Posted by Jorge Guerrero, CPA
Alimony is a payment made to a spouse or former spouse under a divorce or separation agreement. The spouses must not live in the same household and cannot file a joint tax return. Generally, alimony is deducted by the payer spouse and is considered earned income to the payee spouse. The recipient spouse therefore may make IRA contributions based on the amount received. Payments can be made to directly to the recipient spouse or a third party on the spouse’s behalf such as when one spouse is making car payments for the other spouse. Finally, the payments must end after a defined period of years but no later than the death of the recipient spouse.
In contrast, payments made as required under a divorce or separation agreement to benefit one or more children are considered child support. Child support is not deductible by the payer and not included in income of the payee. Things can get confusing when alimony and child support is required but the payer spouse is behind on the payments. By law, child support payments must be satisfied before alimony.
Imagine that Bill and Sally were a married couple now divorced. According to the divorce agreement Sally must pay Bill alimony of $12,000 per year for 3 years and $24,000 per year in child support ($12,000 for each of their two young children) until each child reaches age 18. Assume that Sally makes all of the required payments for year 1 but in year 2 she pays Bill a total $21,000. By law, the entire $21,000 is treated as child support since the annual court ordered requirement was not met. In addition, if the child support remains delinquent, IRS has the ability to seize Sally’s tax refund, while the court could order Sally’s wages be garnished to satisfy her child support liability. Sally also would still owe all the unpaid alimony.
There are two other situations that must be considered involving the “front-loading” of payments. The first situation relates to a rule where alimony is reclassified as child support. In this case, the divorce or separation agreement may state that the payments are alimony, but if the payments have certain characteristics, some or all of the payments will be treated as child support for tax purposes. This rule will take effect when payments are reduced due to:
- The child reaches age 18, 21, or local majority
- Death of child
- Marriage of child
- The child’s completion of school
- The child leaving the household
- The child reaching a specified income level
- The child becoming employed.
For example, assume that Sally only had to pay Bill, the custodial parent $30,000 per year in alimony with the annual payments dropping to $18,000 per year when the first child reaches age 18 and then to $6,000 per year when the second child reaches age 18. For tax purposes, the law will treat $24,000 as child support and $6,000 as alimony because the alimony is reduced when one of the above contingencies is present.
The second situation involves a law that is designed to prevent taxpayers from attempting to “front –load” deductible property settlements characterized as alimony. The alimony recapture rule may be triggered when yearly alimony payments decrease or terminate during any of the first three calendar years in which the payments are made. The rule has a $15,000 per year “Safe Harbor” and does not apply when the payments end early due to death of either spouse, remarriage of the payee spouse, a court order, or pursuant to continuing liability. When the amount of alimony paid decreases by more than $15,000 from year one to two or year two to three, the payee spouse may have some or all of the payments recaptured as income.
The situations above do not mention which spouse receives the exemption for a child. In our example, Bill and Sally have two children. In reality, the law states that the parent who has custody the greater number of nights is the “Custodial Parent” and therefore may claim the exemption for the child. For the noncustodial parent to claim the child, the custodial parent must complete and sign Form 8332 Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent for the noncustodial parent to attach to their tax return. This form can be used for just the current or multiple years but must be attached to the non-custodial parent’s return in any year the exemption is claimed.
Please contact one of our tax professionals to learn more about how your situation is affected by the tax code.
In Part 2 of our series, we will discuss the hidden pitfalls of several types of property transfers.