Under Internal Revenue Code(IRC) 71, alimony or separate maintenance payments, also commonly called "spousal support," are deductible by the payor spouse and must be included in the gross (total) income of the payee spouse.
The deduction for alimony is particularly valuable to the payor because it is an "adjustment to income," which is sometimes called an "above the line deduction." So, for those payor spouses who do not itemize deductions, but rather claim the standard deduction, an adjustment to income for alimony is taken in addition to the standard deduction. This is very advantageous, since the payor can claim the standard deduction and also deduct alimony.
For the payor spouse who itemizes deductions, the alimony deduction, unlike "miscellaneous itemized deductions," is not subject to the two percent floor on miscellaneous itemized deductions or subject to the itemized deduction phase-out under the tax laws, which means that the payor spouse taking this deduction will not lose any value in the deduction as one's income level rises.
Tip: Because often the payor of alimony is in a higher tax bracket than the payee, structuring payments as alimony can generate significant tax savings because the deduction is allowed at a higher rate of tax than the tax owed by the payee on the alimony income. So, you need to consider your tax bracket when structuring alimony and separate maintenance payments.
Example: H is in a 35% tax bracket, and W is in a 25% tax bracket. H makes alimony payments of $10,000. After tax, H's cost of making the $10,000 payment is only $6,500. After tax, W receives $7,500. The difference of $1,000 is a windfall of sorts; the windfall may be even higher if state income taxes are also taken into account. This tax rate differential might come into play when you negotiate alimony payments: both parties might be better off by increasing the amount of alimony rather than requiring H to make a non-deductible, non-taxable payment.
Other Items to Consider
In addition to those general basics, you need to keep in mind these other items when considering the tax implications of alimony and maintenance:
- Only individuals may deduct alimony or separate maintenance payments. That is, the deduction is not allowed to such things as an estate, trust, or corporation.
- Alimony is deductible for purposes of the alternative minimum tax, which is an alternate way of calculating the income tax owed by an individual, and which works to increase the amount of tax paid by a growing number of "middle-class" taxpayers.
- Alimony is deductible by the payor spouse, and included in the recipient spouse's gross income, only if the spouses do not file a joint return with each other. The payor or the recipient can, however, file joint returns with another spouse, for example, if someone has remarried.
Alimony or Separate Maintenance Payments Defined
To be treated as alimony or a separate maintenance payment, a payment must meet the following test:
- It must be in cash
- It must be received by or on behalf of a spouse
- It must be received under a divorce decree or separation agreement
- The divorce or separation instrument cannot designate the payment as something other than alimony
- If the spouses are legally separated under a decree of divorce or separate maintenance, they cannot be members of the same household at the time the payment is made
- The payments must stop when the recipient spouse dies, and
- The payment cannot be for child support
For purposes of this test, it does not matter if payments from one spouse to the other actually represent a division of marital property or property settlement or if the payments are actually used for spousal support. In addition, it is not necessary that payments be made under a pre-set schedule.
Example: As part of divorce negotiations, H and W agree that W will keep the family residence, but will be required to pay H $30,000 per year for eight years to buy out his interest in the house. If the parties structure the payments so that the payments stop when H dies, and so long as the other test requirements are met, the payments will be deductible by W and includible in H's gross income as alimony. It does not matter that the payments are intended by the parties as part of a property settlement.
Requirement of Cash Payment
To qualify as alimony or a separate maintenance, a payment must be in cash. Cash includes checks and money orders payable on demand. Transfers of property or services other than cash do not qualify.
The cash requirement is relatively straightforward and seldom litigated. A scenario where it comes into play at times is when the payee spouse resides rent-free or at a reduced rent in a residence owned by the payor spouse. In such circumstances, the payor cannot deduct as alimony the market rental value of the residence.
Requirement That Payment Be Received by or on Behalf of Spouse
The "on behalf of a spouse" language permits payments of cash that are made to a third party to qualify as alimony or separate maintenance, so long as the payments are made under the terms of the divorce decree or separation agreement, and assuming all other requirements are met. So, cash payments of things such as taxes, rent, and tuition can qualify as alimony if such payments are required by the decree.
However, any payments to maintain property owned by the payor spouse and used by the payee spouse do not qualify as made solely on behalf of the recipient spouse, and so the payments cannot be deducted in full as alimony, even if they are made according to the terms of a divorce decree. Such payments include things like mortgage payments, real estate taxes and insurance premiums. The deduction is limited to the extent that the payment is attributable to the payee spouse's legal interest in the property.
Example: What if the parties own a second residence and use it, in equal amounts of time, but the payor spouse pays all utilities throughout the year? Only one-half of the utility payments are deductible as alimony because only one-half actually benefits the recipient, non-paying spouse.
What if the payor spouse makes a payment to a third party at the written request, consent or ratification (agreement) the other spouse? The payment is deductible by the payor and is taxable to the payee so long as the written request, consent or ratification:
- States that the parties intend the payment to be treated as an alimony or maintenance, subject to the rules of IRC § 71, and
- It must be received by the payor spouse before the due date of the payor's tax return for the year in which the payment was made
Example:W asks H to pay $500 of his August alimony payment directly to her podiatrist. H can deduct this payment as alimony and W must include it as income, so long as the above requirements for the request are satisfied.
What if the payor spouse pays the premiums for whole or term life insurance on the other spouse's life? The payments qualify for the alimony deduction if they are made under the terms of a divorce decree or separation agreement or at the payee spouse's written request, but only to the extent that the payee spouse is the owner of the policy.