Unspecified Tax Purposes in Marital Settlements

The taxability of cash payments in a divorce settlement would seem to be straightforward. What would be needed is an explicit statement that the payments are (or are not) taxable, and if the intent of the parties' agreement is to provide for taxable payments, to provide clearly that liability to make the payments terminates upon the death of the payee spouse. Indeed, the original amendments required just such an explicit statement, but this requirement was repealed in 1986 due to concern that payments that are clearly alimony ' primarily payments provided in temporary support orders ' would fail to qualify. In practice, however, even for parties who are aware of the requirement, including an explicit statement that cash payments are intended to be taxable to the payee is not so simple.

Consider the termination on death requirement first. Because the tax definition no longer depends on a legal obligation to support the payee, the income tax-shifting effect of the payments can be negotiated independently from the underlying obligation of the payor to settle the payee's marital rights, including the right to a share of marital property.

This might make sense, for example, when the income tax bracket of the payor is higher than the tax bracket of the payee, so that an arbitrage can be created. Then designing cash payments in settlement of property rights to be deductible by the payor and taxable to the payee can provide a net tax advantage for both parties. If income-shifting alimony payments are meant to pay for release of the payee's marital property rights, however, the termination on death requirement could mean that the payee will not receive the full value of her property rights should she die too soon. This problem can be solved by increasing the amount of the payments to offset the cost of declining term life insurance on the life of the payee. Obviously, this design requires some sophistication in structuring the agreement, and that may be a problem in stressful divorce negotiations.

Too often, the precise requirements of the statutory definition of alimony may either be overlooked or deliberately omitted. The problem could stem from information asymmetries in that one party is not fully aware of what the tax definition may actually require, or it may result from the desire to finalize the divorce. Sometimes, the parties just do not agree on the tax question, or it is not openly discussed, and the agreement is left ambiguous, with the result that both parties take the position on their income tax returns which is favorable to them. That approach just invites trouble. All too often, marital settlement agreements do not address the tax question. When there is no provision in the divorce instrument, which states that the payor's obligation will terminate on the death of the payee, that contingency can be inferred from an examination of state law, raising the very question that was thought to have been obviated by the 1984/1986 amendments. Resolving the question requires analysis of state authority on this point, but if the state authorities do not provide a clear result, then the tax court will not try to determine what the state courts would do. Instead, the court will reach its own conclusion from an examination of the divorce instrument.

Case Law

Hoover v. Commissioner, 102 F.3d 842 (6th Cir. 1996), aff'g T.C. Memo. 1995-183, is usually cited for this proposition. There, the parties agreed on a Judgment entry under which Husband retained his minority interest in his business, agreed to be worth more than $2 million, and Wife received the parties' residence. In addition, Husband agreed to pay Wife $521,640 in $3,000 monthly installments “alimony as division of equity.” There was no separate provision for marital support, and an explicit statement that Husband's obligation to make the payments would terminate on Wife's death, included in the initial draft, was omitted from the instrument, apparently by agreement.

Moreover, the instrument required that Husband's obligation to make the payments be secured until the aggregate amount had been paid “in full.” Wife excluded the payments from her income, and Husband claimed deductions under ' 215. The courts concluded that the missing termination provision could be inferred if, under state law, Husband's obligation would terminate on Wife's death, but further, if state law did not provide a clear answer to this question, the court would draw its own inference from the language used in the instrument, without considering extrinsic evidence.

This conclusion rested on the court's view that the 1984/86 amendments were intended to eliminate “subjective inquiries” in deciding whether cash payments under divorce instruments were taxable alimony. The court then decided that, under the divorce instrument, the payments were made as part of a property settlement, from which it inferred that the payments were not intended to be taxable. The decision in Hoover does seem to be consistent with economics of the settlement, preserving the value of the installment payments to the Wife, but the reasoning in the opinions does hark back to the labeling used in the earlier tax regime when “support” payments were income and “property” payments were not.

