Divorce, American style: structuring payments to maximize income tax savings.

The Code provides that alimony payments are deductible by the payor spouse and taxable to the payee spouse, (1) but child support is not alimony and is thus not deductible by the payor. (2) The application of these results in a splitting of the payor's income and of the taxability of the alimony payments. If the payments are properly structured to qualify as alimony, it is possible to achieve a net after-tax benefit for the parties.

This article will discuss what constitutes alimony, child support and property settlements; explore the income tax ramifications; and examine the tax planning options available to a divorcing couple.

Net Savings

to Divorced Taxpayers

As the following examples demonstrate, an awareness of the income tax consequences of divorce can result in a net savings to a divorcing couple. This is equally true in terms of the property settlement. By bargaining in terms of after-tax dollars, the parties gain a more realistic perception of their respective financial positions and can reach an equitable resolution more easily.

Example 1: In 1990, ex-husband H made $30,000, and W, his ex-wife, made $10,000. H paid W $5,000 in 1990, which did not qualify as alimony. Therefore, H was not entitled to a deduction and W was not required to include the payment as income.

H claimed the standard deduction for a single taxpayer and one exemption. His taxable income for 1990 was $24,700:

$30,000 - 3,250 (standard deduction) - 2,050 (personal exemption) $24,700 $24,700

H's tax liability was $4,395. Thus, his disposable income for 1990 after paying taxes and the nondeductible amounts to W was $20,605.

W claimed the standard deduction for a single taxpayer and one exemption. Her taxable income for 1990 was $4,700:

$10,000 - 3,250 (standard deduction) - 2,050 (personal exemption) $ 4,700

W's tax liability was $709 and her disposable income was $14,291.

Example 2: Assume the same facts as in Example 1, except that H gave $6,000 to W $5,000 of which qualified as alimony. H was entitled to deduct $5,000 of the payments from his gross income in determining his tax liability and W was required to report the $5,000 as income.

H's taxable income for 1990 was $19,700:

$30,000 - 5,000 (alimony paid) - 3,250 (standard deduction) - 2,050 (personal exemption) $19,700

H's tax liability was $2,995. Thus, his disposable income for 1990 after paying taxes and the amounts to W was $21,005.

W's taxable income for 1990 was $9,700:

$10,000 + 5,000 (alimony) - 3,250 (standard deduction) - 2,050 (personal exemption) $ 9,700

W's tax liability was $1,459 and her disposable income was $14,541.

Simply by having a portion of the payments qualify as alimony, both H and W increased their disposable income for the year.

Classification of

Payments as Alimony

* Sec. 71(b) requirements

A payment qualifies as alimony if it meets the seven requirements set out in Sec. 71(b).

* Payments must be in cash: The definition of "cash" is very limited and includes only cash or its equivalent, such as checks and money orders payable on demand. (3) The transfer of services or property (such as a debt instrument of a third party or an annuity contract), the execution of a debt instrument by the payor, or the use of property of the payor do not meet the "cash" requirement.

* Payments must be made to or on behalf of the payee: A cash payment to a third party may qualify as alimony if it is made on behalf of the payee. However, payments to third parties must be made pursuant to the payee spouse's written request, consent or ratification; the writing must state that the parties intend the payment to be treated as alimony; and the payor spouse must receive this written request before the filing date of the payor's tax return for the tax year in which the payment was made. (4) Qualifying payments to third parties include the cash payment of rent, tax or tuition on the payee's behalf, the cash payment or a home mortgage or expenses of maintaining a residence for the payee (so long as the property is not owned by the payor), the cash payment of life insurance premiums (so long as the payee is the owner of the policy) (5) and donations to charitable organizations. (6)

* Payments must be required by a written divorce or separation instrument: To qualify as alimony, payments must be designated in a decree of divorce or separate maintenance, a written instrument incident to such a decree of divorce or separate maintenance, written separation agreement, or any other kind of decree requiring a spouse to make payments for the support or maintenance of the other spouse (e.g., temporary support orders). (7) Payments under a decree (either of divorce or of separation) may qualify as alimony only if paid after the entry of the decree. (8) Payments under a written separation agreement may qualify as alimony only if paid after the execution of the agreement. (9)

