Tax 7-6,7 Divorce Considerations

Question 1

Divorce Considerations

Identify the general tax treatment of child support payments to the following individuals.

the recipient

Child support payments are taxable/nontaxable to the recipient.

(LO 7-6,7)

Answer 1

Child support payments are nontaxable to the recipient.

Question 2

Divorce Considerations

Identify the general tax treatment of child support payments to the following individuals.

the payor

Child support payments are deductible/nondeductible by the payor.

(LO 7-6,7)

Answer 2

Child support payments are nondeductible by the payor.

Question 3

Divorce Considerations

1. There are certain requirements that must be met to deduct alimony payments.
   a. Identify five requirements that must be met in order to deduct alimony payments subsequent to the Tax Reform Act of 1984.

(LO 7-6,7)

Answer 3

(1) The parties cannot file a joint tax return or live together at the time of payment.
(2) Payments must be in cash (i.e., not property).
(3) Payments must be received by or for the benefit of the payee spouse.
(4) The legal document must not designate the payments as nonincludible in the payee spouse’s income or nondeductible by the payor spouse. (The document does not need to specify the payments as includible and deductible.)
(5) The legal document or state law must require that payments will stop after the recipient spouse dies.

Question 4

Divorce Considerations

1. There are certain requirements that must be met to deduct alimony payments.
   b. Discuss the rules related to payments to third parties.

(LO 7-6,7)

Answer 4

Payments made by the payor spouse to a third party as a result of a divorce or separation instrument can be alimony. Cash payment of the payee spouse’s mortgage, rent, tuition, or tax liability made by the payor spouse as required by the divorce or separation instrument may qualify as alimony.

Question 5

Divorce Considerations

1. There are certain requirements that must be met to deduct alimony payments.
   c. Discuss the provisions relating to the excess front-loading rules.

(LO 7-6,7)

Answer 5

Excess alimony paid in the first and second years must be recaptured (included in income) in the third year if payments decrease by more than $15,000 between years 2 and 3, and if payments in the first year exceed the average payments by more than $15,000 (as adjusted for any recapture) for years 2 and 3.
There is no recapture required if payments cease due to the death of either party or due to the remarriage of the payee spouse. Recapture is not required as a result of temporary support payments or payments that fluctuate based upon a percentage of income from a property, business, or service, as long as the obligation lasts at least three years.

Question 6

Divorce Considerations

3. What is the current presumption concerning potential alimony payment amounts tied to a contingency relating to a minor child?

(LO 7-6,7)

Answer 6

Such amounts are presumed to constitute nondeductible child support.

Question 7

Divorce Considerations

4. The taxation of property settlements arising from a divorce decree underwent substantial change in the Tax Reform Act of 1984. Identify the tax treatment of a current transfer of property from one spouse to the other under Internal Revenue Code Section 1041.

(LO 7-6,7)

Answer 7

Any transfer of property between spouses incident to a divorce is taxfree (i.e., no gain is recognized); the transferor spouse’s basis is carried over to the recipient spouse.

Question 8

Divorce Considerations

5. Under the rules adopted by the Tax Reform Act of 1984, explain the manner in which a dependency exemption for a child of a divorced couple is awarded to either parent. What policing mechanism was included in the 1986 Tax Reform Act to help enforce these rules?

(LO 7-6,7)

Answer 8

Since the 1984 Act, the dependency exemption for a child is awarded to the custodial parent unless there is a written agreement to the contrary. For the rule to apply, the child must receive more than half of his or her support from both parents and be in the custody of one or both parents for more than half of the calendar year. A policing mechanism in the 1986 Act requires that the parent claiming a dependency exemption report the Social Security number for the dependent child on his or her income tax return.

Question 9

Divorce Considerations

6. What is a qualified domestic relations order (QDRO), and why is it important in the settlement of existing pension benefits for divorcing spouses?

(LO 7-6,7)

Answer 9

A QDRO is an order that relates to the provision of marital property rights; it recognizes the existence of the spouse’s right to receive retirement plan benefits of the participant. Such an order is important to prevent an improper assignment of pension benefits between spouses.

Question 10

Divorce Considerations

8. In June of the current year, John Parsons entered into a property settlement agreement with his wife, Cynthia, which arose out of divorce proceedings. As part of this settlement agreement, John agreed to transfer to Cynthia appreciated growth stock held in his name in exchange for her release of all marital claims. It was specified by the parties to the agreement that such a transfer of property was not to be considered alimony. What is the income tax implication of the property transfer from John to Cynthia in this situation?

(LO 7-6,7)

Answer 10

There is no current income tax implication to either John or Cynthia at the time of the stock’s transfer. However, John’s basis in the stock would be “carried over” to Cynthia. (Note: Cynthia could recognize gain, or loss, upon later sale of the stock.)

