Alimony

Posted on August 16, 2008 
Filed Under Deductions, Federal Income Tax

For purposes of the federal income tax, alimony refers to the written obligation of one spouse to make periodic cash or cash equivalent payments to the other spouse for maintenance and support during the time the couple is (1) separated, (2) involved in a matrimonial lawsuit, or (3) divorced. Alimony is also correctly described as maintenance, support, maintenance and support, or spousal support.

In determining the alimony deduction, checks and money orders are considered to be cash equivalents. However, attempts to satisfy an alimonial obligation by (1) transferring property or services, (2) making provision for the free use of property, or (3) executing a debt instrument are not considered alimony under federal tax law and therefore not deductible.

is deductible by the payor spouse and taxable income to the recipient spouse. In the lexicon of tax law, alimony is a deduction from gross income or what is otherwise known as an above the line deduction; in short, a taxpayer doesn’t have to itemize in order to write off alimony payments.

Alimony may be treated as child support if payments change in response to the happening of an event or contingency relating to a child. Specifically, payments designated as alimony may be reclassified as nondeductible child support if they are reduced (1) within six months before or after a child reaches age 18, 21, or the local age of majority; (2) on two or more occasions within a year after a child reaches a certain age between 18 and 24; or (3) at the time a child marries or dies. And if the payor spouse is obligated to make both child support and alimony payments but comes up short, proceeds received by the recipient spouse are first applied to child support. In other words, alimony is deductible only after child support has been paid in full. For a lucid summary of alimony versus child support click on (pdf file).

In deciding whether a payment qualifies as deductible alimony, the Internal Revenue Code trumps state and domestic relations laws, including divorce agreements and court orders. What may be considered as alimony under state law may not be considered as such under the Code and vice versa.

To be deductible, alimony must be governed by a written divorce or separation instrument. Divorce or separation instruments include “(A) a decree of divorce or separate maintenance or a written instrument incident to such a decree, (B) a written separation agreement, or (C) a decree…requiring a spouse to make payments for the support or maintenance of the other spouse” [Code Section 71(b)(2)]. The instrument does not have to be binding under state law but it must clearly outline the terms of support for the separated parties. Payments made before the execution of such instrument or prior to the effective date of a decree or order of support are not deductible as alimony even if the divorce or separation instrument is made to retroactively account for these payments. And voluntary payments or payments that exceed what a written divorce or separation instrument requires are not alimony and hence not deductible.

Payments qualify as alimony under the Code only if all the requirements listed below are satisfied:

  1. Payments must be made in cash or cash equivalents;
  2. Payments must be made to, or on behalf of, a spouse or former spouse;
  3. The divorce or separation instrument cannot explicitly state the payments are not alimony;
  4. Payments are not characterized in the divorce or separation instrument as being nondeductible by the payor spouse and tax-free to the recipient spouse;
  5. Payments cannot be designated as, or considered to be, child support;
  6. Payor and recipient spouses cannot be members of the same household at time of payment;
  7. Payor and recipient spouses cannot file a joint income tax return; and
  8. The obligation to make payments must end at the time of the recipient spouse’s death.

Although listed as constraints, items (3), (4), and (5) above also create financial planning options for the divorcing or separating couple, even if the primary purpose of any given allocation of alimony and child support payments is to avoid tax. But the recipient spouse should be aware that alimony ends upon the death of the payor spouse.

The reason for requiring alimony payments to be made in cash or cash equivalents is to ensure that noncash property transfers between spouses incident to divorce conform to Section 1041 of the Code. In effect, for Section 1041 property transfers incident to divorce (i.e., transfers made within one year of the divorce or related to the dissolution of the marriage), the transferee spouse takes a carryover basis, that is, a basis and holding period equal to that of the transferor spouse. Section 1041 transfers are not deductible by the transferor spouse and not income to the transferee spouse.

Cash payments to third parties by the payor spouse to satisfy a spouse’s or former spouse’s obligations (e.g., automobile insurance, credit card bills, rent, tuition, etc.) qualify as alimony. But if a spouse or former spouse resides in a house owned by the payor spouse (that is, payor spouse is the principal obligor on the mortgage debt), payments on behalf of the spouse or former spouse are not considered alimony. A similar restriction is placed on life insurance: the recipient spouse must be the irrevocable beneficiary and owner of the policy for payments to qualify as alimony.

The IRS considers the substance of a live-in divorce or separation to be tax avoidance despite the existence of a formal, written instrument. In other words, because of the income-shifting potential of a live-in divorce or separation and the negative effects on federal revenue intake that could result from such arrangements, payor and recipient spouses cannot live together.

An essential element in the legal definition of alimony is the existence of a living person for a payor spouse to maintain or support. Therefore, payments made after the death of a spouse or ex-spouse cannot, by definition, be designated as alimony.

Payments must be periodic in nature, and the consider uneven cash or cash equivalent payments posing as alimony to be in substance nondeductible lump sum property settlements unless the lump sum payment represents past-due alimony. If alimony payments decrease significantly after the first or second year of scheduled payments, where a decrease of more than $15,000 is considered significant, the payor spouse may be subject to Section 71(f) recapture.

The first component of possible recapture is based on a comparison between alimony payments in the second and third years. If the second year payment is more than $15,000 higher than the third, the excess is subject to recapture. The second component of recapture examines the difference between the first year payment and the average of the second and third year payments. Again, if the first year payment is more than $15,000 higher than the average of the second and third year payments, then the excess must be recaptured.

For example, if alimony payments are $40,000 in the first and second years and $20,000 in the third, the payor spouse will have to recapture a total of $5,000 in the third year. In this calculation, the first comparison between the second and third years shows a difference of $20,000 ($40,000 second year payment minus $20,000 third year payment), with $5,000 being subject to recapture ($20,000 difference minus $15,000, the amount earmarked in the Code as representing a significant difference between alimony payments). The second comparison between the first year payment of $40,000 and the average of the second and third year payments ([$40,000 + $20,000]/2 or $30,000) yields a difference that is less than $15,000 and therefore not subject to recapture. Click on for a quick and dirty application for those with math anxiety.

However, alimony payments made after the third year are not subject to the recapture provisions of Section 71(f). Furthermore, Section 71(f) recapture does not apply to significant decreases in alimony payments brought about by (1) recipient spouse’s remarriage or death or (2) changes in payments lasting for at least three years and fixed as a percentage of income from the payor spouse’s business, employment, or property.

In the case of recapture, excess alimony deductions taken by the payor spouse are reversed in year three of the payment schedule by including these amounts in income. A similar process holds for the recipient spouse: amounts previously booked to income are reversed by means of a deduction reported on the third-year tax return.

Alimony trusts are governed by Section 682(a) of the Code and, in terms of deduction and inclusion, produce results similar to those under regular alimony arrangements: trust income from a properly crafted alimony trust is excluded from payor’s gross income but is taxable to the recipient spouse.

Additional relevant articles on the federal income tax consequences of alimony are listed below:

Many happy returns, Roger

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