* Payments must not be designated as nondeductible by the payor or nonincludible by the payee: If either the court or the parties designate that all or a portion of the payments will be non-deductible or nontaxable, the payments (or the designated portion thereof) are not alimony. (10) A copy of this written designation must be attached to the payee's first filed tax return for each year that the payments are not includible in the payee's income. (11)

* Parties must not be members of the same household: If the payor and payee are legally separated, they must not be members of the same household at the time a payment is made. (12) A dwelling unit formerly shared by the spouses will not be considered two separate households even if the spouses physically separate themselves within the dwelling unit. (13) The separate-household rule does not apply if one spouse is preparing to move and does so within one month of the payment in question or if the payments are made pursuant to temporary support orders. In addition, this rule does not apply if the parties are not legally separated under a decree of divorce or separate maintenance.

* Payor's obligation to make payments must terminate at the payee's death: (14) The Deficit Reduction Act of 1984 (DRA) had required that the instrument affirmatively state that payments terminated on the death of the payee. The Tax Reform Act of 1986 (TRA) retroactively eliminated this requirement, but did not change the rule that payments must terminate at the payee's death. (15) Thus, when the instrument does not say whether the obligation to pay continues after the payee's death, state law will determine whether the payments qualify as alimony. In such a case, the payments are alimony only if the applicable state law provides that the obligation to pay future maintenance is terminated on the payee's death.

Attempts to circumvent this rule by providing for an increase in child support after the death of the payee spouse will be ineffective, because such an increase in payments at the payee's death will be treated as "substitute" payments and will result in a corresponding decrease in the amounts paid to the payee that would otherwise have qualified as alimony. (16) Any payments that begin, increase or accelerate as a result of the payee's death may be treated as substitute payments, depending on all of the facts and circumstances.

Example 3: Under their divorce decree, W is required to pay H $1,000 per month as alimony. Additionally, at W's death, W's estate must pay $950 per month to H as child support for their child, who is in H's custody. Only $50 of the $1,000 payment each month will be treated as alimony; the other $950 will be treated as a "substitute" child-support payment.

* Payment must not be child support: A payment to a payee spouse will not qualify as alimony or separate maintenance if it is in the nature of child support. (17) (Whether a payment is in the nature of child support is discussed later.) When a payor pays less than the full amounts of child support and alimony that he owes, the payments will be applied first to the child support obligation and only the balance will be treated as payment of the alimony obligation. (18)

* Recapture of excess front-loading

Even if the payments meet all of the Sec. 71(b) requirements, includibility and deductibility of the payments may be recomputed and reallocated when there is excess front-loading of payments. The Sec. 71(f) recapture rules are designed to prevent large decreases (in excess of $15,000) in the alimony paid from one year to the next during the first three calendar years in which alimony is paid. Recapture occurs only in the third postoperation year. To determine whether recapture is required and, if so, the amount of the recapture, the following computations are required.

The amount to be recaptured in the third calendar year is equal to the recapture amount for the second calendar year plus the recapture amount for the first calendar year. The second calendar year recapture amount is equal to the excess of the alimony paid during the second calendar year over the alimony paid during the third calendar year plus $15,000. The first calendar year recapture amount is equal to the excesss of the alimony paid during the first calendar year over $15,000 plus the average of the alimony paid during the second calendar year reduced by the second calendar year recapture amount, if any, and the alimony paid during the third calendar year. See Example 4 on page 176.

The recapture amount must be included in gross income by the payor spouse in his tax year that begins during the third calendar year. The payee spouse is allowed a corresponding deduction in computing adjusted gross income in her tax year beginning during the third calendar year.

