Tax Effects of Spousal Support (Alimony)

ALIMONY IS TAX DEDUCTIBLE BY THE PAYER AND IS CONSIDERED TAXABLE INCOME TO THE RECIPIENT. Paying spousal support (aka alimony) is one of the best tax deals around for the payer.  According to Section 71 of the Internal Revenue Code (“IRC”) (26 U.S.C ¶71), ex-spouses who pay alimony are able to deduct those payments – dollar for dollar – from their adjusted gross income.  The recipient of alimony is, conversely, taxed on the alimony received just as if it were ordinary income (i.e. salary, wages).  (See Section 215 of the Internal Revenue Code, 26 U.S.C §215).

ALIMONY LOWERS THE PAYER’S ADJUSTED GROSS INCOME (TAXABLE INCOME) AND MAY CHANGE BOTH THE PAYER AND THE RECIPIENT’S TAX BRACKET: At the end of the tax year, a person who pays $2,000 per month in spousal support will have a whopping $24,000 shaved off his or her taxable gross income.  This could have a very favorable effect on an alimony payer’s tax burden, and an unfavorable effect on the recipient’s tax burden, in terms of:

  • the reduction in the taxpayer’s adjusted gross income (dollar-for-dollar in relationship to the alimony paid), which is what the payer will be taxed on; and
  • a change in the payer and/or recipient’s tax bracket.

Simplified Example for Payer Who Earns $100,000 Year in Wages:

$2,000/month alimony payments made

x 12 months/year

=

$24,000 alimony paid over course of 1 tax year

-------------------

$100,000 gross income                                   = 28% Tax Bracket

-

$24,000 alimony paid

=

$76,000 adjusted gross income of alimony-payer = 25% Tax Bracket

 

    Simplified Example for Recipient Who Earns $30,000 Year in Wages

$2,000/month alimony payments received

x 12 months/year

=

$24,000 alimony received over course of 1 tax year

-------------------

$30,000 gross income of alimony-payer                 = 15% Tax Bracket

+

24,000 alimony paid

=

$54,000 adjusted gross income of alimony-payer         =  25% Tax Bracket

Of course, we all know that preparing one’s taxes involves a lot more than calculating gross income less alimony paid, but you get the idea:  Alimony has very big tax implications.

CHILD SUPPORT IS NOT DEDUCTIBLE/TAXABLE: Child support, on the other hand, is a tax desert.  There is no tax benefit to the payer; and the recipient is not taxed on the child support received.  This is because the lawmakers determined, many years ago, that parents should be supporting their children whether it is in the form of “child support” or simply “supporting your children”.  Thus, no tax breaks for doing what you should be doing anyway. (Don’t start thinking too hard about all the other tax breaks that parents of dependent children are privy too that are off limits to other child-free Americans. Apparently there is a different story there!)

The disparity in the tax treatment of spousal versus child support explains why many cases are settled with the non primary parent paying a whopping amount of alimony, but just the bare minimum child support.

NON-DEDUCTIBLE ALIMONY: While it is fairly rare, the IRS does allow for the designation of alimony as non-deductible by the payer (and, therefore, non-taxable to the recipient). If this is the parties’ desire, it will need to be spelled out very clearly in the Property Settlement Agreement (PSA).  It is also best if the PSA states that the parties understand that the IRS default is the other way around (alimony is deductible by the payer; taxable to the recipient).

SPOUSAL SUPPORT PAYMENTS MUST BE MADE PURSUANT TO A “DIVORCE OR SEPARATION INSTRUMENT” TO QUALIFY AS ALIMONY: It is important to recognize that spousal support payments which are made prior to the signing of a PSA are not properly tax deductible by the payer (nor will they be taxable to the recipient).   The IRS states, in Section 71 of the IRC (26 U.S.C. ¶71), that there must be a “divorce or separation instrument” – which includes a property settlement agreement, court order, separate maintenance order, and final order of divorce/divorce decree – which sets forth the alimony obligation, before any spousal support payments will receive the default tax treatment afforded alimony payments. Spousal support payments made without such a formalized document are considered “voluntary” and, as such, are not treated as alimony by the IRS.

When a divorce case drags on for years, without a signed Property Settlement Agreement, the spouse who voluntarily supports the other spouse is denied the usual deduction for alimony paid (and the recipient is not taxed on the spousal support received).   A signed Divorce Settlement Agreement resolves this issue.

ALIMONY DEFINED: The IRS has fairly specific criteria for what it does and does not consider alimony. Section 71(b) of the IRC (26 U.S.C §71(b)) defines alimony as any cash (not services) payment that is:  

  1.  Received by a spouse or former spouse pursuant to a divorce or separation instrument;
  2. The divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under Section 71(b) of the IRC;
  3. When the parties are legally separated pursuant to a decree of divorce or of separate maintenance, the payee and recipient spouse must not be members of the same household. However, note that this section does not specifically refer to a payer who pays alimony to his spouse, while living under the same roof, pursuant to a Property Settlement Agreement only; and
  4. The alimony must end upon the death of the payee.

