Divorce

Alimony

Alimony or separate maintenance is a payment ordered by court decree (not an agreement – unsanctioned by the court – between parties) made from one party in a divorce proceeding to the other, in order for the receiving party to maintain a standard of living (Cod. Sec. 215). We see both sides of this situation all the time, so we must be able to determine if the payments are deductible to the payer and/or taxable to the payee. There are conditions that must be known for the tax treatment of the payments to be determined:

1. The spouses must not file a joint return.
2. The payments must be in cash, check, or money order. (Direct deposit and garnishments from wages paid directly to the payees bank are considered cash)
3. The payment must be received by or on behalf of the spouse under a divorce or separation instrument.
4. The instrument does not designate the payment as a non-alimony payment.
5. The payer and payee may not be members of the same household when payments occur.
6. There is no liability to continue making payments after the death of the payee.
7. Payment is not specifically designated as child support.

There have been some recent court cases that have confirmed the long held judgment in Richardson v Comm’r, T.C. Memo 1995-554 in regards to #4 above. Recently, in Delong v Comm’r T.C. Memo 2013-70, the court held that the taxpayer could deduct the entire amount of his unallocated support payments because the support obligation terminated upon the death of the payee and the child support part of the payments were not fixed in the decree.

One exception to the “cash” only portion of the alimony test is life insurance. If the payment of the life insurance premium is court ordered, the policy is absolutely owned by the ex-spouse, and the ex-spouse is the irrevocable beneficiary of the policy then the payments are considered alimony and treated as such by the payer and the payee.

Division of Property

The division of marital property is a subject we, as Tax Professionals, do not usually have to get involved with on the front end. We, however, do get involved after the court has made a decision. IRC Cod. Sec. 1041 discusses the transfer of property between spouse or incident to a divorce.

The general rule is that transfers between spouses or former spouses (incident to a divorce) will recognize no gain or loss on transfer. In order to be considered incident to a divorce the transfer of property must occur within one year of the date of divorce or be directly related to the cessation of the marriage. Unless specific circumstances can be proven a transfer after one year but directly related to the cessation of the marriage, must occur within six years of the date of divorce. These rules also apply to annulments.

When a transfer of property (real, personal, tangible or intangible) incident to a divorce occurs the person receiving the property has a basis that is equal to the adjusted basis immediately before the transfer in the hands of the other party. Therefore any computation of gains, losses, or depreciation will be based on the adjusted basis in the hands of the transferor.

When dealing with the division of property incident to divorce business or investment property can come into the picture. For the most part the same rules apply as above. Basis, gains, losses, depreciation, or carryovers are the same in the hand of the person receiving the property as the person transferring it.

This rule applies to items such as capital loss carryovers, rental property with passive losses, assets in Qualified Joint Ventures, Partnerships, S-Corporations, and Net Operating Losses. If a piece of property that is transferred incident to divorce has a liability attached (an outstanding loan, etc) the liability does not effect the basis. However, if the transferee assumes responsibility for the liability all the tax implications (deduction of mortgage interest, business interest, etc) are also transferred.

One large item, that is overlooked until it is too late in many divorce proceedings, is the tax implication of the distribution from one or the other partners retirement account. In many cases the decree simply orders one spouse to pay the other spouse an amount equal to the appropriate percentage in the account at the time of the separation. Other times, there is a direct order to the administrator of the account to disburse the holding for division. And other times the court or the Attorneys and have a Qualified Domestic Relations Order (QDRO) drawn up.

A QDRO allows the administrator of the account to make the ordered distribution to the appropriate spouse and to code the reporting documents to avoid the 10% early withdrawal penalty. This order, when appropriately worded, also gives the receiving spouse the opportunity to roll the distribution into a qualified retirement account of their own, thereby deferring the taxes until they need the income. I have seen clients that just cashed in their 401(k) and gave the ex-spouse half because that is what the court order said. Then they get hit with the taxes and penalties at the end of the year as well. Unless these orders are well written that does not count as alimony.

Part 3, Child Custody

In accordance with Circular 230 Disclosure