Avoiding Alimony Tax Pitfalls

The purpose of making payments to a spouse or former spouse as alimony under the Internal Revenue Code (the Code) is so that such payments will be taxable to the payee and deductible to the payor. For any stream of payments to be alimony as defined by the Code, payments must meet the following rules:

• The payment must be made by cash, check, money order or the like, on behalf of the payee spouse or former spouse.
• It must be made pursuant to a divorce or separation instrument.
• The instrument cannot designate the payments as not taxable to the payee and not deductible to the payor.
• In the case of individuals divorced or legally separated, the parties cannot be members of the same household.
• The liability to make such payments must cease on the death of the payee.
• The payment may not be fixed as payable for support of the payor's children.
• The parties, if married, cannot file a joint return.

In addition to the seven rules to make a stream of payments alimony, the payments cannot be front-loaded and decrease by more than a permissible amount during the first three post separation years. This arrangement can cause recapture of the excess payments to the payor in the third post-separation year.

Liability for Payments Must Cease on Death of Payee

In order to qualify as alimony, the liability for payments must not only cease on the death of the payee spouse, but no payments (in cash or property) may be made after the death of the payee spouse, or be made as a substitute for the continuation of the pre-death payments. To the extent that one or more payments are to begin, increase in amount, or become accelerated in time as a result of the death of payee spouse, such payments may be treated as a substitute for the continuation of payments terminating on the death of the payee spouse which would otherwise qualify as alimony or separate maintenance payments. If an alimony trust is created, there is no restriction on the continuation of payments or for any substitute for such payments from the trust after the death of the payee spouse or former spouse.

Fixed As Child Support

Payments are fixed as child support if the divorce or separation instrument specifically designates some sum or portion (which sum or portion may fluctuate) as payable for the support of a child of the payee spouse. A payment will be treated as fixed for the support of a child of the payor spouse if the payment is reduced 1) on the happening of a contingency related to a child of the payor, or 2) at a time that can clearly be associated with such a contingency. A payment may be treated as fixed as payable for the support of a child of the payor spouse even if other separate payments specifically are designated as payable for the support of a child of the payor spouse.

A contingency relates to a child if it depends on any event relating to that child regardless of whether such event is likely to occur. Events that relate to a child include the child's attaining a specific age or income level, dying, marrying, leaving school, leaving the spouse's household, or gaining employment.

A payment will be presumed to be reduced at a time clearly associated with the happening of a contingency relating to a child where the payments are to be reduced not more than 6 months before or after the date a child is to attain the age of 18, 21 or local age of majority. In addition, there will be a similar presumption where payments are to be reduced on two or more occasions that occur more than 1 year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24, inclusive, and the age is the same for each child.

When the vehicle for payments is the income from an alimony trust, a contingency relating to a child will not disqualify the income payments from being taxable to the spouse or former spouse. It will not be taxable to the trust or to the creator of the trust, unless the payments are expressly specified as support for a child.

Excess Front-Loading Dangers (Recomputation Rule)

A recalculation and inclusion in income by the payor is required to the extent that the amount of alimony payments is affected by the recomputation rule. The recomputation rule mandates that recapture applies only to payments made during the first 3 post-separation years. The payor spouse is required to include the excess amount in gross income in the payor spouse's third post-separation year. The payee is allowed a deduction from the excess amount in computing adjusted gross income in the payee's third post-separation year.

For purposes of the recomputation rule, the term “first post-separation year” means the first calendar year in which the payor spouse paid to the payee spouse alimony or separate maintenance payments for which the Code applies. The second and third post-separation years shall be in the first and second succeeding calendar years, respectively.

Thus, if the total alimony paid in post-separation year two is more than $7500 less than in year one, there will be recapture. Likewise, if the alimony paid in year three is more than $15,000 less than in year two, there will be recapture of the excess amount. In other words, there is no recapture if year two is greater than or equal to year one minus $7500 and year three is greater than year two minus $15,000. An alimony trust can avoid the unexpected danger of the Draconian effect of this excess front-loading rule. Accordingly, if an alimony trust is created, for example, to pay income from property in trust in lieu of rehabilitative alimony or “bridge the gap” alimony, neither of which need stretch out for 3 calendar years, there will be no recapture.

