Ensuring Alimony Classification by Carolyn Flaherty

Just because a settlement refers to a payment as alimony does not make that payment deductible for income tax purposes. While a payment may indeed be alimony under domestic relations statutes or bankruptcy statutes, it may not be qualified alimony under the Internal Revenue Code. So how do you know the difference?

There are eight requirements, listed below, that ALL must be met in order for a payment to be considered alimony for tax purposes. Each payment is reviewed individually to determine if it meets the criteria to be characterized as alimony. Intent of the parties controls only the property rights of the payment and NOT the classification or deductibility for income tax purposes.

1. Payments must be made under a divorce decree or other written instrument pursuant to such a decree or under a written separation agreement.
2. After divorce or legal separation has been finalized, spouses cannot be members of the same household.
3. Payments must be made in cash or a cash equivalent.
4. The payments must be made to the former spouse or on behalf of the former spouse.
5. The written agreement cannot specifically state that the payments are not alimony.
6. Spouses must file separate income tax returns.
7. The payments cannot be referred to as or deemed to be child support.
8. Payments must terminate upon death of the receiving spouse.

Why does the characterization as alimony matter so much?
The designation effects whether or not the payment is deductible by the payer for federal income tax purposes and includable in income by the recipient. Alimony payments are deductible while child support and other payments are not. Though not commonly utilized, there is an option to elect out of this the alimony classification. In which case the payer agrees not to deduct the payment and the recipient does not include the amounts as income on their return even though the amount qualifies as alimony.

Some common mistakes or stumbling blocks are as follows:

• Any payments that are made before a written agreement is executed are NOT deductible EVEN IF the agreement is made retroactive to the date earlier payments were made.
• Payments made over the amount stipulated in the agreement are NOT deductible. Changes to the amount of alimony must be done via formal modifications of your agreement because an oral agreement is not enough for tax purposes.
• Payments in the form of bonds, annuity contracts, promissory notes, property or services are not deductible.
• Paying the mortgage on a house you own that your former spouse lives in is NOT deductible as alimony. However, if your former spouse owns the home and you pay the mortgage directly to the mortgage company, that payment likely qualifies as a deductible alimony payment.
• Any payments that are automatically reduced upon events related to a child such as a child maintaining a specified age, the death or marriage of a child, completion of child’s schooling, child leaving the household, or a child’s income are deemed child support even if stipulated as alimony by your agreement and are therefore non-deductible.
• When alimony payments stop or drastically reduce within the first three years of your agreement, you may invoke mandatory alimony recapture. Learn more and utilize a recapture calculator at http://www.smartmoney.com/personal-finance/marriage-divorce/deductible-alimony-calculator-9661/

Divorce is messy and confusing emotionally and financially. Properly navigating your settlement agreement and completing your income taxes, particularly in the initial year in which you file separately from your former spouse, will likely require the assistance of a professional. We also recommend that you consult not only an attorney or mediator, but also a tax professional during the preparation of your agreement so that you do not encounter unpleasant and unexpected tax or financial consequences.

Note: Rules as stipulated in this article govern divorce instruments written after January1, 1985. For law prior to that date refer to the prior tax code. Furthermore, the article discusses only federal tax code and does not address state law. Payments qualifying as alimony under federal law do not automatically qualify under state law.