Payments
to
Former Spouses

By Gary L. Maydew

The tax treatment of payments to former spouses differs greatly depending on whether the payments are categorized a property settlement or alimony. Property settlements
are nontaxable events to both parties; alimony is taxed to the recipient and deductible to the payer. Obviously there are many instances in which the distinction is not clear-cut.

Requirements for Alimony

For a payment to a former spouse to be designated as alimony--

* it must be in cash. Transfers of
services or property, execution of a debt instrument, or use of property do not qualify.

* it must be made under a divorce or separation instrument.

* the divorce or separation agreement must not designate the payment as being excludable and nondeductible;

* the payee and payor spouses must not be members of the same household at the time the payments are made.

* the liability to make payments ceases at the death of the payee. However, the instrument does not have to state this if, under state law, the payments must terminate at death.

* the spouses must not file a joint return with each other.

A decree requiring a spouse to make payments for the support or maintenance of the other spouse qualifies for alimony purposes.

The requirement that the parties not be members of the same household can sometimes cause trouble. A residence formerly shared by the spouses is not considered two separate households even if the spouses physically separate themselves within the residence.

Example 1. Smith moves into the basement of their residence after becoming divorced from his wife. For purposes of determining alimony, Smith and his wife are still members of the same household.

The spouses, though living in the same household, will not be treated as members of the same household if one spouse is preparing to leave the household and does depart within one month after the date the payment is made. Payments made under a decree described in IRC section 71(b)(2)(C) may qualify as alimony even if the spouses are members of the same household when the payment is made.

Where the divorce decree is silent with respect to whether the payments stop at death, the courts look to state law for guidance.

Property Settlements

No gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of)--

* a spouse, or

* a former spouse if the transfer is incident to the divorce.

A transfer is incident to a divorce if the transfer either occurs within one year after the date on which the marriage ceases or is related to the cessation of the marriage. A transfer of property is considered related to the cessation of marriage if the transfer is pursuant to a divorce or separation instrument and occurs not more than six years after the marriage ceases. Transfers not made pursuant to a divorce or separation instrument and transfers made more than six years after the end of the marriage are presumed not to be related to the divorce. The presumption may be rebutted only by showing that factors hampered an earlier transfer of the property and the transfer was affected promptly after the impediments to the transfer were removed.

There are three situations in which transfers to third parties on behalf of a spouse (or former spouse) qualifies under IRC section 1041:

* The transfer to the third party is required by the divorce or separation instrument.

* The transfer is pursuant to the written request of the former spouse.

* The transferor receives written consent from the former spouse. In that event, the consent must state that the parties intend the transfer to be treated as a transfer to the former spouse. The consent must be received by the transferor before the date of filing of the transferor's first tax return for the taxable year in which the transfer occurred.

Basis of the Property to the Transferee. The property is treated by the transferee as if acquired by gift and the basis of the property is carried over (the adjusted basis of the transferor). The regulations make it plain that the basis is always carried over, even if fair market value is less. The carryover basis rule applies even if the property is subject to debt in excess of the property's basis.

Alimony Versus Child Support

Payments designated for the support of the payor's children are not treated as alimony, but rather as child support. If any amount of payments specified in the divorce decree are reduced because of the child attaining a certain age, marrying, dying, leaving school, or similar contingencies, such amount is treated as child support. This is so regardless of the likelihood of the contingency occurrence. There are two situations in which payments that would otherwise qualify as alimony will be presumed to be reduced at a time clearly associated with the happening of a contingency relating to the child of a payor:

* The payments are to be reduced not more than six months before or after the date the child turns 18, or 21, or the local age of maturity; and

* The payments are to be reduced on two or more occasions that occur not more than one year before or after
a different child of the payor spouse attains a certain age between the ages of 18 and 24.