The Alimony Trust

The term “alimony trust” is used loosely to refer to any trust making payments to a spouse who is divorced or who is legally separated under a decree of separate maintenance or a written separation agreement. In such a case, the spouse actually entitled to receive payments from the trust is considered the beneficiary rather than the spouse in discharge of whose obligations the payments are made, except to the extent that the payments are specified to be for the support of the obligor spouse's minor children in the divorce or separate maintenance decree, the separation agreement or the governing trust instrument.

Two examples of the use of such trusts are given by the Internal Revenue Service:

Example 1: Upon the marriage of H and W, H irrevocably transfers property in trust to pay the income to W for her life for support, maintenance, and all other expenses. Some years later, W obtains a legal separation from H under an order of court. W, relying upon the income from the trust payable to her, does not ask for any provision for her support and the decree recites that since W is adequately provided for by the trust, no further provision is being made for her … Under the provisions of the Code, the income of the trust which becomes payable to W after the order of separation is includible in her income and is deductible by the trust. No part of the income is includible in H's income or deductible by him.

Example 2: H transfers property in trust for the benefit of W, retaining the power to revoke the trust at any time. H, however, promises that if he revokes the trust he will transfer to W property in the value of $100,000. The transfer in trust and the agreement were not incident to divorce, but some years later W divorces H. The court decree is silent as to alimony and the trust. After the divorce, income of the trust which becomes payable to W is taxable to her, and is not taxable to H or deductible by him. If H later terminates the trust and transfers $100,000 of property to W, the $100,000 is not income to W nor deductible by H. The income is treated as being from an alimony trust whether or not the trust is created in contemplation of divorce. Thus an alimony trust can be set up before or after divorce or separation and even by ante-nuptial agreement.

If the trust specifically provides for support of a child or children the trust income is applied first to support of the minors and then to the beneficiary spouse. If income is not enough for both it is applied first to child support.

• The tax rate of the income is that of the payee spouse or former spouse.
• Capital gain income distributed to the payee is taxed as capital gain income.

The transfer of property to an alimony trust would be a transfer for full and adequate consideration to the extent of the transferee's interest, and thus not trigger gift taxes. The only taxable gift would be the gift of the remainder.

Conclusion

Alimony trusts can be useful to avoid some of the pitfalls of the alimony rules of the Code, provided, of course, that there are sufficient funds to create a trust that will produce the required income to the recipient spouse or former spouse. If so, the recipient will be guaranteed the payments from the funds set aside in the trust.

The purpose of making payments to a spouse or former spouse as alimony under the Internal Revenue Code (the Code) is so that such payments will be taxable to the payee and deductible to the payor. For any stream of payments to be alimony as defined by the Code, payments must meet the following rules:

• The payment must be made by cash, check, money order or the like, on behalf of the payee spouse or former spouse.
• It must be made pursuant to a divorce or separation instrument.
• The instrument cannot designate the payments as not taxable to the payee and not deductible to the payor.
• In the case of individuals divorced or legally separated, the parties cannot be members of the same household.
• The liability to make such payments must cease on the death of the payee.
• The payment may not be fixed as payable for support of the payor's children.
• The parties, if married, cannot file a joint return.

In addition to the seven rules to make a stream of payments alimony, the payments cannot be front-loaded and decrease by more than a permissible amount during the first three post separation years. This arrangement can cause recapture of the excess payments to the payor in the third post-separation year.

Liability for Payments Must Cease on Death of Payee

In order to qualify as alimony, the liability for payments must not only cease on the death of the payee spouse, but no payments (in cash or property) may be made after the death of the payee spouse, or be made as a substitute for the continuation of the pre-death payments. To the extent that one or more payments are to begin, increase in amount, or become accelerated in time as a result of the death of payee spouse, such payments may be treated as a substitute for the continuation of payments terminating on the death of the payee spouse which would otherwise qualify as alimony or separate maintenance payments. If an alimony trust is created, there is no restriction on the continuation of payments or for any substitute for such payments from the trust after the death of the payee spouse or former spouse.

Fixed As Child Support

Payments are fixed as child support if the divorce or separation instrument specifically designates some sum or portion (which sum or portion may fluctuate) as payable for the support of a child of the payee spouse. A payment will be treated as fixed for the support of a child of the payor spouse if the payment is reduced 1) on the happening of a contingency related to a child of the payor, or 2) at a time that can clearly be associated with such a contingency. A payment may be treated as fixed as payable for the support of a child of the payor spouse even if other separate payments specifically are designated as payable for the support of a child of the payor spouse.

A contingency relates to a child if it depends on any event relating to that child regardless of whether such event is likely to occur. Events that relate to a child include the child's attaining a specific age or income level, dying, marrying, leaving school, leaving the spouse's household, or gaining employment.

