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.

Divorce and Transfer Tax Consequences

Some unique gift, estate, and generation-skipping transfer tax issues surround divorce or separation. The following issues should be taken into account.

Gift taxes

Property settlements must be reviewed in light of the possible imposition of a gift tax. The Internal Revenue Code provides for an unlimited marital deduction for transfers between spouses. However, transfers after divorce do not fall into this exception.

The tax laws do provide some gift tax protection for property settlements entered into after a divorce is finalized. For example, transfers for settlement of property rights or child support are exempt from gift tax if:

  • The parties enter into a written agreement. The agreement does not need to be approved by the court.
  • The transfers are payments of cash or property in settlement of spousal martial rights and a “reasonable allowance” of support rights of a minor child of the marriage.
  • The agreement must be entered into within a period beginning two years before the divorce and one year after the divorce. The agreement, but not the transfer of assets, must occur during this three-year period.

Also, the Supreme Court has ruled that divorce-related transfers founded on a court decree are involuntary and, therefore, are not voluntary taxable transfers for gift tax purposes. However, if the divorce decree merely declares the marriage terminated but does not approve the property transfer, the IRS could still argue that the transfer is a gift.

If the parties fail to enter into a written agreement, but make the transfers prior to a final decree of divorce becoming effective, the gift tax marital deduction may eliminate any gift tax on the transfer.

If a divorce agreement requires that one spouse fund the college education of the couple’s children, care should be taken to make sure the payments are made in a manner that does not produce a taxable gift. For example, instead of reimbursing an ex-spouse for the cost of tuition, the payment should be made directly to the institution, for which the tax code allows an unlimited gift tax exclusion for tuition only. Other payments for the child’s education may be covered by the $12,000 annual exclusion. As part of a divorce decree, the couple might also consider pre-funding college costs for children (especially younger children) by using Section 529 Plans. The rules permit donors to pre-pay up to five years of annual exclusion gifts to fund a Section 529 Plan.  

 

Estate Taxes

Divorce agreements often do not pay sufficient attention to the estate tax implications. The Internal Revenue Code provides for an unlimited marital deduction for death transfers to a spouse, but it does not provide any marital deduction for transfers to an ex-spouse. A liability accruing pursuant to a divorce settlement agreement is not necessarily a deductible debt of a decedent’s estate. It is important to make sure the divorce documents create an enforceable debt against the estate to generate an estate tax deduction, rather than a taxable transfer.

If the decedent’s obligations are based on a court decree,the post-death obligations would be deductible. However, if the court did not require the property transfers (e.g., transfers to support a step-child),the post-death transfers may not be deductible for estate tax purposes, unless they were entered into for “adequate and full consideration.”

Transfers satisfying the gift tax requirements listed above will be treated as an expense of the estate. Thus, if former spouses have a written agreement that satisfies the three-prong test, testamentary transfers to a former spouse pursuant to the agreement are treated as deductible claims against the estate.

 

Gift splitting

The law permits a spouse to elect to be treated as the donor of a gift, even when the other spouse is the sole transferor. In order for the “gift splitting” to apply, the donor must file a gift tax return, on which the spouse consents to the treatment of the gifts as made one-half by that spouse. The return must be filed by the donor spouse, even if a gift tax return was not otherwise required (e.g., when only annual exclusion gifts were made). Gift splitting for any year applies to all gifts and cannot be made on a gift-by-gift basis. If gift splitting is elected, the spouses have joint and several liability for any gift tax that may be due.

Because of this rule, consenting spouses should be very careful to assure that the value of the gifts are accurate.

If gift splitting was anticipated early in the year, divorce before year end will terminate the right to split gifts.


Using The Unified Credit

The unified credit should be viewed as an asset of a couple’s divorce estate when it comes to estate planning. For example, assume a wealthy wife agreed to or is required to make a significant property settlement for the benefit of a less wealthy second husband. She wants the funds to eventually revert to her children from a prior marriage. She could create a lifetime trust during the marriage for the benefit of the soon to be ex-spouse. Properly created, the trust would create no gift taxes. At the ex-husband’s death, his unified credit (which he might not otherwise have used in full) benefits her children by reducing the overall transfer taxes. A similar arrangement could be made through a generation-skipping trust and annual exclusion gifts using the couple’s combined generation-skipping and annual exclusion exemptions.

 

Divorce and Your Estate Plan

Dissolution of a marriage raises a number of complicated issues. There is more involved than obtaining a property settlement and divorce decree. The impact of a pending divorce on your estate plan should be considered as a part of the divorce process. The following issues relating to your estate plan should all be reviewed if you are separated from or divorcing your spouse.


Wills

You should discuss with your estate planner the possibility and benefit of executing a new will in contemplation of the divorce. Although Texas provides statutory rights to a surviving spouse, notwithstanding the terms of the decedent’s will, a new will can still provide for the maximum allowable benefits to go to your children or other heirs instead of to the other spouse. This may also be a time when it is particularly important to provide for a trust for your children’s inheritance.

