EXECUTIVE
SUMMARY |
FOR ALIMONY TO BE TAX
DEDUCTIBLE, payments must be
made in cash under a divorce or written
separation instrument, the spouses must
reside in separate households, the payor’s
liability must end with the payee’s death,
the payor and payee must file separate
returns and the divorce or separation
instrument can’t designate nonalimony
treatment.
IT’S CRUCIAL FOR THE
DIVORCE DECREE to contain a
termination-at-death clause to assure
alimony treatment for income tax
purposes.
NONALIMONY TREATMENT IS
PERMITTED if the divorce
agreement designates the payments as not
includable in income and not allowable
as a deduction.
THE COURT OF APPEALS FOR
THE SIXTH CIRCUIT held that
if the language of a domestic relations
order is a “qualified domestic relations
order,” the tax burden is shifted to the
alternate payee. The intent of the
parties is irrelevant.
TAX COURT DECISIONS
ILLUSTRATE THAT CONFORMING
completely to every detail of a
dependency exemption waiver form is not
as important as meeting the requirements
of the Internal Revenue Code and
Treasury regulations. |
LARRY MAPLES, CPA, DBA,
is COBAF Professor of Accounting at
Tennessee Technological University in
Cookeville. His e-mail address is
lmaples@tntech.edu .
|
PAs who prepare tax returns for
divorced individuals must properly report
transactions such as alimony and nonalimony
payments, retirement benefits under qualified
domestic relations orders (QDROs) and dependency
exemptions. The CPA should examine divorce
documents to decide the tax treatment rather than
rely on the client’s characterization of the tax
effects of divorce-related agreements. This
article will help CPAs evaluate the tax effects of
divorce documents and give tax advice to clients
in divorce-settlement negotiations. Remember that
the results in the cases discussed here may not
hold true in other jurisdictions.
DEFINING ALIMONY
Divorcing clients must meet the
requirements of IRC section 71(b) if the payments
from the split are to be classified as alimony for
tax purposes. Specifically,
The payments must be in cash and must
be received under a divorce or written separation
instrument.
The spouses must reside in separate
households.
The payor’s liability must not
continue after the payee’s death.
The payor and payee must file
separate returns.
The divorce or separation instrument
must not designate nonalimony treatment.
What qualifies as alimony? Several important
cases can guide CPAs who interpret divorce
documents or give advice in divorce negotiations.
Divorce Rate
Annual U.S. marriage rate:
7.8 per 1,000*
Annual U.S. divorce rate:
4.0 per 1,000* *Total
U.S. population. Source:
National Center for Health Statistics,
www.cdc.gov/nchs/fastats/divorce.htm
.
| In
Nelson the Tax Court held that payments
that meet the requirements of section 71(b) are
deductible as alimony even though, under local
law, the payments might have represented a
division of marital assets. After the husband sued
for reduction of his “alimony” payments, the
divorce court said that payments described as
alimony in the divorce decree were a property
settlement. The Tax Court said the divorce court’s
property settlement designation was irrelevant in
determining the tax consequences of the payments.
Since the requirements under section 71 were met,
the payments were alimony for tax purposes in
spite of the divorce court’s language. O
missions in the divorce instrument may create a
vacuum that state law may rush in to fill. Suppose
a divorce instrument doesn’t say whether payments
will continue after the payee’s death. In states
in which alimony terminates at the payee’s death
by statute, there is no problem qualifying the
payments as alimony for tax purposes if they are
alimony under state law. But if this is not the
case, the state statute that terminates alimony at
death is not applicable. For example, the Third
Circuit Court of Appeals in Hawley
recently decided whether an unallocated
support order terminates on the custodial parent’s
death under Pennsylvania law. The payor lost a
substantial alimony deduction because he was
unable to prove that Pennsylvania law required
unallocated payments to cease at death. This makes
it crucial for the lawyer preparing the divorce
decree to ensure it contains a
termination-at-death clause for federal tax
purposes. If the decree has no such clause and
state law does not terminate the payments at
death, a CPA might take a tax-return reporting
position that payments for items such as food,
shelter, medical care and education expenses must,
of necessity, end with the payee’s death and thus
satisfy the requirements for alimony. CPAs
advising clients who seek alimony treatment should
not rely on language used in agreements or
decrees. Payments are alimony only if the
requirements of section 71(b) are met.