A more recent example of this problem can be found in Carol A. Johanson v. Commissioner, 541 F.3d 973 (9th Cir. 2008), aff'g T.C. Memo 2006-105. In their divorce settlement agreement, the parties agreed that a business in which both had participated would be retained by husband in exchange for cash payments to be made by Husband to Wife. The agreement provided for three different sets of cash payments, child support and two additional series of payments, which were set out in a section of the agreement labeled “Spousal Support.” The parties waived all rights to support except as provided in the agreement. There were also provisions dealing with the division of property, and possible disagreement over the value of the business, which invited the court to conclude that Wife's interest in the business had been adequately compensated in the property division. The cash payments at issue, labeled “spousal support,” were to continue to a date certain and were expressly non-modifiable except for Husband's death (wife obtained a life insurance policy on Husband's life at the time of the divorce), prolonged unemployment or disability. There was evidence that Husband had proposed to include a provision under which the payments would terminate on Wife's death, but when she objected to it, it was deleted. There was also testimony in the case that Husband had specifically agreed to the continuation of the payments in the event of Wife's remarriage. In fact, Wife did remarry and Husband continued to make the payments. The agreement did not explicitly provide that Husband's liability to make the payments would continue after Wife's death.

Wife viewed these payments as compensation for her interest in the business, and, therefore, as nontaxable installment payments that would not terminate in the event of her death. However, the agreement labeled the payments to be support, provided for them in a section of the agreement that dealt with support questions, and did not explicitly require continuation of the payments after her death. For the payments to be nontaxable, therefore, that requirement would have to be inferred from an examination of state law, in this case, California Family Law Code ' 4337, which provided that spousal support would terminate on either death or remarriage of the payee. There was extrinsic evidence that a provision explicitly terminating Husband's obligation on Wife's death had been omitted from the agreement at Wife's insistence. Moreover, Wife had remarried, and Husband had continued to make the payments, even though there was no provision in the agreement explicitly requiring him to do so. Nonetheless, the structure of the agreement, the language used and uncertainty about the value of the business, made the Wife's position tenuous at best. She may have bargained for the payments with the value of her share in the business in mind, but that position did not appear on the face of the agreement. This left the tax issue open and at risk in litigation where federal courts will not try very hard to apply state law to an ambiguous factual situation. This is what happened in this case.

Arguably, under California case law, the payor's liability to continue payments after the death of the payee can be inferred from extrinsic evidence if there is a provision in the agreement that is consistent with that conclusion ' here, non-modifiability of the term over which the payments were to be made. The Tax Court, however, did not refer to the California cases interpreting the statutory requirement; instead, it decided the case solely from its interpretation of the provisions in the instrument. While the court of appeals did consider the California case law interpreting the statutory termination rule, it concluded that California law was not ambiguous on the termination question. Elimination of an explicit termination provision from the final agreement and emphasis on the non-modifiability of the termination date were insufficient to justify consideration of extrinsic evidence. It is not clear that, were Wife to have died before the payments had been completed, a California court would have excused Husband from his obligation to continue the payments.

Comparing Hoover with Johanson, one can see that, in the application of ' 71 to an agreed stream of payments, the structure and language of the agreement may be determinative of whatever each party may have intended. The way in which these obligations are phrased may, of course, reflect the bargaining positions of the parties. In Johanson, for example, Husband may have been willing to agree to larger payments, perhaps inclusive of an element of spousal or child support, to avoid more explicit bargaining over the value of the business interest he received in the settlement. Wife may have agreed to the characterization of the payments in the agreement, in turn, with the idea that, because an explicit termination provision had been deleted from the agreement, she was protected from an adverse tax consequence. Either way, one of the parties risked the loss of a significant portion of the economic value of the settlement to which each had agreed. So, why did the parties fail to work it out and avoid further dispute over the tax issue?

Importance of Clarity

In every case like this one, one is speculating about the circumstances under which the tax status of the payments has been left unclear. Both parties may have assumed a favorable tax result or may have been concerned that raising the tax issue in negotiations would have compromised in some way their economic positions. Leaving the question open, at least, provides the opportunity for each party to take the favorable tax position, even though it would seem obvious that inconsistent tax treatment of a series of cash payments would invite the attention of the Commissioner of Internal Revenue. And it is inevitably the payor who is more at risk because claiming the deduction will require taking the position on the face of the payor's tax return.

