Whether a payment made by a taxpayer to a former spouse under a divorce or separation instrument constitutes deductible alimony by the payer is often controversial. A payment may be described in a divorce or separation instrument in a variety of ways. The payment may be labeled as alimony, periodic alimony, alimony in gross, child support, division of property, or property settlement. In addition, the definitions of these terms can vary from state to state.
To be deductible as alimony by the payer, the payment must satisfy the requirements of IRC section 71. A recent Tax Court decision involving the payment of military retirement benefits under the Uniformed Services Former Spouses' Protection Act (USFSPA) to the former spouse of a retired serviceman sheds light on the treatment of alimony payments. The interplay between the requirements of IRC section 71 and the USFSPA is analyzed for purposes of structuring a payment under a divorce or separation instrument as deductible alimony.
For payments under instruments executed after December 31, 1984, the requirements for deducting payments of alimony or separate maintenance are relatively straightforward. The payment of alimony or separate maintenance must be in cash. Under IRC section 71(b)(1)(A), such payment must be received by (or on behalf of) a spouse under a divorce or separation instrument. IRC section 71(b)(1)(B) provides that the divorce or separation instrument does not designate such payment as a payment that is not includable in gross income and not allowable as a deduction under IRC section 215. Under IRC section 71(b)(1)(C), in the case of an individual legally separated under a decree of divorce or separate maintenance, the payee spouse or the payer spouse cannot be members of the same household at the time such payments are made. Section 71(b)(1)(D) provides that no liability exists to make any such payment for any period after the death of the payee's spouse (and there is no liability to make any payment in cash or in property as a substitute for such payments after the death of the payee spouse). Furthermore, under section 71 (e), the former spouses must not file a joint return together. For payments under instruments executed before January 1, 1985, however, different requirements apply. An individual, in determining whether a payment constitutes deductible alimony, will continue to apply the requirements of prior-law IRC section 71. Accordingly, the scope of this article is limited to payments under instruments executed after December 31, 1984.
Alimony is deductible by the payer as an adjustment to income and is includable in the payee's income. When a significant difference exists between the marginal tax rate of the payer and payee, structuring payments as alimony can result in significant tax savings to the payer.
Example. Assume that the taxpayer/alimony payer has a marginal tax rate of 35% and that his former spouse/payee has a marginal tax rate of 10%. If the payments of $24,000 per year under the divorce or separation instrument constitute deductible alimony, the payer's tax savings will be $8,400. (Computed as follows: $24,000 ? 35% = $8,400. This assumes that the payer is in the 35% marginal tax bracket both before and after the adjustment to income.) The payee's taxes will increase by $2,400. (Computed as follows: $24,000 ? 10% = $2,400. This assumes that the payee is in the 10% marginal tax bracket both before and after the inclusion in income.) If the above payments constitute child support, however, the payer cannot deduct them. The payee does not include as income the child support she receives.
The USFSPA was the legislative response to the U.S. Supreme Court's decision in McCarty v. McCarty [453 U.S. 210 (1981)]. The taxpayer, a U.S. Army colonel, filed a petition in California Superior Court for the dissolution of his marriage. At the time, the taxpayer had served approximately 18 of the 20 years required for retirement with pay. …