Chapter 12 Flashcards
Chapter 12 Alimony/Child Support
Discuss Child Support
Child Support in General
- Set by Guidelines mandated by the state;
- Usually not negotiable
- Exceptions
- The courts have the power to deviate
- The parents can also agree to a different amount provided the court approves the agreement
- Some states have upper income limits for the application of the guidelines
- Usually as spousal maintenance increases, child support decreases
- Non-taxable to the payee spouse / non-deductible to the payor spouse
- Not dischargeable in bankruptcy
- Always modifiable
Chapter 12 Alimony/Child Support
Discuss Spousal Support
Spousal Support in General Terminology: The Code uses the term “alimony.” Family law practitioners use the term “spousal support.” For our purposes, the terms are interchangeable. “Fault” used to determine spousal support. While it is still a factor, spousal support is based on many criteria - Need - Ability to pay - Length of marriage - Previous lifestyle - Age - Health
Chapter 12 Alimony/Child Support
Discuss Spousal Support cont’d
Spousal support, cont’d
In most states, spousal support is not mandated by guidelines (e.g., it is agreed on by the parties or ordered by the court)
Usually taxable to the payee spouse and deductible by the payor spouse.
Not usually dischargeable in bankruptcy
Chapter 12 Alimony/Child Support
Discuss Spousal Support Inclusion/Deduction
Inclusion: Section 61(a)(8) includes alimony and separate maintenance payments in the recipient’s gross income. Section 71(a) confirms this inclusion.
Deduction: Section 215 provides that an individual may deduct alimony and separate maintenance payments paid.
Code section 215 refers back to Code section 71 for definitions
Code section 71 Definitions: For federal income tax purposes, the definition of alimony found in Code section 71 controls – state law definitions do no t control.
Under TCJA the taxation of alimony is eliminated and so is the deductions but the issues of child support and alimony were not eliminated for past divorces (before 2018).
Chapter 12 Alimony/Child Support
What are the 6 Alimony rules
Alimony defined: In order to be “alimony,” the payment must satisfy the following six requirements.
1. Cash: The payment must be in cash, rather than any other type of property (not stocks, bonds, or diamond rings). Code §71(b)(1). See Code §1041 for property transfers
2. Receipt under instrument or decree: The payment must be received by (or on behalf of) the spouse pursuant to a divorce decree or separation instrument. Code §71(b)(1)(A), (2)(A).
The payor spouse may pay the recipient spouse directly, or the payor spouse may pay a third party on behalf of the former spouse. Code §71(b)(1)(A); Temp. Reg. §1.71-1T(b), A-6.
Common examples of payments on behalf of a former spouse include a mortgage payment, the payment of health insurance premiums, or the payment of the recipient spouse’s tuition. Rev. Rul. 62-106, 1962-2 C.B. 21.
- Not Designated as Non-Alimony: If the divorce decree or separation designates the payment as nondeductible/nonincludable, it cannot be treated as alimony Code §71(b)(1)(B). This, effectively, allows treatment as a cash property settlement.
- Separate Households / No Joint Returns: The payor and recipient must not be members of the same household at the time of the payment. Code §71(b)(1)(C). If married, they cannot file joint returns. Code §71(e).
- Obligation Terminates on Death: The payor spouse’s liability to make payments must end no later than the death of the recipient spouse. Code §71(b)(1)(D). Why? Alimony is meant to support the recipient spouse. If payments are made after payee spouse’s death, the payments must represent something else (e.g., child support or property settlement).
Must be expressly stated in divorce agreement/decree; however, it is enough that state law provides (exception to the Code only rules). - Not Child Support: Child support is excluded from gross income of the custodial spouse. Code §71(c)(1); Thus, in order to qualify as alimony, the payment must not be, in substance, a payment for the support of a child of the payor. Code §71(c)(2); Reg. §1.71-1T(c),
The decree or agreement will generally fix an amount for support of child; this amount is not alimony.
If the payment is tied to a contingency of a child (such as attaining majority), it will be considered child support, even if it is called and otherwise qualifies as alimony. Code §71(c)(2)(A).
