By Donald Paris, CPA, MST, CDFA
So, you have finally reached agreement and now have agreed that alimony will be paid. Your attorney prepares your Property Settlement and Separation Agreement, which included the provision for this alimony. The Agreement had all the bells and whistles so that the alimony would be deductible on the wife’s tax return and included as income on the husband’s tax return.
You think about it a little more, and still not totally happy with this, you don’t sign the Agreement. Instead, you pay the alimony amount you feel is right.
Your spouse, not being happy with your decision to pay this amount, takes you to court in the hopes that a judge will make you pay the amount you verbally agreed on. And, guess what? You lose.
While all of this was happening, you prepared and filed your tax returns, claiming the amount you paid as alimony. And, just like the rest of your luck, you are audited for this alimony for one simple reason, i.e. the amount you paid and deducted did not match the income shown on your spouse’s tax return. And, just like a friend of mine says “If I didn’t have bad luck, I wouldn’t have any luck at all”. IRS disallows the deduction and you now have to pay the tax and penalties and interest.
Fair? Maybe not. But, the IRS was right. The alimony was not deductible since it did not comply with the Internal Revenue Code.
Take a look at the 2015 decision of the Tax Court in Milbourn, TC Memo 2015-13. The draft Agreement in that case called for alimony of $6,000 per month, but the taxpayer wanted it to be $2,500. Because of this disagreement, no one signed the Agreement. Two years later, the final divorce decree was issued. It ordered the husband to pay his ex-wife $4,500 per month in alimony, with payments received treated as earnings in accord with federal and state law. Both parties signed the final Agreement.
The taxpayer argued with the IRS that the payments made prior to the final Agreement were pursuant to the draft Agreement. The IRS argued that the payments did not meet the Code’s definition of alimony because there was no divorce or separation agreement at the time that the earlier set of payments were made.
The Tax Court acknowledged that there was no signed Agreement or divorce decree during the time that the earlier payments were made. Therefore, though payments were made, they were not the result of an Agreement, written or otherwise. Though there was an Agreement, since it was never signed, there was not even a meeting of the minds between the parties.
Let’s take a quick look at Regulation 1.71-1 Alimony and separate maintenance payments, income to wife or former wife. Specifically, 1.71-1(b)(2) deals with Written separation agreement. It says “Where the husband and wife are separated and living apart and do not file a joint income tax return for the taxable year, paragraph (2) of section 71(a) requires the inclusion of gross income of the wife of periodic payments (whether or not made at regular intervals) received by her pursuant to a written separation agreement executed after August 16, 1954. The periodic payments must be made under the terms of the written separation agreement after its execution and because of the marital or family relationship.”
So, what can we learn from this Tax Court decision? Simple, if you do not have a signed written agreement to pay a certain alimony, you can’t deduct any payment that you make. You can only deduct the payments you make after the agreement is signed. And, if for a moment you think the IRS won’t know the difference, do not forget that when you file your tax return claiming the alimony deduction, you state the name and social security number of the person you paid. So, the amount shown as a deduction on your tax return better match the income shown on your spouse’s return. If it doesn’t, the IRS will ask about it.