Question 11

Divorce Considerations

9. Phillip Vickers was recently divorced from his wife, Sharon. They have two minor children. Under the terms of the divorce decree, Sharon received custody of the children and was awarded the dependency exemptions. Phillip provides over half of the support of the children through his child support payments of $7,200 per year. Sharon has maintained custody of the children each year since the divorce, with visitation rights afforded Phillip.

Given the facts of this situation, which parent is entitled to the dependency exemptions for the minor children, and why?

(LO 7-6,7)

Answer 11

Sharon is entitled to the dependency exemptions for the children. This is the case (even though Phillip provided over half their support) because there was no written agreement stipulating that the noncustodial parent (Phillip) would receive the exemptions.

Question 12

Divorce Considerations

10. Late last year, Frederic Barton divorced his wife of 15 years, Jennifer. They have one child, Matthew, age 10. The terms of the divorce decree require that Frederic pay Jennifer the sum of $1,000 per month as qualifying alimony and child support. This amount is to be reduced to $400 when Matthew turns 18. The alimony is to be paid until Jennifer’s death or remarriage. What is the income tax implication of each payment to both parties?

(LO 7-6,7)

Answer 12

Frederic could deduct $400 of each monthly payment as alimony, which is the same amount that must be reported as taxable income by Jennifer. The remainder of the payment, or $600, is nondeductible child support to Frederic and nontaxable “income” to Jennifer.

Question 13

Divorce Considerations

11. Robert Evans made alimony payments of $55,000 in his first post-separation year, $30,000 in the second year, and $10,000 in the third year. What is the amount of recapture?

(LO 7-6,7)

Answer 13

Recapture equals $27,500.

Step 1: Compare Year 2 to Year 3
  $30,000 Year 2 
- $10,000 Year 3
= $20,000 Decrease
- $15,000 Safe Harbor
= $5,000	Recapture from Year 2

Step 2: Find new amount
$30,000 Year 2
- $5,000 Recapture from Year 2
= $25,000 New Amount for Year 2

Step 3: Average of Year 2 and Year 3
  $25,000 Year 2 
\+ $10,000 Year 3
= $35,000 Total 
* 1/2	
= $17,500 Average of Year 2 and Year 3

Step 4: Subtract Average from Year 1
  $55,000 Year 1
- $17,500	Average of Year 2 and Year 3
= $37,500 Decrease
- $15,000 Safe Harbor 
= $22,500 Recapture from Year 1

Step 5: Total Recapture
$22,500 Recapture from Year 1
+ $5,000 Recapture from Year 2
= $27,500 Total Recapture

Thus, the total recapture of $27,500 will be included in the payor’s income, and the payee will be allowed a corresponding deduction at the end of the third year.

Question 14

Divorce Considerations

12. Irwin Hall made alimony payments of $42,000 in his first post-separation year, payments of $25,000 in the second year, and no payments in the third year. What is the amount of recapture?

(LO 7-6,7)

Answer 14

Recapture equals $29,500.

Step 1: Compare Year 2 to Year 3
  $25,000 Year 2 
- $0	Year 3
= $25,000 Decrease
- $15,000 Safe Harbor
= $10,000 Recapture from Year 2

Step 2: Find new amount
$25,000 Year 2
- $10,000 Recapture from Year 2
= $15,000 New Amount for Year 2

Step 3: Average of Year 2 and Year 3
  $15,000 Year 2 
\+ $0 Year 3
= $15,000 Total 
* 1/2	
= $7,500	Average of Year 2 and Year 3

Step 4: Subtract Average from Year 1
  $42,000 Year 1
- $7,500 Average of Year 2 and Year 3
= $34,500 Decrease
- $15,000 Safe Harbor 
= $19,500 Recapture from Year 1

Step 5: Total Recapture
$19,500 Recapture from Year 1
+ $10,000 Recapture from Year 2
= $29,500 Total Recapture

Thus, the total recapture of $29,500 will be included in the payor’s income, and the payee will be allowed a corresponding deduction at the end of the third year.

Question 15

Divorce Considerations

13. What is the purpose of a premarital agreement, and how is it commonly structured?

(LO 7-6,7)

Answer 15

The purpose of a premarital agreement is to limit the presumed effect of marriage on property acquired prior to, or during, the marriage. Normally, there is a transfer of property from the more affluent spouse to the other spouse in exchange for a release of all marital claims.

Question 16

Divorce Considerations

14. the four requirements that must be met if a agreement is to be held enforceable by a court of law.
    a. It must be in writing and be signed by both affected parties.
    b. Full and complete disclosure of each party’s net worth must be made (i.e., there must be no designed concealment).
    c. It must not be intended to promote the procurement of a divorce.
    d. It must be shown to have been executed willingly by both parties without duress or coercion.

