Originally published on Forbes.com April 30th, 2014
When money flows from one ex-spouse to another it will generally be one of three things – alimony, child support or property division. Alimony has tax consequences. It reduces the adjusted gross income of the paying ex-spouse and increases the income of the receiving ex-spouse. If this is news to you and you are of the plotting sort, you probably immediately leaped to a conclusion. As long as the paying spouse is in a higher bracket than the receiving spouse, let’s call it alimony and we’ll figure out how to share the savings. Much as we might hate one another, we hate paying taxes more.
If that is how your thinking went, you just ran afoul of Reilly’s Second Law of Tax Planning – Any clever idea that is fairly obvious runs into rules that make it hard. The rules in this case are in the Internal Revenue Code Section 71. They are designed to not allow alimony treatment to payments that are in substance child support or property division. If a payment meets all the requirements of alimony, the agreement can still state that it is not to be treated as alimony for tax purposes.
So if an agreement says that the payments are to be treated as alimony for tax purposes, that really means nothing. What matters is whether the requirements are met, such as terminating on the death of the recipient and not terminating on an event tied to a child such as high school graduation. If the requirements are met, a statement that the payments are not to be treated as alimony does have an effect.
Here is the part that is really interesting. These rules were put into effect by the Tax Reform Act of 1984 and then modified by the Tax Reform Act of 1986. They are a little tricky, but hardly rocket science. Nonetheless, divorce attorneys still have not absorbed them. People end up in Tax Court with agreements that say they should be treated as alimony for tax purposes, but fail on one or more of the requirements.
The case of Jana Renea Henson is a variation on this theme. The “Settlement Agreement and Judgment” in her divorce from Michael Henson in 2006 did not say one way or the other whether the payments were to be treated as alimony. Ms. Henson got audited on issues surrounding her cellular phone business.
Respondent’s Determinations Respondent selected petitioner’s 2007 and 2008 income tax returns for examination. Because petitioner was unable to provide records with respect to her business, respondent’s examining agent used petitioner’s 6087, 4077, and 5929 bank account statements to reconstruct her income. Respondent’s agent determined petitioner’s gross receipts for the years in issue by adding up deposits to these accounts and then subtracting the deposits that he was able to identify as nontaxable, such as loan proceeds, equalization of property payments, and transfers from petitioner’s other bank accounts.
The case is mainly about the deposits related to her cellular phone business. She argued that some of the deposits were advance payments that might be refundable and other were loan proceeds. She had no records to back this up, because of successive moves. That is not the part that I found interesting. Here is the interesting part.
At trial petitioner asserted that the $50,000 of alimony she reported on her 2007 tax return should be nontaxable. Petitioner argues that her divorce decree “even states that it’s not alimony, it’s just separating marital property, and *** money.
The Tax Court wasn’t buying it.
The settlement agreement does not designate the maintenance payments as not includible in petitioner’s gross income and not allowable as a deduction to Mr. Henson; petitioner and Mr. Henson were not members of the same household at the time the payments were made; and under the settlement agreement, Mr. Henson does not have to make any additional maintenance payments to petitioner after her death. On the record before us, we hold, consistent with petitioner’s reporting position on her 2007 return, that the $50,000 she received from Mr. Henson in 2007 was alimony and taxable pursuant to section 71.
Ms. Henson was representing herself in Tax Court and perhaps her argument might be viewed as something of a “Hail Mary” pass to extricate herself from her other problems. Still, I think that the point is instructive. Her argument had at least enough surface plausibility to avoid being considered frivolous. We don’t learn from the case whether Mr. Henson deducted the payments. The lesson I would take away is that people who are expecting payments to not be taxable as alimony should probably insist on an explicit statement in the agreement to avoid being blindsided.
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