The exact wording of a marital settlement agreement or a divorce decree incorporating an agreement may also make the difference, even in cases where the intent of both parties to treat payments as spousal support would seem to be clear. This problem is illustrated by the Ninth Circuit decision, Fithian v. United States, 45 Fed. Appx. 700 (9th Cir.2002). There, Husband agreed to pay Wife one-half of the net bonuses paid to him from his medical corporation as support. Husband retained all of the ownership interest in the corporation. The operative provisions of the agreement contained an explicit termination on death clause, but when the agreement was incorporated into the divorce decree, the judgment provision of the decree did not contain this clause. One might conclude that neither party thought at the time that the provision setting forth the judgment of the divorce court would override the provisions of the agreement, but that is exactly what both courts concluded. Note that in Fithian, the payments were defined to be a share of compensatory payments to be made to Husband, so one would expect the parties to have agreed to make them compensatory.

In many of these cases, unlike the situation in Johanson, it is the payor's tax treatment that is challenged by the Internal Revenue Service, probably because the payments in question were omitted from the payee's tax return. Fithian seems to be a particularly questionable result from that point of view. Nonetheless, scrivener beware, when the taxability of cash payments is in question, attention to careful drafting in every provision of the settlement agreement or judgment form is essential.

This problem will not disappear from divorce negotiation, as recent cases demonstrate. In Rood v. Commissioner, T.C. Memo. 2012-122, the parties negotiated a series of cash payments from Husband to Wife which, from the tenor of the negotiations, were intended to provide short-term support for Wife. The original proposal was for Husband to make $5,000 monthly payments while Wife was attending college, but for no more than 60 months. Under this formulation, Wife's death would have resulted in termination of the payments. The terms for the proposed series of payments changed as negotiations progressed to “non-modifiable lump sum alimony in the amount of $300,000,” language that was incorporated in the divorce decree. Husband asserted that the intent was to pay rehabilitative alimony, but, under state law, the language used in the agreement made this obligation a final obligation of Husband. Because there were also property settlement provisions in the final agreement, the parties, or at least Husband, considered the payments to be support, and therefore taxable alimony. The circumstances under which the change occurred are not disclosed, although the tax implications of the change appear not to have been explained to Husband.

An obligation expressed as a principal sum, as in Rood, whether payable in installments or not, will, without an express termination, invariably fail the termination on death requirement. This may happen when one party is required to reimburse the other for payment of a preexisting debt. See, e.g., Moore v. Commissioner, T.C. Memo. 2011-200 (Husband agreed to reimburse Wife for her payment of the mortgage on the principal residence when the residence was sold; payments not taxable alimony because Husband's obligation would not end on her death.) The argument that payments for the benefit of the spouse with fewer resources are taxable alimony is frequently used when addressing attorneys' fees, but this obligation to a third party will always fail to meet the termination on death condition. See, e.g., Stedman v. Commissioner, T.C. Memo. 2008-239; Brown v. Commissioner, T.C. Summ. Op. 2011-114; Nicolas v. Commissioner, T.C. Summ. Op. 2011-91.

Make the Intent Clear

The advantage of making the intended tax treatment of a series of cash payments clear, and thus protecting the net economic value of a negotiated settlement, would seem to be obvious. The tax definition of alimony, through the second requirement, provides this opportunity. Under ' 71(b)(1)(B), the parties may “designate such payment as a payment which is not includible in gross income ' and not allowable as a deduction under section 215.” A cash payment not so designated meets the requirement of ' 71(b)(1)(B). One might think that the “designation,” to be effective, would require a specific reference to ' 71, but here again the case law strays from the obvious purpose of this provision.

