Keeping Alimony from Being Reclassified as Nondeductible Payments

Editor: Albert B. Ellentuck, Esq.

After a married couple has filed a divorce petition, the higher-earning spouse often must make various types of support payments to the lower-earning spouse. Some of these payments represent alimony and separate maintenance payments (referred to simply as alimony in this column), which are deductible by the payer in arriving at adjusted gross income and are taxable income to the payee (Secs. 71(a) and 215(a)). Other payments represent nondeductible child support and/or property distribution payments.

Taxpayers are free to choose the tax effect of alimony. It can either be deductible to the payer and taxable to the payee or receive the same tax treatment as child support if an “election out” is made. With child support payments or property settlements (i.e., payments that do not qualify as alimony), however, there is no option. Such payments are always nondeductible to the payer and nontaxable to the payee.

The following discussion of alimony applies to payments determined under post-1984 divorce or separation instruments and to pre-1985 instruments that have been amended to be made subject to these rules. Pre-1985 agreements that do not contain such an amendment are subject to Sec. 71 as it existed prior to enactment of the Tax Reform Act of 1984. These rules govern all divorce instruments written since January 1, 1985.

What Is Alimony or Spousal Support?

The Internal Revenue Code governs the federal tax treatment of alimony, not any divorce agreements or court orders. There are several definitions of alimony and/or spousal support. There are domestic relations statutes and bankruptcy statutes as well as the Code. Since each of these definitions is different, practitioners must take care not to assume that an item called alimony or spousal support qualifies as such under the Code. Thus, it is entirely possible for a divorce instrument to call a given payment alimony even though it does not qualify as alimony for income tax. It is also possible to have a payment that is treated as alimony for income tax purposes even though it does not qualify as alimony under state law.

For post-1984 divorce instruments, a payment is treated as alimony for federal tax purposes if all the following requirements are met (Sec. 71):

1. Divorce decree or written separation instrument: The payment must be made under a divorce decree (or a written instrument incident to such a decree) or a written separation agreement.
2. Spouses cannot live together after divorce: After the divorce or legal separation is final (i.e., the couple is no longer married for federal tax purposes), the paying spouse and receiving spouse cannot be members of the same household when the payment is made.
3. Cash: The payment must be in cash or cash equivalents.
4. Marriage relationship: The payment must be paid to or on behalf of a spouse or former spouse.
5. No contrary designation or election out of alimony: The divorce or separation instrument cannot specifically state that payments are not alimony (Estate of Goldman, 242 F.3d 390 (10th Cir. 2000)).
6. Must file separate returns: The paying spouse and the receiving spouse cannot file a joint tax return with each other.
7. Must not be child support: The payment cannot be called child support or deemed to be child support.
8. Must terminate at death: The obligation to make a nondelinquent payment cannot survive the death of the receiving spouse, and there must be no liability to make any payment (in cash or property) as a substitute for alimony after the death of the receiving spouse. Payments that continue past the receiving spouse’s death usually are considered to be part of a property settlement and should not be treated as alimony.

Divorce decrees and related agreements frequently contain multiple provisions requiring one spouse to make payments to or on behalf of the other spouse. Each payment or stream of payments is tested separately for all alimony criteria. If a payment or stream of payments fails one of the tests, that payment cannot be treated as alimony for tax purposes. Other payments or streams of payments that meet all the tests qualify as alimony even though one or more of the payments do not.

Practice tip: Practitioners should advise clients and their attorneys early in their discussions that payments must meet specific criteria to qualify as alimony and that each payment must meet these criteria. The client’s intentions or the intended language of the settlement controls only the property rights of the payments, not recognition or deductibility for income tax purposes.

Divorce Decree or Written Separation Agreement

To qualify as alimony for income tax purposes, the spouse must make a payment under a divorce decree or written separation agreement. Generally, a decree comes from a judge (or the court), and an agreement is negotiated by the divorcing couple. Agreements under which payments may qualify as alimony include the following.

Decrees of divorce or separate maintenance: This category includes a final decree of divorce or separate maintenance or a written instrument incident to such a decree. A divorce decree is issued when a marriage is dissolved. A separate maintenance decree is issued when a couple becomes legally separated and lives apart. Under either of these decrees, the couple is no longer married for federal tax purposes.

Written separation agreements: A separation agreement is an agreement between two spouses settling the terms of their marital rights. This agreement often precedes a divorce or separate maintenance decree and may be incorporated into the final decree. A divorce proceeding is not necessary, however, for payments under a written separation agreement to qualify as alimony for tax purposes. The written separation agreement must specify the sums to be paid or a formula for calculating the payments (Mitchell, T.C. Memo. 1991-188). In the absence of a specific dollar amount of support, it is sufficient if the agreement states an ascertainable standard, such as “pay all normal and usual expenses of maintenance and operation” (Leventhal, T.C. Memo. 2000-92). The parties to a separation agreement generally are still married for tax purposes and may file a joint return.

Other court decrees: Certain court decrees (e.g., temporary support orders), other than final divorce decrees, require one spouse to make payments for the support or maintenance of the other spouse. Typically, these orders call for support payments from the time a divorce or separate maintenance petition is filed until it is granted. In some states, the payments are described as pendente lite. This category also includes divorce decrees that are not yet final, which sometimes are called interlocutory decrees or decrees pending entry of final judgment.

