Originally published on Forbes.com May 15th, 2014
Here is a real IRS scandal for you. The Treasury Inspector General has identified about $2.3 Billion in income adjustments that are low hanging fruit for the IRS. Most likely the IRS will not pick much of that fruit. A TIGTA report looked at the way taxpayers are reporting alimony. I’m not easily shocked, but this report did it. Here is the background.
Reporting Alimony
Taxpayers who pay alimony get to reduce adjusted gross income by the amount of alimony paid. The reduction is on Line 31 of Form 1040. A bit further up on Line 11 is Alimony Received where alimony recipients report the income. Putting aside the complications of multiple divorces, you would expect there to be a one to one correspondence between those numbers on pairs of returns representing divorced couples.
Many accountants get quite passionate about things like that. They think that there is a big balance sheet in the sky. After all the paying ex-spouse has to put down the social security number of the payee. We can think of ways that there would be minor discrepancy. Consider my favorite couple Robin and Terry, who help me avoid awkward pronoun problems. Robin puts an alimony check for $10,000 in the mail on December 29th. Terry receives it on January 2. With lots of people though that stuff will tend to balance out. But if Robin is deducting $5,000 a month and Terry is just not reporting it, that should automatically get caught. Right? Apparently not.
How Big Is The Discrepancy?
According to the TIGTA report there were 567,887 Forms 1040 for 2010 that had alimony deductions. The total claimed was $10 Billion. When they compared the corresponding returns that should have recorded the income, there were discrepancies on 266,190 returns including 122,870 returns that had no alimony income at all reported. There were nearly 25,000 returns where the income recognized was greater than the deduction claimed which produced a bit of an offset ($75 million). On net, deductions exceeded income by $2.3 billion. In her piece “Alimony Tax Gap is $1.7 Billion” Ashlea Ebeling goes into more details on the report, so I’m going to get a little more into what I see as the big picture here.
It’s Not As Easy As You Might Think
One of the thought experiments I like to try when I see something like this is to ponder “What would Herb Cohan do if he were in charge?”. Herb Cohan was my first managing partner. I was the last person to become a partner in Joseph B. Cohan Associates – founded in 1917 by Herb’s eponymous father whose Massachusetts CPA license was numbered in the low hundreds.
If Herb were in charge, here is what would happen when that report came to him. He would yell at the nearest assistant to get him every single one of those 266,190 returns. There are just over 90,000 people working for the IRS, but only about 20,000 or so are actually enforcement people (revenue agents, revenue officers, etc.). He’d put 10 to 15 returns on the desk of each agent and tell him or her to get those returns straightened out, right away – and not to let it interfere with anything else they were doing. That’s not going to happen, but it is a nice fantasy.
If you don’t report interest income that you get 1099 for, there is a pretty good chance you will get a notice from the IRS, so why doesn’t the same thing happen with alimony? Part of the problem is that when it comes to alimony, the IRS does not have an off the bat assumption about who is right. Is it Robin who took the deduction or Terry who did not pick up the income? They can’t both be right, but they might each have a reasonably plausible argument.
Are Divorce Lawyers Helping Taxpayers Game The System?
Robin deducting the payments and Terry not picking up the income is a really sweet deal. How can they both be right? I look at lots and lots of tax decisions, both federal and state. Alimony comes up pretty frequently – a couple of times a month anyway. I always figured the decided Tax Court cases must be the tip of the iceberg. Now thanks to TIGTA, I learn that those cases are the snowflake on top of the polar icecap before global warming got started. A divorce agreement can state that periodic payments are not deductible alimony. If that is what the agreement says then the payments are not deductible to Robin or taxable to Terry, end of story.
On the other hand, if the agreement says that the payments are deductible alimony, that does not mean that they are. It actually does not mean anything. The payments have to meet a variety of requirements that distinguish them from child support or property divisions. Here are a couple:
in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made
there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse
The death one comes up a lot. I can see why people would want to leave it out of the agreement. It is a little gruesome. Makes you think of a Law and Order episode. That might be one reason a death termination clause gets left out of some agreements, but there is another possibility if you are cynical.
The lack of a death termination clause does not necessarily defeat the alimony deduction. If state law requires that the payment ceases on death then the alimony deduction is good. The thing is it is frequently not crystal clear whether state law so provides. So if the agreement does not address the death contingency, Robin and Terry might each have a reasonable basis, or at least a plausible argument, for the more favorable position. Now we know that more likely than not, the discrepancy will slide by.
Of the 266,190 returns that had discrepancies, IRS examined 10,870. That is 4% so I guess you could say, you are sharply increasing your chance of being audited by deducting alimony your ex-spouse does not pick up as income. On the other hand, you and your ex collectively have a 96% chance of getting away with something that is in your face blatantly wrong even though you are, in effect, ratting yourselves out.
This Is Really Bad
TIGTA and the IRS had some differences over the recommendations in the report. The main problem IRS cited was lack of resources to chase these dollars. TIGTA suggested sending out “soft notices” pointing out the discrepancy. So essentially they are saying we can spend a few bucks and some of the timid people will come into compliance. That is really not fair. The right answer is to put a few hundred, maybe a thousand agents on these cases. If they are not available, hire them. They will more than pay for themselves.
What is very sad is that the right thing for practitioners might be to let attorneys keep drafting ambiguous agreements that have a 96% chance of being a win/win. Just make sure that the recipient and the payer don’t use the same tax preparer.
You can follow me on twitter @peterreillycpa.
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