Recall that the definition of taxable alimony does not depend on the characterization of the payment under state law. Therefore, a stream of cash payments that are part of a property settlement may be tax-shifting payments, taxable to the recipient and deductible by the payor. And in a marital settlement agreement, the parties may want to clarify that these payments, even if taxable, are part of the property settlement, and further, they may decide to waive state law claims for support. Note also that this provision is stated in the negative; a cash payment, inter alia, is taxable alimony if it is not designated as non-taxable. Now this would seem, on its face, to require a specific statement that the payment is not taxable and not deductible. But what happens if the structure of the agreement or decree seems inconsistent with a taxable payment, particularly when the viewer is conflating the purpose of the payment with its taxable consequences?

This problem is the obverse of the one involved in Johanson. The classic illustration of planning for the tax consequences is found in Goldman's Estate v. Commissioner, 112 T.C. 317 (1999), aff'd mem. sub nom. Schutter v. Commissioner, 242 F.3d 390 (10th Cir. 2000). In their marital settlement agreement, Husband agreed to make several large lump sum payments in settlement of Wife's marital property rights. In addition, and in the same part of the agreement, Husband agreed to pay Wife, “in furtherance of the equitable division of property,” $20,000 per month for 240 months. The obligation to make these payments terminated on her death before the end of the payout period. The agreement provided that ' 1041 would apply to transfers of property (although ' 1041 is a non-recognition provision and would have no application to cash payments that have a tax basis equal to their face amount) and specified that each party waived its rights to support from the other. There was no explicit statement as to the tax effect of the monthly payments.

The question before the court was whether there was a designation that the monthly payments would not be taxable alimony. The Tax Court had little difficulty reaching its conclusion, although, as noted above, the taxable consequences of a payment under a divorce instrument were intentionally separated from the purpose for which the payment is to be made. Concluding that a designation need not mimic the statutory formulation in ' 71(b)(1)(B), “if the substance of such a designation is reflected in the instrument.” (Emphasis supplied.) But what is the “substance”? In Goldman, the payments were quite clearly part of an elaborate property settlement, but that should not be determinative. The structure of the payout was different from the quite large lump-sum payments, and they were made explicitly contingent on Wife's death. Nonetheless, the court inferred that property settlement payments are intended to be nontaxable, and concluded that “the agreement contains a clear, explicit and express direction” to that effect. This statement stems from the opinion in Richardson v. Commissioner, 128 F.3d 551, 556 (7th Cir. 1997), involving a different set of payments. But of course, the agreement contained no such direction. These distinctions were significant under the pre-1984 definition of alimony, and the purpose of the 1984/1986 amendments was to get rid of these distinctions.

The decision in Goldman may be unusual, mainly because of the explicit reference to ' 1041, as well as the carefully structured property settlement provisions. The Tax Court has elsewhere stated that the labels attached to payments are not determinative. See Proctor v. Commissioner, 129 T.C. 92 (2007); Baker v. Commissioner, T.C. Memo. 2000-164. These cases involve the payor's obligation to pay to the recipient a share of his military retirement pay as a “property settlement,” but the context there feels more like an income-sharing arrangement that would preclude an inferred designation.

Conclusion

The lesson is that care should be taken to specify the tax consequences of a payment explicitly when cash payments are intended to be taxable to the recipient even as part of a property settlement. The conclusion from these cases is clear: It is not a good strategy to leave the tax consequences of a marital settlement unstated. An adverse decision in tax litigation, quite likely to follow conflicting tax positions on the parties' tax returns, can completely upset the economics of the settlement.

Thomas R. White, 3rd, a member of this newsletter's Board of Editors, is a John C. Stennis Professor of Law at the University of Virginia Law School.

For tax purposes, “alimony” payments meeting the definition in ' 71 of the Internal Revenue Code (IRC) are taxable to the recipient and deductible by the payor. When the definition of alimony in ' 71 was amended in 1984, it was said that the purpose of the amendment was to eliminate the dependence of the definition of taxable alimony on state law dealing with spousal support. Before then, alimony was taxable to the recipient when “received ' in discharge of ' a legal obligation which, because of the marital or family relationship, is imposed on ' the [payor] ' ” The statutory requirement of a “ legal obligation” was interpreted to mean the payor's obligation to support the payee, and that, in turn, required examination of state law and the specific provisions in the settlement agreement or divorce decree (“divorce instrument”) to determine the source of the obligation. Often, this inquiry required consideration of extrinsic evidence to identify the purpose of the payments in question. Under current law, ' 71(b) of the IRC sets out requirements that are said to be objective and independent of state law, obviating the “subjective” search for the support obligation under prior law.

