Avoiding Unwanted Tax Costs in Divorce Settlements

By: Tyler B. Korn, Esq.

Why is divorce so expensive?” is a question that attorneys often hear. Experienced family law practitioners usually respond “Because it’s worth it.”

Indeed, costs to the client often continue well after legal fees are paid because of unanticipated tax costs. Unexpected tax burdens cause the pain of divorce to persist, exacerbating the client’s resentment of the ex-spouse, which is often transferred to the attorney. With effective tax planning, however, divorce need not be unnecessarily expensive or distressing for clients.

Significant tax implications exist for all three types of financial settlements incident to divorce: property transfers, alimony and separate maintenance payments, and child support.

In general, upon a transfer of property between spouses or former spouses incident to divorce, no gain or loss is recognized to the transferor, and the transferee does not include the value of the property in income. Alimony payments received by a divorced or separated spouse are generally treated as gross income to the recipient spouse and deductible from adjusted gross income by the payor. And child support payments, for their part, are non-deductible by the payor and non-includible in income by the payee.

However, the apparent simplicity of these general rules belies the complexity in the tax law governing divorce settlements.

In the case of alimony, not all payments to a former spouse qualify for deductibility. For example, if a payor is required to continue making payments after the death of the payee spouse, or to make any payment as a substitute for the payments after the death of the payee spouse, the payments do not qualify as alimony for tax purposes. The rationale for this rule is that alimony payments are intended for the support of the payee spouse. If the payments continue after the death of the payee spouse, they are considered to have been intended as property settlement or child support – both non-deductible. This rule often surprises clients when they discover (too late) that their payments for certain of their former spouse’s expenses (e.g., mortgage payments) are non-deductible because liability for those expenses does not necessarily terminate upon the payee’s death. Payments made to third parties on behalf of the payee spouse and “indirect” payments made to a recipient spouse, such as from the payor’s company, also often fail to qualify as deductible alimony if they are not properly structured.

Complex “anti-front-loading” recapture rules also apply to alimony payments in order to prevent property settlement payments from qualifying for alimony treatment. The recapture rule can be triggered by a decrease or termination of alimony payments during the first three calendar years, and requires that the payor spouse report the excess alimony as income. The recapture rule can be triggered by modifications to the divorce or separation instrument, a failure to make timely payments, a reduction in the payor’s ability to provide support, or a reduction in a payee’s support needs. Certain exceptions to the recapture rule do exist.

It should be noted that it is generally to the advantage of the alimony payor to have the payments treated as alimony in order to deduct the payments for tax purposes. The parties, however, may elect that the payments be treated as non-deductible by the payor and excludible from gross income by the payee. This designation is relatively uncommon in practice but is sometimes advantageous where it results in a lower tax bill for the two parties. Counsel for the recipient spouse may also negotiate for this designation so that it is the payor spouse who pays the tax on the amounts used for payments. This ensures that the recipient spouse receives the full benefit of the payments.

Tax mistakes are often made in the treatment and classification of child support payments. For example, if a divorce instrument provides that alimony payments will be reduced upon the occurrence or non-occurrence of certain child support contingencies, then the amount of the specified reduction may be treated as non-deductible child support from the outset.

Even more significant tax implications (beyond the scope of this article) will arise if IRA interests, debt, promissory notes, or certain types of preferred stock are to be transferred.

Seemingly slight differences in payment classification and structuring can significantly affect the tax cost of divorce. Proper and timely tax guidance can minimize these effects. Without proper planning, even the best settlement can yield disaster for one or both of the parties because of the underlying tax consequences. A review of the tax implications of the settlement agreement is essential to identify planning

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