The recapture rules do not apply when payments decline by $15,000 or less over the three-year perod. The recapture rules also do not apply if either spouse dies or the payee spouse remarries, thus causing the alimony payments to cease before the close of the third calendar year. (19) This is true even though recapture would have been required absent the death or remarriage. In addition, recapture is not required if payments were received pursuant to a decree other than a decree of divorce or separate maintenance. (20) As a result< large payments can be made and deducted by the payor spouse without triggering the recapture penalty as alimony under a temporary support decree. And finally, the recapture rules do not apply to fluctuations in alimony paid that are attributable to the payor spouse's continuing liability over a period of three or money years to pay a fixed portion or portions of income from business or property, or employment or self employment. (21) The term "portions" clarifies that staggered percentages are permissible (e.g., 50% of the first $50,000, 40% of the next $20,000, 30% of the next $20,000, etc.).

Classification of

Payments as Child Support

Payments for the support of the payor's children are not alimony and are not deductible by the payor. (22) Under Sec. 71(c)(2), reductions in alimony amounts may be treated as disguised child support if the reductions occur on "the happening of" a child-related contingency.

A contingency is child related if it depends on any event expressly connected with a child, even if that event is certain to occur. Events that are child related include the child's attaining a specified age or income level, dying, marrying, leaving school, leaving the spouse's household or gaining employment. (23)

The regulations specify two situations in which it is presumed that a reduction is associated with a child-related contingency. In the first situation, the reduction occurs within six months before or after a child reaches age 18, 21 or the local age of majority. In the second, the reduction occurs on two or more occasions that occur not more than one year before or after a different child of the payor attains a certain age between the ages of 18 and 24. (The age need not be a whole number of years but must be the same for each child.) (24)

A presumption that payments were child related may be rebutted by showing that the time at which the payments are to be reduced was determined independently of any contingencies relating to the children, 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. (25)

With careful planning, payments to a payee spouse to support children may still meet the qualifications for alimony treatment if the parties are willing to scrifice the exactness in the timing of the termination of child support payment. This can be accomplished by agreeing on a termination date that does not impermissibly coincide with a child-related contingency.

Example 5: On Jan. 1, 1991, H and W divorce and agree that H will pay $2,000 per month to W as alimony. On Jan. 1, 2001, these payments will be reduced to $1,500 per month; on Jan. 1, 2006, they will be reduced to $1,000 per month. In the event that W dies, the payments will totally cease. H and W have two children: A is 14 (born on Oct. 1, 1976) and B is 7 (born on Dec. 1, 1983).

Because the termination of child support for each child does not violate the child-related contingency rules, the entire $2,000 per month is to be treated as alimony even though $1,000 of its represents child support ($500 for each child). Payments on A's behalf will cease when A is 24 years and three months; payments on B's behalf will cease when B is 22 years and one month. Thus, termination of payments does not fall within six months of either child's reaching age 18, 21 or the age of majority, nor do the payments cease within one year of the two children reaching the same age. (26)

Classification of

Payments as Property Settlement

Sec. 1041 provides that property transfers between spouses incident to divorce are nonrecogntion events for income tax purposes, unless the donee is a nonresident alien. (27) The spouse receiving the property is treated as having received the property as a gift. (28) On the subsequent sale of the property by the recipient spouse, the recipient's basis in the property is equal to its basis in the hands of the transferor spouse. [29]

A transfer is incident to a divorce if it occurs within one year after the date on which the marriage ceases or is related to the cessation of the marriage. [30] A transfer is related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument and the transfer occurs not more than six years after the date on which the marriage ceases. [31] Any transfer that is not pursuant to a divorce or separation instrument and any transfer occurring more than six years after the cessation of the marriage is presumed to be unrelated to the cessation of the marriage and thus, a taxable transfer. The presumption may be rebutted only by showing that the transfer was made to affect the division of property owned by the former spouses at the cessation of their marriage.

