Military Retirement Benefits
Structuring Payments as Deductible Alimony

By Bruce M. Bird and Marcia Sakai

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To be deductible as alimony by the payer, the payment must satisfy the requirements of IRC section 71. A recent Tax Court decision involving the payment of military retirement benefits under the Uniformed Services Former Spouses’ Protection Act (USFSPA) to the former spouse of a retired serviceman sheds light on the treatment of alimony payments. The interplay between the requirements of IRC section 71 and the USFSPA is analyzed for purposes of structuring a payment under a divorce or separation instrument as deductible alimony.

Background

For payments under instruments executed after December 31, 1984, the requirements for deducting payments of alimony or separate maintenance are relatively straightforward. The payment of alimony or separate maintenance must be in cash. Under IRC section 71(b)(1)(A), such payment must be received by (or on behalf of) a spouse under a divorce or separation instrument. IRC section 71(b)(1)(B) provides that the divorce or separation instrument does not designate such payment as a payment that is not includable in gross income and not allowable as a deduction under IRC section 215. Under IRC section 71(b)(1)(C), in the case of an individual legally separated under a decree of divorce or separate maintenance, the payee spouse or the payer spouse cannot be members of the same household at the time such payments are made. Section 71(b)(1)(D) provides that no liability exists to make any such payment for any period after the death of the payee’s spouse (and there is no liability to make any payment in cash or in property as a substitute for such payments after the death of the payee spouse). Furthermore, under section 71(e), the former spouses must not file a joint return together. For payments under instruments executed before January 1, 1985, however, different requirements apply. An individual, in determining whether a payment constitutes deductible alimony, will continue to apply the requirements of prior-law IRC section 71. Accordingly, the scope of this article is limited to payments under instruments executed after December 31, 1984.

Alimony is deductible by the payer as an adjustment to income and is includable in the payee’s income. When a significant difference exists between the marginal tax rate of the payer and payee, structuring payments as alimony can result in significant tax savings to the payer.

Example. Assume that the taxpayer/alimony payer has a marginal tax rate of 35% and that his former spouse/payee has a marginal tax rate of 10%. If the payments of $24,000 per year under the divorce or separation instrument constitute deductible alimony, the payer’s tax savings will be $8,400. (Computed as follows: $24,000 x 35% = $8,400. This assumes that the payer is in the 35% marginal tax bracket both before and after the adjustment to income.) The payee’s taxes will increase by $2,400. (Computed as follows: $24,000 x 10% = $2,400. This assumes that the payee is in the 10% marginal tax bracket both before and after the inclusion in income.) If the above payments constitute child support, however, the payer cannot deduct them. The payee does not include as income the child support she receives.

USFSPA

The USFSPA was the legislative response to the U.S. Supreme Court’s decision in McCarty v. McCarty [453 U.S. 210 (1981)]. The taxpayer, a U.S. Army colonel, filed a petition in California Superior Court for the dissolution of his marriage. At the time, the taxpayer had served approximately 18 of the 20 years required for retirement with pay.

The Superior Court of California held that military retirement benefits constituted quasicommunity property subject to division under California law. (Herein, the terms “military retirement benefits” and “military retired pay” are used interchangeably and include both military retirement pay and other benefits.) Accordingly, the court ordered the taxpayer, upon retirement, to pay a portion—approximately 45%—of his military retirement benefits to his former spouse. The California Court of Appeal affirmed the ruling.

On appeal, the U.S. Supreme Court, in reversing the lower courts’ rulings, held that the Supremacy Clause of Article VI of the U.S. Constitution preempted a state court from dividing military retirement pay pursuant to state community property laws. After noting the distressed plight of many former spouses of military members, the Supreme Court also observed that Congress was free to change the statutory framework. Soon thereafter, in 1982, the USFSPA was passed. The USFSPA permits state courts to treat military retirement pay as marital property. Accordingly, state courts now have the authority, pursuant to a divorce or separation instrument, to divide military retirement pay between a retired service member and former spouse.

