The Internal Revenue Code only refers to “alimony”. Payments that meet the qualifications outlined in Section 71(b) of the Internal Revenue Code are considered to be taxable alimony and are deductible by the payer under Section 215 of the Internal Revenue Code. Even if the agreement states that the payments are to be considered alimony, only payments that meet all of the qualifications will be considered alimony by the IRS for tax purposes.
In general, all of the following requirements must be met to be considered alimony (for post-1984 divorces):
- Payment is made under a written divorce or separation instrument
- The parties are not living in the same household after the divorce or legal separation is final
- The payment is in cash
- The payment is made to (or on the behalf of ) a spouse or former spouse
- The agreement does not state that it is not alimony for tax purposes
- Payer and payee do not file a joint return with each other
- No obligation exists for payments to continue to the recipient after the recipient’s death
- The payment is not child support or deemed child support
The necessity for an agreement indicates that the payment cannot be voluntary. The payment must occur because there is a divorce decree, a separation agreement, a temporary support order, or some other court-related written document requiring the payer to make such a payment. Other divorce-related agreements between the parties may qualify including signed letters and signed memorandums of understanding. In Leventhal v. Commissioner, letters between attorneys, outlining the agreement of the parties as to the payment of household expenses during their divorce, qualified as a written separation agreement by the tax court.
Amounts paid, before an agreement or order obligates such a payment, are not alimony for tax purposes. This is true even if the payments are later retroactively approved by the state court as spousal support (see Ali, T.C. Memo 2004-284). There is an exception for when an order retroactively corrects a previously issued order to reflect the true intention at the time the payments were ordered.
If the original unpaid obligation would have qualified as alimony, the arrearage payment will then qualify as alimony and is taxable in the year received.
If properly structured, a property settlement payment may qualify as alimony, as long as the qualifications for alimony (see question regarding qualifications) are met. This includes the requirement that the obligation ceases upon the recipient’s death.
Child Related Credits & Deductions (4)
The “support” test was replaced by the “place of abode” test. The child must still receive more than half of his or her support from the parents (or others), but the parent with whom the child lives with most, in that year, will be the parent who may claim the child, assuming all other qualifications are met.
The qualifying noncustodial parent may claim the dependency exemption, as per the agreement, but must obtain the custodial parent’s signature on Form 8332 indicating that the custodial parent is releasing the right to claim the child. Reliance on the agreement without the signed form may result in a denial of the deduction and the related child tax credit.
Once a child reaches the age of majority, the child is not in the “custody” of either parent. Therefore the parents are no longer bound to the agreement and will need to refer to the general rules regarding dependency exemptions.
The custodial parent can then claim the child as a qualifying child for head of household status, credit for child and dependent care expenses, exclusion for dependent care benefits, and the earned income credit.
Financial Planning Services (1)
As early as possible and certainly well before signing a final agreement. Here’s why:
During the divorce process, you may be awarded a temporary payment of support, or you may be ordered to pay a temporary payment of support. Structured correctly these payments may qualify as taxable alimony or deductible alimony. You should make sure you are aware of the tax consequences of these temporary payments. They may go on for longer than one would expect since this process doesn’t always move along very quickly.
Certain tax benefits from prior years may be overlooked. Typically benefits include capital loss carryovers from prior years and unused passive losses. The IRS has special rules for determining how these will be handled and it’s simply not “divide equally” as is sometimes agreed to.
Child-related deductions and credits may need proper planning. For instance, if you agree to split childcare expense equally but are ineligible to claim the credit, you may be paying more than your share of childcare expense. Perhaps a reduction in payment by the ineligible parent would help offset the loss of the credit. You may need to demonstrate to your spouse’s attorney the after-tax cost of each parent towards childcare.
The division of the marital assets should be reviewed to address a couple of questions: Can I afford to keep those items? What is the after-tax value of those items? Unfortunately individuals are asked to make decisions at a time when it feels like life is out of control. We tend to want to hang on to items from our past but we don’t necessarily have a sound financial reason to do so.
Legal & Other Fees (2)
Generally costs incurred by an individual related to a divorce or separation are not deductible by either the husband or the wife. These are considered to be personal expenses and, therefore, nondeductible.