(LO 7-6,7)

Answer 16

premarital

Question 17

Divorce Considerations

Module Check

7. Which one of the following is generally a characteristic of deductible alimony payments?
   a. The divorce decree regarding such alimony payments must state that the payments are deductible by the payor, and includible in the payee’s income.
   b. Such payments cannot extend beyond the death of the payee spouse.
   c. Payments to third parties cannot be treated as alimony.

(LO 7-6)

Answer 17

b. Such payments cannot extend beyond the death of the payee spouse.

In order to qualify as alimony, the payments cannot extend beyond the death of the recipient spouse. The divorce decree does not need to address the deductibility or includibility of the payments.

The decree does not need to address that the payments are deductible and includible. However, if the decree specifies that the payments are not deductible or includible, then the payments are nondeductible and nonincludible.

Payments to third parties may be treated as alimony if required by the decree and paid on behalf of the payee spouse. Payments for the payee spouse’s rent, tuition, or tax liability, for example, may be treated as alimony.

Question 18

Divorce Considerations

Module Check

8. Paul Shepard was divorced from his wife, Patricia, late last year. As part of the property settlement agreement, Paul agreed to transfer his interest in a residential rental real estate tract to Patricia in exchange for her release of marital claims. Paul’s cost basis in this real estate tract was $50,000. The tract was appraised at a fair market value of $100,000 at the time of its transfer to Patricia.

Which one of the following is an income tax implication of Paul’s transfer of the real estate tract to Patricia?

1. Patricia receives a basis in the real estate that is equal to its fair market value at the time of transfer.
2. Paul’s basis in the real estate is carried over to Patricia for income tax purposes.
3. At the time of transfer, Paul must recognize the gain on the real estate as ordinary income.
4. Paul is allowed a deduction that is equal to the excess of the property’s fair market value over his basis in the property.

(LO 7-7)

Answer 18

2. Paul’s basis in the real estate is carried over to Patricia for income tax purposes.

A transfer of property between spouses incident to a divorce is tax-free. No gain or loss is recognized, and for income tax purposes, the transferor’s basis in the property is carried over to the transferee.

There is no deduction allowed upon a transfer of property between spouses incident to divorce.

Question 19

Divorce Considerations

Module Check

9. Ed Wiley recently was divorced from his wife, Julie. Julie received custody of their only child, Sally, age 5. Ed was ordered to pay $1,500 per month to Julie until Sally reaches age 18. At that time, the payments are to decrease to $1,200 per month.

What portion of each payment, if any, is deductible by Ed as qualifying alimony?

1. No portion of each payment is deductible by Ed.
2. A total of $1,200 of each payment is deductible by Ed.
3. A total of $300 of each payment is deductible by Ed.

(LO 7-7)

Answer 19

2. A total of $1,200 of each payment is deductible by Ed.

If any amount specified in the decree can be reduced on the happening of a contingency or occurrence of an event relating to the child, this amount will be presumed to constitute nondeductible child support. In this case, $300 per month is tied to the child turning age 18 and is presumed to be child support.

A portion of the payment is not tied to the child turning 18; therefore it is not treated as child support.

Question 20

Module Check

24. Which one of the following is not a requirement that must be met in order to deduct qualifying alimony?
25. The terms of the divorce decree must state that the payments will be made only until the death of the recipient.
26. The terms of the divorce decree must state that alimony payments will be made only until the remarriage of the recipient.
27. The parties cannot live together at the time of the payment.

(LO 7-6,7)

Answer 20

2. The terms of the divorce decree must state that alimony payments will be made only until the remarriage of the recipient.

In order for alimony to qualify for a tax deduction, the terms of the divorce decree, or state law, must require that alimony payments be made only until the death of the recipient. There is no requirement that payments cease upon remarriage. There is a requirement that the parties not live together (or file a joint income tax return) at the time of the payment.

Question 21

Module Check

27. Alimony paid in the first and second years after a divorce must be recaptured by the payor in the third year if, during the three years, the amount of the alimony payments decreased by more than

$10,000

$15,000

$20,000

(LO 7-6)

Answer 21

$15,000

Alimony paid in the first and second years must be recaptured by the payor in the third year if the amount of the alimony payments decreased by more than $15,000 between years two and three, or decreased by more than $15,000 from the year-one amount to the average amount for years two and three.

Question 22

Divorce Considerations

8. David Mifflin has an AGI of $100,000. During the current year, he donated stock to his church. The stock had been held for 11 months. The stock was valued at $95,000 and basis in this stock was $35,000. What is David’s maximum allowable charitable contribution for the current year?