Example 2. Andy and Jennifer are divorced on July 1, 1997. Their children, Greg and Sonja, were born on July 15, 1982 and Sept. 23, 1984 respectively. The divorce decree states that Andy is to make alimony payments to Jennifer of $3,000 per month. Such payments are to be reduced to $2,250 per month on January 1, 2003, and to $1,500 per month on January 1, 2007. On January 1, 2003, Greg will be 20 years and five months plus old. On January 1, 2007, Sonja will be 22 years and three months plus old. Because the payment reductions occur not more than one year before or after a child attains an age between 18 and 24, the presumption is that the sum of the reductions ($1,000) are not alimony. If the payor does not pay the full amount of payments, the payment is first considered to be child support.

Other Issues

Does the assignment of income doctrine affect property settlements? In the case of a transfer of U.S. Savings Bonds, the IRS ruled that the deferred accrued interest on the bonds was taxable to the transferor. Basis to the transferee was thereby increased by the interest income recognized by the transferor. However, transfers of installment obligations do not result in the recognition of any gain or loss. Instead, the transferee steps into the shoes of the transferor.

Indirect payments (cash payments made to third parties) can qualify as alimony if paid under the terms of the divorce or separation instrument. Examples include rent, mortgage, tax, and tuition.

Judicial Decisions

Payments Stopping at Death. The tax laws are symmetric with respect to alimony, i.e., if the payment is taxable to the recipient, it is deductible to the payer. However, the mere fact a payer is not in a position to benefit from the alimony payment does not render the payments nontaxable to the recipient. In Kitch, the ex-husband died owing $480,000 in unpaid alimony. In settlement of this claim, the ex-wife's estate (she had died 11 days before the ex-husband) agreed to a payment of $362,326 from the estate of the ex-husband. The beneficiaries reported only $8,767 of this amount, up to the distributable net income (DNI) of the ex-husband's estate. The Tenth Circuit held that the alimony claims represented income in respect of a decedent, since had the ex-wife received the alimony before death it would have been taxed to her. Therefore, the alimony was taxed to the beneficiaries under the pass-through DNI rules. The fact the ex-husband's estate was unable to benefit from the alimony deduction was irrelevant. The Tenth Circuit noted that a payor never is guaranteed to benefit from the alimony deduction.

If payments do not cease at the death of the payee, the payments are treated as property settlements, not alimony, and therefore the amounts are not taxed to the payee, nor deductible by the payor. In Hoover, the ex-husband agreed to make installment payments to the ex-wife. The divorce decree, as modified, made no mention of the payments stopping at death. The IRS argued that the decree specified the payments were to be alimony, and that under Ohio law, alimony payable in installments generally stops at the death of the payee. However, the Tax Court held that the term "alimony" under Ohio law included both a division of property and support payments, and that this agreement represented a property settlement. Therefore, the amounts were not deductible by the husband or taxable to the wife. Similarly, in Rosenthal, although the settlement agreement stated the payments were intended to be deductible by the husband and taxable to the wife, in fact, the payments were to continue after the death of the wife. Since the provisions of IRC section 71(b)(1)(D) were not met, the payments were not alimony.

In Cunningham, the ex-husband and ex-wife executed an agreement that their lawyers called alimony. However, the agreement was not made part of the court proceedings, as was required under North Carolina law to be designated as alimony. The agreement also did not provide for payments to stop upon the death of the payee ex-wife. Therefore, the Tax Court held the payments were not alimony and not deductible by the husband. Merely calling a payment alimony does not necessarily make it so.

In Stokes, the payments were made under a divorce decree issued by a Georgia court. The agreement did not specifically call for payments to stop at death of the payee, and under Georgia law alimony payments are not required to end at death of the payee. Therefore, the Tax Court held that the payments were not deductible as alimony.

In Israel, the agreement provided that the husband would pay rent on the wife's apartment. Because the husband was obligated to continue to make lease payments after the wife's death, the IRS asserted the payments were not alimony. However, the Tax Court noted that the lease had always been in the husband's name, and that upon the death of the wife, he would continue to be contractually obligated, but the lease payments would not continue to be made on behalf of the wife upon the wife's death. Therefore, the amount was alimony.

