Divorce and Separation Tax Issues

1. Divorce and Separation Tax Issues

2. Today’s Discussion Topics • Alimony payments • Recapture of alimony rules • Child support issues • Property settlement issues • Handling the dependency exemption • Addressing available dependent credits • And more!

3. Chapter IAlimony Payments Code Section 71

4. The Nature and Definition of Alimony • Alimony: A payment to or for a spouse or former spouse made under a divorce or separation instrument • Deductible by the payor and includible in the income of the payee spouse or former spouse • Alimony income and deduction are reported on IRS Form 1040 • Alimony is an “above-the-line deduction”

5. The Nature and Definition of Alimony • As a general rule, there is no requirement for the payor spouse to withhold income taxes on alimony payments • Alimony constitutes taxable income—be sure to include any alimony received in the tax calculation for purposes of determining liability for estimated taxes • It is NOT considered income from self-employment, so that Social Security and Medicare taxes are not applied to it • Since alimony is treated as earned income, the divorced recipient spouse may separately create an IRA and contribute to the IRA based on the amount of alimony received

6. General Requirements for a Payment to be Deemed Alimony In order to be considered alimony, a payment must meet certain specific requirements • Does not have to be fixed • Does not have to be a specific amount • Does not need to be periodic in nature • It is not required that the payments constitute support of a spouse

7. Seven Specific Requirements for a Payment to be Deemed Alimony A payment will be classified as alimony, regardless of the parties’ designation of such payment, regardless of whether or not it is specifically designated as satisfying a support obligation, and regardless of how the payment may be classified under state law, if it satisfies the criteria

8. 1. The Payment is Made in Cash Transfers of services or property, the execution of a promissory note, or other debt instrument, or allowing the payee to use property of the payor do NOT qualify as cash payments of alimony

9. 2. Payment Must be Received By or On Behalf of a Spouse Pursuant to a “Qualifying Instrument” • A divorce or separation instrument is a decree of divorce or separate maintenance or a written instrument incident to such a decree; or a written separation agreement • Payment must be made under the instrument • Cash payments to a third party on behalf of the payee spouse under the terms of a divorce or separation agreement can qualify as a cash payment to the spouse

10. 2. Payment Must be Received By or On Behalf of a Spouse Pursuant to a “Qualifying Instrument” • Cash payments made to a third party at the written request, consent, or ratification of a spouse qualify as alimony, provided the payments are in lieu of payments of alimony directly to the spouse; are intended by both spouses, per the written request, to be treated as alimony • Where the property constitutes jointly-owned residential property, one-half of the total amount of mortgage payments, including both principal and interest, may be treated as alimony, and one-half of the interest may be deducted as mortgage interest, if it is qualified residential interest

11. 3. The Parties Do Not Designate That the Payment is NOT Alimony The divorce or separation agreement does not designate the payment as nondeductible by the payor or excludable from the payee’s income • The decree must make the tax effect known directly or expressly • The payee spouse must attach a copy of the instrument designating the payments as not constituting alimony to his or her income tax return for each year that such a designation applies

12. 4. Must Reside in Separate HouseholdsWhen the Payment is Made A formerly shared home is considered one household, even if the parties are physically separated within the home

13. 5. The Payor is NOT Liable to Make Any Payment for Any Period After the Death of the Payee Spouse • Alimony payments must end at the death of the payee spouse • An agreement may provide that payments are to continue to the payee spouse after the death of the payor spouse

14. 6. The Parties MUST File Separate Income Tax Returns • The payor must include the payee’s Social Security number on his or her first tax return for the taxable year in which the payment is made • The payee is required to furnish this number to the payor • Alimony payments will NOT be recognized if the payor and payee file a joint return

15. 7. The Payment Must Not Be a Payment for Child Support When a payor having both an alimony obligation and a child support obligation makes a payment that is less than the amount otherwise specified as due under the agreement, the payment is first applied to the child support obligation, and then to the alimony obligation

16. Chapter IIRecapture of Alimony and Separate Maintenance PaymentsCode Section 71(f)

17. Purpose of Recapture Exists to prevent taxpayers from “disguising” otherwise nondeductible property settlement payments as alimony payments by attempting to “front-load” and deduct property settlement payments that are purportedly characterized as alimony

18. How the Recapture Rules Work • The alimony recapture rule may be applicable if the payor’s alimony payments decrease or terminate during the first three calendar years in which payments are made • “First post-separation year” • Recapture will apply with respect to excess amounts of alimony payments made in the first and the second post-separation years • Only payments made in the first and second post-separation years are subject to recapture • “Safe harbor” threshold of $15,000 per year • Recapture rules will apply in the third post-separation year if the alimony paid in the third year decreases by more than $15,000 from the second year, or • The alimony paid in the second and third year’s decreases significantly from the alimony paid in the first year

