This blog is part two of a three-part series discussing how a divorce could affect your taxes. You can read the first blog post in this series here.
Alimony comes in many forms, including permanent, rehabilitative, limited duration, reimbursement and temporary (pendente lite) support. It is important to recognize that whether payments qualify as alimony under federal tax law is determined by the characteristics of the payment and not by how they are labeled under state law.
In 1954, the Internal Revenue Code added two key provisions, Section 71, which provided that alimony payments were includeable in the taxable income of the recipient and Section 215, which provided that such payments were deductible to the payor. These provisions remain part of current tax law although they have been subject to revisions over the years.
Initially, to qualify as alimony, the payments have to be “periodic”. Thus, installment payments of a principle sum did not qualify for periodic payment treatment unless the installments were payable for a period of more than ten years. This ten year requirement was rigidly enforced. Payments over a shorter period of time could qualify as periodic provided that the total sum was rendered uncertain by a contingency, such as the death of either party or the remarriage of the recipient. Additionally, the payments must be in discharge of a support obligation, as opposed to payment for transfer of property or a property settlement.
Additionally, the payments must have made pursuant to a decree, court order or written agreement. In the case of an agreement, the requirement was that it be signed by both parties.
Thus, agreements for payment of support that were confirmed by an exchange of letters between lawyers did not qualify, nor did oral agreements between the parties. Importantly, the requirement of a writing has remained unchanged despite subsequent amendments to the Internal Revenue Code.
The Domestic Relations Tax Reform Act of 1984 and Tax Reform Act of 1986 amended the Internal Revenue Code and dramatically changed tax law with respect to alimony. Most of the changes are beneficial to divorcing parties and have provided lawyers with previously non-existent planning possibilities.
For example, since1984, parties have been able to designate alimony payments as non-taxable to the payee and non-deductible to the payor and this designation is accepted without question by the IRS. The concept of alimony “recapture” was also introduced to prevent “frontloading” or disguising property settlements as alimony to gain tax advantages. To eliminate such problems, the new law placed limits on accelerated alimony by “recpaturing” excess payments in earlier years and adding that excess back to the payor’s income. The recapture rules do not apply to temporary support or to fluctuating payments not in the control of the payor, such as an obligation to pay a percentage of income. Importantly, the rule is applicable only to qualifying payments in the first three post-separation years.
Unlike alimony, child support payments are neither deductible to the payor nor taxable to the payee; however, payments that are “unallocated” between spousal support and child support are entitled to alimony treatment under the Internal Revenue Code. Unallocated payments became a popular device which resulted in making additional funds available to the family assuming that the payor is in a higher tax bracket than the payee, he or she could afford to pay a larger amount, a portion of which would be retained by the payee rather than paid out in taxes. This principle proved to be so popular that many states have adopted the unallocated payment structure.
The next and final article in this series will deal with the tax considerations of property distributions, dependency exemptions and childcare credits.