The courts and the IRS have been very active recently in the divorce arena. Developments in nonalimony designations, dependency waivers, interest, retirement plans, IRAs, stock options, and stock redemptions may significantly affect the negotiation of divorces and the tax return positions taken after a divorce. This is part one of a two-part series on those developments. Reprinted with permission from the September 2004 issue of The CPA Journal, the official publication of the New York State Society of CPAs.
Alimony and separate maintenance payments are deductible by the payor and are includible in the payee’s income under IRC sections 215 and 71. If structured properly, however, such payments need not be taxable or deductible. Under current law [Temporary Treasury Regulations section 1.71-1T(A-3)], it makes no difference whether the payments are for support or property rights or whether they are periodic. For payments to qualify as alimony, they must meet all the requirements of IRC section 71:
- Cash must be received by or on behalf of a spouse.
- Payments must be received under a divorce or separation instrument.
- Payments must not be designated as not includible in gross income under section 71 and not allowable as a deduction under section 215.
- Where the parties are separated under a judgment of dissolution or legal separation, the spouses or former spouses cannot be members of the same household.
- Payments must cease upon the death of the payee.
- Payment may not be fixed by the instrument as support for children of the payor spouse.
IRC section 71 also provides that alimony payments cannot be front-loaded in excess of permissible amounts. Front-loading will trigger a recomputation in the third postseparation year, resulting in phantom income to the payor (IRC section 71(f)).
In order for payments to qualify as alimony, the specific requirements of IRC section 71 must be met. The requirement that the divorce or separation instrument not designate the payment as nonalimony has been a source of conflict between taxpayers and the IRS. IRC section 71(b)(1)(B) permits nonalimony treatment if the divorce agreement designates the payments as not includible as income under section 71(a) and not allowable as a deduction under section 215. How explicit does the nonalimony designation have to be?
The Seventh Circuit in Richardson defined “designate” as “to make known directly, to point out, to name, to indicate” [125 F.3d 352 (CA 7, 1997), affirming T.C. Memo 1995-554]. The wife in this case argued that a nonalimony designation was obvious because the divorce court arrived at the payment on the basis that it would constitute 40% of the husband’s after-tax income. The Seventh Circuit, however, said that a “clear, explicit and express” statement regarding the tax effect was required. Even a statement that the husband would be responsible for income taxes or alimony while the suit was in progress was not an explicit nonalimony designation, according to the Tax Court (Jaffee, T.C. Memo 1999-196).
Normally, a property settlement is a nontaxable event under IRC section 1041. A property settlement without explicit tax language, however, may not suffice to create a nonalimony designation. In LTR 200141036, an exchange of a farm for a monthly income was ruled alimony because there was no clear and explicit language related to the tax consequences. In Baker (T.C. Memo 2000-164), the court underlined that using the term property settlement alone “does not clearly inform us that the parties considered the income-tax consequences of the payments under Section 71, 215, and/or 1041.” This statement by the Tax Court might be interpreted to mean that specific IRC references are required, but a nonalimony designation was upheld in Maloney (T.C. Memo 2000-214) without specific IRC references. The decree provided that both spouses shall be denied spousal support, and the court order said that the money transferred “shall not be considered a taxable event.” (See also LTR 9610019.)
Advisors involved in divorce negotiations where the parties agree on nonalimony tax treatment should incorporate clear, unambiguous language like “the payments are designated as excludible/nondeductible under IRC sections 71 and 215.” If the language is already finalized, there may still be a reasonable basis for taking a nonalimony position in the absence of IRC references if the situation closely mirrors Maloney.
Dependency and Divisions
The Tax Court continues to hear numerous cases concerning whether a divorced parent may claim dependency exemptions. Because the custodial parent can claim dependents unless he or she waives that right, the waiver has been central to many of these disputes. Two cases from 2003 illustrate how the waivers are scrutinized.
In Bramante (T.C. Memo 2003-228), the wife was the custodial parent and agreed to waive her right to exemptions on Form 8332. As her income increased, the value of the exemptions increased. She discovered that her Social Security number was missing on the form and that her ex-husband, the noncustodial parent, had dated the form in his handwriting. But the Tax Court would not allow her to escape the consequences of the waiver, emphasizing that the missing, but not required, details from Form 8332 should not void the waiver.
It appears that a custodial parent can take back waived exemptions only after the noncustodial parent forfeits the exemption (see IRS Chief Counsel Advice 200007031). Consequently, the custodial parent should waive the exemptions only on a year-by-year basis.
In Boltinghouse, the IRS argued that missing details defeated the waiver (T.C. Memo 2003-134). In this case, the couple had executed a separation agreement allowing the noncustodial parent to claim one of his daughters, but did not file a Form 8332. Therefore, the court had to decide whether the agreement conformed in substance to Form 8332. The IRS contended that the agreement was not in substance a Form 8332 because it did not reflect the years the exemptions were to be waived and it did not provide Social Security numbers for the parents. Although the IRS pointed to some cases in which the Tax Court had rejected waivers that were ambiguous as to the applicable years, the Tax Court said that it was clear that this agreement applied to the years the parents began filing separate returns.
As in Bramante, a lack of Social Security numbers was not considered a serious defect by the Tax Court.