NONALIMONY DESIGNATIONS
The choice of
language by the parties or the divorce court is
crucial for taking a nonalimony tax position. IRC
section 71(b)(1)(B) permits nonalimony treatment
if the divorce agreement designates the payments
as not includable in income under section 71(a)
and not allowable as a deduction under IRC section
215. The courts have recently grappled with how
the word designate should be construed
under the tax code. In the Seventh Circuit
Court of Appeals case Richardson , the
wife received $10,000 a month and some of her
other expenses under a separation agreement. In
later proceedings the state divorce court
increased this amount to more than $26,000,
holding that the original agreement was
“unconscionable.” The Seventh Circuit provided a
definition of the term designate that has
been used as a touchstone to solve tax dilemmas in
several recent cases. According to the court,
designate means to include a “clear,
explicit and express” statement regarding the tax
effect. The wife had argued the payments weren’t
alimony because the divorce court had ruled that a
reasonable payment would constitute 40% of her
spouse’s aftertax income. Thus, she reasoned her
husband already would have paid tax on the money
paid her. The Seventh Circuit resisted defining
designate in such an indirect way
because it then would be necessary to pick apart
the assumptions of a divorce court in future
cases. The Seventh Circuit pointed to the
dictionary’s definition of the word designate
“to make known directly, to point out, to
name, to indicate,” and concluded the divorce
instrument must contain a clear, explicit and
express statement regarding the tax effect. The
decree in Richardson lacked such an
express statement. It said only the husband’s
aftertax income was to be used to determine the
reasonableness of the proposed alimony amount.
Therefore, the payments were considered alimony.
In contrast to Richardson , in
which the divorce court merely implied who would
bear the tax burden, in Jaffee a
temporary order by the state court clearly showed
the husband would be responsible for income taxes
on his wife’s “alimony pendente lite,” that is,
alimony while the suit was in progress. Ms. Jaffee
was permitted to withdraw $18,500 from their joint
brokerage account for her support while the
divorce was being finalized. Half the amount was
deemed to come from her own funds, but the issue
was whether the statement that “he was responsible
for taxes” meant Mr. Jaffee’s half was properly
designated as nonalimony. The Tax Court said such
language was not a sufficient nonalimony
designation, allowed Mr. Jaffee’s alimony
deduction and required Ms. Jaffee to include the
withdrawals in income. Language which
clearly establishes that a property settlement is
to occur does not create a nonalimony designation
unless tax consequences are clearly stated,
according to the IRS. In letter ruling 200141036,
a taxpayer and spouse entered into an agreement
which stated in part: “[Former spouse]
agrees to…deliver to [Taxpayer] a deed conveying
to [Taxpayer] all her rights, title and interest
in and to the farm…[Taxpayer] agrees…to provide
[Former spouse] with an income of $x per
month…continuing as long as she lives. That income
will constitute [Former spouse’s] separate
property.” The IRS said that the lack of
“clear, explicit and express direction” concerning
the tax consequence made the payments alimony. A
simple statement that the parties designate the
payments as excludable/nondeductible under code
sections 71 and 215 would have avoided this
result. In Baker the judgment of
divorce said the husband would pay his former wife
“50% of his monthly gross military retirement pay
from the U.S. Army each month as a property
settlement.” Mr. Baker deducted these payments as
alimony, but Ms. Baker did not report them as
income. The Tax Court said they should be treated
as alimony because a label of “property
settlement” is not the clear and explicit
direction required by Richardson . The
wife argued that her half of the pension was not
alimony because a property settlement in a divorce
clearly comes under the nontaxable umbrella of
section 1041—yet another taxpayer learned the hard
way that labeling carries no weight unless it is
explicit “tax labeling.” Again, a statement that
the parties designate the payments as
excludable/nondeductible under code sections 71
and 215 would have avoided this result.
Case Citations
These cases are listed in
the order of their appearance in the
article.
Thomas H. Nelson, et
ux. v. Commissioner, TC
Memo 1998-268.
Hawley v.
Commissioner, 94 FedAppx 126
(3rd Cir. 2004), aff’g Gilbert
v. Commissioner TC Memo
2003-92.
Richardson v.
Commissioner, 125 F3rd 551
(7th Cir. 1997).
Irv C. Jaffe, et al.
v. Commissioner, TC Memo
1999-196.
Marilyn J. Baker
v. Commissioner, TC Memo
2000-164.
Thomas Clarence
Maloney, et ux., v.
Commissioner, TC Memo
2000-214.
Estate of Monte H.
Goldman v. Commissioner,
112 TC 317 (1999), aff’d sub. nom.
Shutter v. Commissioner,
242 F3d 390 (10th Cir. 2000).
Randolph S. Simpson I,
v. Commissioner, TC Memo
2003-294.
Hawkins v.
Commissioner, 86 F3d 982
(1996).
Golsen v.
Commissioner, 54 TC 742
(1970).
Michael Kevin
Boltinghouse, et ux. v.