Legal fees and other costs incurred in a divorce or separation attributable to the production or collection of amounts includible in gross income are deductible. Since spousal support, as long as it is not nontaxable spousal support, is to be included in the recipient’s gross income as alimony, the recipient is allowed to deduct, as a miscellaneous itemized deduction, subject to the 2%-of-adjusted-gross-income limit, the amount paid in that year for services related to spousal support. Fees paid to recover spousal support arrearages or to increase spousal support are also considered to be allowable deductions.
Social Security Benefit Issues (6)
The following requirements must be met by the divorced individual:
- The divorced individual was married for at least 10 years to the now ex-spouse
- The divorced individual is unmarried at the time of filing for benefits
- The divorced individual’s own benefits would be less
- The now ex-spouse has applied or is receiving his or her own Social Security or disability benefits
If the divorced individual meets the requirements noted above, except that the now ex-spouse is not retired nor has applied for benefits, the divorced individual can receive benefits if they have been divorced from that spouse for at least two years. This may create a delay in those situations where the divorced spouse, wanting to start benefits, is older than the ex-spouse worker and they divorce when the divorced spouse is 62 or older. He or she will need to wait until either the ex-spouse applies for benefits or two years, whichever occurs first.
The divorced individual must be at least age 62 if the ex-spouse is alive and the ex-spouse has applied for or is collecting benefits. The divorced individual may collect at age 60 (50 is disabled) if ex-spouse is deceased. Benefits will be reduced if received before the divorced individual attains normal retirement age but will not be reduced if ex-spouse receives benefits before normal retirement age.
The divorced spouse will be eligible for benefits as a widow or widower. The surviving divorced-spouse benefits are greater than the divorced-spouse benefits.
The impact of any remarriage will depend on the type of benefit. For benefits as a divorced former-spouse, benefits are not paid to the divorced individual once they remarry someone other than the ex-spouse, with some exceptions. For surviving former-spouse benefits, if the divorced individual remarries before age 60 they cannot receive benefits as a surviving spouse while married. If the divorced individual remarries after age 60 they will continue to receive benefits as a surviving spouse.
Divorced individuals should be sure to maintain certain information regarding their ex-spouse that may be needed at the time of application for Social Security benefits. This would include the ex-spouse’s name, date of birth, and social security number. Divorced individuals should also maintain their final divorce decree and marriage certificate. This same information should be maintained for any other former spouses.
Tax Issues (4)
A taxpayer’s filing status, for any year, is determined by his or her marital status as of December 31. Therefore, if you are single on December 31, you will file as a single taxpayer for the entire twelve-month period ending December 31, no matter what your status was during the year. This rule, when unknown or forgotten, may leave one party, solely, to bear the cost or reap the benefit of the tax consequences accrued during the marriage.
The typical marital balance sheet includes cash, investments, real estate, etc. Don’t overlook current year tax liabilities or overpayments, as of the valuation date. In my tax practice, seldom is there a tax return showing no payment due or overpaid. Many taxpayers find themselves with some amount to be paid or an amount due to them. There are many reasons that this happens. Some individuals, though advised not to do this, will purposely over-withhold as a forced-savings method. A taxpayer, who receives a bonus during the year, usually has a difficult time of getting to break-even.
Some months after the divorce is final, each spouse will be sitting down with their preparer to file their tax return for the year before. There are usually questions about claiming mortgage interest and real estate taxes that were made while married, and how to allocate estimated tax payments made in the prior year. If these were brought up while the couple was working on the disentanglement of the financial affairs, each would be clear on how they were going to allocate these marriage-related items.
When discussing the allocation of income, deductions, and other tax-related payments that occurred during the marriage, here are some general guidelines as to how they will be reported on separate returns:
- Income is reported by the person who has earned the income. Therefore, all wages and self-employment income is reported by the husband or wife who earned it, even though this income may have been used to support both husband and wife.
- Investment earnings in joint accounts are normally reported under one primary social security number, but would be divided equally on two separate returns. If the investment earnings are generated from an individually-owned account, the owner claims the income. If an account, including all the earnings, is allocated to one spouse only, wouldn’t it make sense to allocate all the investment earnings to the sole owner of the account?
- Deductions are generally claimed by the individual who paid it from their own account. However, if a deductible expense was paid from a joint account, generally the deduction is equally divided, with exceptions for mortgage interest and real estate taxes.
- Estimated tax payments will be considered to be paid in proportion to the taxpayers separate tax liability, unless agreed otherwise. It has been my experience that the IRS gives credit to the primary taxpayer (usually the husband), even when you instruct otherwise. This usually just takes some letter writing to fix.