The courts and the IRS have been very active recently in the divorce arena. Developments in nonalimony designations, dependency waivers, interest, retirement plans, IRAs, stock options, and stock redemptions may significantly affect the negotiation of divorces and the tax return positions taken after a divorce. This is part one of a two-part series on those developments. Reprinted with permission from the September 2004 issue of The CPA Journal, the official publication of the New York State Society of CPAs.
Alimony and separate maintenance payments are deductible by the payor and are includible in the payee's income under IRC sections 215 and 71. If structured properly, however, such payments need not be taxable or deductible. Under current law [Temporary Treasury Regulations section 1.71-1T(A-3)], it makes no difference whether the payments are for support or property rights or whether they are periodic. For payments to qualify as alimony, they must meet all the requirements of IRC section 71:
- Cash must be received by or on behalf of a spouse.
- Payments must be received under a divorce or separation instrument.
- Payments must not be designated as not includible in gross income under section 71 and not allowable as a deduction under section 215.
- Where the parties are separated under a judgment of dissolution or legal separation, the spouses or former spouses cannot be members of the same household.
- Payments must cease upon the death of the payee.
- Payment may not be fixed by the instrument as support for children of the payor spouse.
IRC section 71 also provides that alimony payments cannot be front-loaded in excess of permissible amounts. Front-loading will trigger a recomputation in the third postseparation year, resulting in phantom income to the payor (IRC section 71(f)).
Nonalimony Designations
In order for payments to qualify as alimony, the specific requirements of IRC section 71 must be met. The requirement that the divorce or separation instrument not designate the payment as nonalimony has been a source of conflict between taxpayers and the IRS. IRC section 71(b)(1)(B) permits nonalimony treatment if the divorce agreement designates the payments as not includible as income under section 71(a) and not allowable as a deduction under section 215. How explicit does the nonalimony designation have to be?
The Seventh Circuit in Richardson defined "designate" as "to make known directly, to point out, to name, to indicate" [125 F.3d 352 (CA 7, 1997), affirming T.C. Memo 1995-554]. The wife in this case argued that a nonalimony designation was obvious because the divorce court arrived at the payment on the basis that it would constitute 40% of the husband's after-tax income. The Seventh Circuit, however, said that a "clear, explicit and express" statement regarding the tax effect was required. Even a statement that the husband would be responsible for income taxes or alimony while the suit was in progress was not an explicit nonalimony designation, according to the Tax Court (Jaffee, T.C. Memo 1999-196).
Normally, a property settlement is a nontaxable event under IRC section 1041. A property settlement without explicit tax language, however, may not suffice to create a nonalimony designation. In LTR 200141036, an exchange of a farm for a monthly income was ruled alimony because there was no clear and explicit language related to the tax consequences. In Baker (T.C. Memo 2000-164), the court underlined that using the term property settlement alone "does not clearly inform us that the parties considered the income-tax consequences of the payments under Section 71, 215, and/or 1041." This statement by the Tax Court might be interpreted to mean that specific IRC references are required, but a nonalimony designation was upheld in Maloney (T.C. Memo 2000-214) without specific IRC references. The decree provided that both spouses shall be denied spousal support, and the court order said that the money transferred "shall not be considered a taxable event." (See also LTR 9610019.)
Advisors involved in divorce negotiations where the parties agree on nonalimony tax treatment should incorporate clear, unambiguous language like "the payments are designated as excludible/nondeductible under IRC sections 71 and 215." If the language is already finalized, there may still be a reasonable basis for taking a nonalimony position in the absence of IRC references if the situation closely mirrors Maloney.
Dependency and Divisions
The Tax Court continues to hear numerous cases concerning whether a divorced parent may claim dependency exemptions. Because the custodial parent can claim dependents unless he or she waives that right, the waiver has been central to many of these disputes. Two cases from 2003 illustrate how the waivers are scrutinized.
In Bramante (T.C. Memo 2003-228), the wife was the custodial parent and agreed to waive her right to exemptions on Form 8332. As her income increased, the value of the exemptions increased. She discovered that her Social Security number was missing on the form and that her ex-husband, the noncustodial parent, had dated the form in his handwriting. But the Tax Court would not allow her to escape the consequences of the waiver, emphasizing that the missing, but not required, details from Form 8332 should not void the waiver.
It appears that a custodial parent can take back waived exemptions only after the noncustodial parent forfeits the exemption (see IRS Chief Counsel Advice 200007031). Consequently, the custodial parent should waive the exemptions only on a year-by-year basis.
In Boltinghouse, the IRS argued that missing details defeated the waiver (T.C. Memo 2003-134). In this case, the couple had executed a separation agreement allowing the noncustodial parent to claim one of his daughters, but did not file a Form 8332. Therefore, the court had to decide whether the agreement conformed in substance to Form 8332. The IRS contended that the agreement was not in substance a Form 8332 because it did not reflect the years the exemptions were to be waived and it did not provide Social Security numbers for the parents. Although the IRS pointed to some cases in which the Tax Court had rejected waivers that were ambiguous as to the applicable years, the Tax Court said that it was clear that this agreement applied to the years the parents began filing separate returns.