These cases illustrate that neither taxpayers nor the IRS can assume that missing details on Form 8332 will defeat the waiver. Nevertheless, the noncustodial parent seeking the exemption should supply details on Form 8332. Note that the waiver can be executed on an annual basis, for alternate years, or for all future years. The custodial parent may prefer granting the waiver on an annual basis to retain some leverage if child support or alimony payments are delinquent. The completed Form 8332 must be attached to the noncustodial parent’s return each year.
When a note is given to equalize the division of property incident to a divorce, the interest paid can have significant ramifications. Stated interest is included in income. In Gibbs (T.C. Memo 1997-196), a property settlement required Mrs. Gibbs to convey her interest in a convenience store for a note to be paid in 10 installments with stated interest. She argued that the interest was excludible under IRC section 1041(a), which provides for nonrecognition of gain in marital settlements. She relied on Balding (98 T.C. 368), another installment note case in which no interest was required to be included in income. The Tax Court pointed out that the interest was unstated in Balding, and required Mrs. Gibbs to report her stated interest as income. This distinction points to the possibility of the parties to a divorce eliminating the interest component, particularly if some or all of the interest would not be deductible.
All interest is nondeductible personal interest except for investment interest, passive activity interest, and qualified residence interest [IRC section 163(h)(1)]. The character of the interest expense is determined by tracing the use of the related debt per the Treasury Regulations section 1.163-8T. In Seymour (109 T.C. 279), a property settlement agreement incident to a divorce required a wife to transfer some investment property, a personal residence, and some personal property to her husband. The property he was required to transfer to his wife was insufficient to equalize the division of marital assets. Therefore, the husband agreed to equalize the division by giving his wife a note. The agreement was silent on identifying the assets for which the note was given. The Tax Court said the interest should be allocated among all the assets received after the qualified residence interest was determined. Qualified resident interest is not subject to the tracing rules per Treasury Regulations section 1.163-8T(m)(3).
However, the Tax Court will apparently not follow this allocation approach in all situations. In Armacost (T.C. Memo 1998-150), another case in which the settlement agreement was silent on identifying assets for which a note was given, the court allowed all of the interest to be traced to investment property. The husband convinced the court that the couple’s personal property had been equally divided and that the note was solely for the wife’s interest in investment property.
This uncertainty about how interest will be traced or allocated should favor settlement agreements that expressly identify the assets for which debt is not being given. Otherwise, a significant portion of the interest expense may be allocated to personal interest. But even an agreement identifying an asset given for a note may not have any effect if the spouse who receives the note has no preexisting property right in the asset. In FSA 200203061, the IRS held that interest on a note to a wife could not be allocated as investment interest because the company stock was 100% owned by the husband prior to the division of assets. Therefore, the intent to equally divide all jointly and separately held property may not mean that the interest can simply be allocated among all the property.
Income from a preexisting property interest will usually be taxed to the ultimate recipient regardless of the source of the payments. For example, in Mess (T.C. Memo 2000-37), a wife was held to have a 43% community interest in her husband’s military pension. She was taxed on the payments because she had a property interest in them under California law. The result would be the same whether she received payments directly from the military or from her husband. Taxpayers have attempted to argue that a regular cash payment from an ex-spouse was a tax-free IRC section 1041 exchange for community property rights they had given up. Although this approach was successful in a lump sum payment situation [see Balding 98 TC 368(1992)], it was not successful for a stream of payments [see Weir T.C. Memo 2001-184].
In contrast to these community property situations, a spouse with no preexisting property interest may receive retirement benefits incident to a divorce. The taxability of these payments to the recipient may depend upon the vagaries of state law. Benefits under IRC section 401 plans are generally taxed to the “distributee” (the plan participant) unless a Qualified Domestic Relations Order (QDRO) shifts the tax burden to an alternate payee [see Hawkins, 96-1 USTC 50,136 (CA-6-1996) reversing and remanding 102 TC 61]. It is irrelevant whether a property interest in these section 401 benefits has been transferred under state law. But state law may be crucial in determining whether a property interest in a military pension has been transferred. The Tax Court recently ruled that military pensions are not distributions from a 401(a) trust and thus not subject to the “distributee” rule.
In Newell (T.C. Summary Opinion 2003-1), a military spouse in a divorce settlement was granted a $1,017 monthly award to be satisfied by payments directly from the government. The Tax Court said she would be taxed on the payments if an ownership interest had been transferred to her. Under Virginia law, however, the state court had no power to order a transfer of an ownership interest. The Uniformed Service Former Spouse’s Protection Act allows state courts to “treat” pensions as jointly or separately held property, but the federal law does not permit a court to direct a transfer of an ownership interest.
Although a state court cannot cause a transfer of a property interest, it can approve a transfer. In Pfister (T.C. Memo 2002-198), the parties agreed on the division of a military pension that was then incorporated into the decree. The wife argued that she should not be taxed on her portion because Virginia law prohibited a court from ordering a property transfer. But the Tax Court said she should be taxed because Virginia law prohibits a property transfer only in the absence of an agreement between the parties.
Larry Maples is the COBAF Professor of Accounting and Melanie James Earles is an associate professor of accounting at Tennessee Technological University in Cookeville, Tennessee.