"Divorce, Pensions and Community Property"

BY EDWARD J. SCHNEE

The Internal Revenue Code has relatively clear rules detailing the taxation of normal payments made on account of divorce. How these rules apply to pension plan distributions has been explained in several court cases. Recently, the Tax Court had to determine the taxation of a payment in divorce that was related to a pension plan in a community property state.

John Michael Dunkin was employed by the city of Los Angeles. On May 19, 1989, he became eligible to receive a pension, but decided not to retire. He was divorced on August 19, 1997. The divorce decree said John’s former spouse was entitled to half of his earned pension—at that point, $2,072. Since John did not retire on that date, the decree required him to pay his former spouse $2,072 monthly until he did retire. In 2000, he made the payments which totaled $25,511 and deducted this amount as alimony on his 2000 tax return. The IRS objected to the deduction.

Result. For the taxpayer. It has been long established that state law determines a person’s right to income and property and federal law determines the taxation of those rights. California law determined the $25,511 payment had to be made. The question, therefore, was the appropriate taxation of that payment.

In prior cases the Tax Court had ruled a former spouse was liable for the taxes due on her receipt of pension funds resulting from community property law. Likewise, she was liable if she received a lump-sum distribution from a pension plan. The IRS argued that these cases did not apply in this case because Dunkin had not started to receive his pension. The Tax Court rejected this argument. Prior cases had held the taxation of a former spouse was not determined based on the form of the payments. Dunkin’s former spouse received the payment from him because she was entitled to receive the pension regardless of the fact that he had not retired. Therefore the court was able to disregard the form of payment as meaningless.

The IRS then argued that taxing the former spouse would violate the assignment-of-income doctrine. The Tax Court rejected this argument on the grounds that under California community property law the former spouse earned the income and did not simply collect income earned by her former husband.

The government’s final argument was that the deduction was not allowed because the income was nontaxable to the former spouse since it had not come from the pension plan and had not, therefore, been covered by the rules governing such distributions. The fact that the code specifies how pension plan distributions should be taxed does not mean other payments related to pensions are nontaxable. Likewise, that a qualified domestic relations order directing the pension to pay the former spouse did not exist was immaterial. The former spouse had received a payment based on her share of a pension plan, and the court said it was taxable to her and deductible by her former husband if he had been ordered to make the payment.

The taxation of payment made on account of a divorce can be complicated. It is important, therefore, to carefully evaluate the true nature of the payment and not rely on the label or source of payment to determine the taxation.

John Michael Dunkin v. Commissioner, 124 TC no. 10.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

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