Alimony deduction allowed for health care premiums purchased with pretax wages

In a case of first impression, the Tax Court rejected the IRS’s objection to a taxpayer’s alimony deduction of pretax medical insurance premiums for coverage of a separated spouse.

Facts: In 2012, Charles and Cynthia Leyh separated in Pennsylvania and signed an agreement in 2014 incident to their divorce. Charles Leyh promised to pay Cynthia Leyh alimony until the final divorce was granted. As part of the agreement, he paid for her health and vision insurance.

In 2015 Charles Leyh paid $10,683 for Cynthia Leyh’s health insurance premiums as pretax payroll reductions through his employer’s cafeteria plan. On his 2015 Form 1040, U.S. Individual Income Tax Return, Leyh, using the married filing separately status, excluded the total amount of the premiums for health care coverage he and Cynthia Leyh received through the cafeteria plan and claimed an alimony deduction of $10,683 for the premium payments made on Cynthia Leyh’s behalf.

Following an audit of Charles Leyh’s 2015 return, the IRS disallowed his deduction for the alimony payments and determined a $3,770 income tax deficiency and a $754 Sec. 6662(a) accuracy-related penalty. Leyh timely petitioned the Tax Court for a redetermination of the deficiency and penalty.

Issues: One issue was whether Leyh claimed an impermissible “double deduction” by deducting as alimony payments his spouse’s health insurance premiums that were paid to him as compensation but excluded from gross income, which the Tax Court had not previously considered.

When an employee receives health coverage covering the employee and/or the employee’s spouse as a benefit through an employer-sponsored health care plan, the premiums paid for the coverage may generally be excluded from the employee’s gross income (Secs. 106(a) and 125(a); Regs. Sec. 1.125-1(h)(2)).

In general, before repeal by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amounts received as alimony were includible in income in the year received and deductible by the payer in the same year (former Secs. 71 and 215). The TCJA repealed Secs. 71 and 215 with respect to divorce or separation instruments executed after Dec. 31, 2018 (or modified after that date to apply the change). Therefore, the TCJA did not apply to the agreement at issue.

The IRS argued that permitting the alimony deduction would create a “windfall” to Leyh by granting him the practical equivalent of multiple deductions. It further argued a second issue, that Sec. 265 prohibits deductions for amounts attributable to tax-exempt income.

Holding: The Tax Court held that Leyh was entitled to deduct the premiums as alimony. The court noted that Leyh received the health insurance compensation while the parties were still married, as Pennsylvania law recognizes only divorce, not legal separation. The final decree of divorce was not issued until 2016. Therefore, the Leyhs could have filed a joint return in 2015 and avoided the alimony regime. Cynthia Leyh would then not have been required to include any portion of the alimony payments in her income. But because she was required to include them, the court reasoned, the matching principle of the alimony regime allowed Charles Leyh a corresponding deduction.

In response to the IRS’s windfall argument, the court stated that there was no risk of a windfall and that disallowing the deduction would leave Leyh with a greater tax burden, which ran counter to the alimony regime’s purpose of shifting the burden to the alimony’s recipient. With respect to the Sec. 265 argument, the court stated that it was not aware of any case in which an alimony deduction had been disallowed on that basis, and as Cynthia Leyh was required to include the alimony in her income, it was not wholly allocable to tax-exempt income for Sec. 265 purposes.

“Neither the double deduction common law principle nor section 265 applies to prevent the deduction of alimony where a separated couple pending a final decree of divorce create an alimony pendente lite agreement that includes continued health coverage as provided by the payor spouse’s employer, premiums for which are properly excluded from the payor’s gross income and included in the recipient spouse’s gross income,” the court concluded (slip op. at 14-15).

• Leyh, 157 T.C. No.

— By Maria M. Pirrone, CPA, LL.M., and Joseph Trainor, CPA, Ph.D., CFE, both associate professors of accounting at St. John’s University, Queens, N.Y.