June 07, 2017 Articles

How to Build Tax-Proof Settlement Instruments

By Sahmra A. Stevenson

Most, if not all, family law attorneys are familiar with the alimony recapture rules. Their intended purpose is to safeguard against improperly labeling nondeductible property settlements as deductible alimony. Not all abuses are intentional, however, and it is easy to overlook the potential for future conflict when drafting divorce instruments.

The Alimony Recapture Rule
To guard against property settlements being disguised as alimony, the Internal Revenue Code (IRC or the Code) contains a three-year rule pertaining to the excess front-loading of alimony. Retrospective in nature, the rule applies only to alimony paid during the first three post-separation years, where the first post-separation year is the calendar year in which the payer spouse first makes payments to the payee spouse under an applicable divorce or separation instrument. See I.R.C. § 71(f). Alimony recapture may result from a change in the divorce decree or separation agreement, a failure to make timely alimony payments, a reduction in the payer’s ability to provide support due to job loss or other financial or nonfinancial reasons, a poorly drafted alimony award, or a reduction in the recipient’s support needs.

Alimony in General
Before digging into the complicated nature of excess alimony payments, it makes sense to review the criteria that must be met for alimony to be considered taxable or tax-deductible. Alimony is (i) the payment to a spouse or a former spouse; (ii) in cash; (iii) under a divorce or separation instrument; (iv) while spouses are living separate and apart; (v) with payments that cease upon the death of the payee; and (vi) while spouses are not filing joint income tax returns with one another. See I.R.C. § 71(b) (to qualify as alimony under section 71 of the Code, the payer and recipient must live separately, the payment must be in cash, the divorce instrument must not designate the payment as not alimony, the spouses may not be members of the same household at the time the payments are made, there is no liability to make any payment after the death of the recipient, and the payments are not nondeductible child support).

A “divorce or separation instrument” may be a decree of divorce or separate maintenance, a written separation agreement, or any court order (including a temporary or interlocutory order) requiring a spouse to make payments for the support or maintenance of the other spouse. See I.R.C. § 71(b)(2) (amendments to a divorce or separation instrument are generally not retroactive for federal tax purposes, unless to correct an error to reflect the parties’ original intent). It is important that practitioners distinguish state and local definitions, rules, and requirements from those mandated by the Code when drafting settlement agreements, establishing positions, or making arguments in court to ensure that a divorce or separation instrument comports with the Code and to avoid future negative tax ramifications for clients.

Third-party payments can be considered deductible alimony if they are made on behalf of the payee spouse. Examples of third-party payments are medical expenses, housing costs, taxes, tuition, and life insurance premiums on a policy own by a spouse. Payments must also be made in cash, including check or money order.

Not all payments to a spouse or former spouse can be considered alimony. For instance, voluntary payments or payments not made pursuant to a divorce or separation instrument do not constitute alimony. Transfers of services or property, including a debt instrument or annuity contract executed by the payer, do not qualify as alimony. Child support, noncash property settlements, or payments for the use or maintenance of the payer’s property do not qualify as alimony. Id.

Focus on the parties’ treatment of payments as opposed to the cause of a potential alimony recapture issue. Whether payments pursuant to a divorce or separation instrument are intended as child support, nontaxable alimony, cash payments in lieu of property, any combination of alimony and these types of payments, or otherwise, the only way to prevent improper tax reporting by parties or unintentionally being subject to recapture is by careful drafting and clear definition of the terms of an agreement.

Intentional Language and Clear Designations
A simple way to help your clients stay out of conflict is to be clear when addressing what is not alimony. For example, spouses may designate that otherwise qualifying payments are not alimony, by including such a provision in the divorce or separation agreement. Such an agreement may be made at any time, so long as it is in writing, signed by both the payer and the recipient, and refers to the divorce or separation agreement and states that payments are not deductible as alimony by the payer and are excludable from the recipient’s income.

In cases involving payments toward both alimony and child support required under a divorce or separation instrument, it is important to advise clients that if the payments are less than the total required, the payments apply first to child support and then to alimony. See I.R.C. § 71(c)(3). A payment will be treated as specially designated as child support to the extent that the payment is reduced either when a contingency relating to a child occurs or at a time that can be clearly associated with such a contingency. A contingency relating to a child commonly includes the child becoming employed, dying, leaving the household, leaving school, getting married, or reaching a specified age or income level. A payment clearly associated with a contingency relating to the child occurs only when (1) the payments are to be reduced not more than 6 months before or after the date the child will reach the age of 18, 21, or the local age of majority; or (2) the payments are to be reduced on two or more occasions that occur not more than 1 year before or after a different child reaches a certain age from 18 to 24, which is the same for each child. See I.R.C. § 71(c)(2).

Recapture Arithmetic
Due to the formulaic nature of the IRC rules, the amount of alimony to be recaptured, if any, can be determined only after the third post-separation year. The arithmetic works in reverse order. That is, excess alimony payments in the second post-separation year are calculated first, and excess alimony payments in the first post-separation year are calculated second.

Excess alimony payments in the second post-separation year are equal to the amount by which alimony payments in the third post-separation year fall short of alimony payments in the second post-separation year, but only to the extent that the shortfall is greater than $15,000. For excess alimony payments in the first post-separation year, the math gets a little more complicated. Excess first-year payments are equal to the amount by which the average of third-year payments and un­recaptured second-year payments falls short of first-year payments, but again only to the extent that the shortfall is greater than $15,000. Excess second-year payments are then added to excess first-year payments to arrive at the amount recaptured in the third year. See Jeffery Capron & William C. Foote, “Avoiding Alimony Recapture,” Section of Family and Juvenile Law Newsletter and Family Law News (Md. State Bar Ass’n Oct. 2008).

Avoiding Excess Front-Loading
The focus when drafting divorce instruments should be on the avoidance of unintentional front-loading. As a rule, parties can steer clear of the recapture rules if they can ensure that alimony payments in the second post-separation year do not exceed alimony payments in the third post-separation year by more than $15,000 and that alimony payments in the first post-separation year do not exceed alimony payments in the second post-separation year by more than $7,500. Also, the later in the year alimony payments commence, the less likely it is that the recapture provisions will apply. Id.

Practical Tips
It is helpful to keep in mind that the recapture calculations are based on actual payment dates, so failure to make scheduled payments consistently and on time can subject the parties to recapture, even in the face of efforts to avoid it at the time of drafting.

  • Three types of alimony need not be considered for the recapture calculations: (1) payments pursuant to temporary support orders, (2) payments that fluctuate and are not in the control of the payer spouse, and (3) payments that decrease due to the death or remarriage of the payee spouse before the end of the third post-separation year.

  • When designing provisions intended to be tax-deductible by one party and taxable to the other party, practitioners should carefully and explicitly describe the tax treatment for the specific payments referenced, ensuring that the description conforms with the requirements of the Code. A recapture issue could be caused by the intentional or mistaken reporting of one or both parties. In representing the best interests of clients, the goal should be to eliminate the possibility of misreporting with clear terms.

  • Practicing attorneys must always be conscious of the possibility that parties might form a post-judgment agreement for modification of an order or judgment that results in a reduction in the payments without a separate, subsequent court order or judgment.

Copyright © 2018, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).