By Bruce M. Bird and Mark A. Segal
In Brief
Avoiding Recapture of Front-loaded Payments
Special rules apply to accelerated payments of alimony or separate maintenance that may result in their unintended recapture and additional income tax for the payer. The authors explain the alimony recapture rules of IRC section 71(f) and provide an algorithm and spreadsheet for calculating the maximum amount of front-loading attainable without triggering recapture.
When marriages dissolve, two issues arise concerning the amount and timing of alimony or separate maintenance payments. In many cases, extensive negotiation determines the amount, but the timing of payments often receives cursory consideration. Consequently, the typical divorce or separation agreement provides for level monthly payments.
There are situations in which both the payer and recipient would benefit by accelerating—or “front-loading”—alimony payments. While this may at first seem counterintuitive, because the payment of alimony is typically both deductible to the payer (IRC section 215) and includable to the recipient (IRC section 61), both parties may benefit from front-loaded payments if the payer’s marginal tax rate is higher than the recipient’s. Front-loading may also be desirable if the payer expects a decline in marginal tax rate in subsequent years and the recipient prefers to receive the payments as soon as possible.
The requirements for a payment to a former spouse to qualify for tax purposes as alimony or separate maintenance are straightforward:
Although a payment must satisfy all of the above requirements in order to be classified as alimony, IRC section 71 does not require that such payments be equal in amount. Nevertheless, excessive front-loading of payments leads to the recapture of the “excess” amount in the third year following the agreement or decree of divorce or separation. The recaptured amount is included in gross income of the payer and is allowed as a deduction toward adjusted gross income of the recipient [IRC section 71(f)].
Alimony Recapture Under IRC Section 71(f)
The Tax Reform Act of 1984 introduced the alimony recapture rules, which applied to payments made under decrees, agreements, or instruments executed in 1985 or 1986. Congress enacted the rules out of concern over the net loss of revenue that excessive front-loading could produce. The recapture rules currently found in IRC section 71(f) apply to divorce or separation payments made under decrees, agreements, or instruments executed after December 31, 1986. Without section 71(f), a payer could more easily disguise a nondeductible property settlement as deductible alimony. The current rules simplify the computation of recapture and shorten the recapture period.
For the purposes of IRC section 71(f), the term “excess alimony payments” means the sum of—
The amount of the excess payments for the first post-separation year is the excess (if any) of the amount of alimony or separate maintenance payments paid by the payer spouse during the first post-separation year, over the sum of the average of—
The amount of the excess payments for the second post-separation year is the excess (if any) of the amount of the alimony or separate maintenance payments paid by the payer spouse during the second post-separation year, over the sum of—
Exceptions. The tax law provides several exceptions to the alimony recapture rules [IRC section 71(f)(5)]. Recapture will not apply if either spouse dies before the close of the third post-separation year or the recipient spouse remarries before the close of the third post-separation year and the alimony or separate maintenance payments cease because of such death or remarriage. Another exception excludes payments made under a temporary support order. In addition, the alimony recapture rules do not apply to any payment pursuant to a continuing liability (over a period of not less than three years) to pay a fixed portion or portions of the income from a business or property or from compensation from employment or self-employment.
Using the Decision Rule to Maximize Front-loading
Where the total amount of alimony to be paid is unknown. The amount of alimony recapture that the payer must include in gross income can be calculated as follows: Let Ry3 represent the amount of alimony recapture in year 3. Let Ey1, and Ey2 represent the excess alimony payments in years 1 and 2. If either Ey1, or Ey2 is negative, treat it as zero in computing Ry3. In addition, let P1, P2, and P3 equal the alimony payment in the first, second, and third years of the agreement or decree. Expressing the recapture rules algebraically,
Ry3 = Ey1+Ey2
Ey1 = P1–[(P2–Ey2+P3)/2 + $15,000]
Ey2 = P2–(P3+$15,000).
An example of the alimony recapture rules would be as follows:
In 1999, Bob and Carol were divorced. The divorce decree provided that Carol would receive $70,000 in 1999, $20,000 in 2000, and $0 in later years. These payments would cease upon the earlier of Carol’s death or remarriage. Consequently, in 2001 Bob will include $52,500 in gross income due to alimony recapture. Accordingly, Carol will be allowed a deduction of $52,500 towards her adjusted gross income in 2001.
Ey2 = $20,000–($0+$15,000) = $5,000
Ey1 = $70,000–[($20,000–$5,000 + $0)/2+$15,000]=$47,500
Ry3 = $5,000+$47,500=$52,500.
In order to maximize front-loading without triggering recapture, both Ey1 and Ey2 should exactly equal zero. Although no recapture would be required if 1) both Eyl and Ey2 are negative or 2) one is negative and the other zero, the presence of a negative figure indicates a failure to maximize front-loading due to excessive payments in either year 2 or 3. Therefore, maximization of front-loading without triggering recapture only occurs when—
P1=P2+$7,500 and P1=P3+$22,500.
An example of this rule follows:
Assume that the taxpayer makes alimony payments of $35,000 in year 1, $27,500 in year 2, and $12,500 in year 3. Using the alimony recapture rules under IRC section 71(f), the amount of recapture in year 3 will be zero.
Exhibit 1 contains information allowing the user to construct an Excel spreadsheet that calculates the amount of alimony recapture for any given series of alimony payments. Exhibit 2 contains an example of the alimony recapture computation. Trying different alimony payment patterns for years 1, 2, and 3 allows the planner to discover the one that maximizes the front-loading of alimony without triggering alimony recapture.
Where the total amount of alimony to be paid is known. In the above example, the alimony payments for years 2 and 3 were determined using the year 1 payment as a known base. However, sometimes the payer will agree to pay a total amount of alimony so that the payments for years 1, 2, and 3 must be determined. For example, assume that a divorce decree or agreement for separate maintenance calls for the payment of total alimony of $100,000. Therefore,
P2 = P1–$7,500
P3 = P2–$15,000=P1–$22,500 P1+P2+P3=$100,000
P1 + (P1–$7,500)+(P1–$22,500) = $100,000
3P1 – $30,000=$100,000
P1 = $130,00/3=$43,333
P2 = P1–$7,500=$43,333–$7,500 = $35,833
P3 = P1–$22,500=$43,333 – $22,500=$20,833
As a result, the payer will maximize the front-loading of alimony without triggering recapture by making alimony payments of $43,333, $35,833, and $20,833 in years 1, 2, and 3, respectively.
A Win-Win Arrangement
Front-loading is often desirable from the perspective of both the payer and recipient. The formulas contained in this article can be used to maximize front-loading without alimony recapture and the corresponding optimal annual allocation of alimony payments. The taxpayer can escape the excess alimony recapture rules under IRC section 71(f) by using the following decision rule:
The maximum amount of front-loading of alimony payments in year 1 and year 2 without triggering recapture in year 3 will occur when both the payment in year 1 exceeds the payment in year 2 by $7,500 and the payment in year 1 exceeds the payment in year 3 by $22,500.
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