A property settlement divides marital property – assets as well as debts. Presumably, the spouses purchased assets with after-tax dollars and so its allocation to one spouse or the other should not be the occasion for another layer of income tax.
- What role does § 1041 play in a property settlement?
- Does the rule of § 1041 suggest how parties might agree to divide property in which there is unrealized loss? – unrealized gain?
Alimony is an allowance that one party pays the other for maintenance and support. The Code treats alimony as income to the recipient and deductible to the payor. It is income that only one ex-spouse receives and so pays income tax on, the marital union having been dissolved. When the tax brackets of the parties are different, there is an opportunity to “enlarge the pie.” If the pie is larger, then each can have a bigger slice.
Consider: H’s tax bracket is (going to be) 35%. W’s tax bracket is (going to be 10%). W wants to receive $100 that is not subject to tax.
- To satisfy W’s wishes, how much before-tax income will this cost H?
- If W is willing to pay the income tax on some amount so long as she is left with $100, what is the minimum amount she could accept?
- What is the range within which the parties should settle, assuming that H can deduct whatever payment he makes, and W must include that amount in her gross income?
You should see that characterization of transfers between divorcing spouses presents an opportunity to “enlarge the pie” at the expense of the Treasury. Divorcing spouses may agree between themselves to require payments that they label “alimony” that in fact more accurately represent a division of marital property. And of course, the ex-spouse who makes a payment may simply wish to claim a deduction – irrespective of the source of his/her obligation to make the payment. For these reasons, Congress enacted § 71 to set the parameters of what is and what is not “alimony.”
Section 71(b) sets forth the elements of “alimony.” They are –
- a payment in cash
- received by or on behalf of a spouse under a divorce or separation instrument
- that does not designate a payment as not includible in the gross income of the recipient and not allowable as a deduction for the payor.
- An individual legally separated from his spouse under a decree of divorce or separate maintenance cannot together with his spouse be members of the same household at the time of making a payment.
- There can be no liability to make any payment (or a substitute for payment) after the death of the payee spouse.
If any one of these elements is not present, a payment is not “alimony.” The tone of § 71(b) seems strict, but in fact the parties have considerable discretion to label a payment “alimony” or not. The third condition enables them to designate in the divorce or separation instrument whether a payment is alimony.
Excess front-loading is a characteristic of what parties may label as alimony that is in fact a property settlement. It refers to the phenomenon of an obligor undertaking to meet most of a property settlement obligation over a very few years. Alimony does not have the characteristic of terminating after only a few years.
- Performance of obligations under a property settlement would usually occur relatively quickly after the divorce.
- An alimony obligation, on the other hand, may last a long time.
- If a divorce or separation agreement requires very high payments for a short period followed by greatly reduced payments, it is likely that the parties are trying to make a property
settlement appear to be alimony.
- The phrase for this phenomenon is “excess front-loading of alimony payments.”
The Code adopts a mechanical 1 approach to identifying whether payments are alimony or property settlements. § 71(f). The Code takes a “wait-and-see” approach, allowing the parties to characterize payments as “alimony” for three tax years and requiring “recapture” only if “excess front-loading” actually occurred.
Section 71(f)(1)(A) states that if there are excess alimony payments, the payor spouse must include such excess in the third post-separation year and the payee spouse may deduct such excess from his/her adjusted gross income. § 71(f)(1). Section 71(f)(2) defines “excess alimony payments” to be “excess payments” for the first post-separation year plus “excess payments” for the second post-separation year.
- The first post-separation years” means the first calendar year in which the payor spouse actually paid to the payee spouse alimony or separate maintenance payments. § 71(f)(6). The second and third post-separation years are the first and second succeeding years. Id.
- Computation of the excess payments for the first post-separation year requires that taxpayer know what the excess payment is for the second post-separation year. See § 71(f)(3).
- Excess alimony payments for the second post-separation year: Excess alimony payments for the second post-separation year are (§ 71(f)(4)) –
(alimony or separate maintenance paid during 2nd post-separation year) MINUS [(alimony or separate maintenance paid during 3rd post-separation year) + $15,000]
- Excess alimony payments for the first post-separation year: Excess alimony payments for the first post-separation year are (§ 71(f)(3)) –
(alimony or separate maintenance payments paid during 1st post-separation year) MINUS [(alimony or separate maintenance paid during 2nd post-separation year) MINUS (excess payment for 2nd post-separation year) PLUS (alimony or separate maintenance paid during 3rd post-separation year)/2 + $15,000]
- There are no “excess alimony payments” if either spouse dies before the close of the third post-separation year or if the payee spouse remarries before the close of the third post-separation year and the payments cease by reason of such death or remarriage. § 71(f)(5)(A).
- The term “alimony” for purposes of these calculations does not include any payment to the extent it is made pursuant to a continuing liability over not less than three years to pay a fixed portion of income from a business, property, or compensation (whether as employee or as self-employer). § 71(f)(5)(C).
- Payments made pursuant a decree requiring payments for support or maintenance, but not pursuant to a decree of divorce or separate maintenance or incident to such a decree, are not “alimony or separate maintenance” for purposes of these calculations. § 71(f)(5)(B) (referencing § 71(b)(2)(C)).
Section 71(f) focuses on how precipitously alimony or separate maintenance payments decline from the first post-separation year to the second post-separation year and from the second post-separation year to the third post-separation year. Some other matters to notice or consider:
- Excess front-loading only occurs with respect to alimony payments that the payor actually makes, not those that s/he may owe.
- The definition of first “post-separation years” is the first calendar year “in which the payor spouse paid to the payee spouse[.]” § 71(f)(6). If payment obligations are monthly and the payor spouse makes the first payment late in the year, the first year payment may in fact be quite small.
- The numbers work out so that if the decrease from the first to second post-separation years is $7500 or less and the decrease from the second post-separation to the third post-separation years is $15,000 or less, there is no excess front-loading problem.
- There will always be an excess front-loading problem if the decrease from the second to the third post-separation year is more than $15,000.
- For every $1 difference between the first and second post-separation years in excess of $7500, the difference between the second and third post-separation year must be reduced by $2 to avoid an excess front loading recapture income/deduction problem.
Do the CALI Lesson Basic Federal Income Taxation: Gross Income: Alimony and Alimony Recapture