Keeping Alimony From Being Reclassified As Nondeductible Payments

Tax implications of alimony or spousal support and the specific criteria that payments must meet to qualify as alimony revealed.

November 2011
by Albert Ellentuck/The Tax Adviser

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 (AGI) 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 (IRC) 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 non-delinquent 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.

This article has been excerpted from The Tax Adviser. View the full article here.