It’s not enough to simply give money to your ex-spouse to qualify for an alimony deduction. The payment must be part of a legally valid divorce or separation agreement, according to a recent US Tax Court case.
In Mudrich v. Commissioner, TC Memo 2017-101, Paul Mudrich learned this lesson the hard way after he agreed to split a bonus with his soon-to-be ex-wife.
Although many property settlements are a wash for tax purposes, alimony is deductible by the payor and taxable to the recipient. Conversely, child support payments are not. To qualify for a deduction, alimony must meet the following requirements:
- The payment must be made under a “divorce or separation instrument.”
- The instrument can’t specify terms that the payment is nondeductible and nontaxable.
- The parties can’t be living in the same household when the payment is made.
- The payor’s obligation to make the payment must end at the death of the recipient.
In this new case, Mudrich, an attorney, earned a $250,000 bonus in 2006 while married to his wife, Lauri. After tax withholding, Paul received more than $155,000. He filed for divorce from his wife in January 2007.
Prior to the divorce being finalized, Paul paid nearly half of the bonus to Lauri on May 18, 2007. On May 21, 2007, Lauri signed an agreement providing that the bonus was community property, that Paul would pay her one-half of the bonus net of withholding, and that he would report the entire bonus on his tax return. This agreement was signed on June 18, 2007.
The couple’s marriage was terminated on Aug. 8, 2007. A spousal support order required Paul to pay Lauri $3,270 per month in temporary support, plus 31.3 percent of any income he earned in excess of $12,500 per month. The support order didn’t mention the bonus payment.
On an amended joint 2007 return filed with his new spouse, Paul claimed a $127,000 alimony deduction representing the bonus payment, seven monthly temporary support payments, and a remaining amount that he subsequently conceded wasn’t alimony. The IRS challenged the alimony deduction for the bonus.
The Tax Court found that because the bonus agreement was not a divorce or separation instrument, the payment to Lauri pursuant to the bonus agreement was not alimony. There was no evidence that the bonus agreement ever became an order in the divorce proceeding, nor was it a written separation agreement.
A written separation agreement must be a clear, written statement memorializing the support terms between the parties and entered into in contemplation of separation.
What makes this tax outcome especially hard for Paul to take is that he could have preserved an alimony deduction by incorporating the allocation of the bonus in his divorce agreement.
This was one attorney who needed some timely tax advice.