When do family support payments constitute alimony? CPAs advising clients about their tax status in a divorce need to know the rules.
Alimony payments are deductible for tax purposes for a payor spouse but represent gross income to the payee. Under a divorce or separation agreement, payments are considered alimony if they are made in cash to an ex-spouse not living in the same household as the payor and not designated as either child support or a property settlement. Also the payor can’t be liable to make payments after the death of the spouse (a continuing payment liability) or in place of postdeath payments (substitute payment liability).
Michael Berry was divorced from his wife in 1997. The divorce judgment required him to pay approximately $4,000 a month in support to his ex-wife and their two minor children. Under California law, a family support agreement combines spousal and child support without stating the specific amount of each component. Berry deducted the family support payments as alimony on his 1999 tax return; however that deduction was disallowed by the IRS. The taxpayer petitioned the Tax Court for relief.
Result. For the taxpayer. Family support payments would not be deductible as alimony if they created either a continuing payment liability or a substitute payment liability. The court first determined whether Berry had any obligation to make those payments after the death of his ex-wife. Since the divorce agreement did not address the issue, the court examined California and related case law. Neither dealt directly with the issue. In the court’s judgment Berry would not have had to continue making those payments to her estate since it was unlikely a state court would recognize her estate as having an enforceable interest in the payments. Thus there was no continuing payment liability.
The court then examined whether Berry had an obligation to make payments in lieu of the child support component after his ex-wife’s death. The IRS argued that all parents are required to support their children until the age of emancipation; therefore the taxpayer would be required to make child support payments if his ex-wife died, thus creating a substitute payment liability. This argument is based on a “worst case scenario approach” previously advanced by the Tax Court in which it is assumed that a third party is awarded custody of the minor children after the death of an ex-spouse and state law requires the taxpayer to make child support payments to that third party ( Wells v. Commissioner, TC Memo (1998-2)). Under that theory, family support payments represent substitute payments since they include an undesignated child support component for which the taxpayer’s obligation continues after the death of his ex-wife.
The court rejected this argument stating that it implied the only amount required to be designated as child support in a divorce agreement is an amount in excess of that required under state law, since state law automatically would cause part of unallocated support payments to be considered child support. The court further stated it clearly was not the intent of Congress to have state law determine what portion of unallocated support payments represented child support when the divorce agreement did not. In addition, if state law automatically fixes a portion of unallocated payments as child support, IRC section 71(c)(1)—which disqualifies as alimony any amount specifically designated as child support in the divorce agreement—would not be necessary.
This case resolves the issue of whether parents’ general obligation to support their minor children after the death of an ex-spouse automatically causes the creation of a substitute payment liability when undesignated family support payments are present, and rejects the application of the “worst case scenario approach” to that situation.
Michael K. Berry v. Commissioner, TC Memo, 2005-91.
Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.