Commissioner, TC Memo
2003-134.
Joann Bramante v.
Commissioner, TC Memo
2002-228.
| T he tax
language in an agreement has to be explicit. In
Baker the Tax Court said using the term
property settlement alone “does not
clearly inform us that the parties considered the
federal income tax consequence of the payments
under sections 71, 215 and/or 1041.” But explicit
mention of these code sections is not a hard and
fast requirement, because both the IRS and the Tax
Court have upheld nonalimony designations in the
absence of specific tax code references. In
Maloney the husband separated but did
not retire from the U.S. Navy and was paid a
lump-sum separation amount. An Illinois court had
awarded Ms. Maloney about 40% of the payment,
noting that the “transfer shall not be considered
a taxable event.” The Tax Court held that the
transfer was not alimony. It would be
tempting to deduce from these examples that CPAs
could be comfortable advising their clients to
take nonalimony positions when no code provisions
are mentioned. But this conclusion may not be
warranted. Compare the Baker case with
Estate of Goldman, aff’d sub. nom. Shutter
v. Com’r.: Both clearly involved
property settlements, but the Tax Court
characterized the payments as nonalimony only in
Goldman because the boilerplate
language mentioned section 1041. CPAs comparing
these two cases might conclude the mention of a
code section may be crucial to a nonalimony
designation when the agreement describes the
transfer as a property settlement. However, in the
recent Simpson case, the Tax Court made a
nonalimony decision when the decree specified the
division was a property settlement but did not
mention tax implications or code sections.
To help clients accomplish nonalimony
treatment, CPAs can avoid the interpretive
difficulties discussed above by suggesting to the
divorce lawyers this simple language be used in
divorce documents: “The parties designate the
payments as excludable/nondeductible under IRC
sections 71 and 215.”
QUALIFIED DOMESTIC RELATIONS ORDERS
The 10th Circuit
Court of Appeals in Hawkins v.
Commissioner held that express tax
language in a QDRO is not necessary to shift the
tax consequences of a distribution. At stake was
whether the husband or the wife should bear the
tax burden of a $1 million pension distribution
made to the wife. The key issue was whether a
valid QDRO existed. The wife argued and the Tax
Court concurred the settlement agreement did not
satisfy the statutory definition of a QDRO;
therefore, the husband should pay the tax.
Generally, the plan participant (here, the
husband) pays the tax on distributions. B
ut section 402(e)(1)(A) (formerly 402(a)(9))
provides the exception whereby an “alternate payee
who is the spouse or former spouse of the
participant shall be treated as the
distributee…under a qualified domestic relations
order.” Such an order is a QDRO under the tax code
if it assigns benefits under a plan to an
alternate payee, clearly specifies certain
information and does not alter the amount or form
of benefits under the plan (IRC section 414(p)).
In Hawkins the agreement said the wife
“shall receive as her separate property cash of
one million dollars from her husband’s share” of
the plan. The wife argued that such language did
not establish that benefits under the plan were
assigned to her as an alternate payee. Rather, the
language made her former husband personally liable
to her for $1 million and merely identified the
pension plan as the source of the $1 million cash.
The Tax Court, in agreeing with her, pointed out
that the QDRO did not refer to her as an alternate
payee. The 10th Circuit believed the Tax
Court took too narrow an approach because it
assumed that a valid QDRO must express the
parties’ intent to reallocate the tax burden of a
pension distribution and must use the exact
statutory terminology. The appeals court pointed
out that section 414(p) requires neither step. The
court then clearly stated the principle it
believes should govern the relevancy of tax
language in a QDRO: “Nothing in the statute
requires the parties to a marital settlement
agreement to indicate unambiguously their desire
to shift the tax consequences of a particular
distribution. Allocation of tax liability between
the parties is a consequence of having a QDRO; yet
it is not a prerequisite to the creation of a
QDRO.” Therefore, the appeals court’s view clearly
is that the tax intent of the parties is
irrelevant. If the language qualifies as a QDRO,
the tax burden is shifted to the alternate payee.
This view stands in marked contrast to alimony
issues, where, as we’ve seen, tax language or the
lack thereof may be the determining factor in
whether a payment qualifies as alimony for tax
purposes. A CPA trying to decide on a
tax-return position may not have to be overly
concerned about tax language in a QDRO if the
client is in the 10th Circuit. But in
jurisdictions where the issue has not been
explicitly addressed, the Tax Court under the
Golsen rule may not follow Hawkins
. (Under the Golsen rule, the Tax
Court may decide to follow its own precedent if
the court of appeals of the appropriate
jurisdiction has not passed on this issue.)
|
PRACTICAL TIPS TO
REMEMBER
| |
Payments to
former spouses are deductible
alimony only if the
requirements of IRC section
71(b) are met. Don’t rely on
statements in divorce
agreements or decrees that
describe payments as alimony;
rely instead on how the code
requirements have been applied
by the courts.