19. A Two-Step Process to Determine Excess Alimony Payments • Step One: Compare the aggregate amount of alimony payments in the third post-separation year to the aggregate alimony payments made in the second post-separation year • Step Two: Compare the aggregate amount of alimony payments made in the first post-separation year to the average of the aggregate amount of the non-excessive alimony payments made in the second post-separation year and the alimony payments made in the third post-separation year

20. Example • Alimony payor makes payments of $50,000 in the first post-separation year • $20,000 in the second post-separation year and nothing in the third post-separation year

21. Exceptions to the Alimony Recapture Rules • Payments in the three post-separation years are under $15,000 per year • No recapture is required if either spouse dies before the end of the third post-separation year, and the alimony payments cease as the result of such death • No recapture is required if the payee spouse remarries before the end of the third post-separation year, and the alimony payments cease as the result of such remarriage • The recapture rules do not apply to support payments made pursuant to a court order for temporary or pendente lite support • The recapture rules do not apply to payments made pursuant to a continuing liability

22. Planning to Avoid the Alimony Recapture Rules Recapture will be avoided if: • Equal payments of alimony are made over at least three years • Payments increase over the three-year period • Payments are structured to avoid triggering recapture • The agreement provides that the obligation of the payor spouse to make payments of alimony terminates upon the death of the payee spouse, and the payee spouse in fact dies during the three-year “testing” period

23. Chapter IIIChild Support Issues

24. The Nature ofChild Support Payments Payments that are specifically designated as child support or treated as specifically designated as child support under a divorce or separation instrument are not alimony, and are not includible in the recipient’s gross income

25. Tax Consequences of Child Support Payments Payments made for child support are NOT deductible by the payor spouse and are NOT taxable income to either the payee spouse or to the child

26. Payment ‘Fixed’ as Child Support • Refers to a clearly determinable payment for child support, rather than a specific amount • A payment may be treated as constituting child support even if the parent does not have a legal obligation under state law to support the child

27. Designated Payments;Contingent Payments • A contingency relates to a child if it depends on any event relating to that child • Contingencies relating to the child include: • Dying • Becoming employed • Leaving school • Leaving the household of the custodial parent • Marrying • Attaining a specified age or level of income

28. Allocation of Paymentsto Alimony and Child Support In a situation where the operative divorce instrument calls for payments of both alimony and child support, and the payor pays less than the entire amount required, the payment is first allocated to child support until that requirement is satisfied in full

29. Recharacterized Payments If a payment is recharacterized as child support, defeating an attempted characterization of it as alimony, an amount equal to the reduction in alimony is treated as child support from the outset, causing both the payor and payee spouse to possibly be required to amend a number of their income tax returns

30. Strict Construction of Contingencies and Ambiguities A payment reduction will not be treated as being clearly associated with the happening of a contingency relating to a child of the payor unless one of the factual situations described above is present • Payments of unallocated family support may still be taxable to the payee spouse as alimony unless child support is “fixed” with some specificity

31. Seizure of Refund to Satisfy Delinquent Child Support Obligation The IRS may seize an income tax refund to pay a parent’s delinquent child support obligation • If the parent is filing a joint return, the non-obligated spouse may file a claim as an injured spouse to avoid having the portion of the refund attributed to his or her income from being seized • Must write “Injured Spouse” in the upper left corner of Form 1040 and attach Form 8379 “Injured Spouse Allocation”

32. Chapter IVProperty Settlement Issues in Divorce and Separation

33. Introduction Transfers and payments between spouses and former spouses generally fall into three categories: • Payments for alimony • Payments for child support • Property settlements

34. Pre-1984 Act Rules • A transfer of property incident to divorce was a sale or exchange of property made in consideration of the relinquishment of valuable marital property rights and a taxable event • Code Section 1001; United States v. Davis

35. Current Rules Code Section 1041 • 1984 Act introduced Code Section 1041 • Provides that the transfer of property outright or in trust between spouses or former spouses incident to a divorce is NOT a taxable event • “Property” includes all property, whether real or personal, tangible or intangible, or separate or community • Applies to property acquired before, during or after the end of a marriage and transferred to a former spouse • Regardless of whether the transfer is of property separately owned by the transferor, or is a division of marital property or community property • It does NOT apply to services

36. Basis Rules—Analogy to a Gift Property is treated as if it had been acquired by the transferee by gift • Transferee’s basis in the transferred property carries over from the transferor • Applies whether the property’s adjusted basis is less than, equal to, or greater than either the property’s value at the time of the transfer, and ignores any consideration paid for the property by the transferee • The transferee spouse must take a carryover basis • Applies if the liabilities associated with the property at the time of its transfer exceed its adjusted basis

