Divorce and Income Tax Consequences

The income tax issues of alimony, child support, and property settlements are generally straightforward but worth reminding.


Alimony

Properly structured, alimony payments are considered gross income to the recipient, and are deductible to the payor. To qualify as alimony, all of the following must occur:
  • The payment must be made in cash.
  • The payment must be made pursuant to a divorce or written separation agreement.
  • If divorced or legally separated, the couple must live in separate households.
  • Payments made on behalf of the recipient spouse to a third party must be evidenced by a timely executed document.
  • The payor’s obligation to make the payment terminates at the recipient’s death.
  • The couple does not file a joint tax return.
  • The divorce or separation agreement does not provide that the payments are not considered alimony.
Normally, the paying ex-spouse does not have to withhold taxes on alimony payments. It is the responsibility of the recipient ex-spouse to make sure sufficient taxes have been withheld or estimated taxes have been paid. If the recipient spouse is a nonresident alien, a withholding tax may be imposed on alimony payments.

While the alimony rules seem fairly straightforward, this is one area in which drafting documents without proper tax advice can have disturbing consequences. For example, in one Tax Court case, a taxpayer drafted his own settlement agreement. Because of improper language, the court ruled that $34,000 in “alimony” payments were instead a nondeductible property settlement. Not only did the husband lose a $34,000 deduction, the court also imposed an accuracy-related penalty.


Child Support

Payments designated as child support are not deductible by the payor or taxable to the recipient parent. A payment is deemed to be for child support if any one of the following occurs:
  • The divorce agreement designates it as child support.
  • The payment reduces at times tied to a child’s pivotal birthdays (e.g., age 18).
  • The payment reduces when an event occurs to the child (e.g., marriage).
  • The payment reduces at a time clearly associated with a child-related event.
An issue related to child support is deciding which parent receives the dependency exemption for the child. Assuming all of the dependency exemption requirements are met, the parents themselves can decide which parent is entitled to the exemption for a minor child. However, once the child reaches majority, the parent claiming the dependency exemption must supply over 50% of the child’s support.


Property Transfers

Most property transfers that are “incident to divorce” are not taxable to either spouse for income tax purposes. However, there are some situations in which income taxes may be imposed, including:
  • A stock redemption done as a result of a divorce.
  • A property settlement made with a nonresident alien.
  • A direct transfer of property to a divorcing spouse is not taxable even when the liabilities secured by the property exceed the transferor’s basis in the property. However, if the transfer of the same property is made to a trust for the benefit of the divorcing spouse, the difference between the secured liability and the basis in the property may be taxable to the transferor.
  • Accrued interest on Series E and EE U.S. Savings Bonds must be recognized by the transferor of the bonds.
  • Many divorcing spouses make settlement payments over a number of years. Any interest on an installment obligation will be taxable to the recipient spouse.