The USFSPA limits the amount of the service member’s retirement pay that can be payable to a former spouse to 50% of disposable military retirement pay. Disposable military retirement pay is defined as gross monthly retirement pay less qualified deductions. For a division of retirement pay to be enforceable under the USFSPA, the service member and former spouse must have been married for at least 10 years, during which the service member earned 10 years of creditable service.

The USFSPA does not require that a former spouse be given a portion of a service member’s disposable retirement pay. Rather, the USFSPA permits a state court to treat the service member’s disposable retirement pay as marital property. Whether it is treated as marital property is determined by state law.

Military Retirement Benefits: Common Law States

In Proctor v. Comm’r [129 T.C. No. 12 (2007)] the taxpayer, a serviceman in the U.S. Navy, was married with two children. In 1993, a Georgia state court entered a final judgment and decree that terminated the marriage. The divorce decree required the taxpayer to pay $675 per month for child support, to maintain medical and dental insurance for each child, and to share equally with his former spouse any medical and dental costs not covered by insurance. In addition, the divorce decree required the taxpayer to pay 25% of his disposable retirement pay to his former spouse pursuant to the USFSPA.

In 2000, the taxpayer retired from the U.S. Navy. In August 2000, the taxpayer began receiving retirement pay; however, he failed to make payments to his former spouse relating to his retirement pay and to the amount of his share of his children’s past dental bills pursuant to the 1993 divorce decree. After being the subject of a series of contempt proceedings, in 2002 the taxpayer paid a total of $6,074 to his former spouse. Of this amount, $2,687 was for his children’s uninsured dental expenses. In 2002, the taxpayer also deducted as alimony the entire $6,074 paid to his former spouse.

The Tax Court first analyzed whether any portion of the $6,074 paid to the taxpayer’s former spouse constituted child support. According to IRC section 71(c)(1), any payment by which the terms of the divorce decree fixes a sum payable for the support of children is not alimony.

As provided for by IRC section 71(c)(3), if any payment is less than the amount specified in the divorce decree, then to the extent the payment does not exceed the amount required to be paid for child support, such amount shall be considered support. Of the $6,074 paid by the taxpayer in 2002, the Tax Court characterized the $2,687 related to his children’s uninsured medical expenses as child support.

The Tax Court then examined whether the $3,397 that remained of the $6,074 paid by the taxpayer constituted alimony. [The $3,397 amount contained in the Proctor decision appears to be a typographical error and should instead be $3,387 ($6,074 – $2,687). For purposes of this article, the $3,397 amount in the decision will be used.] The IRS contended that the retirement payments did not meet all of the requirements of IRC section (b)(1)(A)–(D). While conceding that the payments met the requirements of IRC sections 71(b)(1)(A) and 71(b)(1)(C), the IRS contended that the retirement payments did not meet the requirements of sections 71(b)(1)(B) and 71(b)(1)(D).

IRC section 71(b)(1)(B) requires that the divorce instrument “not designate such payment as a payment which is not includable in gross income under the Section and not allowed as a deduction under Section 215.” The IRS contended that the requirement was not met because the divorce decree referred to the payment as part of a division of marital property. In Benedict v. Comm’r [82 TC 573 at 575 (1984)], the Tax Court held that labels attached to tax payments mandated by a decree of divorce or a marriage settlement agreement are not controlling. The Tax Court also noted that the requirements of subsection B will generally be met if the divorce decree has no “clear explicit and express direction” stating that the payment is not to be treated as alimony. As a result, the Tax Court in Proctor held that even though the divorce decree in question referred to the payments as part of the division of marital property, the retirement payments satisfied the requirements of IRC section 71(b)(1)(B).

IRC section 71(b)(1)(D) provides that there must be no liability for the payer to make such payments, or for the payer to make substitute payments, after the death of the payee spouse. The IRS contended that because the divorce decree did not state whether such payments would terminate upon the death of the payee, the payments did not satisfy section 71(b)(1)(D). The Tax Court noted, however, that when Congress amended IRC section 71(b)(1)(D) in 1986, it removed the requirement that a divorce instrument expressly state that a liability terminates upon the death of a payee spouse (see 1986 TRA 196, P.L. 99-514, section 1843(b), 100 Stat. 2853). Under current law, if the liability ceases by the death of the payee spouse by operation of law, then IRC section 71(b)(1)(D) is satisfied.