Certain transfers to trusts do not qualify under Sec. 1041. A transferor must recognize the gain deferred on an installment obligation on transferring the obligation to a trust for the benefit of the other spouse. [32] Also, if property is transferred in trust incident to divorce and the sum of the liabilities assumed plus the amount of liabilities to which the transferred property is subject exceeds the transferor spouse's adjusted basis in the transferred property, the transferor spouse will recognize gain on the transfer. [33] It is unclear what happens when encumbered property is transferred to an alimony trust, with the transferor spouse retaining a reversionary interest in the corpus of the trust. Under the grantor trust rules, the transferor spouse should ultimately recognize the gain on the property when it is realized in the normal course of events. [34]

Allocating Child-Related

Deductions and Exemptions

Generally, the custodial parent is entitled to the dependency exemption for the children. However, the noncustodial parent may receive the benefit of the exemption if the custodial parent executes the proper forms. [35] Because the TRA reduced the tax benefit of the dependency exemption for high income earners, parties to a divorce should not allocate a dependency exemption to a high income parent if that parent would receive no tax benefit from the exemption while the other parent, who is in a lower tax bracket, would benefit from the exemption.

Either spouse may claim the deduction for medical expenses incurred and paid on behalf of dependent children. [36] However, because the floor on medical expense deductions is now 7.5% of adjusted gross income, few taxpayers will be able to deduct their medical expenses. The medical expense deduction should, then, be allocated to the spouse who is most likely to exceed the 7.5% floor, i.e., the spouse who has the best combination of high deductions and low income to make use of the deduction.

Unearned income of children under the age of 14 is taxed at a rate at least equal to the marginal tax rate to which the custodial parent is subject. [37] This additional tax should be considered, especially if the custodial spouse is, as a practical matter, the party to bear the burden of paying the tax.

Conclusion

While it is impractical (and probably unwise) for advisers to divorcing couples to focus entirely on tax issues, divorcing couples should consider the income tax consequences in structuring their settlements. By structuring payments to qualify as alimony, child support or a property settlement, and by prudently allocating child-related deductions and exemptions, significant and mutually beneficial savings can be achieved.

[1] Secs. 71(a) and 215(a).

[2] Sec. 71(c).

[3] Temp. Regs. Sec. 1.71-1T(b), O&A-5.

[4] Temp. Regs. Sec. 1.71-1T(b), Q&A-7.

[5] Temp Regs. Sec. 1.71-1T(b), Q&A-6.

[6] Temp. Regs. Sec. 1.71-1T(b), Q&A-7.

[7] Sec. 71(b)(1)(A) and (b)(2).

[8] Tegs. Sec. 1.71-1(b)(2).

[9] Regs. Sec. 1.71-1(b)(2).

[10] Sec. 71(b)(1)(B).

[11] Temp. Regs. Sec. 1.71-1T(b), A&A-8.

[12] Sex. 71(b)(1)(C).

[13] Temp. Regs. Sec. 1.71-1T(b), Q&A-9.

[14] Sec. 71(b)(1)(D); Temp. Regs. Sec. 1.71-1T(b), Q&A-11 and -12.

[15] H. Rep. No. 99-841, 99th Cong., 2d Sess. II-849 (1986).

[16] Sec. 71(b)(1)(D); Temp. Regs. Sec. 1.71-1T(b), Q&A-14.

[17] Sec. 21(c).

[18] Regs. Sec. 1.71-1(e).

[19] Sec. 71(f)(5)(A).

[20] Sec. 71(f)(5)(B).

[21] Sex. 71(f)(5)(C).

[22] Sec. 71 (c)(1).

[23] Sec. 71(c)(2); Temp. Regs. Sec. 1.71-1T(c), Q&A-17.

[24] Temp. Regs. Sec. 1.71-1T(c), Q&A-18.

[25] Id.

[26] Adapted from the example in Temp. Regs. Sec. 1.71-1T(c), Q&A-18.

[27] Sec. 1041(a)(2) and (d).

[28] Sec. 1041(b)(1)>

[29] Sec. 1041(b)(2).

[30] Sec. 1041(c).

[31] Temp. Regs. Sec. 1.1041-1T(b), Q&A-7.

[32] Sec. 453B(g).

[33] Sec. 1041(e).

[34] Sec. 673.

[35] The appropriate form to execute for a noncustodial parent to take advantage of Sec. 152(e) is Form 8332, Release of Claim to Exemption for Child of divorced or Separated Parents.

[36] Sec. 213(d)(5).

[37] Sec. 1(g).