Parties to a divorce action may dispute the intent or impact of their agreement or the court's order. One area of dispute is the character of a payment as alimony/maintenance or a property settlement. The payment of alimony/maintenance is deductible by the payor while the payment of a property settlement is not deductible.
This issue can arise even when the parties seem to agree to the treatment of the payments at the time of their divorce. The parties can enter a Marital Termination Agreement (MTA) that seems to clearly address the issue but, if the language of the MTA does not meet the technical prescriptions of the Internal Revenue Code (Code), one of the parties could change their mind and claim the payments are alimony/maintenance while the other party reports them as a property settlement. This creates a “whipsaw” situation for the IRS and will most likely lead to an audit of both taxpayers' returns.
Assume the following facts:
1. The MTA stated that neither party shall pay or receive spousal maintenance. 2. The MTA also states that, beginning on a certain date, as part of a property settlement, the former husband, Joe, will pay his former wife, Jane, a monthly payment for 60 months. 3. The MTA does not specify how the parties are to treat the payment for tax purposes. 4. The MTA also does not specify whether the payment ceases upon the death of the recipient. 5. Joe made the payments as specified in the MTA each month in the first year of the agreement. In the second year, he notified Jane that he intended to treat the payments as spousal maintenance and deduct them on his Form 1040. 6. Because these payments were specified as payments for a “Property Settlement” in the MTA, Jane never reported the payments as income.
Internal Revenue Code (Code) Section 215 allows for the deduction of spousal maintenance payments, Code section 71 defines “spousal maintenance” or “alimony” as:
Any payment in cash if–
A. Such payment is received by (or on behalf of) a spouse under a divorce or separation instrument, B. The divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under [Section 71] and not allowable as a deduction under Section 215, C. In the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and payor spouse are not members of the same household at the time such payment is made, and D. There is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.
If one of these four statements is not true for Joe's payment to Jane, then the payment is part of a property settlement and not deductible by Joe nor includible in Jane's gross income.
Under the former Code Section 71, labels for payments to an ex-spouse were insignificant. The parties' intent controlled. The 1984 and 1986 revisions were intended to “eliminate the subjective inquiries into intent . . . in favor of a simpler, more objective test.” See Nelson v. Comm'r, T.C. Memo 1998-268. Since the revision of Section 71, the courts focus solely on the parties' intent as reflected in the divorce or separation instrument. Baker v. Comm'r, T.C. Memo 2000-164. See also, Estate of Goldman v. Comm'r, 112 T.C. 317 (1999); Clarence v. Comm'r, T.C. Memo 2000-214; Fields v. Comm'r, T.C. Memo 2008-207; Richardson v. Comm'r, 125 F.3d 551 (7th. Cir. 1997); Baker v. Comm'r, T.C. Memo 2004-164; Nelson v. Comm'r, T.C. Memo 1998-268.
Using this approach, what dispute could there be between Joe and Jane? The payment certainly appears to be a property settlement.
1. The MTA shows that they intended the payments to be a nontaxable property settlement. 2. The MTA has two separate sections for spousal maintenance and property settlement. The payment in question is included in the “Property Settlement” section. 3. Joe and Jane agreed to waive any right to spousal maintenance, which is additional evidence that the parties intended the payment to be treated as a property settlement. 4. Joe treated the payment as a Property Settlement in the first year.
However, Joe will argue:
1. The MTA contained no express language regarding the tax treatment of the payment. 2. The MTA contained no express language about the continuation of the payment upon the death of Jane.
This matter will most likely be resolved through audit, appeal or Tax Court litigation, but an audit may have been avoided had the additional issues, which seem addressed by the other language, been specifically addressed in the MTA.
When drafting an MTA, be certain to address all of the issues raised in Code section 71.