Generally, alimony payments are deductible by the payor in computing adjusted gross income, and are includible in gross income by the payee.
However, the payor and the payee can avoid this general rule by specifying in their divorce or separation instrument that the payments are not includible by the payee or deductible by the payor.
The parties to a divorce should consider having payments that would otherwise qualify as alimony treated as nondeductible by the payor and nontaxable to the payee if this result will lead to an overall reduction in taxes for the parties. This can happen if the payor is in a lower tax bracket than the payee.
Proper planning can cause the after-tax cost to the payor to be less without reducing the after-tax benefit to the payee, if the payor is not allowed to deduct the payment and the payee does not have to include the payment in gross income.
Example 1: Your client, who is divorcing her husband, will be paying him an amount sufficient to give him after-tax income of about $30,000 a year. Your client’s lawyer wants your help in planning whether to make the payments deductible by your client and taxable to her husband.
After the divorce, your client’s taxable income will be about $140,000 a year, which will put her near the top of the 28 percent federal income tax bracket for a single taxpayer. Her husband’s taxable income will be about $150,000 a year, which will be near the bottom of the 33 percent federal income tax bracket for a single taxpayer. Neither will be eligible to claim head-of-household status, and there are no state income taxes in the state where they live.
Even though she will be in a lower tax bracket than her husband, your client has substantially more income that he does, mainly because most of her income comes from tax-exempt interest and from qualified dividends that are taxable at a maximum rate of 15 percent. She also has substantial investments in non-dividend-paying growth stocks, while her husband has little income besides his salary, and has few assets with any value. This is why she will be paying him alimony.
If the alimony paid by your client to her husband were deductible by her and includible in his gross income, she would have to pay about $44,775 a year for him to receive $30,000 after taxes ($44,775 less federal income taxes of $14,775 [33 percent of $44,775]). The after-tax cost of this payment to your client would be about $32,238 a year ($44,775 less $12,537 [28 percent of $44,775, her tax savings on making the deductible alimony payment]).
On the other hand, if your client’s payment to her husband were nondeductible to her and nontaxable to him, she would only have to pay him $30,000 a year, which also would be the after-tax amount she would have to pay him. Thus, she would save $2,238 a year by making the payment nondeductible instead of deductible alimony.
Example 2: The facts are the same as in Example 1 except that, after the divorce, your client will be in the 33 percent tax bracket and her husband will be in the 28 percent tax bracket. If the payment is deductible by her and taxable to him, then to provide her husband with $30,000 a year after taxes, your client will have to pay him $41,666 a year, since $41,666 less $11,666 (28 percent of $41,666) equals $30,000.
The after-tax cost to your client of paying her husband $41,666 a year is $27,916 ($41,666 less $13,750 [33 percent of $41,166]). Thus, under these facts, your client’s after-tax cost will be less if the annual payment to her husband is deductible by her and includible in his income.
Caution: If the parties to a divorce (or at least one of them) will be living in a state with a state income tax, those taxes should also be taken into account in determining the after-tax course of payments by the payor spouse and the after-tax amount to be received by the payee spouse. Also, if one or both of the parties will qualify for head-of-household status, that should also be taken into account.
Requirements for deductibility
Assuming that the parties to a divorce agree that payments by the payor will be deductible as alimony and includible in the payee’s gross income, the following requirements must be met to achieve that result.
- The payment must be in cash. Cash includes checks and money orders payable on demand, but not promissory notes. Payments in property don’t qualify as deductible alimony. Thus, if the payor is short of cash but has a substantial securities portfolio, he must sell securities and raise the cash needed to make the alimony payment instead of simply giving the payee spouse the securities in payment. Such a sale may result in capital gain or loss, which the payor must consider when determining how to proceed.
Observation: If the parties want to shift the tax burden on the alimony from the payee spouse to the payor (e.g., if the payee gets into a higher tax bracket than the payor), this can be done by having the payor make a payment in something other than cash. However, the payee must bear in mind that the property transferred to her will have the same basis in the payee’s hands as it had in the payor’s hands. This means that if the payor gives the payee appreciated property, the payee will have gain if she has to sell the property to raise cash.
- The payment must be received by, or on behalf of, the payee spouse under a divorce or separation instrument. Cash payments of rent, mortgage, taxes or tuition liabilities of the payee spouse made under the terms of the divorce or separation instrument can qualify as alimony, as can cash payments made to a charitable organization at the written request of the payee spouse.
- If the spouses are legally separated under a decree of divorce or of separate maintenance, a payment from one spouse to the other will qualify as alimony only if the spouses are not members of the same household at the time that the payment is made.
If, however, the spouses are not legally separated under a decree of divorce or separate maintenance, a payment under a written separation agreement or under a decree requiring one spouse to make payments for the support and maintenance of the other spouse may qualify as alimony even though the payor and the payee are members of the same household at the time the payment is made.
- No payment (even payments made before the payee’s death) will qualify as alimony if the payor spouse is liable to continue making payments for any period after the payee’s death (e.g., to the payee’s estate).
However, payments made to the payee by the estate of the payor spouse after his death can qualify as deductible alimony payments both on the estate tax return (the commuted value of payments to be made can be deducted) and on the estate income tax return.
- To the extent that any payment under a divorce or separation instrument is fixed or treated as fixed as support for a child of the payor spouse, it is not treated as deductible alimony. My next article will discuss child support payments.
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