This article discusses two of those requirements: ' 71(b)(1)(B), which provides that a cash payment is taxed to the recipient as alimony when, inter alia, the “divorce or separation instrument does not designate such payment as ' not includible in gross income ' and not allowable as a deduction ' “; and ' 71(b)(1)(D), which provides that the payment is taxable when, inter alia, “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 ' as a substitute for such payments after the death of the payee spouse ' .” (Emphasis supplied.)

Taxability

The taxability of cash payments in a divorce settlement would seem to be straightforward. What would be needed is an explicit statement that the payments are (or are not) taxable, and if the intent of the parties' agreement is to provide for taxable payments, to provide clearly that liability to make the payments terminates upon the death of the payee spouse. Indeed, the original amendments required just such an explicit statement, but this requirement was repealed in 1986 due to concern that payments that are clearly alimony ' primarily payments provided in temporary support orders ' would fail to qualify. In practice, however, even for parties who are aware of the requirement, including an explicit statement that cash payments are intended to be taxable to the payee is not so simple.

Consider the termination on death requirement first. Because the tax definition no longer depends on a legal obligation to support the payee, the income tax-shifting effect of the payments can be negotiated independently from the underlying obligation of the payor to settle the payee's marital rights, including the right to a share of marital property.

This might make sense, for example, when the income tax bracket of the payor is higher than the tax bracket of the payee, so that an arbitrage can be created. Then designing cash payments in settlement of property rights to be deductible by the payor and taxable to the payee can provide a net tax advantage for both parties. If income-shifting alimony payments are meant to pay for release of the payee's marital property rights, however, the termination on death requirement could mean that the payee will not receive the full value of her property rights should she die too soon. This problem can be solved by increasing the amount of the payments to offset the cost of declining term life insurance on the life of the payee. Obviously, this design requires some sophistication in structuring the agreement, and that may be a problem in stressful divorce negotiations.

Too often, the precise requirements of the statutory definition of alimony may either be overlooked or deliberately omitted. The problem could stem from information asymmetries in that one party is not fully aware of what the tax definition may actually require, or it may result from the desire to finalize the divorce. Sometimes, the parties just do not agree on the tax question, or it is not openly discussed, and the agreement is left ambiguous, with the result that both parties take the position on their income tax returns which is favorable to them. That approach just invites trouble. All too often, marital settlement agreements do not address the tax question. When there is no provision in the divorce instrument, which states that the payor's obligation will terminate on the death of the payee, that contingency can be inferred from an examination of state law, raising the very question that was thought to have been obviated by the 1984/1986 amendments. Resolving the question requires analysis of state authority on this point, but if the state authorities do not provide a clear result, then the tax court will not try to determine what the state courts would do. Instead, the court will reach its own conclusion from an examination of the divorce instrument.

Case Law

Hoover v. Commissioner , 102 F.3d 842 (6th Cir. 1996), aff'g T.C. Memo. 1995-183, is usually cited for this proposition. There, the parties agreed on a Judgment entry under which Husband retained his minority interest in his business, agreed to be worth more than $2 million, and Wife received the parties' residence. In addition, Husband agreed to pay Wife $521,640 in $3,000 monthly installments “alimony as division of equity.” There was no separate provision for marital support, and an explicit statement that Husband's obligation to make the payments would terminate on Wife's death, included in the initial draft, was omitted from the instrument, apparently by agreement.

Moreover, the instrument required that Husband's obligation to make the payments be secured until the aggregate amount had been paid “in full.” Wife excluded the payments from her income, and Husband claimed deductions under ' 215. The courts concluded that the missing termination provision could be inferred if, under state law, Husband's obligation would terminate on Wife's death, but further, if state law did not provide a clear answer to this question, the court would draw its own inference from the language used in the instrument, without considering extrinsic evidence.

