Unallocated Support Payments as Alimony

BY CHARLES J. REICHERT

T he requirements that determine whether payments between ex-spouses qualify as alimony were discussed in a tax case in the November issue of the JofA (“ What Makes It Alimony? ” page 95) If payments are to qualify as alimony, the payor spouse cannot be liable for payments after the payee spouse’s death (a continuing payment liability) or any amounts in lieu of those payments (substitute payment liability). When unallocated support payments are present, the courts have looked first at the language in the written agreement when deciding whether either a continuing payment liability or a substitute payment liability exists. If the agreement does not address the issue, the courts in previous cases have examined the payor spouse’s legal responsibilities under state law to determine whether those payments terminate upon the death of the payee spouse ( Lovejoy v. Commissioner, 293 F3d 1208 (10th Cir. 2002) and Gonzales v. Commissioner, TC Memo, 1999-332).

Patricia Kean filed for divorce in 1991. Until the divorce became final in 1997, a temporary court order granted her and her husband joint custody of their three children and also required Mr. Kean to deposit specified amounts into a joint bank account for the support of his wife and the children.

In 1993 Mrs. Kean was granted the exclusive use of the money deposited into the account, though she did not withdraw any of it from March 1993 to December 1996. She reported none of the money received from her former spouse as gross income for tax years 1992–1996; however, Mr. Kean deducted the payments as alimony during that period. The IRS determined the amounts Mrs. Kean received were taxable alimony payments and assessed her a deficiency of approximately $75,000 in unpaid income taxes.

Mrs. Kean petitioned the Tax Court for relief, arguing that the amounts deposited into the account were not alimony. The court rejected her first argument that she did not receive the payments because the money was deposited into a bank account.

She then argued that the Tax Court should follow its decision in Gonzales in which unallocated support payments a taxpayer received while a divorce was pending were not considered alimony. In Gonzales, the court determined that under a temporary court order a noncustodial payor-spouse was liable for a continuing payment because New Jersey state law could require that spouse to make family support payments if the payee-spouse died before the final decree was granted.

The Tax Court distinguished the Kean case from Gonzales , stating that if Mrs. Kean had died before the divorce was finalized, her spouse would not have been liable to make payments to a third party. Under New Jersey state law, he had joint custody rights and thus automatically would have been given custody of the children.

Mrs. Kean appealed the decision to the Third Circuit Court of Appeals, making the same arguments she had presented to the Tax Court.

Result. For the IRS. The Third Circuit held that, because Mrs. Kean had access and control of the money, she had received the funds. The court also rejected her argument that Mr. Kean had a continuing payment liability, saying that if Mrs. Kean had died her husband would not have had to make payments to her estate or on her behalf due to the separation instrument. Thus, under IRC section 71(b)(1)(A), those payments could not have been considered continuing liability payments.

The court also noted that IRC section 71(c) permits the parties to distinguish child support payments from alimony in the instrument. The court said it would be inconsistent with the intent of this section for state law to dictate that a parent had a continuing payment liability. The court concluded that the entire amount of unallocated support payments represented alimony; otherwise the payor-spouse would be taxed on amounts intended to support the payee-spouse.

The Third Circuit reached the same conclusion as the Tax Court for a different reason, saying previous decisions regarding unallocated family support payments placed too much emphasis on a parent’s legal responsibility under state law and ignored the overall purpose of section 71(c). This court’s position was that a continuing payment liability or a substitute payment liability is created when an instrument requires payments to the payee-spouse’s estate or on his or her behalf and is not created by a parent’s legal responsibility to support his or her children under state law. The court noted that unallocated support payments provide flexibility to parents in the use of that money and, when designing section 71(c), Congress permitted spouses to determine which of them would bear the tax burden of any payments. If the parties agree to have the payor spouse incur the tax burden, nondeductible child support payments can be specifically identified in the instrument rather than using unallocated payments; therefore the payee-spouse should be taxed in full for unallocated support payments.

Patricia P. Kean v. Commissioner, 407 F3d 186 (3rd Cir. 2005).

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

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