A payment will be presumed to be reduced at a time clearly associated with the happening of a contingency relating to a child where the payments are to be reduced not more than 6 months before or after the date a child is to attain the age of 18, 21 or local age of majority. In addition, there will be a similar presumption where payments are to be reduced on two or more occasions that occur more than 1 year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24, inclusive, and the age is the same for each child.

When the vehicle for payments is the income from an alimony trust, a contingency relating to a child will not disqualify the income payments from being taxable to the spouse or former spouse. It will not be taxable to the trust or to the creator of the trust, unless the payments are expressly specified as support for a child.

Excess Front-Loading Dangers (Recomputation Rule)

A recalculation and inclusion in income by the payor is required to the extent that the amount of alimony payments is affected by the recomputation rule. The recomputation rule mandates that recapture applies only to payments made during the first 3 post-separation years. The payor spouse is required to include the excess amount in gross income in the payor spouse's third post-separation year. The payee is allowed a deduction from the excess amount in computing adjusted gross income in the payee's third post-separation year.

For purposes of the recomputation rule, the term “first post-separation year” means the first calendar year in which the payor spouse paid to the payee spouse alimony or separate maintenance payments for which the Code applies. The second and third post-separation years shall be in the first and second succeeding calendar years, respectively.

Thus, if the total alimony paid in post-separation year two is more than $7500 less than in year one, there will be recapture. Likewise, if the alimony paid in year three is more than $15,000 less than in year two, there will be recapture of the excess amount. In other words, there is no recapture if year two is greater than or equal to year one minus $7500 and year three is greater than year two minus $15,000. An alimony trust can avoid the unexpected danger of the Draconian effect of this excess front-loading rule. Accordingly, if an alimony trust is created, for example, to pay income from property in trust in lieu of rehabilitative alimony or “bridge the gap” alimony, neither of which need stretch out for 3 calendar years, there will be no recapture.

The Alimony Trust

The term “alimony trust” is used loosely to refer to any trust making payments to a spouse who is divorced or who is legally separated under a decree of separate maintenance or a written separation agreement. In such a case, the spouse actually entitled to receive payments from the trust is considered the beneficiary rather than the spouse in discharge of whose obligations the payments are made, except to the extent that the payments are specified to be for the support of the obligor spouse's minor children in the divorce or separate maintenance decree, the separation agreement or the governing trust instrument.

Two examples of the use of such trusts are given by the Internal Revenue Service:

Example 1: Upon the marriage of H and W, H irrevocably transfers property in trust to pay the income to W for her life for support, maintenance, and all other expenses. Some years later, W obtains a legal separation from H under an order of court. W, relying upon the income from the trust payable to her, does not ask for any provision for her support and the decree recites that since W is adequately provided for by the trust, no further provision is being made for her … Under the provisions of the Code, the income of the trust which becomes payable to W after the order of separation is includible in her income and is deductible by the trust. No part of the income is includible in H's income or deductible by him.

Example 2: H transfers property in trust for the benefit of W, retaining the power to revoke the trust at any time. H, however, promises that if he revokes the trust he will transfer to W property in the value of $100,000. The transfer in trust and the agreement were not incident to divorce, but some years later W divorces H. The court decree is silent as to alimony and the trust. After the divorce, income of the trust which becomes payable to W is taxable to her, and is not taxable to H or deductible by him. If H later terminates the trust and transfers $100,000 of property to W, the $100,000 is not income to W nor deductible by H. The income is treated as being from an alimony trust whether or not the trust is created in contemplation of divorce. Thus an alimony trust can be set up before or after divorce or separation and even by ante-nuptial agreement.

If the trust specifically provides for support of a child or children the trust income is applied first to support of the minors and then to the beneficiary spouse. If income is not enough for both it is applied first to child support.

• The tax rate of the income is that of the payee spouse or former spouse.
• Capital gain income distributed to the payee is taxed as capital gain income.

The transfer of property to an alimony trust would be a transfer for full and adequate consideration to the extent of the transferee's interest, and thus not trigger gift taxes. The only taxable gift would be the gift of the remainder.

Conclusion

Alimony trusts can be useful to avoid some of the pitfalls of the alimony rules of the Code, provided, of course, that there are sufficient funds to create a trust that will produce the required income to the recipient spouse or former spouse. If so, the recipient will be guaranteed the payments from the funds set aside in the trust.