument must specifically state that alimony payments must terminate upon the payee spouse's death.30 The elimination of this express statement requirement was made retroactive to 1 January 1985.31 It is important to realize that Congress only repealed the requirement to expressly provide that alimony payments must cease upon the payee's death in the divorce or separation instrument. The general prohibition that there must be no liability to make any alimony payment for any period subsequent to the payee's death remains in effect.32 Therefore, a prudent attorney should include a specific provision in the divorce or separation instrument precluding alimony payments after the payee spouse dies. Since this 1986 revision, Q&A 11 and Q&A 12 of the Temporary Treasury Regulations33

      remain unchanged. Question 11 asks what the consequences would be if the divorce or separation instrument did not state that there was no liability to continue to make alimony payments for any period after the death of the payee spouse. The response was that if the instrument failed to include such a statement, none of the payments, regardless if they were made before or after the payee spouse's death, would qualify as alimony. It is also clear that Answer 11 has no validity when state law does not require payments after the payee spouse dies. However, when state law does not contain this requirement, it would remain valid. Note that Section 20-109 of the Virginia Code provides that spousal support and maintenance (alimony) "shall terminate upon the death of the spouse receiving such support unless otherwise provided by stipulation or contract between the parties."34

      Question 12 of the Temporary Treasury Regulations asks if a divorce or separation instrument will be treated as if it stated that there is no liability to make alimony payments after the payee spouse's death where such liability terminates under local (state) law. Answer 12 provides that the divorce or separation agreement must state that liability to pay alimony will terminate upon the payee spouse's death. While Answer 12 no longer states a requirement after the Tax Reform Act of 1986 revisions,35 attorneys should still follow it and write a specific provision into divorce or separation instruments precluding alimony payments after the death of the payee spouse.

      The TRA 1986's two other changes involving the alimony provisions concern the recapture rules. Congress revised the anti-front-loading rules to permit a wider fluctuation of payments, reduced the six-post-separation-year recapture period to three years, and increased the difference level triggering the recapture rules from $10,000 to $15,000.36

3. Explanation of the Current Alimony Rules

   1. General Requirements

      Under TRA 1986, any payments that meet the statutory requirements of I.R.C. § 71 and Temporary Treasury Regulation § 1.71-1T(a), Q&A-2 will be deductible by the payor spouse as alimony and taxable as income to the payee spouse.37 An alimony or separation maintenance payment is any payment received by or on behalf of a spouse (which includes a former spouse for this purpose) of the payor under a divorce or separation instrument that meets all of the following requirements:

   2. Payment Must Be in Cash

      Sections 71(b)(1) and 215(b) require alimony or separate maintenance payments to be made in cash. The Temporary Treasury Regulations include checks and money orders that are payable upon demand within the definition of cash.39 Transfers of services or property, including a debt instrument of a third party or an annuity contract, execution of a debt instrument by the payor, or the use of property of the payor do not qualify as alimony or separate maintenance payments.40 Cash payments made by the payor to a third party, if such payments are pursuant to the terms of the divorce or separation instrument, will qualify as a payment of cash that is received "on behalf of a spouse." Examples of such payments include cash payments of rent, mortgage, and tax and tuition liabilities of the payee spouse.41 Premiums paid by the payor spouse for term or whole life insurance on the payor's life, if made under the terms of the divorce or separation instrument, will qualify as alimony payments on behalf of the payee spouse to the extent that the payee spouse is the owner of the policy.42 In

      addition to alimony payments made to third parties under the terms of the divorce or separation instrument, a payor spouse may make a cash alimony payment to a third party if such payment is made at the written request of the payee spouse. The writing must specifically state that the parties intend the payment to be treated as an alimony payment. The payor spouse must receive this writing before filing of his or her first tax return for the taxable year in which the payment is made.43

      If the payor spouse must make payments to maintain property owned by the payor spouse and used by the payee spouse...