Unpaid child support and alimony payments - bad debt deduction?
One may ask why, 24 years after Swenson, 43 TC 897 (1965), the Tax Court decided to issue another regular opinion and even further why the IRS decided to issue a revenue ruling on the subject at all.
The Tax Court and the Service's position generally involves two points: the taxpayer never established a basis in the alleged debt or the worthlessness of the debt.
Taxpayers have generally argued that a worthless debt is created by the unpaid court-ordered payments. As a result of the alleged unpaid debt, taxpayers seek a deduction under Sec. 166(a)(1). Sec. 166(b) provides that the amount of the deduction will be the adjusted basis provided in Sec. 1011 for computing gain or loss. This basis is provided for in Sec. 1012 as cost. Sec. 166(d) allows short-term capital loss treatment for the nonbusiness bad debts of noncorporate taxpayers.
The courts' analyses
The taxpayers generally argue that they have developed a creditor relationship with the former spouse for out-of-pocket payments they have had to make to support either their children (child support) or themselves (alimony). As long as these payments were more than the amount received from the former spouse, but not more than the amount originally ordered by the court, taxpayers allege that they should have a bad debt deduction.
The Tax Court has repeatedly stated that there is no creditor relationship. All the out-of-pocket payments made by the taxpayers are made at their own discretion and have no relationship to the court-ordered payments of former spouses. In Swenson, the Tax Court stated that it is a well-known principle that "bad debts" must be "debts created by advances out of capital or out of income previously taxed or exempted or, in other words, debts with a regard to which the taxpayer has a basis. The court continued:
Waldram's obligation to make the payments here involved was imposed on him by law, arose from his status as a father, and was defined by the divorce court; it was in no way contingent on any payments for support of the children made by petitioner. Therefore it cannot be said that such payments by petitioner were made for the acquisition of any right of action against Waldram. We are unable to see how petitioners could have any cost or other basis with regard to the arrearages in such payments, or to see how any funds of theirs can be said to have created the debt here in question or to have constituted its cost.
In Imeson, the Tax Court reaffirmed its Swenson decision with an almost verbatim opinion. But the Ninth Circuit stirred the issue by stating:
The Tax Court has treated these obligations as if they were uncollectible unpaid wages or salary . . . . It is arguable, however, that Mrs. Imeson's position, in which she is legally obligated to support her children if her husband, who has been ordered to do so, defaults, is not analogous to that of the unpaid wage earner. It can be argued that her position is more like that of a taxpayer who pays materialmen's liens on his house after the builder has defaulted . . . . It can also be argued that her position is analogous to that of a guarantor who pays the creditor when the principal debtor defaults.
The Ninth Circuit failed to resolve these arguments since it decided that the taxpayer failed to establish how much she expended or the worthlessness of the debt.
There was no action on the issue until 1984 when the Tax Court had the opportunity to review its Swenson decision in three memo decisions (Meyer, TC Memo 1984-487; Pierson, TC Memo 1984-452; and Diez-Arguelles, TC Memo 1984-356). Since the Ninth Circuit brought up the two new arguments in Imeson, the Tax Court felt obligated to resolve its position on these new arguments. In Diez-Arguelles, the Tax Court stated:
Because of this dictum we subsequently reexamined our position on this issue and concluded that the cases cited by the Ninth Circuit were distinguishable . . . . Consequently, our position on this issue is still the same as set forth in Swenson . . . and Imeson.
However, in Perry, 92 TC 470 (1989), the Tax Court discussed its rationale for not agreeing with the analogy to the payment of the materialmen's lien or the debt of another.
We conclude that the materialmen's lien and guarantor analogies only serve to illustrate the shortcomings in petitioner's case. In the materialmen's lien and guarantor situations, the taxpayer's role as creditor would have arisen only when and to the extent that the taxpayer paid the original debt. In the instant cases, any debt that Perry owed to petitioner arose, and was determined as to amount, without regard to petitioner's expenditures.
We conclude that the Guarantee did not provide petitioner with a hasis in the support obligations.
The "guarantee" referred to in the last sentence is one in which the taxpayer tried a legal maneuver to form a guarantee for the unpaid child support and alimony. To accomplish this the taxpayer's attorney drafted a retroactive guarantee that the taxpayer would retroactively guarantee the former spouse's obligations. The Tax Court said the guarantee was worthless for two reasons: (1) one cannot retroactively guarantee payment and become a creditor and (2) one cannot guarantee an obligation that is required by state law (i.e., to support one's children if the former spouse fails to do so).
Rev. Rul. 93-27's impact
The IRS appears to have issued this ruling either as a result of receiving many letter ruling requests or just generally to make it clear that this item has no merit for deductibility. The Service appears to want to clarify that the taxpayer has no basis in the unpaid amounts. Therefore, there is no debt for which to prove worthlessness.
While the IRS position on this matter is clear, there may be techniques for more aggressive taxpayers to secure bad debt deductions by planning for the possibility of "default" on child support payments at the time of divorce. For example, the child support agreement (or a separate agreement) could state that amounts required to be expended by the custodial parent because of unpaid child support become a debt from the nonpaying parent to the custodial parent. In this case, the custodial parent's support expenditures create an obligation to the nonpaying parent, and a creditor relationship is established. If the custodial parent can prove the debt is worthless, arguably a bad debt deduction may be available.
In other cases, a third party (i.e., a relative) may make gifts to the custodial parent to replace the unpaid child support. If, instead, this third party made loans to the nonpaying parent to satisfy the support obligation, the third party could obtain a bad debt if the loan became worthless. Of course, the loan money would go directly to the custodial parent. The nonpaying parent may prefer a debt to this third party rather than unpaid child support.
The key to a bad debt deduction in the case of unpaid child support is to plan for this contingency at the time of the divorce. In the cases cited, the taxpayers did not consider this contingency until after the fact.
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|Author:||Price, Charles E.|
|Publication:||The Tax Adviser|
|Date:||Oct 1, 1993|
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