Substance over Form. In determining whether a payment is a property settlement or alimony, how the payment is labeled by the divorce court is not controlling. In Mills, the Tenth Circuit noted that "Whether these payments were alimony or property settlements depends on the real substance of the arrangement and the intent of the parties." The courts also look to the law of the state; in this instance Oklahoma law provided that property acquired jointly, regardless of who has title, may be divided by the courts as is just and reasonable. In McCombs, in addition to other property going to the wife, the ex-husband gave a promissory note, the payments on which were to continue without regard to death or remarriage. The Tenth Circuit held that the payments have "all the elements and characteristics of a division of capital and none of support or alimony...."

Modified Divorce Decrees. Often the alimony sections of divorce decrees are modified. The inadvertent result of the modification may be to change the nature of the payment from alimony to a property settlement. In Barrett, the original decree provided for alimony to end at the death of the payee. However, a modified decree "irrevocably terminated [the] obligation to pay any past or future alimony...." The Tax Court held that this modification rescinded the original decree that required the payment of alimony until death or remarriage of the payee. The plaintiffs argued that at the very least the ex-husband should be allowed to deduct unpaid alimony existing at the date of the modification of the original decree. The Tax Court said that the modification did not mention payment of the amount in arrears and it therefore terminated all previous alimony obligations. However, the Tenth Circuit, while mostly upholding the Tax Court, ruled the alimony in arrears prior to the modification of the original decree was deductible. It rejected the IRS argument that the new decree extinguished the obligation to pay the past-due alimony, noting that "... it is apparent that Helen relinquished her rights to past and future alimony in exchange for the lump sum payments made by Pat."

The courts tend to interpret IRC section 71(b) requirements strictly. In Sroufe, the taxpayers executed a memorandum of understanding that provided for payments of $21,401 every year for 10 years. The payor deducted the amount as alimony; the recipient did not report the income. The IRS demanded that both the payor not deduct the payment and the recipient report the income. Although such a demand may appear unfair, the Tax Court noted that the practice of issuing inconsistent deficiency notices to protect revenue is a valid practice. In this case, the Tax Court held that the payments would not stop at the death of the recipient, but in fact the payments were specifically required to be guaranteed and secured by the payor. Therefore, the payments were not alimony.

Indirect Payments as Alimony. Indirect payments made on behalf of a payee may qualify as alimony; however, the six criteria listed earlier must be met. In Heffron, part of the divorce instrument provided that the ex-husband would pay certain credit card and other debts. However, the ex-husband continued to pay off these debts after she remarried (probably because many of the debts were those of his business). Based on that fact, the Tax Court held that the debt agreement was intended to be unconditional, and not dependent on her remarriage or death. Therefore, the payments were not deductible.

In Tseng, the ex-husband was required under the divorce decree to make the mortgage payment. However, he also owned the residence. The Tax Court cited Temp. Reg. section 1.71-1T(b) in ruling that mortgage payments are not deductible as alimony if the payor owns the property. The taxpayer in this case had both deducted the mortgage payments as alimony and the interest
element of the payment as home mortgage interest.

When is payment of life insurance premiums an indirect alimony payment? In Piel, the divorce decree required the husband to maintain a policy on his life with his wife as beneficiary. However, the husband retained ownership of the policy. The Second Circuit held that "almost complete rights of ownership were retained by the husband" and that the wife "received nothing in the tax year in question from the premium payments beyond an aid to her 'peace of mind.'" Therefore, the premium payments were not alimony. In Griffith, a somewhat complicated agreement required the husband to take out a life insurance policy on his life and to pay the premiums for 20 years. The wife could demand the cash surrender value at any time, but ownership of the policy resided in the husband. The husband argued that the wife constructively received the premiums because they resulted in an increase in the cash surrender value. However, the wife could take the cash surrender value only at the cost of surrendering her rights as beneficiary to the face value of the policy. A District Court ruled that the wife did not receive constructive income from the premium payments. The IRS set out its position on life insurance policies in Rev. Rul. 70-218, in which it said that if a policy is absolutely assigned to the wife and she is the irrevocable beneficiary, the premium payments made by the husband constitute alimony. However, where the wife is only a contingent beneficiary and the policy is not assigned to her, the premium payments do not constitute alimony.