This conclusion rested on the court's view that the 1984/86 amendments were intended to eliminate “subjective inquiries” in deciding whether cash payments under divorce instruments were taxable alimony. The court then decided that, under the divorce instrument, the payments were made as part of a property settlement, from which it inferred that the payments were not intended to be taxable. The decision in Hoover does seem to be consistent with economics of the settlement, preserving the value of the installment payments to the Wife, but the reasoning in the opinions does hark back to the labeling used in the earlier tax regime when “support” payments were income and “property” payments were not.

A more recent example of this problem can be found in Carol A. Johanson v. Commissioner , 541 F.3d 973 (9th Cir. 2008), aff'g T.C. Memo 2006-105. In their divorce settlement agreement, the parties agreed that a business in which both had participated would be retained by husband in exchange for cash payments to be made by Husband to Wife. The agreement provided for three different sets of cash payments, child support and two additional series of payments, which were set out in a section of the agreement labeled “Spousal Support.” The parties waived all rights to support except as provided in the agreement. There were also provisions dealing with the division of property, and possible disagreement over the value of the business, which invited the court to conclude that Wife's interest in the business had been adequately compensated in the property division. The cash payments at issue, labeled “spousal support,” were to continue to a date certain and were expressly non-modifiable except for Husband's death (wife obtained a life insurance policy on Husband's life at the time of the divorce), prolonged unemployment or disability. There was evidence that Husband had proposed to include a provision under which the payments would terminate on Wife's death, but when she objected to it, it was deleted. There was also testimony in the case that Husband had specifically agreed to the continuation of the payments in the event of Wife's remarriage. In fact, Wife did remarry and Husband continued to make the payments. The agreement did not explicitly provide that Husband's liability to make the payments would continue after Wife's death.

Wife viewed these payments as compensation for her interest in the business, and, therefore, as nontaxable installment payments that would not terminate in the event of her death. However, the agreement labeled the payments to be support, provided for them in a section of the agreement that dealt with support questions, and did not explicitly require continuation of the payments after her death. For the payments to be nontaxable, therefore, that requirement would have to be inferred from an examination of state law, in this case, California Family Law Code ' 4337, which provided that spousal support would terminate on either death or remarriage of the payee. There was extrinsic evidence that a provision explicitly terminating Husband's obligation on Wife's death had been omitted from the agreement at Wife's insistence. Moreover, Wife had remarried, and Husband had continued to make the payments, even though there was no provision in the agreement explicitly requiring him to do so. Nonetheless, the structure of the agreement, the language used and uncertainty about the value of the business, made the Wife's position tenuous at best. She may have bargained for the payments with the value of her share in the business in mind, but that position did not appear on the face of the agreement. This left the tax issue open and at risk in litigation where federal courts will not try very hard to apply state law to an ambiguous factual situation. This is what happened in this case.

Arguably, under California case law, the payor's liability to continue payments after the death of the payee can be inferred from extrinsic evidence if there is a provision in the agreement that is consistent with that conclusion ' here, non-modifiability of the term over which the payments were to be made. The Tax Court, however, did not refer to the California cases interpreting the statutory requirement; instead, it decided the case solely from its interpretation of the provisions in the instrument. While the court of appeals did consider the California case law interpreting the statutory termination rule, it concluded that California law was not ambiguous on the termination question. Elimination of an explicit termination provision from the final agreement and emphasis on the non-modifiability of the termination date were insufficient to justify consideration of extrinsic evidence. It is not clear that, were Wife to have died before the payments had been completed, a California court would have excused Husband from his obligation to continue the payments.

Comparing Hoover with Johanson, one can see that, in the application of ' 71 to an agreed stream of payments, the structure and language of the agreement may be determinative of whatever each party may have intended. The way in which these obligations are phrased may, of course, reflect the bargaining positions of the parties. In Johanson, for example, Husband may have been willing to agree to larger payments, perhaps inclusive of an element of spousal or child support, to avoid more explicit bargaining over the value of the business interest he received in the settlement. Wife may have agreed to the characterization of the payments in the agreement, in turn, with the idea that, because an explicit termination provision had been deleted from the agreement, she was protected from an adverse tax consequence. Either way, one of the parties risked the loss of a significant portion of the economic value of the settlement to which each had agreed. So, why did the parties fail to work it out and avoid further dispute over the tax issue?