The divorce decree in Proctor required the taxpayer, pursuant to the USFSPA, to pay 25% of his military retirement pay to his former spouse. Under the USFSPA, payments from the serviceman’s disposable retirement pay shall terminate under the terms of the applicable court order, but not later than the date of the death of the service member or the date of the death of the spouse or former spouse to whom payments are being made, whichever occurs first (10 USC 1408). Accordingly, the Tax Court held that the retirement payments will terminate, by operation of law, on the date that either the taxpayer or the former spouse dies, whichever occurs first.

In addition, the Tax Court noted that the USFSPA does not create any right, title, or any interest that can be sold, set aside, transferred, or otherwise disposed of—including by inheritance—by a spouse or former spouse. Because the taxpayer has no liability to make retirement payments after the death of a former spouse, the retirement payments met the legal requirements of IRC section 71(b)(1)(D). Accordingly, the Tax Court permitted the taxpayer to deduct the remaining $3,397 amount as alimony.

Military Retirement Benefits: Community Property States

The USFSPA gives state courts the authority to treat military retirement pay as marital property and to divide it, pursuant to a divorce or separation instrument, between the retired service member and former spouse. In a common-law state, military retirement pay is typically treated as the separate property of the spouse who served in the military.

A significant portion of the U.S. population, however, lives in community-property states (e.g., Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington). Wisconsin and Alaska are also often considered to be community-property states because Wisconsin has a marital property act, and Alaska has an optional community-property system.

Most decisions involving military retirement benefits received pursuant to divorce in a community-property state focus upon the ex-spouse of a retired service member [as in Mess v. Comm’r, 79 TCM 1443 (2000); Denbow v. Comm’r, 56 TCM 1397 (1989); and Pfister v. Comm’r, 359 F3d 352 (2004)]. Eatinger v. Comm’r [59 TCM 954 (1990)] involved the taxpayer’s share of her former husband’s retirement pay. The Eatingers were married in 1955 and lived in various community and non–community property states before settling in California. Lieutenant Colonel Eatinger retired from active duty in 1972. In 1977, the couple divorced under California law.

Eatinger’s wife was married to her former husband for 17 of the 20 years that he spent in military service. The Superior Court of California, after determining the taxpayer’s community property share of her former husband’s military retirement benefits, awarded her 42.5% (17/20 x 50% = 42.5%) of her ex-husband’s retirement pay incident to their divorce. The taxpayer contended, however, that the amounts she received as her share of her husband’s military retirement pay constituted nontaxable property transfers. The IRS argued that these amounts represented taxable pension income.

In its memorandum decision, the Tax Court held that applicable state law should be examined to determine property ownership and the nature of the property law. Under California law, a retirement pension represented deferred compensation for past employment. Additionally, as part of the property settlement incident to her divorce, the taxpayer was awarded a portion of her ex-husband’s military retirement pension as her sole and separate property. Accordingly, the Tax Court held in favor of the IRS.

Alimony Recapture

The payment of alimony can be accelerated to a certain extent, but any excess front-loading of alimony is typically subject to the recapture provisions of IRC section 71(f). (See Bruce M. Bird and Mark A. Segal, “Maximizing the Front-Loading of Alimony Payments,” The CPA Journal, February 2001.) Under current law, the recapture rules in IRC section 71(f) apply to certain payments made under divorce or separation decrees, agreements, or instruments occurring after December 31, 1986. The amount of recapture, if any, will occur in the third post-separation year. The recapture amount will be included in the payer’s income, while the payee will be entitled to deduct it.

