There are certain tax topics that repeat – weekly, monthly, ceaselessly and without end. One such is the tax issues surrounding divorce. I have often wondered why this happens, as divorce is surely one of the most lawyered life events an average person can experience. I will often skip divorce tax cases, as I am just tired of the topic.
But a recent one caught my eye.
The spouses were trying to work something out between them. It was clear to me that they solicited no tax advice, as they plunged off the bridge without checking the depth of the water below.
John and Beatrix were married. They legally separated in 2008 and divorced in 2013. In the interim John agreed to make 48 monthly maintenance payments of $2,289. There was a clause stipulating that payments were to be taxable to her and deductible by him, and the payments were to cease upon her remarriage or death.
John found himself unemployed. His payments were to begin in 2010. Presumably concerned about his financial situation, he and Beatrix agreed in 2009 to transfer his IRA worth $38,913.
John did not deduct the IRA as an alimony payment on his 2009 tax return.
Why not? Because Beatrix was to start withdrawing $2,289 monthly from the IRA the following year, presumably until the $38,913 was exhausted. It made more sense to John that those monthly payments would trigger the alimony.
There is some rhyme or reason to his thinking.
It appears his finances improved, as in 2010 he was able to directly pay Beatrix $6,920.
In 2010 he deducted $27,468 ($2,289 times 12) as alimony.
The IRS disallowed all but $6,920.
Off to Tax Court they went.
There are four key statutory requirements before any payment can be deductible as alimony:
(1) The payment must be required under a divorce or separation decree.
(2) The decree cannot say that the payments are not deductible/taxable.
(3) The two individuals cannot be members of the same household.
(4) There cannot be any requirement to continue the payments after the death of the payee spouse.
It is amazing how often someone will fail one of these. A common story is one spouse beginning payments before the court issues the order, or a spouse paying more than the court order. Do that and the payment is not “required.” Another story is presuming that the payment is deductible because the decree says that it is. The IRS does not consider itself bound because one included such language in the decree.
Then there are the softer, non-key requirements.
For example, only cash payments will qualify as alimony.
If you think about this one for a moment, it makes sense. The Code already allows spouses to transfer property in a divorce without triggering tax (Code section 1041). This allows spouses to transfer the house, for example, as well as retirement benefits under a QDRO order. The Code views these transactions as property settlements – meaning the ex-spouses are simply dividing into separate ownership what they previously owned together.
COMMENT: It is highly debatable whether John’s IRA is “cash.” Granted, there may be cash in the IRA, but that not is not the same as saying the IRA is cash or a cash equivalent. It would make more sense to say that it is the equivalent of stocks or mutual funds. This would make it property, not cash.
Let’s next go back to rule (4) above. A way to rephrase that rule is that the payee spouse cannot be enriched after death. Obviously, if maintenance payments were to continue after death, then the payee-spouse’s estate would be enriched. That is not allowed.
In our situation, Beatrix now owned an IRA. Granted, the expectation may have been that she would outlive any balance in the IRA, but that expectation is not controlling. If she passed away, the balance in the IRA would be hers to transfer pursuant to her beneficiary designation.
She was enriched. She had something that continued past her (albeit hypothetical) death.
Another issue was whether John should get credit for IRA withdrawals by Beatrix in 2010. Why? John transferred the IRA to her in 2009. The account was no longer his. It was hers, and he could no longer piggyback on anything the IRA did. If he was going to deduct anything, he would have had to deduct it in 2009.
Which, by the way, he could not because of rule (1): it was not required under the decree. The decree called for payments beginning in 2010, not in 2009.
The Tax Court decided that John had a 2010 alimony deduction for $6,920, the amount he paid Beatrix directly.
Why did John do it this way?
If John was less than 59 1/2, so he could not get into his IRA without penalty. He could QDRO, but that is just a property settlement. John wanted an alimony deduction. If he kept the IRA, he would have income on the withdrawal and a deduction for the alimony. That is a push - except for the 10% penalty on the early withdrawal. John was in a tough spot.
Then again, maybe he didn't think of tax matters at all.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.