|
Picture this, it's March of 1943, the US has been at war with the Axis for over a year now and you're sitting down to file your taxes. A patriot, you understand the recent tax increases to fund the war are necessary. Granted, a top tax bracket of 90% is a bit on the steep side, but you're also one of the few Americans well off enough to see that that rate. A few hours of paperwork later and your tax return is done. Then, you take out your checkbook to write your ex-spouse an alimony check. No sooner do you notice the amount the check is being written for, as you realize between your ex-spouse's alimony payments and your income tax burden you're left with negative income. That can't be right can it? Actually, it used to be, which is precisely the reason congress enacted IRC 215 & 71 which enabled alimony payments to be deducted by the paying ex-spouse and taxed by the receiving ex-spouse.
While timing a divorce's finalization can have noticeable tax effects, the treatment of alimony is at least as important. An alimony agreement poorly drafted can serve to recharacterize the payments intended as alimony as part of the property settlement or additional child support payments. This can serve to eliminate any intended tax benefits, place an unintended burden on the payer, and ultimately result in a smaller net amount to distribute in the property settlement.
Interestingly, one of the issues to come up on this subject is whether or not the couple is divorced yet. Divorces have been known to drag out over time and sometimes separate maintenance payments are scheduled to begin before the divorce is actually finalized. If the timing difference is corrected within the same tax year this is a moot point because under IRC 7703 a person is deemed to be divorced for the entire year in which they are divorced. If the timing difference is not corrected within the same year it may result in the payments being recharacterized as part of the property distribution. The reason for this is hidden in the tax definition of alimony. Alimony can only be paid between individuals legally divorced or legally separated. While separate maintenance payments are only likely to be paid between separated spouses finalizing a divorce, it doesn't necessarily follow those spouses count as legally separated. This falls to a matter of state law and not all states have provisions for legal separation. For example, while New York does, New Jersey does not.
Another risk for recharacterization as part of the marital property distribution is a front loaded alimony agreement. IRC 71(f) contains a complex limitation intended to prevent property distributions from being reclassified as alimony. If, during the 1st year after a divorce, the alimony payments exceed the average of the alimony payments for the 2nd and 3rd years, plus $15,000, the difference is reclassified as part of the property settlement. Expressed algebraically: reclassified amount=(1st year's alimony) - (((2nd year's alimony + 3rd year's alimony)/2) +$15,000), but only if greater than 0. If during the 2nd year alimony payments exceed the 3rd year's alimony payments plus $15,000 the difference is reclassified as part of the property settlement. Expressed algebraically: reclassified amount=(2nd year's alimony)-(3rd year's alimony + $15,000), but only if greater than 0.
Another risk in alimony agreements is having the amount reclassified as child support. Unlike alimony, child support is not deductible by the payer and taxable by the receiver. Unclear language or unusual features that pass muster in the divorce court can wreak havoc for a separated couple's intended tax situation. Unlike divorce law, which is a matter of equity, tax law is statutory. This means fairness doesn't enter the equation, and the letter of the law is final. It's the specific wording of an alimony agreement, as well as whether or not the situation complies with the alimony regulations under IRC 71(b), not the intention of the parties that matters. For example, alimony payments that do not end at the recipient's death will not be deemed alimony for tax purposes, nor will alimony payments made in property instead of cash. Alimony payments that increase, decrease, or cease, based on the age of a separated couple's children or whom they live with will be deemed child support for tax purposes. Also, if a single amount is specified for the ambiguous purpose of alimony and child support, the entire amount will be deemed child support.
However, the circumstances of these rules are a double-edged sword. While they create a number of pitfalls they also create tax strategy opportunities for separating couples under specific circumstances. For example, what is and isn't considered alimony can have a large effect on each party's tax burden and may also serve as a negotiating point for the total amount of alimony paid. Alternately, an alimony agreement can be written to declare payments as non-alimony and will be respected as such under the tax code. For separated couples with large disparities of income, or where one spouse derives the majority of their income through qualified dividends and/or capital gains, or couples where taxable income is not representative of economic income, these rules can form a plethora of tax planning opportunities. However, this level of strategy can make for a very complicated projections and it may be best to obtain professional tax advice.
|
|