Child Support. In Sharer, the wife and husband were living apart, and the Tax Court held the wife was an abandoned spouse, thus qualifying for head of household filing status. She received some payments from her husband's business that were marked "spousal wages." She sought to exclude the payments as child support. However, the Tax Court held that for an amount to be deemed child support, it must be received pursuant to a divorce or separate maintenance. Therefore, the somewhat illogical result was that although the wife was considered unmarried for filing status purposes, for purposes of defining child support, she was considered still married.

Undesignated Payments. In Heller, the California Superior Court ordered payments to the ex-wife. The payments under the temporary order were undesignated; the payments under the second order designated part to be child support and part to be "spousal support." The ex-wife argued that the temporary order was not a divorce or separation instrument; therefore, payments under it could not be alimony. The Tax Court disagreed, noting that the two orders taken together intended to establish payment obligations. To determine the portion of the undesignated payments that were alimony, the court looked to the second order that specified a monthly amount of child support. Another issue was whether or not payments were to stop at death. The court order was silent in this respect; however, the Tax Court noted that under California law spousal payments do not continue beyond the death of either spouse, unless agreed by the parties. Therefore, a portion of the payments were alimony.

The Tax Court ruled in Keegan that payments made after the payor's attorney sent a letter proposing to pay spousal support but before the filing of a "Capital Stipulation and Order to Show Cause" with the Superior Court of California were not deductible.

What if the separation agreement is later designated invalid? In Richardson, an Illinois state court held that the couple's separation agreement was invalid. The wife sought to exclude the payments from income on the grounds that the agreement was declared invalid. The Tax Court, however, ruled that the unenforceability of an agreement does not prevent the payments from being treated as alimony.

Divorce Decrees. What if a divorce is granted in one local jurisdiction, but declared invalid in another? In Borax and Feinberg, the Second and Third Circuits have held that the requirements for alimony may still hold. However, the IRS has refused to follow those decisions, stating that although they will generally not question the validity of any divorce decree, if a divorce is later ruled invalid, the IRS will usually follow the later court decision.

If the parties are not divorced and there is no written separation agreement, can payments under an oral agreement, if periodic, qualify as alimony? In Watt, the Tax Court said no, that there was no written agreement incident to the divorce. In Clark, the ex-husband made the rather novel claim that signatures on money orders constituted a written separation agreement. The Tax Court demurred.

The written agreement must be incident to a divorce or separation. In Healey, the husband was issued a restraining order that also required him to pay his wife a specified amount. The Tax Court held that the payments under the restraining order were not incident to a decree of divorce or written separation and therefore did not qualify as alimony.

Although there must be a written agreement, it need not be formal. In Jefferson, the Tax Court held that a letter written from the husband to the wife promising to pay her $6,000 per year or a larger amount should it be required to keep her in comfort, did constitute a written agreement incident to divorce. In Azenaro, a letter from the taxpayer's attorney that was received and signed by the wife, was considered to be a valid written agreement. Although the husband had not signed the agreement, the attorney was acting as the husband's agent. However, there must be an agreement between the spouses. In Hill, the Tax Court ruled that a letter from the husband's attorney that was not agreed to by the wife, constituted a mere unilateral offer.

To be deductible, the payment must be required under a written agreement. In Abood, the husband made voluntary payments after the expiration of the requirement to pay alimony. He argued that he "felt morally obligated to provide for her support." However, the Tax Court noted that while commendable, such payment is not deductible as alimony because there was not a legal obligation to make the payments. *

Gary L. Maydew, PhD, CPA, is an associate professor at Iowa State University.

References used in this article
are available upon request and
in the download section of The
CPA Journal's home page (www.cpajournal.com).

In Brief

Court Cases Abound

Payments determined to be property settlements are nontaxable events to both parties. Alimony is taxed to the recipient and deductible by the payer. However, to qualify as alimony, payments must meet six tests. Payments designated for the support of the payor's children are treated as child support and not alimony.

Judicial decisions have been handed down in the following areas for these type payments:

* Payments stopping at death

* Substance over form

* Modified divorce decrees

* Indirect payments

* Child support

* Undesignated payments

* Divorce decrees