Likewise, this is an important time to re-think the persons whom you have named as the executor of your estate and the trustee of any trusts you may have provided for in your will and change your will accordingly.  

Once divorced, Texas law provides that the divorce results in the ex-spouse being treated as a predeceased heir of the maker of the will. However, “updating” your will by means of relying on the inflexibility of statutory law is not generally the best solution. Therefore, if you did not execute a new will in contemplation of a divorce, then it is certainly advisable to do so once the divorce is final.

If a divorce or legal separation has occurred and results in financial obligations placed upon you, your will should reflect the terms of the agreement that must be carried out. Your new will should also be careful to provide that any bequests to an ex-spouse are in satisfaction of your legal obligations and are not meant to be in addition to those obligations. For example, assume the divorce decree provides that a payment of $100,000 be made to an ex-spouse in ten years. Your will says, “If my ex-spouse is alive in ten years, I convey to her $100,000.” As a result, the ex-spouse may receive a double benefit of both the bequest and divorce settlement rights.

 

Retirement Plans

You may also need to explore the possibility and benefit of executing new beneficiary designations for your retirement plans in contemplation of the divorce. Federal law generally provides that the retirement benefits of a qualified retirement plan must pass to the surviving spouse even if separated or if a divorce is pending, unless the spouse waives those rights. However, federal law does not require a spouse to be the designated beneficiary of an IRA.

Once divorced, Texas law provides that a designation made prior to divorce of the other spouse as a beneficiary under an individual retirement account, employee stock option plan, stock option, or other form of savings, bonus, profit-sharing, or other employer plan or financial plan of an employee or a participant in force at the time of divorce, the designating provision in the plan in favor of the former spouse is not effective, and the proceeds of the policy are payable to the named alternate beneficiary, unless:

  1. the decree designates the other former spouse as the beneficiary;
  2. the designating former spouse re-designates the other former spouse as the beneficiary after rendition of the decree; or
  3. the other former spouse is designated to receive the proceeds or benefits in trust for, on behalf of, or for the benefit of a child or dependent of either former spouse.

 

Life Insurance

You should discuss with your estate planner the possibility and benefit of executing new beneficiary designations for your life insurance in contemplation of the divorce. Although Texas law provides that a designation of an ex-spouse as beneficiary becomes void upon divorce, if your spouse is the named beneficiary and you are merely separated or if a divorce is pending at the time of your death, the beneficiary-spouse will receive the life insurance benefits.

Similar to retirement plans, Texas law provides that a designation made prior to divorce of the insured’s spouse as a beneficiary of a life insurance policy is not effective, and the proceeds of the policy are payable to the named alternate beneficiary, unless the decree designates the insured’s former spouse as the beneficiary; the insured re-designates the former spouse as the beneficiary after rendition of the decree; or the former spouse is designated to receive the proceeds in trust for, on behalf of, or for the benefit of a child or a dependent of either former spouse.

 If a divorce has occurred and results in your obligation to name a certain person as the beneficiary of a life insurance policy, you should execute a new beneficiary designation form to reflect the terms of the agreement to be carried out.

 

Other Beneficiary Designations

Don’t forget to review your annuities, bank accounts, brokerage accounts, and any other assets that may have a beneficiary designation. However, in certain circumstances Texas law requires notice be given to the other spouse or may require both spouses to sign the beneficiary change form.

 

Powers of Attorney

Many couples have executed powers of attorney naming each other to provide for the handling of medical and property issues in the event of incapacity. In many cases, estranged spouses do not focus on revising these important documents during or after divorce. In Texas, divorce terminates the powers granted to a former spouse under a durable power of attorney, but it does not do so until the divorce is granted. Having a soon-to-be ex-spouse in charge of medical and property decisions is usually not advisable. Therefore, you should consider changing your powers of attorney on the first hint of divorce. Alternatively, your documents can provide that if divorce or legal separation proceedings are initiated, the spouse’s right to serve as power holder immediately terminates and the next named successor is automatically appointed.

 

Your Parents’ Estate Plan

If you are separated from or divorcing your spouse, your parents may need to review their own estate plans as well. For example, your parents’ wills may provide gifts or other benefits for your spouse or may name your spouse as an executor or trustee. Your parents’ powers of attorney may also name your spouse as an agent to make medical and property decisions.  Though Texas laws may automatically “revise” your documents to read as though your ex-spouse predeceased you, they do not revise your parents’ documents.

A key element to planning for the potential divorce of a child or heir is flexible drafting. Every plan needs to address the possibility that a child or an heir will face a future divorce. The use of spendthrift trusts for the intended beneficiaries is oftentimes a good solution. Basically a spendthrift trust is any trust that restricts the ability of any trust beneficiary to assign or otherwise transfer his or her interest in the trust. It also restricts the right of a beneficiary’s creditors (which may include an ex-spouse) to demand payment of income or principal to satisfy the beneficiary’s obligations.