Chapter 12 Alimony/Child Support
Review Alimony example
Non-Alimony: The parties have the power to determine which spouse will pay tax on the alimony income. Generally, the payor will wish to claim the deduction, because he or she will be in a higher tax bracket than the recipient. If, however, the payor’s tax bracket is lower, the parties should specify in the decree that the payment is nondeductible to the payor and nonincludable to the recipient.
Example: Karl and Linda are getting a divorce. Karl’s tax bracket is 33%, and Linda’s is 15%. Under the terms of the divorce decree, Karl is to pay Linda $1,000 per month for four years. Compare the effects of treating this $12,000 annual payment as deductible and nondeductible alimony: Treatment as deductible to payor and includable to recipient. Treating the payments as deductible to Karl and includable in Linda’s gross income means that Linda will be taxed on the $12,000 annual payment. Linda includes the $12,000 in gross income and pays a tax of $1,800 on it ($12,000 × 15%). Thus, the total tax on the $12,000 is $1,800. Because Karl deducts the alimony payment, he is not taxed on the income that generated the payment.
Treatment as nondeductible to payor and nonincludable to recipient. Treating the payments as nondeductible to Karl and excluded from Linda’s gross income means that Karl will earn the funds to make the payment, and will be taxed on them without an offsetting deduction. Linda will not be taxed on this amount. Karl will pay a tax of $3,960 ($12,000×33%) on this amount.
Comparison. Rational taxpayers would clearly opt to treat this payment as deductible to Karl (assuming it otherwise meets the requirements for alimony) because this treatment saves the parties $2,160 in tax, equal to the difference between the tax Karl would pay and the tax Linda would pay on the annual alimony payment.
Chapter 12 Alimony/Child Support
Review Alimony partial payment example
Hugh is required to pay $5,000 alimony and $5,000 child support each year. Hugh has made annual payments of $3,000 in years 1 and 2, and designated each payment as “in satisfaction of alimony obligation.” Despite this designation, each of the payments will be deemed as child support since child support obligations had not been satisfied in either year. In order to get alimony treatment in year 3, Hugh must catch up on all child support obligations for the current and preceding years. Thus, in year 3, the first $9,000 of any payments would be treated as child support (i.e., $2,000 child support shortfall in years 1 and 2, plus $5,000 child support obligation in year 3.) Any payments above $9,000 would be deemed to be alimony (limited to $15,000, the aggregate alimony obligation for years 1, 2, and 3).
Chapter 12 Alimony/Child Support
Review Alimony front loaded
This special rule seeks out “disguised” property settlements (a property settlement is not deductible by the payor nor includible by the payee – it is, generally, a nonrecognition event)
Excess Alimony Recaptured in Third Year: If alimony payments are front-loaded, the statute requires an adjustment in the third taxable year. In that year, the payor includes the “excess alimony payments” in gross income, and the recipient is entitled to a deduction in the same amount. Code §71(f)(1)(A), (B).
Third year: The adjustment is made in the taxable year beginning in the third post-separation year. The first post-separation year is the first calendar year in which alimony is paid, and the next two years are the second and third post-separation years. Code §71(f)(6).
Chapter 12 Alimony/Child Support
Review Alimony example 2
Example: Rita and Jeff are getting a divorce. Jeff is to pay Rita $100,000 on January 1, Year One; $50,000 on January 1, Year Two; and $25,000 on January 1, Year Three. Assume that the payments qualify as alimony. Because they are front-end loaded, in the third post-separation year Jeff will include in gross income, and Rita will deduct, the excess alimony amount.
What is going on? Time value of money – a deduction today is worth more than a deduction next year.
Chapter 12 Alimony/Child Support
Review Alimony Recapture
What is Front-Loaded / Excess Alimony? A front-end loaded payment is what it sounds like—a payment that is relatively large in the early year or years compared with later payments.
The statute only requires analysis of the three years following the divorce; payments in the fourth year and thereafter are irrelevant.
Recapture rules apply ONLY IF payments in the 1st or 2nd year exceed $15,000.
How does the recapture work? In the third year, the payor must include the excess alimony payments for the 1st and 2nd years in gross income, and the payee is allowed a deduction for the excess alimony payments.
