Alimony reductions: avoiding the trap.

CPAs are often called on to assist divorcing clients and their attorneys in structuring marital separation agreements that ultimately become part of the final divorce decrees. For most marriages, child support and alimony may be issues. Practitioners not only drafting agreements, but also assisting in the review of such agreements, must use extra caution.

A trap for the unwary is present in situations in which final marital separation agreements not only call for child support payments, but also modifiable alimony payments on a reduction schedule for the future (Temp. Regs. Sec. 1.71-1T(c)). Modifiable alimony may operate to provide the recipient of such alimony payments with larger payments immediately after a divorce, and smaller payments in the future. The reduction schedule for modifiable alimony payments must be carefully constructed not only to make good economic sense for the client, but also to avoid possible adverse tax treatment in the event of an IRS inquiry.

Prior to 1984, one could easily include a "Lester clause" in a final agreement and avoid alimony payments being reclassified as nondeductible child support. The Supreme Court, in Lester, 366 US 299 (1961), ruled that if alimony was modified or reduced, based on a contingency related to a child, such a reduction did not fix that part of the payment as being of the character of child support unless the agreement explicitly stated it. In order for child support to be treated as child support for tax purposes, the payment (or any part of such payment) was required to be fixed by the divorce decree as being payable for the support of the child (or children) of the payor spouse.

The Tax Reform Act of 1984 (TRA) completely reversed the Supreme Court's decision in Lester. Currently, a payment will be treated as nondeductible child support if any of three conditions exist:

1. The decree specifically states the payment to be for child support.

2. A payment, usually called modifiable alimony, is reduced on the occurrence of a contingency related to a child (with the corresponding reduction being classified for tax purposes as child support).

3. The reduction of the payment takes place at a time "clearly associated" with a contingency related to a child (Sec. 71(c)).

Temp. Regs. Sec. 1.71-1T(c) provides that a contingency relates to a child of a payor spouse if that contingency associates itself with any event relating to that child, regardless of whether the event is certain or likely to occur. The regulations go on to provide some specific examples of contingencies related to a child: a child attaining a certain age or income level, dying, marrying, leaving school, leaving the custodial parent's household or gainful employment.

A modifiable alimony payment reduction will be treated as clearly associated with the occurrence of a contingency related to a child under two situations that should be avoided when structuring marital settlement agreements. If final agreements are properly drafted, reductions in alimony payments will avoid these situations.

If an alimony payment reduction occurs not more than six months before or after the date a child is to attain the age of 18, 21 or the local age of majority, that portion of the reduction of the original alimony payment will be considered to be clearly associated with a contingency related to the child (the one-year window rule).

The second situation refers to alimony payments that are to be reduced on two or more occasions. In this situation, the alimony payment reductions must not occur within a two-year window surrounding the time a child (or children) reaches a certain age. Alimony payment reductions will be treated as child support for tax purposes if the reductions occur on two or more occasions and take place not more than one year before or after a different child of the payor spouse reaches a certain age between 18 and 24, inclusive (the two-year window rule).

The certain age referred to in the regulations must be the same for each child involved. Furthermore, the age need not be a whole number of years. It is imperative when drafting agreements not only to address how old children are in years on the date of a scheduled reduction of a modifiable alimony payment, but also to consider the number of months old and the number of days old those children are on the payment reduction dates.

Examples will easily clarify these concepts. For a one-child, one-payment reduction arrangement, the reduction must not occur within a six-month window before or after that child reaches 18, 21 or the local age of majority.

Example 1: The local age of majority in the jurisdiction is 21 years of age. Child X will be 18 years old on May 15, 1997, and 21 years old on May 15, 2000. The final marital separation agreement must not schedule a reduction in the payments of modifiable alimony amounts during the period Nov. 15, 1996 through Nov. 15, 1997 (six months before and after X's 18th birthday), or during the period Nov. 15, 1999 through Nov. 15, 2000 (six months before and after X's 21st birthday).

The second situation set forth in the regulations is more complicated and can most easily be explained through the following example:

Example 2: A and B are divorced on July 1, 1996, when their children C and D are 14 years old (born July 15, 1981) and 12 years old (born Sept. 23, 1983), respectively.

Under the divorce decree, A is to make alimony payments to B of $2,000 per month. These payments are modifiable and are to be reduced to $1,500 per month on Jan. 1, 2002 and then to $1,000 per month on Jan. 1, 2006.

On Jan. 1, 2002, the date of the first reduction in the alimony payments, the children will be the following ages: C, 20 years, 5 months and 17 days old; D, 18 years, 3 months and 9 days old.

On Jan. 1, 2006, the children will be the following ages: C, 24 years, 5 months and 17 days old; D, 22 years, 3 months and 9 days old.

A time line will assist in visualizing and understanding how the Service applies its presumption.

C's age on the first reduction date is 20 years, 5 months and 17 days. The two-year window, which is one year either before or after this age, sets the range for analysis below:

[ILLUSTRATION OMITTED]

D's age on the second reduction date is 22 years, 3 months and 9 days. The two-year window, which is one year either before or after this age, sets the range for analysis above.

As can be seen, the timing of the reduction of the second payment violates the two-year window rule. Once the two-year ranges are set up centering on the dates of the scheduled reductions, C's and D's ages overlap between the ages of 21 years, 3 months and 9 days and 21 years, 5 months and 17 days. Thus, both children are at the same certain age (within the window) when the payment reductions are to take place. Therefore, the agreement reduction dates and the amount of the reductions may be presumed by the IRS to be clearly associated with a contingency related to the children. The $1,000 total of the two reductions will then be treated as child support payments for tax purposes and not as deductible alimony. In order to structure this agreement so that favorable tax treatment will result to the payor spouse, one must arrange the modifiable alimony payment reduction dates to fall outside of the overlapping time frame.

The Service's presumption may be rebutted. One must show that the time at which the payments are to be reduced was determined independently of any contingencies relating to the payor's children. The presumption may be rebutted, for example, by showing that alimony payments are to be made for a period customarily provided in the local jurisdiction, such as a period equal to one-half the duration of the marriage.

Practitioners must use extra care in timing the reductions in modifiable alimony payments when child support issues are also present. When in this situation, always remember to ask the client for the exact dates of birth of all his children. Note: Because 1996 is a leap year, it is important not to overlook the impact the extra day in February may have on a child's age when drafting current documents and reviewing modifiable alimony reductions scheduled for 1996, as they were set forth in past documents regarding the client's final marital separation agreement.