It is very common in many divorces for one spouse to make payments to the other spouse after a divorce petition has been filed. Some payments are intended to provide support for a lower-income spouse. Other payments represent child support or as a financing tool for property distribution payments. Generally, the tax treatment of these payments is governed by the Internal Revenue Code, not by divorce agreements or court orders.
Today, most planners encounter divorce instruments that were finalized after 1984. Prior year rules differ from current rules. The focus of this article relates to post 1984 rules.For federal income tax purposes, payments to a former spouse fall into the following three categories:
- Alimony. Alimony is taxable as earned income to the receiving spouse and deductible to the payer in computing adjusted gross income. There is no requirement to withhold taxes on alimony payments, other than payments to nonresident aliens.
- Child Support. Child support payments are not taxable to the receiving spouse (or the child) and are not deductible by the paying spouse.
- Property Settlement. Payments in exchange for property generally are not taxable to the receiving spouse nor deductible by the paying spouse. But, special rules for tax basis and other considerations require special attention.
Planning is important when deciding whether payments should qualify as alimony or child support for tax purposes. If the paying spouse is in a higher income tax bracket than the receiving spouse, structuring all payments as alimony usually is beneficial in terms of total tax paid. Transferring the tax liability for the alimony payments to the spouse in the lower bracket reduces the combined tax burden of both spouses. The tax savings can then be split between the divorcing spouses. In theory, the receiving spouse should not pay tax on payments received in exchange for property since property transfers in divorce are generally nontaxable.
Although structuring support payments as alimony often minimizes taxes for a divorcing couple, specifying in the divorce agreement that payments are alimony for tax purposes is not enough. A payment is alimony for federal tax purposes only if all of the following requirements are met:
- The payment is made under a written divorce or separation instrument.
- For payments made after the divorce or legal separation is final (the couple is no longer married for tax purposes), the paying spouse and receiving spouse cannot live in the same household.
- The payment is in cash or cash equivalents.
- The payment is made to (or on behalf of) a spouse or former spouse.
- The divorce or separation instrument does not state that the payment is not alimony for tax purposes.
- The paying spouse and the receiving spouse do not file a joint tax return with each other.
- The obligation to make a nondelinquent payment does not survive the receiving spouse’s death.
- The payment cannot be called child support in the written agreement or be deemed child support.
Alimony is taxable to the receiving spouse and the payer deducts the payment to compute adjusted gross income. There is no withholding on alimony payments, other than 30% withholding on alimony payments to nonresident aliens (unless a tax treaty exempts the alimony from withholding). Alimony payments are treated as earned income to the recipient, potentially qualifying the recipient for an IRA contribution.
A divorcing couple can elect out of alimony treatment for federal income tax purposes simply by stating in the applicable agreement or decree that the payments are not to be treated as alimony for tax purposes. The document should specify which payments are not to be treated as alimony and expressly state that they are not deductible by the paying spouse and are excludable from gross income by the receiving spouse. An election out is dictated by the applicable agreement or decree; there is no ability to elect out of alimony treatment on an annual basis, other than via language in the divorce instrument itself. The receiving spouse must attach a copy of the not-alimony designation to the original tax return for each year that not-alimony payments are received. However, failure to do so should not affect the election out of alimony treatment.
Electing out of alimony treatment for federal income tax purposes may be appropriate in the following instances:
- The payor and recipient are in approximately the same tax bracket, or the recipient is in a higher tax bracket than the payor.
- The payor does not realize a tax benefit from the deduction because of a lack of current income or because income is from nontaxable sources.
- The payments are front-loaded and the payor wants to avoid excess alimony recapture in later years.
- The payor has established an alimony trust and wants the payments to be treated under the trust rules rather than as alimony.
- The payee cannot get the payor to gross up the alimony payments for the tax that will be paid on the payments (applicable when alimony is being used as a property settlement.)
Child support payments are not alimony and are not taxable to the receiving spouse nor deductible by the payer. Payments are child support for tax if they are either
- so designated in the divorce or separation agreement (fixed child support), or
- deemed to be child support.
Fixed child support is an amount designated as such in the divorce or separation instrument. A payment is fixed (or treated as fixed) child support if the divorce or separation agreement instrument specifically designates some amount or portion of an amount as child support, even though such amount may fluctuate. Even if all the other criteria for alimony treatment are met, a specific designation in the divorce or separation instrument that the payment is child support causes the payment to fail as alimony.
Certain payments are not identified in a divorce or settlement agreement as child support, but are treated as such for income tax purposes. This occurs when the instrument reduces the payment
- due to a child contingency, or
- at a time that is clearly associated with a child contingency.
Designating such a payment as alimony in a divorce instrument does not change this result. Payments that increase based on a child contingency are not addressed in the Code or regulations, but presumably, if the change is clearly associated, it would be deemed child support.
If the payments are terminated (or reduced) by a contingency related to the payer’s child, the payment (or the reduction amount) is deemed child support. Contingencies related to a child include the child’s reaching age 18, 21, or the local age of majority; his death, marriage, completion of school, leaving the household, reaching a specified income level, or becoming employed.
The tax consequences of the future support payments should become part of the dissolution negotiations. Once taxation becomes an integral part of the negotiations, the planner has an opportunity to encourage the couple to work together to produce the lowest combined tax liability and thereby maximize their spendable resources. There is a finite “pool” of money between the two parties, and the less paid to the taxing authorities in the aggregate, the more the couple has to spend on themselves and any children.
As it is, divorce is very prevalent in our society. Careful document and tax planning can make this event a little more bearable.
