As a practical matter, many CPAs are unaware that spousal support, also known as alimony, is not automatically deductible to the payer and taxable to the recipient unless it meets particular requirements. Similarly, clients and other parties often assume that spousal support is always income to the recipient and a deduction for the payer.
The IRS views alimony as tax rate arbitrage because, usually, the person paying the support is in a higher tax bracket than the recipient. The author, in her role as a Certified Divorce Financial Analyst (CDFA), shows the after-tax cost to the payer and the after-tax income to the recipient from spousal support payments. A critical point in this analysis is determining whether spousal support qualifies to be treated as tax-deductible alimony.
The portions of the Code that prescribe the treatment of spousal support are Secs. 61, 71, and 215. The best way to paraphrase Sec. 61 is that everything is income unless the Code contains a specific exception. Alimony and separate maintenance payments are specifically included in gross income under Sec. 61(a)(8). Alimony is defined in Sec. 71. Sec. 215 discusses the payer's deduction and refers to the Sec. 71 requirements. A simpler and easier guide to access is IRS Publication 17, Your Federal Income Tax: For Individuals. This is a key resource for making practitioners aware of how the IRS looks at the transaction.
The three biggest questions faced in this area are the following:
- How can alimony not be taxable to the recipient or deductible by the payer?
- Is temporary support deductible?
- Are lump-sum alimony payments or buyouts deductible?
Alimony and temporary support
The simplest response to the first question is that if a payment does not meet the requirements of Sec. 71, then it is not considered alimony for income or deduction purposes. However, even if the payment does not qualify as alimony, assuming the payment is between spouses, or to a former spouse "incident to the divorce," it would be exempt from income or gift tax under Sec. 1041(a)(2). Payments made within one year of divorce or related to the divorce or separation agreement and made not more than six years after the divorce (as described in Temp. Regs. Sec. 1.1041-1T, Q&A-7) are considered incident to the divorce. In such instances, the recipient would not be required to report the payment as income, and it would not be deductible.
Often, what is buried in this question is why someone would want the payment to be taxable or not. As indicated in the introduction to this discussion, alimony can amount to tax rate arbitrage if it is taxable.
Example: The higher-earning spouse is in the 33% federal tax bracket, and the other spouse is in the 25% bracket (ignoring state taxes). The after-tax cost to the high-income earner of $60,000 in alimony or spousal support ($60,000 × (1 - 33%) = $40,200) is much smaller than the after-tax income to the recipient ($60,000 × (1 - 25%) = $45,000), resulting in a net benefit of $4,800.
Although it might seem an obvious advantage to always treat alimony as taxable, there can be drawbacks. If the recipient spouse needs $60,000 of the net after-tax cash flow from the support, grossing up the amount for taxes would be necessary. But this might be difficult for the payer to stomach, even if the payer takes into account the tax benefit of the deduction when calculating withholding or estimated payments. Paying support that is not treated as taxable can reduce complexity for the recipient and make both individuals' budgets clearer. Also, not all situations meet all of the requirements of Sec. 71 to qualify as tax-deductible alimony or temporary support, which are as follows:
- The payments are received under a divorce or separation instrument (as defined by Sec. 71(b)(2));
- The payer and the recipient do not file a joint return together;
- The payments are in cash;
- The payments are not designated as "not alimony" in the divorce or separation instrument, written separation agreement, or a writing signed by both spouses making a designation that refers to a previous written separation agreement;
- If legally separated under a decree of divorce or separate maintenance, the spouses do not live in the same household;
- No payment or substitute for it is required to be made after the recipient's death; and
- The payments are not considered child support.
Given all of the requirements, it is important for practitioners to review the settlement agreement or final judgment. Practitioners must also keep in mind that the final document can be extremely sensitive. A CPA should be proactive for the client and review the document before it is finalized to verify that the language meets the client's intentions.
If the CPA notices that the language regarding the termination of spousal support upon death is missing from a settlement agreement or final judgment, it is possible that it is not the norm to include that language in a particular state. In some states, statutes and/or case law may require that spousal support terminate upon the recipient's death.
Clients often do not consult Publication 17 or a CPA when making temporary support decisions. These decisions can be part of an urgent and contentious matter. CPAs need to consider taking the lead when they hear of a client's pending divorce to provide advice and insight that the client might not have considered but that he or she needs in order to make an informed decision. This should include information about the CPA's limitations in continuing to serve both parties to a divorce because of conflict-of-interest rules.
Due to the often hasty nature of temporary support arrangements, it is easy for a requirement to be missed. Often, a CPA does not learn whether the necessary steps were taken and the requirements met until the time comes to file the tax return for the year.
If the CPA is lucky, he or she will get pulled into the process before the terms are finalized. Often, at that point, the couple are considering whether they should file jointly for that tax year if the divorce is not going to be finalized by the end of the year, or if the marital estate would benefit from filing jointly and delaying the divorce past the current year end. In this situation, the CPA should ask about temporary support payments so that his or her analysis is complete and takes into account the many potential events that could occur along the way that could lead to different results than expected.
Lump-sum or alimony buyout payments
Another key alimony question that can pop up during the divorce proceedings or years later is whether a lump-sum or alimony buyout payment is deductible. Once again, it depends on the facts and circumstances. If the written agreement and other facts and circumstances fulfill all of the requirements, the amount can qualify as alimony or spousal support. However, there is the risk that the IRS will try to argue the payment is a property division instead of alimony.
If the buyout is to be made in the first two years following the divorce, a practitioner needs to warn clients of alimony recapture, which can occur if the support decreases by too much during the first three years. The concept is that a front-loaded support agreement could be a disguised property division, which would not be deductible by the payer. A taxpayer is subject to the recapture rule in the third year if the alimony he or she pays in the third year decreases by more than $15,000 from the second year or the alimony he or she pays in the second and third years decreases significantly from the alimony paid in the first year. Losing this tax benefit can increase the cost of support for the payer significantly.
Divorce and taxes are complex. Whether educating clients or colleagues, it is imperative to understand the rules so that clients are not faced with other questions or issues after the dust settles on the divorce.
EditorNotes
Michael D. Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