Other divorce-related documents: In some instances, correspondence between the parties or other documents relative to the divorce may qualify as written separation agreements. For example, in Leventhal the court found that letters between the parties’ attorneys qualified as a written separation agreement because they clearly documented that the husband and wife had reached an agreement requiring the husband to pay for the operation and maintenance of the couple’s two residences.

The timing of payments is critical. Payments made before a written agreement is executed or a decree or order of support becomes effective are not alimony for tax purposes, even if the divorce or separation instrument is made retroactive to the date the earlier payments were made (Beaugard, T.C. Memo. 1980-311).

Example 1: J moves into an apartment before he and his wife, M, decide to divorce. J pays M $1,500 support per month for four months before executing a separation agreement that continues the support payments at the same level. The $6,000 J pays before executing the separation agreement is not alimony for income tax purposes. J cannot deduct the payments, nor is M required to report them as income. After J and M execute their written separation agreement, providing all the alimony requirements are met, any future payments are deductible for J and counted as income for M.

Payments over the amount required by any of the divorce or separation instruments as previously defined are not alimony for tax purposes (Taylor, 55 T.C. 1134 (1971)).

Changes to the amount of alimony paid must be done via a formal modification to the divorce or separation instrument. If alimony payments are increased voluntarily due to an oral agreement between the divorced spouses, the additional amount paid does not qualify as deductible alimony (Wondsel, 350 F.2d 339 (2d Cir. 1965)).

Spouses Cannot Live Together After Divorce

Payments made under a final decree of divorce or separate maintenance are not alimony for tax purposes if the spouses are living together. For this test, each payment is tested separately. A one-month “grace period” is allowed for one spouse to move out of the household (Temp. Regs. Sec. 1.71-1T(b), Q&A-9).

Before a final divorce or separate maintenance decree is issued, payments made under either a separation agreement or a temporary support order generally can qualify as alimony, even if the spouses are members of the same household. However, once a court has entered a divorce or separate maintenance decree, the spouses are no longer married for tax purposes. Then generally any payments between members of the same household cannot be treated as alimony.

A house formerly occupied by both spouses is considered the same household even if the spouses physically separate themselves within the dwelling unit. For example, one spouse cannot move into the maid’s quarters of the marital home, even if the maid’s quarters have a separate entrance.

Payments Must Be in Cash

To qualify as alimony for tax purposes, payments must be cash or cash equivalents (such as checks or money orders). Bonds, annuity contracts, promissory notes, and other similar assets do not qualify (Lofstrom, 125 T.C. 271 (2005)). Transferring services or property other than cash or using the payer’s property (e.g., rent-free use of the paying spouse’s house) is not alimony.

Example 2: F and S have been divorced for several years. Per their divorce decree, F pays S alimony of $2,000 per month. F loses his job. Instead of making a scheduled payment, he gives S a promissory note. F cannot deduct the value of the promissory note as alimony until it is actually paid.

Caution: It is not unusual for a spouse to use property to satisfy alimony arrearages. But such payments should be made cautiously since they may not qualify as alimony for tax purposes.

Payments Must Be to (or on Behalf of) a Spouse or Former Spouse

Payments to third parties can qualify as alimony if they are made under the terms of the divorce or separation instrument or at the receiving spouse’s written request or consent. The written request or consent must state that the payment is intended to be an alimony payment for tax purposes. The paying spouse must have the written request or consent before the first tax return is filed for the year of payment (Temp. Regs. Sec. 1.71-1T(b), Q&A-7).

Common payments made to third parties and treated as alimony include medical expenses and rent or mortgage payments. Alimony may also include direct third-party payments of attorney fees, tuition, and mortgage payments made on behalf of the former spouse (Hopkinson, T.C. Memo. 1999-154; Leventhal). However, any payments to maintain property owned by the paying spouse and used by the receiving spouse are not considered alimony (Temp. Regs. Sec. 1.71-1T(b), Q&A-6).

Example 3: T and G’s divorce is final. Under the divorce decree, T must make monthly alimony payments to G. G receives the house as part of the divorce settlement. Under the divorce decree, T must make the monthly mortgage payments out of his checking account. T can deduct the monthly mortgage payment as alimony because he must make the payments to a third party under the divorce or separation instrument.

Example 4: The facts are the same as in Example 3, except T owns the house after the divorce and allows G to live there. T continues to make the mortgage payments. The mortgage payments are not deductible alimony since they are for property owned by the paying spouse. To avoid this, the house would have to be in G’s name.

Example 5: The facts are the same as in Example 3, except T and G each own half of the house and are responsible for half of the mortgage after the divorce. G resides in the house, and T makes the full mortgage payment (as required under the divorce decree). In this case, 50% of the mortgage payments are deductible alimony. T may deduct the other 50% of the mortgage interest and taxes as itemized deductions. (See Information Letter 2004-0160.)

Note: The paying (nonresident) spouse may be entitled to treat the house as a qualified residence if he or she has at least one child living in the house. Here, the house would be treated as a second residence and the interest would be deductible under Sec. 163(h)(4)(A)(i)(II).

Palimony

The requirement that a payment must be to or on behalf of a spouse or former spouse means that payments made to a live-in companion, commonly called palimony, do not qualify as alimony. Palimony may be subject to gift tax or other provisions.

This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 12th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Ft. Worth, TX, 2011 ((800) 323-8724; ppc.thomson.com).