Is it alimony as defined in I.R.C. s. 71?

Common errors as to whether a stream of payments are taxable / deductible 

Part II

This is a continuation of the column which appeared in last month's Florida Bar Journal dealing with some common errors as to whether a stream of payments are taxable/deductible under the Internal Revenue Code. Last month the following common errors were discussed: lack of distinctions as to whether the payments are for support or for property, if for support whether the payments must be taxable/deductible, whether voluntary payments can be taxable/deductible and whether payments under an invalid agreement or order are taxable/deductible.

* If it is temporary alimony, it must be taxable to the payee.

Answer: Wrong.

When, in dicta, the court in Rihl v. Rihl, 727 So. 2d 272 (Fla. 3d DCA 1999), wrote "temporary alimony is taxable to the wife and deductible to the husband," it was misleading. Temporary alimony need not be taxable/deductible.

There are exceptions to that which is required in an order for temporary support, i.e., a "decree (not described in subparagraph (A)) requiring a spouse to make payments for the support of maintenance of the other spouse,"(1) to qualify as taxable/deductible.

Under an order for temporary support it is all right for the payee spouse and the payor spouse to be members of the same household at the time such payment is made. The requirements that the parties must maintain separate households applies "in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance."(2) The separate household requirement is only in the event of a change in the status of marriage.

Another exception is that the re-computation rule (also referred to as the "recapture" or "front loading" rule) does not apply. There need be no fear of recapture of alimony paid pursuant to an order for temporary support. Payments under an order for temporary support are excluded from the recomputation rule.(3)

The other requirements of I.R.C. [sections] 71 to make a stream of payments taxable/deductible are necessary. Thus, if the payments are cash, to or on behalf of spouse or former spouse, paid pursuant to a divorce or separation instrument that ceases upon death of the payee, not fixed as child support, and not designated as nontaxable/nondeductible, it will be taxable/deductible. Thus, to make a stream of payments under an order for temporary support not taxable/deductible all that need be done is to designate the payment as not taxable/not deductible in the order for temporary support.

* If the award includes both alimony and child support (unallocated), it cannot be taxable/deductible because child support we know is not deductible.

Answer: Wrong.

It is true that if a stream of payments is "fixed" as child support, it is not taxable/deductible.(4) However, an award of family support, e.g., an amount of support unallocated (undesignated) as to alimony and child support, does not "fix" any amount as child support.

Internal Revenue Service's Priv. Ltr. Rul. 8710089 (December 11, 1986), released March 6, 1987, discusses a temporary order which required that "until further order of the court, husband was required to pay to wife, as child support and alimony."(5)

I.R.C. [sections] 71(c)(2) states that if any amount specified in the instrument will be reduced 1) on the happening of a contingency specified in the instrument relating to a child (such as attaining a specified age, marrying, dying, leaving school, or a similar contingency), or 2) at a time which can clearly be associated with such a contingency, an amount equal to the amount of such reduction will be treated as an amount fixed as payable for the support of children of the payor spouse, and thus not taxable/deductible as alimony. There was no reduction provided in the temporary order.

Note that all other of the requirements of I.R.C. [sections] 71 must be met, including that the payments must cease upon the death of the payee. Thus, the unallocated child support and maintenance payments made pursuant to a Colorado order for temporary support was held in Miller v. Commissioner, T.C. Memo 1999-273(6) to be not taxable/deductible because the payments did not cease upon the death of the payee. Under Colorado law the support under temporary orders continue "until further Order of the Court" or "terminates when the final decree is entered, unless continued by the court for good cause to a date certain, or when the petition for dissolution or legal separation is voluntarily dismissed." The court held:

In this case, the Temporary Orders are silent regarding the tax consequences of the unallocated family support payments. Although petitioner could have agreed to the tax consequences of the payments, they failed to do so. See sec. 71(b)(1)(B) and (c). Colorado's UDMA does not state expressly whether combined spousal and child support payments must terminate on the death of the payee spouse.

The Miller case gives us a real message to be "tax safe":

1) If the payments are to be nontaxable/nondeductible, so designate as such.

2) If the payments are to be taxable/deductible make sure they cease upon the death of the payee. Add such a provision in the order or agreement.

3) Spell out what the intended tax consequences are to be and provide for an adjustment if the results are otherwise.

As to unallocated alimony and child support the difficulty is, of course, that many state courts feel mandated to award "child support guideline" amounts and categorize that amount as "child support," thus no tax saving. In Florida, appellate courts have articulated that child support guidelines are applicable to temporary support awards.(7) However, unless a party seeks an allocation, trial courts have traditionally ordered unallocated temporary family support. If one party seeks an allocation, the court should determine which portion of the award is for child support, applying the guidelines.(8)

* My spouse needs support for only one year. This can be taxable/deductible.