$30,000

$35,000
.
$50,000

(LO 7-5).

Answer 22

$35,000

Since the stock was not held for more than one year, the contribution is of short-term capital gain property.

As a result, the deductible amount would be limited to the basis of $35,000.

Since the 50% limitation applies, the maximum deduction could be as high as $50,000, but since we use basis, his deduction is $35,000

Question 23

Practice Test 2

Divorce Considerations

57. Which one of the following is not a requirement to be met in order to deduct alimony payments?
    a. Payments must be in cash.
    b. The parties must not file a joint tax return at the time of payment.
    c. The legal document or state law must require that payments will stop after the recipient spouse dies.
    d. Payments must be received by or for the benefit of the payee spouse.
    e. Payments must be equal in each year of the agreement.

Answer 23

e. Payments must be equal in each year of the agreement.

All of the options except e. are requirements; the payments do not need to be equal each year. However, unequal and declining payments can trigger the alimony recapture rules.

Question 24

Practice Test 2

Divorce Considerations

58. William Cochran and his wife, Lisa, recently divorced. Under the terms of the divorce decree, William is required to pay Lisa $2,000 per month for five consecutive years. The divorce was finalized on December 15 of last year, with the first alimony payment to be made on January 15 of this year, and on the 15th of each month thereafter. There is no provision in the decree (or under state law) that payments terminate upon the death of the payee spouse, Lisa.

How much of each payment, if any, is deductible, and why?

a. $0, because the excess front-loading rules are violated
b. $0, because the payments do not terminate at death
c. $1,000, because of the limitation applied by the front-loading rules
d. $2,000, because the payments are qualifying alimony

(LO 7–7)

Answer 24

b. $0, because the payments do not terminate at death

Payments that do not terminate upon the death of the payee spouse are not considered alimony. This applies to all payments, even those made prior to death

Question 25

59. Cal Pratt made alimony payments of $60,000 in his first post-separation year, $35,000 in the second year, and $5,000 in the third year.

What amount of alimony, if any, must be recaptured by Cal?

$0

$25,000

$37,500

$47,500

(LO 7–7)

Answer 25

$47,500

Step 1: Compare Year 2 to Year 3
  $35,000 Year 2 
- $5,000	Year 3
= $30,000 Decrease
- $15,000 Safe Harbor
= $15,000 Recapture from Year 2

Step 2: Find new amount
$35,000 Year 2
- $15,000 Recapture from Year 2
= $20,000 New Amount for Year 2

Step 3: Average of Year 2 and Year 3
  $20,000 Year 2 
\+ $5,000	Year 3
= $25,000 Total 
* 1/2	
= $12,500 Average of Year 2 and Year 3

Step 4: Subtract Average from Year 1
  $60,000 Year 1
- $12,500 Average of Year 2 and Year 3
= $47,500 Decrease
- $15,000 Safe Harbor 
= $32,500 Recapture from Year 1

Step 5: Total Recapture
$32,500 Recapture from Year 1
+ $15,000 Recapture from Year 2
= $47,500 Total Recapture

Question 26

Practice Test 1

33. Which one of the following is a characteristic of deductible alimony payments?

The divorce decree must state that the payments are deductible by the payor.

Payments must be made to discharge a support obligation arising from the marriage.

The payee must file a joint income tax return with the payor at the end of the calendar year.

The payments cannot extend beyond the death of the payee spouse.

The divorce decree must state that the payments are includible by the payee.

(LO 7-6)

Answer 26

The payments cannot extend beyond the death of the payee spouse.

To be considered qualifying (deductible) alimony, the payments may not extend beyond the death of the recipient spouse. The decree does not need to state that the payments are deductible, nor includible. There does not need to be a support obligation. The parties specifically may not file a joint income tax return.

Question 27

57. Ed Wiley recently was divorced from his wife, Julie. Julie received custody of their only child, Sally, age 5. Ed was ordered to pay $2,500 per month to Julie until Sally reaches age 18. At that time, the payments are to decrease to $1,200 per month.

What portion of each payment, if any, is deductible by Ed as qualifying alimony?

None of each payment is deductible by Ed.

A total of $1,200 of each payment is deductible by Ed.

A total of $1,300 of each payment is deductible by Ed.

All of each payment is deductible by Ed.

(LO 7-7)

Answer 27

A total of $1,200 of each payment is deductible by Ed.

In a divorce decree, any amount tied to the happening of a contingency or an event related to a minor child is deemed to constitute nondeductible child support. In this situation, $1,300 is tied to Sally’s turning 18. Thus, only the remaining $1,200 is considered to be alimony.