Distinguishing Alimony from Property Settlements

In the course of a marital dissolution, spouses may divvy up their financial assets. Some may take the form of property settlements, which are tax-free events, or alimony, which is taxable to the recipient and deductible by the payer. Unfortunately, it’s not always clear how certain property transfers or payments should be treated.

Income payments

If one spouse earns income but gives it to the other pursuant to a marital agreement or court order, who is taxed on it? For example, when income earned by one spouse is collected by the other, who is taxed on it?

• Shared professional fees. An attorney who earns a contingency fee is taxable on it. However, if the attorney is required to share a portion with a spouse/former spouse, it can be treated as deductible alimony. For example, in a recent case, an attorney earned a $55 million fee and was required by the terms of the marital settlement agreement signed before earning the fee to give his former spouse 10%. The court said this was an alimony payment.
• Transferred savings bonds. Accrued interest on U.S. savings bonds transferred to the spouse/former spouse is taxable to the spouse who owned the bonds when the interest accrued.

Retirement plan benefits

A spouse may be required to give some or all of his/her retirement accounts to the other party. If the transfer is done correctly, even though the spouse with the accounts had earned the income, the other spouse pays taxes on it when distributions from the accounts are taken.

• For qualified retirement plans, the transfer must be pursuant to a qualified domestic relations order (QDRO). This is a court order directing the plan trustee to transfer the benefits to an alternate payee (e.g., the spouse/former spouse). The portion of the account transferred can be a dollar amount or a percentage of the account.
• For transfers of IRAs, the transfer must be “incident to divorce,” which means transfers required to be made after the divorce. They should be done in a trustee-to-trustee transfer. If the IRA owner takes a distribution to make a required payment to a former spouse, the spouse owning the IRA is taxable on the distribution; this is not a transfer incident to divorce.

Marital residence

In the course of a split up, the marital residence may be sold, or one spouse may continue to reside there. He or she may continue to share ownership or receive full ownership under the terms of a property settlement. The transfer of the home between spouses is a tax-free property settlement.

When the home is sold, the home sale exclusion may be available, permitting $250,000 of gain to be tax free ($500,000 on a joint return). For purposes of the home sale exclusion, which requires the seller to own and use the home as his/her principal residence for two of the five years preceding the date of sale, consider the following in the case of divorce:

• The spouse who moves from the home but continues to own it, or part of it, can treat the other spouse’s use as his/her own when the home is sold.
• The spouse who obtains ownership of the home can treat the other’s period of use as his/her own.

Alimony technicalities

Even though a payment by one spouse to the other is not a property settlement, it may not necessarily qualify for alimony treatment. In order to be deductible by the payer and taxable to the recipient, all of the following conditions must be met:

1. Payments must be in cash to the spouse/former spouse or a third party for the benefit of the spouse/former spouse.
2. Payments must be made pursuant to a divorce decree or separation agreement.
3. Payments are designated as other than alimony.
4. The parties reside in separate households when payment is made.
5. The payer is not required to make payments after the death of the recipient.
6. The parties file separate tax returns and the payer includes the Social Security number of the recipient.
7. The payment must not be child support.

If, for example, payments can continue to be made after the death of the recipient, then alimony treatment does not apply. This means the payer has simply made a nondeductible payment; the recipient does not have to include it in income.

Conclusion

Anyone going through a marital dissolution should get tax advice about the financial details. Don’t assume that a family law attorney handling the legal end to the marriage is knowledgeable in tax law.