BE CAREFUL! The IRS has 2 important peculiarities with regard to classifying “alimony” payments from one spouse/former spouse to the other. These peculiarities:

(1) The Alimony Recapture Rule; and

(2) The Child Contingency Rule.

THE ALIMONY RECAPTURE RULE: Under §71 of the IRC, the IRS has the right to take back alimony deductions if there is a violation of the “Alimony Recapture Rule”. In other words, the IRS can make the payer spouse/former spouse go back and pay taxes on the dollar amount of alimony deducted from the payer spouse’s gross income if the IRS determines, under its Alimony Recapture Rule, that those payments were wrongly deducted.  This can occur whether or not the payer (or his or her attorney) was aware of the Alimony Recapture rule or not.  (Ignorance is not a defense.)

The Alimony Recapture Rule applies when spousal support payments are “front-loaded” during the first 3 years from the first date that alimony is paid (as defined by the IRS, see “Alimony Defined” above).  The purpose of the Alimony Recapture Rule is to discourage divorcing spouses from improperly classifying property settlement payments (such as, for example, monthly payments to a former spouse as part of a  “buy out” deal on the marital residence) as alimony.   In other words, the IRS is trying to prevent “sham” deductions.

Alimony Recapture Worksheet: For most people who are concerned about the Alimony Recapture Rule, the best way to determine whether or not there will be an Alimony Recapture situation during the first 3 years of paying spousal support is by using a simple “Recapture of Alimony” Worksheet provided by the IRS in Publication 504. It is reproduced below:

  1. Alimony paid in 2nd year  _______
  2. Alimony paid in 3rd year   _______
  3. Floor                                       $15,000
  4. Add lines 2 and 3                 _______
  5. Subtract line 4 from line 1 _______
  6. Alimony paid in 1st year    _______
  7. Adjusted alimony paid in 2nd year

(line 1 less line 5)                       _______

  1. Alimony paid in 3rd year  _______
  2.  Add lines 7 and 8               _______
  3. Divide line 9 by 2

(the number 2, not line 2!)   _______

  1. Floor                                      $15,000
  2. Add line 10 and 11               _______
  3. Subtract line 12 from line 6 _______
  4. Recaptured alimony.

Add lines 5 and 13                  _______

 

The above calculation is actually factoring two computations, as follows, to determine if recapture is necessary.

(1) A taxpayer is subject to recapture of alimony payments made if, in the third-post separation year, the alimony paid decreases by more than $15,000 from the second post-separation year.  The excess over $15,000 is subject to recapture.

(2) A taxpayer is subject to recapture in the third year of making alimony payments if the payments made in the first post-separation year exceed the average of the payments in the second and third post-separation years by more than $15,000.

If both of these computations result in recapture, the amount recaptured under the first computation is subtracted from the second year payments for purposes of making the second computation.

THE CHILD CONTINGENCY RULE:  All deductions for alimony made under Section 215 of the IRC (26 U.S.C. §215) are at risk of being taken back by the IRS if the the cessation of those alimony payments are contingent upon any of the following child-related fact patterns:

(A) A child of the marriage obtaining a specified age, marrying, dying, leaving school or a similar contingency; or

(B) At a time which is clearly associated with a contingency of a kind specified in Paragraph (A), above (e.g. graduation from high school).

(26 U.S.C. 71(c)(2))

As clarified in the recent case of Johnson vs. Commissioner of the Internal Revenue Service (7th Circuit, 2014) (http://caselaw.findlaw.com/us-7th-circuit/1302834.html), even if the parties’ PSA clearly delineates which payments are for child support and which are for spousal support, the IRS still has the right to reclassify even agreed spousal support payments as child support if there is any contingency, involving a child, attached to that spousal support obligation.

If the IRS determine that a spousal support award was actually contingent upon a child-related event, it has the right to convert all payments made, from when the payer first commenced making spousal support payments to the recipient, into non-deductible child support.

Details about his fairly complex rule can be found by reading IRS Temporary Regulation 1.71-1T(c), Q&A 17 and 18 at:

http://www.law.cornell.edu/cfr/text/26/1.71-1T

PROFESSIONAL TAX SERVICES REQUIRED: As with all information provided in www.fairfaxdivorceblog.com, nothing in this article is intended to substitute for professional tax or legal advice.  The tax implications with respect to alimony are huge.  Anytime “alimony” or “spousal support” form part of a couple’s divorce settlement discussions, you can be assured that a visit to the CPA is well-advised and a good use of your time and divorce dollars.


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