The alimony recapture rules have several exceptions. For example, if the payer or payee spouse dies before the close of the third post-separation year—or if the payee spouse remarries within this period—and the payment of alimony or separate maintenance stops as a result of one of these events, then the alimony recapture rules will not apply. Any payment made under a temporary support order is not subject to the alimony recapture rules. Moreover, any payment related to a continuing liability of at least three years to pay a fixed portion (or portions) of income from a business or from property is not subject to the alimony recapture rules. (Under this exception, the fixed portion or portions of income can also be related to employment or self-employment compensation.)

The payment of military retirement benefits may be subject to the alimony recapture rules. One situation involves a divorce or separation agreement in which the division of retirement pay is not enforceable under USFSPA and the service member stops paying alimony to his former spouse. For example, a service member and his spouse divorced after nine years of marriage. In year 1 after the divorce, the service member made payments of $2,000 per month of his retirement benefits—legally designated as alimony in the divorce agreement—to his former spouse. At the beginning of year 2, the service member, although contractually obligated under the divorce agreement to pay alimony, stopped paying it. (The Deadbeat Parents Punishment Act of 1998 increases the penalties for nonpayment of child support. In some cases, such as moving to another state to avoid paying child support, nonpayment can be a federal criminal offense. However, collecting unpaid alimony is typically difficult and time-consuming.) In an attempt to receive a portion of the service member’s retirement pay, the former spouse sued under the USFSPA but lost. (To be enforceable under the USFSPA, the service member and former spouse must have been married for a period of at least 10 years, during which the service member earned 10 years of creditable service). Based upon this information, the service member will have alimony recapture of $9,000 in year 3. Alimony recapture, if any, will occur in the third post-separation year if: 1) payments made in the second post-separation year exceed payments made in the third post-separation year by more than $15,000; or 2) payments made in the first post-separation year exceed the average alimony payments of the second post-separation year and the third post-separation year by more than $15,000 (see Ephraim P. Smith, Philip J. Harmelink, and James Hasselback, 2009 CCH Federal Taxation Comprehensive Topics).

For purposes of computing alimony recapture, if either 1) or 2) above is less than zero, then $0 should be used. [If both 1) and 2) above are less than zero, then there is no alimony recapture in year 3.] In computing 2) above, the average of the payments made in the second and third years does not include that portion of the payment made in the second year that is recaptured in the third year. The calculation of 1) above is $0, and the calculation of 2) above is: $24,000 -- [($0 -- $0 + 0)/2 + $15,000] = $9,000. Therefore, the alimony recapture in year 3 is $9,000 ($0 + $9,000).

Tax Planning Implications

Structuring the payment of military retirement benefits to an ex-spouse as deductible alimony by the payer involves a number of issues. The taxpayer should first analyze the applicable law of the state in which the divorce or separate maintenance instrument will be executed. Divorce law can vary—often significantly—by state.

In addition, the payer should carefully read the divorce or separation agreement before signing it. By way of example, a payer who wishes to deduct the payment of military retirement benefits to an ex-spouse should make sure that the agreement does not contain a clear directive or statement that the military retirement benefits are not to be treated as alimony. A so-called “not alimony” provision will preclude the payer from deducting the payment.

The payment of retirement benefits under a divorce or separation instrument executed in a common law state typically can be structured to satisfy the requirements of both IRC section 71 and the USFSPA. It is important to determine that all of the applicable requirements of IRC section 71 are satisfied. The decision in Proctor indicates that the USFSPA can, in some situations, satisfy IRC section 71(b)(1)(D).

The payment of retirement benefits to an ex-spouse under a divorce or separation instrument executed in a community-property state will usually preclude the payer from claiming a deduction for alimony. In a community-property state, the former spouse of a service member is often entitled to receive a 50% community-property interest in the service member’s military retirement benefits. If so, the receipt of 50% of the military retirement pay by the former spouse would result in pension income to the payee, while the payment would not be deductible as alimony by the payer.

It is possible in a community-property state for a portion of the military retirement pay to be structured as deductible alimony. For example, if the former spouse’s community property share of a service member’s military retirement pay is 50% but the divorce or separation instrument provides the former spouse with a share greater than 50%, the excess can be structured to satisfy the requirements for the payer to deduct alimony under IRC section 71.

©2009 The New York State Society of CPAs. Legal Notices