General Rules

Generally, a payment is alimony if it meets the four-part test in Section 71(b)(1). Roughly summarized, these tests provide:

1. Payment is received under a divorce or separation instrument and
2. The agreement does not clearly indicate that the amount is not to be treated as alimony under Section 71 and
3. If paid under decree of divorce or of separate maintenance, the parties were not members of the same
4. household when the payment was made and
5. Payments cease with no substitute liability upon the death of the payee spouse

In addition to those tests, there are additional tests involving whether it appears the payments are disguised child support (Section 71(c)(2)) and the alimony recapture rules that are meant to catch disguised property settlements (Section 71(f)).

In the following cases the Tax Court applied these rules to specific cases, with an outcome that most likely generally surprised one party to the divorce. A study of these cases will help assure your client does not face one of these surprises.

Danger of Not Informing Spouse of Section 71(c)(2)

Sometimes it is possible to be too clever for your own good. In the case of Shepherd v. Commissioner (T.C. Memo 2000-174), the issue of the disguised child support rules came into play, this time by a recipient of the payments who wanted to exclude the payments from income as child support. The payments in question were to terminate within six months of a child's 18th birthday, one of the triggers mentioned in Reg § 1.71-1T(c) Q&A 18.

In the regulation, such a termination clause triggers a rebuttable presumption that the payment is disguised child support as described in Section 71(c)(2). Based on these rules, Ms. Shepherd did not include these amounts in income for the years in question.

The court noted that Ms. Shepherd's divorce counsel "...testified that he had discussed with petitioner the presumption arising under the temporary regulations that payments coinciding with a child's 18th birthday would be considered to be child support, and he indicated that petitioner's willingness to enter into the settlement agreement was based on her understanding of this presumption." That is, she expected these payments to be treated as child support and not includable in her income.

However, the court went on to note "neither petitioner nor her lead divorce counsel, however, indicated that this issue was discussed with Mr. Shepherd or with his attorney. " In fact, both Mr. Shepherd and his counsel testified that they had never considered this issue and that the other side had never mentioned it to them. Because Mr. Shepherd was found to not have been aware of this issue, the court found that the presumption was overcome and that the amounts truly were alimony.

Separate Residences Not Necessarily Required

The next case depends on the specific wording of Section 72(b)(1)(C) and Section 72(b)(2). In the case of Benham v. Commissioner (T.C. Memo. 2000-165), the issue to be decided was whether Mr. Benham could deduct payments made to his wife as alimony even though they shared the same house at the time.

Over IRS objections, the court held that, in the circumstances of this case, the deduction was allowable. The reason: Mr. Benham paid the alimony not under a decree of divorce or of separate maintenance as described in Section 72(b)(1)(C), but rather under a "written separation agreement" as contemplated by Section 72(b)(2)(B).

The court notes that "a 'Temporary Agreement' (Agreement) prepared by Leslie Benham's attorney was signed by Leslie Benham and petitioner in July of 1994. The Agreement included a provision for conditional joint use and possession of the marital residence. The Agreement granted Leslie Benham, upon 10 days' notice to petitioner, exclusive use of the residence. The Agreement also provided for an 'alimony' payment of $2,000 a month to Leslie Benham, 'contingent on her death'."

The court ruled that this agreement was the type contemplated by Section 72(b)(2)(B) and therefore did not require the parties to live apart under Section 72(b)(1)(C). From the court's logic, it would appear that an instrument that fell under Section 72(b)(2)(C) (" a decree (not described in subparagraph (A) requiring a spouse to make payments for the support or maintenance of the other spouse") would also not require the parties to live apart.

It is also interesting to note that a "written separation agreement" would not even have to be legally enforceable, but that "it is sufficient that it was entered 'in contemplation of a separation status' and includes a statement of the terms of support."

When Labels Are Not Enough

When a document is being designed to fall under the Section 72(b)(1)(B) exception to treatment as alimony, it is important that the designation be clear. In the case of Baker v. Commissioner (T.C. Memo. 2000-164), amounts that were designated as property settlement in the divorce decree were held to actually be alimony.

Ms. Baker's decree provided that she would receive one half of Mr. Baker's retirement pay as property settlement, until she either remarried, cohabitated with another individual or died. In the event of remarriage, her payments would be reduced to 25% of Mr. Baker's retirement.

The court indicated that the only issue to be decided was whether the agreement clearly designated the amounts as not includable as alimony under Section 71 pursuant to Section 71(b)(1)(B). While the court noted that the language does not have to specifically refer to Sections 71 and 215, it found that in this case the language fell short of what was required.

The court differentiated this case from the one of Estate of Goldman v. Commissioner (112 T.C. No. 21), decided in 1999, where payments that were designated for treatment under Section 1041 by the decree were held to clearly indicate the payments were not alimony.

State Law Fills in the Holes

What if a decree does not explicitly provide that payments will cease at death? The Tax Court will then look to state law to determine if that law provides that the payments would stop. In the case of Heckaman v. Commissioner (T.C. Memo. 2000-85), a provisional maintenance order did not specify that the payments would terminate upon death.

However, after examining the underlying state law in question (Indiana in this case), the Tax Court determined that the provisional order would cease if the divorce action terminated, and that the death of either spouse would terminate the divorce proceeding.

For that reason, the court held that the payments were alimony and that Ms. Heckaman had to pick up the amounts as income

Summary

Alimony is an area that continues to be troublesome for taxpayers and their advisers. The above cases indicate that care must be taken to insure that clients are not unpleasantly surprised by the tax consequences of payments related to their divorce.