Answer: Yes, but if it exceeds $7,500 in the first calendar year it will be subject to recapture.

A recalculation and inclusion in income by the payor is required to the extent that the amount of such payments are affected by the recomputation rule.(9) The payor spouse is required to include the excess amount in gross income(10) in the payor spouse's third post-separation year.(11) The payee is allowed a deduction for the excess amount in computing adjusted gross income in the payee's third post-separation year.

A suggested worksheet to determine whether or not there will be any recapture and the amount follows at the end of this article.

* There is no need to determine as to a temporary alimony award whether or not it is taxable/deductible. This can be done at the final hearing.

Answer: Wrong.

Retroactive tax effect can be given only if a subsequent order corrects a mistake, omission or mathematical error.(12) Thus, a later allocation of alimony and child support may or may not have retroactive effect, depending on the facts and how the order is structured. A later designation as nontaxable will not have retroactive effect.

Johnson v. Commissioner, 45 T.C. 530 (1966), is applicable. Although the case involved the modification of a final judgment, the same principles are involved. There, the original decree from the Illinois divorce court provided for $75 per week for alimony and child support. Eight years later a corrective decree of divorce was entered which acknowledged that the wife, at the final hearing, had waived alimony and "by reason of clerical error such finding was omitted." Therefore, the award of $75 per week for alimony and child support was in error. The provision was stricken and corrected to provide for $75 per week for child support. The Tax Court found retroactive effect to the corrective order as "[i]t seems obvious that the decree that was entered was incorrect in that it did not record the court's announced ruling."

The court came to the conclusion contrary to Johnson in Turkoglee v. Commissioner, 36 T.C. 552 (1961). There, the original order from the divorce court provided for unallocated alimony and child support. Two years later an order for modification was entered providing for an allocation of the amount between alimony and child support. The court said:

Here, the Delaware County court did not label its "Order for Modification" a nunc pro tunc order and nothing in the order itself shows that it was issued to correct an error or inadvertence appearing in the original order. Indeed, the contrary appears. The term "modification" used by the court, connotes change, not correction. We conclude that the court's later order was not issued nuncpro tunc. We can find nothing to indicate that its original decree did not correctly reflect the court's intention at the time it was entered.

The State court's "Order for Modification" of April 1959 does not correct a mistake which appeared in the original order, but rather changes the rights of the parties.

If a party or the court realizes at final hearing that the recipient of a stream of payments during the pendency of the proceedings not designated as nontaxable results in a tax liability, does the court have the authority to distribute that liability to the other party? A court can distribute marital liabilities if it determines the amount.(13) But if the liability is incurred after the filing, as it would be if the liability is created by virtue of temporary support, is it a marital liability?

* If there is a substantial alimony award and the payor suffers a serious loss of income in the first or second post-separation years, the divorce court can modify the payments downward without tax consequences to that payor.

Answer: Wrong.

There is a genuine possibility that a payor may become disabled due to an illness, suffer a debilitating accident, partially or fully retire, or suffer any other disaster which would drastically reduce the payor's ability to work, thus decreasing the level of the payor's ability to pay alimony in the second or third post-separation year. If any such event were to occur, the payor would obviously be entitled to request and most likely receive a downward modification of an alimony award pursuant to F.S. [sections] 61.14. In doing so, however, the payor could be subjected to recapture requiring the payor to claim as income a portion of the deduction for alimony payments taken in previous years.

There is nothing a divorce court can do if the payor eventually suffers a devastating recapture of income unless the court takes action at the time of entry of the judgment requiring the payment of alimony. The trial court cannot change the tax law, nor the effect of the law, but it can and should consider ensuring that a payor does not become subject to the potentially devastating results of the tax law.

The parties could, however, consider one of the exceptions to the recomputation ("recapture" or "anti-front-loading") rule.

The recapture problem can be obviated by providing that the alimony payments equal a fixed portion or portions (i.e., percentage) of the payor's income froth a business or property or compensation from employment or self-employment, rather than a fixed amount (the usual periodic alimony in a specific periodic amount). Under I.R.C. [sections] 71(f)(5)(A), such fluctuating payments are specifically excluded from the recapture provision. Payments of a fixed amount (as opposed to a fixed "portion") of alimony which decrease (i.e., fluctuates) as a result of a modification by court order or cease as a result of various contingencies (except only death of either party or remarriage of the payee) are not excluded from the recapture provision.

