The tax deduction and income provisions for alimony have been repealed for divorce decrees entered into after December 31, 2018 or for earlier divorces where the agreements are modified after that date. This gives married couples and formerly married couples a window of time to structure or restructure their agreements to reduce their overall taxes. The recent Hexum v. Commissioner, No. 17-2460 (7th Cir. 2018), provides an opportunity to consider these rules given the new law changes.
Facts & Procedural History
The taxpayer divorced his spouse. The divorce decree provided that the taxpayer was to pay alimony to his wife. The divorce decree also provided that he was to sell the marital residence and split the proceeds with his then ex-wife.
The taxpayer installed new carpet and sold the property, incurring approximately $25,000 for the carpet and carrying costs before the property sold.
The taxpayer deduct half of the $25,000 as alimony on his personal tax return. The IRS audited his return.
The IRS and the U.S. Tax Court concluded that the $12,000 of expenses was not alimony.
Taxation of Alimony, Generally
Under the current rules, alimony is generally deductible by the payor and taxable as income to the recipient.
To be deductible as alimony, the payment must meet several requirements. It must be a payment in cash that is:
- received by (or on behalf of) a spouse under a divorce or separation instrument,
- not identified in the divorce or separation instrument as not being included in gross income for the recipient or deductible by the payor,
- made when the spouses are not living in the household, and
- a liability the payment of which terminates upon the death of the would-be recipient.
The dispute in this case focused on the last requirement.
Liability Terminates Upon Death
The requirement that the liability terminates upon death is intended to distinguish between alimony and disguised property settlements. Property settlements are not deductible.
In this case, the U.S. Tax Court considered the taxpayer’s testimony about whether the $12,000 amount would be paid to his ex-wife if, hypothetically, she were to die. The taxpayer testified that he was not certain about this, but that he might have an obligation to pay the amounts to his sons in that event. The appeals court noted that relying on this testimony was in error. However, it essentially concluded that the error was harmless.
Like the courts have in other similar cases, the appeals court considered state law and the language of the divorce decree. Both state law and the language in the divorce decree can be relied on for the deduction. See our prior article that considered a case involving whether payments actually made during lifetime qualify, given that the court would not have to ask the hypothetical question as to whether the payment would have to be paid if the recipient died given the actual payment. This type of case can be compared to the case addressed in another article we wrote that addressed a settlement payment the spouse received after divorce that state law dictated was alimony given the state statute. There are also cases that focus on the adequacy of the language in the divorce decree, such as Nazum v. Commissioner, T.C. Summary Opinion 2016-9, which address the common scenario where the language tracks the language in the tax code.
In the present case, the appeals court considered Illinois law. Under Illinois law, liability for the payment would not have ended upon the death of the taxpayer’s ex-wife. The appeals court considered Illinois statutes to make this determination. The taxpayer’s divorce decree also did not say that the liability for the payment would terminate. Thus, the appeals court held that the $12,000 payment was not deductible as alimony.
Planning for Alimony
This case is an example of a situation where it is often advisable to consult with a tax advisor at the time the agreement is being entered into. Tax questions about alimony deductions can be more difficult to work after the fact or on audit with the IRS, given the dynamics and relationship issues involved.
These problems are compounded by the magnitude of the alimony deductions. Given that alimony payments are usually a percentage or are based on the working spouses’ income, the tax deduction for alimony can be significant. This deduction may then qualify the taxpayer for other deductions, etc. that would have otherwise phased out or limited. This raises the stakes for making sure that the amount deducted as alimony is correct.