Compute 2nd year recapture 1st
Compute 1st year recapture next
Compute total excess alimony last
Note: Alimony paid in a lump sum that is more than $15,000 will always be front-loaded
Chapter 12 Alimony/Child Support
Indirect payments of alimony
Section 71(b)(1)(A) defines alimony to include cash payments to third parties on behalf of a spouse under a qualified divorce instrument (if the payments otherwise meet the definition of alimony). Regs. §1.71-1T(b), Q & A-7, construes §71(b)(1)(A) to encompass payments to third parties made pursuant to the written request, consent or ratification of the payee.
Allowable types of 3rd Party payments: Regs. §1.71-1T(b), Q & A-6, gives several examples of qualifying third-party payments, including:
payment of the payee’s housing costs, and
payment of premiums of payee-owned life insurance on the payor’s life.
Chapter 12 Alimony/Child Support
Property Settlements
Prior law – Davis case: Prior law: Divorces as taxable events—United States v. Davis, 370 U.S. 65 (1962): Mr. and Mrs. Davis were divorcing. Mr. Davis transferred 1,000 shares of DuPont stock to Mrs. Davis in satisfaction of all her marital rights under Delaware law.
a. Issues: Was this a taxable exchange, i.e., a sale? If so, what is the amount of gain recognized by Mr. Davis? What is Mrs. Davis’ basis in the shares?
b. Result and rationale: The transfer was a sale, resulting in a gain to Mr. Davis of the difference between the fair market value of the shares and his basis in them. Mrs. Davis took a cost (fair market value) basis in the shares. Mrs. Davis’ rights in the stock under Delaware law were inchoate during marriage, not the rights of a co-owner. (This result might have been different in a community property state, where a spouse has a present interest in property.) Thus, she received the property by transfer from her husband. Since clearly this was not a gift, we must assume the parties acted at arms-length. She relinquished rights equal in value to the fair market value of the shares. As a result, both parties must treat the transaction as a sale. (The Court did not need to reach the question of the wife’s gain, if any; it would be difficult to assign a basis to the marital rights she relinquished.)
Chapter 12 Alimony/Child Support
Property Settlements cont’d
Application of Code §1041: For Code §1041 to apply, a taxpayer must transfer property to a spouse, or to a former spouse, in a transfer that is “incident to a divorce.” Code §1041(a).
Effect of Code §1041:
Nonrecognition: In a transfer meeting the requirements of §1041, the transferor recognizes no gain or loss. Code §1041(a).
Basis: The recipient of property takes it with the adjusted basis it had immediately before the transfer. Code §1041(b)(2).
Gift: The recipient of property is treated as if he or she received a gift, and so the recipient need not include the value of the property in his or her gross income. Code §1041(b)(1).
BASIS: The gift basis rules (§1041 has its own basis rules).
GIFT TAX: The transfer is not treated as a gift for gift tax purposes. Code §2516.
Chapter 12 Alimony/Child Support
Alimony Definitions
Definitions:
Spouses: State law determines the legal status of individuals as married or unmarried, except when specifically that law is preempted by federal law.
Incident to a divorce: A transfer of property is “incident to a divorce” if it satisfies either of two tests.
One-year rule: A transfer of property is incident to a divorce if it occurs within one year after the date the marriage is terminated. Code §1041(c)(1).
Cessation of marriage: A transfer of property is incident to a divorce if it is “related to the cessation of marriage.” Code 1041(c)(2).
A safe harbor is provided for transfers that are contemplated by the divorce decree and occur within six years of dissolution or thereafter if there is a good reason for delay. Reg. §1. 1041-1T(b),Q-7.
A property transfer made after one year after the marriage is terminated that is not mentioned in the divorce decree is rebuttably presumed not to be related to the cessation of marriage.
Chapter 12 Alimony/Child Support
Alimony divorce decree example
The “divorce decree” will include subsequent judicial modifications of the decree or actions to carry out the transfers contemplated in the decree. See Young v. Commissioner, 113 T.C. 152 (1999), aff’d 240 F.3d 369 (4th Cir. 2001).
Example: Tim and Melissa are getting a divorce. Their divorce decree, issued July 1, 1995, provides that Melissa will be awarded Blackacre, and title should be recorded in her name as soon as possible. However, Blackacre is the subject of litigation as to title, and in fact the transfer to Melissa does not occur until September 2002. Regardless of the delay, this transfer would be related to the cessation of marriage and thus incident to the divorce because it was contemplated by the divorce decree, and there was good reason (litigation) for exceeding the six-year limit.