To accomplish
nonalimony treatment,
recommend using this language:
“The parties designate the
payments as
excludable/nondeductible under
IRC sections 71 and 215.”
In disputes about
the tax effect of a dependency
release (form 8332), remember
that omitted details are not
nearly as crucial as whether
the requirements of the tax
code and Treasury regulations
are met.
| |
DEPENDENCY EXEMPTION WAIVERS
Another crucial
document in many divorces is IRS Form 8332,
Release of Claim to Exemption for Child of
Divorced or Separated Parents. Since
current law gives the dependency exemption for
children to the custodial parent unless he or she
waives that right, the information included in
form 8332 has been at issue in several recent
disputes before the Tax Court. Specifically, how
literally must the form’s requirements be met in
order for the noncustodial parent to claim the
exemptions? Two recent cases illustrate the
tension between the IRS and the petitioning
taxpayer. In one the IRS argued unsuccessfully
that omission of certain details on the form
defeated the release of the exemption. In another
the IRS argued successfully that omission of
certain details did not change the substance of
the release. In Boltinghouse a
couple executed a separation agreement saying that
Michael, the noncustodial parent, could claim one
of their daughters as a dependent. The IRS argued
the agreement did not meet the requirements
because it was not incorporated in the final
divorce decree and did not conform to the
substance of form 8332 because it didn’t reflect
the years for which the exemptions were to be
released or provide Social Security numbers for
the parents. T he court disposed of the
first argument by pointing out that requiring the
release to be incorporated in the decree would
mean that form 8332 did not stand on its own.
Thus, CPAs can be sure a release, whether executed
on form 8332 or not, will suffice if it conforms
in substance to the form’s requirements. But what
about the details in the release? The IRS
argued the agreement did not explicitly state the
tax year to which the taxpayer wanted it to apply
and pointed to cases where the Tax Court had
rejected agreements that were ambiguous about the
year involved. But the court found no ambiguity
existed in Boltinghouse because the
agreement clearly said it applied to years
starting when the parents began filing separate
returns. The lack of Social Security numbers was
not crucial, according to the court, because
neither statute nor the regulations require them,
and, in any case, they were furnished on the tax
return. In Bramante a custodial
parent executed a release of exemptions on form
8332. Later, when her income increased, she had
second thoughts and argued that the form 8332 was
not a valid release because it did not include her
Social Security number and her ex-husband (the
noncustodial parent) had dated it in his own
handwriting. Again, as in Boltinghouse ,
the Tax Court was not overly concerned about
details on the release form that were not required
by the code and regulations. The court would not
allow the custodial parent to wriggle out of the
exemption release. Apparently, the only
way a custodial parent can change his or her mind
and void form 8332 is to convince the noncustodial
parent to forfeit the exemption (see IRS Chief
Counsel Advice 200007031). A real inequity can
exist when a noncustodial parent fails to make
child-support payments yet continues to claim the
exemption under the waiver. CPAs should advise
clients to sign waivers only on a year-to-year
basis to guard against this problem. In
disputes about the tax effect of a dependency
release, the CPA should remember that omitted
details are not nearly as crucial as whether the
requirements of the tax code and regulations are
met. A release will be effective, whether form
8332 is used or not, if the agreement conforms to
the law’s requirements. When form 8332 is used,
omission of information called for on the form
will not void the release unless the omitted
details are called for in the code or regulations.
WHAT LANGUAGE IS NEEDED
CPAs may find
themselves searching the language of
divorce-related agreements to support a tax
position. If a client wants an alimony deduction,
the CPA should scrutinize the agreement to
determine whether it meets the requirements of
section 71. No tax language is necessary to
characterize payments as alimony. In fact, case
law demonstrates that words such as alimony
or property settlement are
irrelevant in determining whether payments qualify
as alimony for federal tax purposes. On the other
hand, if a CPA is gathering support for a tax
position that payments received are not alimony,
more specific language is required. The degree of
specificity has been at issue in several recent
court cases. A CPA looking to the language of a
QDRO to shift the burden of taxation should be
forewarned: The 10th Circuit has held that such
tax language in a QDRO is irrelevant. Under
Hawkins the tax impact is based solely
on whether the order qualifies as a QDRO. If it
does, the tax burden shifts to the alternate payee
regardless of the tax language used. Finally, when
exemption waivers have been executed, the CPA
should carefully note any missing information on
form 8332 and the duration of the waiver. |