Whether a court can or will utilize this exception to the recapture rule remains to be seen. Provisions in final judgments for automatic adjustments in alimony have been rejected by the appellate courts. For example, it was held error for a trial court to include in the alimony award an automatic reduction on the husband's retirement. Rion v. Rion, 421 So. 2d 541 (Fla. 5th DCA 1982). Automatic increase provisions have been overruled in Stoler v. Stoler, 376 So. 2d 253 (Fla. 3d DCA 1979), cert. den. 389 So. 2d 1115; and Reid v. Reid, 365 So. 2d 1050 (Fla. 4th DCA 1978). See also Potter v. Potter, 477 So. 2d 67 (Fla. 1st DCA 1985) (Automatic increases to permanent periodic alimony on the basis of a fixed formula adjusted pursuant only to the parties' income without the necessary relationship to the existing relevant circumstances will not be upheld); and Antonini v. Antonini, 473 So. 2d 739 (Fla. 1st DCA 1985) (A provision for an automatic reduction in future permanent periodic alimony is in error absent clear evidence that the receiving spouse's financial needs will change).

The decisions of the trial courts in the above cited cases all pre-date the 1984 change in the tax code effective as to alimony paid on or after January 1, 1985. Because the tax law has changed, should the Florida case law change?

                                   3d Year   2d Year   1st Year(1)

Alimony paid in each year          $--       $--       $--

1st Calculation:
 Add $15,000 to 3d year            15,000
 Compare 3d year to
  2d year (i.e., subtract
  3d year, as adjusted,
  from 2d year, unless in
  excess of second year)                     <-->
 Recapture from 1st                          $--(2)
  calculation

2nd Calculation:
 Add payments made in
  years 2                          $
  and 3                            --
                                   $

 Adjust by reducing
  any recapture from
  1st calculation                  <-->
                                   $--

 Average (divide
  by 2)                            $
 Add $15,000                       15,000
 Compare to 1st year
  (i.e., substract above
  from 1st year, unless in
  excess of first year)
                                                       <-->
Recapture from 2d calculation
                                                       $--(2)

Recapitulation:
  Recapture from 1st calculation                       $
  Recapture from 2d calculation                        --
  Total recapture                                      $--

(1) Note that the applicable years are set forth in reverse order with
the third year first.

(2) There will never be a negative recapture.

(1) I.R.C. [sections] 71(b)(2)(C).

(2) I.R.C. [sections] 71(a)(1)(C).

(3) I.R.C. [sections] 71(f)(5)(B).

(4) I.R.C. [sections] 71(c) and Temp. Treas. Reg. Q&A 15-18 of 1.71-1T.

(5) The Priv. Ltr. Rul. states that it is assumed "that there is no liability on your part [the taxpayer making the inquiry] to make such support payments (and substitute for the payments) for any period after the death of wife."

(6) In Miller, the tax court suggested the benefit of an unallocated amount of alimony and child support if done right. It said: "Unallocated family support is a technique sometimes used in domestic relations cases to encourage sensible cash-flow planning between separated spouses. If used correctly, the technique enables the parties to achieve a higher net transfer of funds to the payee spouse because the payor spouse, who is generally in a higher tax bracket, reaps an economic benefit from the larger tax deduction obtained when allocated family support payments are structured to be deducible as alimony. These unallocated payments, while typically temporary, can facilitate the economic transition that must occur as a result of a divorce or separation, provided the parties understand and agree to the tax consequences."

(7) Abraham v. Abraham, 700 So. 2d 421 (Fla. 3d DCA 1997); Burkhart v. Burkhart, 620 So. 2d 225 (Fla. 1st DCA 1993). In both the expressions were dicta.

(8) See Abraham v. Abraham, 700 So. 2d 421.

(9) A reduction in alimony that exceeds $7,500 between the first and second post-separation years and $15,000 between the second and third post-separation years.

(10) Some writers have referred to this as "phantom income."

(11) I.R.C. [sections] 71(f)(6) defines "post separation year" as the calendar year in which alimony that qualifies under that act is paid.

(12) Rev. Rul. 871-416 (1971-2).

(13) Lorman v. Lorman, 633 So. 2d 106 (Fla. 2d D.C.A. 1994).

Melvyn B. Frumkes maintains offices for the practice of law in Miami and Boca Raton. He restricts his practice to marital and family law. He is a graduate, with honors, from the University of Florida College of Law. Mr. Frumkes is the author of Frumkes on Divorce Taxation.

This column is submitted on behalf o the Family Law Section, Jeffrey P. Wasserman, chair, and Tom Sasser, editor.