If you are facing a divorce or legal separation, remember that in addition to the difficult personal issues involved with the process, you need to understand the tax issues. Planning is very important when deciding whether payments qualify as alimony or child support for tax purposes. Both are payments made to a spouse or former spouse, but each have very different tax consequences which are governed by §71 of the Internal Revenue Code. All divorce agreements written since January 1, 1985 are governed by these rules.
Alimony is deductible by the paying spouse and is taxable to the recipient spouse or former spouse. To be considered alimony, payments must meet certain requirements:
- In writing: Alimony must be required by a divorce decree, support decree, written separation agreement, or any other written court decree. Any “extra” or voluntary payments will not qualify. Additionally, the timing of payments is critical. Payments made before a written instrument is executed or a divorce decree becomes effective are not alimony for tax purposes, even if the agreement is retroactive to the date the earlier payments are made.
- Cash only: Only payments of cash or cash equivalents qualify as deductible alimony. The cash can be paid either directly to the spouse or be paid on the spouse’s behalf to cover any expenses such as rent or a mortgage.
- Marriage relationship: The payment must be paid to or on behalf of a spouse or former spouse.
- Separate returns: The paying spouse and receiving spouse cannot file a joint tax return together.
- Death: Payments must be required to stop when the spouse dies. Many individuals seek to have the payments stop at the remarriage of the spouse as well, but this will not prevent deductibility. However, if the payments are to continue after the spouse dies, then none of the payments, including those made while the spouse is alive are deductible. To compensate for this, the parties sometimes provide for life insurance as part of the divorce agreement.
- Separate Living arrangements: Spouses must be living apart for payments to qualify as alimony. For this test, each payment is tested separately. A one-month “grace-period” is allowed for one spouse to move out of the household.
- Must not be child support: The payment cannot be called child support or deemed to be child support.
Child support payments for children are not deductible by the paying spouse, or taxable to the recipient. Fixed child support payments should be identified in the divorce or separation agreement, as a simple way to avoid alimony treatment. Child support also includes payments specifically designated as child support, as well as payments which otherwise look like alimony but are linked to an event or date related to a child. Examples of contingency events relating to a child include: Becoming employed, dying, leaving the household, leaving school, marrying, or reaching a specified age or income level. Payments are deemed to be child support if they meet either of two mechanical tests:
- Payments are reduced within six months before or after a child attains age 18, 21, or the local age of majority, or
- Payer has more than one child, and payments are reduced more than once, and the reductions occur within a year of the same age for each child, and the age is between 18 and 24, inclusive.
For example, the monthly “alimony” is $1,500, but drops to $1,000 the month the child turns 18. In this example, the “extra” $500 a month will be treated as nondeductible child support.
Remember, the federal tax treatment of alimony is governed by the Internal Revenue Code, not by any divorce agreements or court orders. Thus, it is entirely possible for a given payment to be called “alimony” or “child support” in a divorce agreement even though it does not qualify as alimony or child support for income tax purposes.
Tax planning for alimony and child support payments generally seeks to maximize the tax benefits to both spouses. Generally, if the paying spouse is in a higher income tax bracket than the receiving spouse, it is beneficial to structure all payments as alimony, since this reduces the combined tax burden. The paying spouse could also offer additional payments in the divorce negotiation to cover the recipient’s tax cost, however, care needs to be taken.
Please contact us at (908) 782-7900 or email email@example.com if you have any further questions regarding alimony and child support obligations.