Tax issues in divorce.

• Author: Schnee, Edward J.

EXECUTIVE SUMMARY

* Because there is no clear pattern in the court decisions, taxpayers must arm themselves with expert tax advice.

* Knowledge of state law is critical to proper drafting or review of a divorce agreement.

* Alimony is includible by the recipient and deductible by the payer; child support is the exact opposite.

As if divorce were not traumatic enough, a host of tax issues accompanies the dissolution of marriage. This article examines alimony, child support and property settlement issues, and explains the critical rules tax advisers need to know when drafting or reviewing divorce documents.

Divorce is an intensely personal issue affecting more and more Americans; thus, it is important for tax advisers to understand both the legal and tax ramifications of specific types of transfers. In a divorce, a transfer between spouses can be a property settlement, alimony or child support, each with its own tax rules.

This article examines the tax effects of transfers intended to be alimony or property settlements under a divorce agreement, settlement or decree. The rulings illustrate that substance overrules form. Because there is no clear pattern in the court decisions, taxpayers must arm themselves with expert tax advice. The article also addresses pitfalls and identifies planning opportunities.

Alimony

Sec. 71(a) provides that gross income includes amounts received as alimony or separate maintenance payments. Sec. 215(a) allows an "above the line" deduction for alimony paid. Sec. 71(b) defines alimony as any payment in cash, if all of the following are met:

1. Payment is received by (or on behalf of) a spouse under a divorce or separation instrument (Sec. 71(b)(1)(A)).

2. The divorce agreement does not designate such payment as not being alimony (Sec. 71(b)(1)(B)).

3. The spouses are not members of the same household when the payment is made (Sec. 71(b)(1)(C)).

4. There is no liability to make the payment after the recipient's death (Sec. 71(b)(1)(D)).

   A payment that fails to meet any of these requirements is not alimony and is excludible from the recipient's income and nondeductible by the payer.

   Example: H and W's divorce decree provided for H to make payments to W for two years and to assume certain marital debts until paid in full. The debt assumption is labeled "additional alimony" in the decree. The debt assumption does not meet Sec. 71(b)(1)(D); thus, it is excludible by W and nondeductible by H.

   Although in the example, the decree termed the debt assumption "alimony" it was really a property division. Courts have ruled that the term"alimony" in a divorce settlement does not determine whether a payment meets Sec. 71(b)(1)(1); all the requirements must be met. The decree's or agreement's wording makes all the difference to the tax result.

   However, courts will sometimes allow minor variations in the decree's wording. For example, it can refer to monthly payments owed to the former spouse as part of a property settlement, in lieu of a specific designation as not being alimony.(2)

   "On Behalf of a Spouse"

   Sec. 71(b)(1)(A) requires that a payment be received by or on behalf of a spouse. A direct cash payment by one ex-spouse to the other is usually straightforward in nature. Payments made on behalf of a spouse can include loan payments on property received in the divorce or payment of the ex-spouse's insurance premiums, monthly bills or divorce-related legal fees.(3) In addition, payments made to an ex-spouse's agent have been deemed constructively received by the ex-spouse(4); thus, they qualified as alimony.

   Written Agreement

   A decree is the final decision issued by a judge in a divorce action. A divorce is generally effective after a judge signs a divorce judgment and it is recorded. Payments made under a temporary settlement (as opposed to a final divorce decree) are usually treated differently; only payments made after a final decree may be classified as alimony. Amounts paid under a temporary agreement are excludible by the recipient and nondeductible by the payer; they are part of the property settlement and reduce the amount received under the final agreement. This motivates a payer to settle a divorce as quickly as possible, so payments will qualify as deductible alimony.

   Although payments made under a temporary agreement are not alimony, Sec. 71(b)(1)(A) and (2)(B) include in alimony payments made under a"written separation agreement" a term not defined in the Code, regulations or legislative history. The courts have interpreted the phrase to require a clear statement in written form memorializing the terms of support between the parties.(5) A valid separation agreement existed when one spouse assented in writing to a letter proposing support by the other spouse.(6) The keys to the existence of a written separation agreement are both parties' consent and clear and specific payment language.

   Example: H and W are divorcing. H's attorney sends W's attorney a letter, setting forth that H is willing to pay expenses and support and offering to divide the marital property. The letter omits specific amounts for the expense and support payments; further, there is no space for W to sign her assent.

   W's attorney sends a letter in reply that contains specific amounts of expenses and support acceptable to W, with space for H to sign his assent. Only W's letter is deemed a written separation agreement.(7) H's letter lacks specificity and consent. Thus, any payments H makes that are not covered by W's letter are not alimony.

   All payments intended to be alimony need to be specifically stated in both a written separation agreement and the final written divorce agreement; further, both spouses must consent in writing.

   Payments End at Recipient's Death

   Sec. 71(b) (1) (D) was amended by Tax Reform Act of 1986 Section 1843(b) to delete the requirement that a divorce agreement specifically provide for termination of payments on the payee's death. Thus, the liability must terminate at the recipient's death, but the instrument does not have to specifically so state. The Tax Court has reasoned that the termination requirement is central to Congress's intended distinction between support and property settlements.(8) If a divorce agreement does not explicitly state that payments cease on the payee's death, state law controls. Whether a payment meets Sec. 71(b)(1)(D) depends on whether state law requires alimony payments to terminate on a payee's death. (State law does not control the Federal tax status of other payments.) Each state's rules on the termination of divorce payments differ. Many states provide that such payments will cease on the payee's death. If a state statute is silent or ambiguous on this issue, amounts paid by one spouse to another cannot be alimony, unless the agreement provides for termination at death.

   Example: A state B divorce agreement specifies $1,000 monthly payments from W to H as spousal support. The divorce decree did not state that payments would cease on H's death. B law provides that support payments in a divorce decree cease on the recipient's death; thus, a court would rule that W's payments are alimony. However, if B's law were ambiguous as to this issue, the payments would be classified as part of the property settlement. Thus, knowledge of state law is critical to proper drafting or review of a divorce agreement.

   A twist on the requirement that payments cease at the payee's death could occur if spouses die within a short period of time of one another. If a recipient dies shortly before a payer, what is the tax treatment of any alimony unpaid at the payer's death? In one case,(9) after both spouses died, the husband's estate paid...