Divorce can create a host of personal and financial problems for the parties involved. A misunderstanding about the tax consequences of a settlement agreement can exacerbate these difficulties.
John Lovejoy instituted divorce proceedings against his wife. He made support payments to her while the divorce was pending. These payments were not formally designated as either alimony or child support. Lovejoy deducted the payments on his tax return as alimony. His wife died before the divorce was finalized, and the proceedings were discontinued. The IRS denied the taxpayer’s alimony deduction because the payments failed to meet the requirement that they terminate at death—even though Lovejoy made no payments after his wife’s death. The Tax Court ruled for the IRS and the taxpayer appealed.
Result. For the IRS. To meet the requirement for deductible alimony, payments must fulfill all the conditions in IRC section 215.
The payments are received under a divorce or separation
The instrument does not designate the payments as something other than alimony.
The payments occur when the taxpayers are not members of the same household.
The payments will terminate at death.
The IRS conceded the taxpayer had met the first and third conditions. It also acknowledged that, under federal law, payments will be treated as alimony unless specifically designated as “nonalimony.” The IRS also agreed that in Colorado, where Lovejoy resided, the law says alimony stops at death, and state law usually is sufficient to meet the termination-at-death requirement. However, it disagreed that Colorado would treat the payments in question as alimony. It argued that, under Colorado law, an unlabeled payment that replaces both alimony and child support would be treated at least in part as child support, which continues even after the payor’s death. Therefore the undesignated payment does not terminate at death. The fact there were no postmortem payments was immaterial. The Tenth Circuit Court of Appeals agreed with this analysis and denied the deduction.
Although federal law makes provisions for classifying undesignated payments and determining termination rules under state law, it always is risky for taxpayers to depend on a federal interpretation of state law and its application to federal tax rules. If the separation agreement had either designated the payments as alimony or specifically provided for their termination upon the spouse’s death, the taxpayer would have been entitled to the deduction. A well-drafted agreement will cover all aspects of a divorce, including the taxation of any payments or transfers.
John H. Lovejoy v. Commissioner, CA-10, 6/02.
Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.