37. Basis Rules—Analogy to a Gift • Circumstances where the transferor will be required to recognize gain include: • Transfers to trusts of installment obligations • Transfers to trusts where the adjusted basis of the property transferred is exceeded by the sum of the liabilities assumed and the amount of liabilities to which the property is subject • Transfers of U.S. Savings Bonds bearing accrued interest • The transferor spouse is required to provide the transferee spouse with records sufficient to determine his or her adjusted basis and holding period in the transferred property

38. Holding Period • The transferee of any carryover basis property is permitted to include the holding period during which the transferor held the property • Code Sections 1041(b)(2) and 1223(2)

39. Transfers of PropertyIncident to a Divorce • There is no requirement that a divorce or separation ever occur for this Code Section to apply • In order for Code Section 1041 to apply to a property transfer between former spouses, the transfer must be “incident to the divorce”

40. Transfers of PropertyIncident to a Divorce • In order for a transfer to be considered “incident to a divorce” one of the two following conditions must be satisfied: • The transfer occurs not more than one year after the date on which the marriage ceases • The transfer is related to the cessation of the marriage • If these conditions are not met, the transfer is presumed to be not related to the cessation of the marriage

41. Transfers to Third Parties on Behalf of a Spouse A transfer to a third party “on behalf of” a spouse or former spouse may allow the transferor to be treated under Code Section 1041 if: • The transfer to the third party is required by a divorce or separation instrument; or, • The transfer to the third party is pursuant to the written request of the transferee spouse; or, • The transferor receives from the transferee spouse a written consent or ratification of the transfer to the third party.

42. Redemption of Stock in aClosely Held Business Code Sec. 1041 Regs (1.1041-2) provide clear rules that someone must recognize taxable income on the distribution of funds in connection with a stock redemption pursuant to a divorce • Prevents the application of Code Section 1041 to the spouse whose interest is redeemed • Applies when the other spouse does not have a primary and unconditional obligation to purchase the stock of the redeeming spouse • The rule of Reg. 1.1041-2(a)(2) applies the nonrecognition rules of Code Section 1041 to the redeeming spouse and applies the constructive distribution rules to the other spouse • Key determination of whether one spouse has a primary and unconditional obligation to purchase the ownership interest of the other spouse is a question of fact

43. Transfers of Property Into Trusts • The transfer is treated as if the transferee spouse received the beneficial interest in the trust as a gift from the transferor spouse • For income tax purposes, Code Section 682 applies to trusts involved in a divorce or separation, not Code Section 71

44. Code Section 682 • Applies if the transferor and transferee are divorced, have a written separation agreement, or are legally separated • Provides that the transferee spouse is taxed as a trust beneficiary • Since the recipient spouse is not receiving alimony, the transferor spouse is not entitled to an income tax deduction when the trust is created • Does not apply to the portion of any income of a trust fixed as child support payments under a divorce decree, written separation agreement or the trust instrument

45. Use of a Trust Use of a trust avoids most of the alimony restrictions contained in Code Section 71 • A trust may be designed to continue payments to the estate of the payee spouse, or to his or her beneficiaries • A trust may make decreasing payments to a spouse without any concern for recapture • A trust may provide lifetime support for a divorced spouse • Or it may provide for payments for a fixed period of time, followed by a reversion to the transferor spouse (or such person’s estate) or a payment to the transferor’s children

46. Special Types of PropertyTransfer Issues Considered Recapture of depreciation, investment tax credits • The transfer of property incident to divorce will not result in the recognition of depreciation or investment tax credit recapture • Even if the property is Section 1245 or Section 1250 property

47. Special Types of PropertyTransfer Issues Considered Installment Obligations • The transfer of an installment obligation will not be treated as a disposition of the obligation, and will not cause acceleration of gain to the transferor spouse • The same tax treatment as would have applied to the transferor spouse will be applied to the transferee spouse • Code Section 453B(g)

48. Special Types of PropertyTransfer Issues Considered United States Savings Bonds • The transfer of Series E and EE United States Savings Bonds will be taxable to the transferor spouse to the extent of untaxed accrued interest inherent in the bonds at the time of the transfer • The transferee spouse will take a basis in the transferred bonds equal to the transferor spouse’s basis plus the amount of income recognized by the transferor • Code Section 1041 is not applicable here since Section 1041 shields gain from recognition, not income

49. Special Types of PropertyTransfer Issues Considered S Corporation Shares • Any suspended losses incurred by the transferor are transferred to the transferee • Code Section 1366(d)(2)(B)

50. Special Types of PropertyTransfer Issues Considered Passive Activity Property • The transfer will not trigger a deduction for suspended losses by the transferor spouse • Code Section 469(j)(6)