Importance of Clarity

In every case like this one, one is speculating about the circumstances under which the tax status of the payments has been left unclear. Both parties may have assumed a favorable tax result or may have been concerned that raising the tax issue in negotiations would have compromised in some way their economic positions. Leaving the question open, at least, provides the opportunity for each party to take the favorable tax position, even though it would seem obvious that inconsistent tax treatment of a series of cash payments would invite the attention of the Commissioner of Internal Revenue. And it is inevitably the payor who is more at risk because claiming the deduction will require taking the position on the face of the payor's tax return.

The exact wording of a marital settlement agreement or a divorce decree incorporating an agreement may also make the difference, even in cases where the intent of both parties to treat payments as spousal support would seem to be clear. This problem is illustrated by the Ninth Circuit decision, Fithian v. United States , 45 Fed. Appx. 700 (9th Cir.2002). There, Husband agreed to pay Wife one-half of the net bonuses paid to him from his medical corporation as support. Husband retained all of the ownership interest in the corporation. The operative provisions of the agreement contained an explicit termination on death clause, but when the agreement was incorporated into the divorce decree, the judgment provision of the decree did not contain this clause. One might conclude that neither party thought at the time that the provision setting forth the judgment of the divorce court would override the provisions of the agreement, but that is exactly what both courts concluded. Note that in Fithian, the payments were defined to be a share of compensatory payments to be made to Husband, so one would expect the parties to have agreed to make them compensatory.

In many of these cases, unlike the situation in Johanson, it is the payor's tax treatment that is challenged by the Internal Revenue Service, probably because the payments in question were omitted from the payee's tax return. Fithian seems to be a particularly questionable result from that point of view. Nonetheless, scrivener beware, when the taxability of cash payments is in question, attention to careful drafting in every provision of the settlement agreement or judgment form is essential.

This problem will not disappear from divorce negotiation, as recent cases demonstrate. In Rood v. Commissioner, T.C. Memo. 2012-122, the parties negotiated a series of cash payments from Husband to Wife which, from the tenor of the negotiations, were intended to provide short-term support for Wife. The original proposal was for Husband to make $5,000 monthly payments while Wife was attending college, but for no more than 60 months. Under this formulation, Wife's death would have resulted in termination of the payments. The terms for the proposed series of payments changed as negotiations progressed to “non-modifiable lump sum alimony in the amount of $300,000,” language that was incorporated in the divorce decree. Husband asserted that the intent was to pay rehabilitative alimony, but, under state law, the language used in the agreement made this obligation a final obligation of Husband. Because there were also property settlement provisions in the final agreement, the parties, or at least Husband, considered the payments to be support, and therefore taxable alimony. The circumstances under which the change occurred are not disclosed, although the tax implications of the change appear not to have been explained to Husband.

An obligation expressed as a principal sum, as in Rood, whether payable in installments or not, will, without an express termination, invariably fail the termination on death requirement. This may happen when one party is required to reimburse the other for payment of a preexisting debt. See, e.g., Moore v. Commissioner, T.C. Memo. 2011-200 (Husband agreed to reimburse Wife for her payment of the mortgage on the principal residence when the residence was sold; payments not taxable alimony because Husband's obligation would not end on her death.) The argument that payments for the benefit of the spouse with fewer resources are taxable alimony is frequently used when addressing attorneys' fees, but this obligation to a third party will always fail to meet the termination on death condition. See, e.g., Stedman v. Commissioner, T.C. Memo. 2008-239; Brown v. Commissioner, T.C. Summ. Op. 2011-114; Nicolas v. Commissioner, T.C. Summ. Op. 2011-91.

Make the Intent Clear

The advantage of making the intended tax treatment of a series of cash payments clear, and thus protecting the net economic value of a negotiated settlement, would seem to be obvious. The tax definition of alimony, through the second requirement, provides this opportunity. Under ' 71(b)(1)(B), the parties may “designate such payment as a payment which is not includible in gross income ' and not allowable as a deduction under section 215.” A cash payment not so designated meets the requirement of ' 71(b)(1)(B). One might think that the “designation,” to be effective, would require a specific reference to ' 71, but here again the case law strays from the obvious purpose of this provision.

Recall that the definition of taxable alimony does not depend on the characterization of the payment under state law. Therefore, a stream of cash payments that are part of a property settlement may be tax-shifting payments, taxable to the recipient and deductible by the payor. And in a marital settlement agreement, the parties may want to clarify that these payments, even if taxable, are part of the property settlement, and further, they may decide to waive state law claims for support. Note also that this provision is stated in the negative; a cash payment, inter alia, is taxable alimony if it is not designated as non-taxable. Now this would seem, on its face, to require a specific statement that the payment is not taxable and not deductible. But what happens if the structure of the agreement or decree seems inconsistent with a taxable payment, particularly when the viewer is conflating the purpose of the payment with its taxable consequences?

This problem is the obverse of the one involved in Johanson. The classic illustration of planning for the tax consequences is found in Goldman's Estate v. Commissioner , 112 T.C. 317 (1999), aff'd mem. sub nom. Schutter v. Commissioner , 242 F.3d 390 (10th Cir. 2000). In their marital settlement agreement, Husband agreed to make several large lump sum payments in settlement of Wife's marital property rights. In addition, and in the same part of the agreement, Husband agreed to pay Wife, “in furtherance of the equitable division of property,” $20,000 per month for 240 months. The obligation to make these payments terminated on her death before the end of the payout period. The agreement provided that ' 1041 would apply to transfers of property (although ' 1041 is a non-recognition provision and would have no application to cash payments that have a tax basis equal to their face amount) and specified that each party waived its rights to support from the other. There was no explicit statement as to the tax effect of the monthly payments.

The question before the court was whether there was a designation that the monthly payments would not be taxable alimony. The Tax Court had little difficulty reaching its conclusion, although, as noted above, the taxable consequences of a payment under a divorce instrument were intentionally separated from the purpose for which the payment is to be made. Concluding that a designation need not mimic the statutory formulation in ' 71(b)(1)(B), “if the substance of such a designation is reflected in the instrument.” (Emphasis supplied.) But what is the “substance”? In Goldman, the payments were quite clearly part of an elaborate property settlement, but that should not be determinative. The structure of the payout was different from the quite large lump-sum payments, and they were made explicitly contingent on Wife's death. Nonetheless, the court inferred that property settlement payments are intended to be nontaxable, and concluded that “the agreement contains a clear, explicit and express direction” to that effect. This statement stems from the opinion in Richardson v. Commissioner , 128 F.3d 551, 556 (7th Cir. 1997), involving a different set of payments. But of course, the agreement contained no such direction. These distinctions were significant under the pre-1984 definition of alimony, and the purpose of the 1984/1986 amendments was to get rid of these distinctions.

The decision in Goldman may be unusual, mainly because of the explicit reference to ' 1041, as well as the carefully structured property settlement provisions. The Tax Court has elsewhere stated that the labels attached to payments are not determinative. S ee Proctor v. Commissioner , 129 T.C. 92 (2007); Baker v. Commissioner, T.C. Memo. 2000-164. These cases involve the payor's obligation to pay to the recipient a share of his military retirement pay as a “property settlement,” but the context there feels more like an income-sharing arrangement that would preclude an inferred designation.

Conclusion

The lesson is that care should be taken to specify the tax consequences of a payment explicitly when cash payments are intended to be taxable to the recipient even as part of a property settlement. The conclusion from these cases is clear: It is not a good strategy to leave the tax consequences of a marital settlement unstated. An adverse decision in tax litigation, quite likely to follow conflicting tax positions on the parties' tax returns, can completely upset the economics of the settlement.

Thomas R. White, 3rd, a member of this newsletter's Board of Editors, is a John C. Stennis Professor of Law at the University of Virginia Law School.