The Spousal Maintenance Arrearages Quagmire: Yet Another Problem to Consider
Occasionally, a client is unable to pay his or her spousal maintenance obligation. This causes several tax problems, especially if the payor is receiving a tax deduction for the spousal maintenance payments, which is typically the case. If the payor takes care of the arrearage with one large payment, the recipient is likely to end up with bunched income — and a higher tax bill. The payor, on the other hand, may have a tax deduction for the overdue payment that provides a smaller-than-expected tax benefit. Alimony recapture issues can also affect the payor in this circumstance.
The ruling in a recent Tax Court case raises yet another potential tax problem to consider: If the payor is behind on spousal maintenance payments, he or she could risk losing the tax deduction altogether.
In the Iglicki case, T.C. Memo 2015-80, the ex-wife obtained a judgment against her ex-husband for a spousal maintenance arrearage. Under governing Colorado law, the judgment against the ex-husband related to the arrearage was payable in all events, even if the ex-wife died. This proved to be fatal to the tax deduction when the judgment was paid. One of the requirements for spousal maintenance to be deductible is that it must terminate upon the death of the recipient.
The Tax Court explained:
Under Colorado law liability for payment of a final money judgment is not affected by the death of either the payor or the payee. Therefore, the spousal maintenance payments fail to qualify as alimony under section 71(b)(1)(D) and petitioners are not entitled to an alimony deduction under section 215(a) for the payments.
To add insult to injury, the Tax Court assessed a 20 percent accuracy-related penalty against the ex-husband.
An obvious solution to the problem raised by this case is to negotiate a settlement, so that a court does not enter a judgment against the delinquent party. If the recipient spouse does desire a judgment against the delinquent party, it should contain language indicating that the judgment lapses upon the death of the recipient.
Another solution to the problem is to make the payment of the arrearage non-deductible to the payor and non-taxable to the recipient.
Under the tax code, both parties may designate payments otherwise qualifying as alimony or separate maintenance payments as nondeductible by the payor, and as excludible from gross income by the payee. Accomplishing this, however, requires proper planning—the designation must be stated in the divorce or separation instrument governing the arrearage payment. The payment amount should be adjusted (i.e., reduced) to reflect the fact that it will not be taxable to the recipient or deductible by the payor. This solution eliminates the bunching-of-income problem and permits the payment to be made after the recipient’s death. The value of the tax deduction to the payor and the tax to the payee has already been taken into account, eliminating any Iglicki-type surprises.
If your client is in an arrearage situation, remember to seek the counsel of a good divorce taxation specialist to help you navigate the situation and determine the best option.
If you have questions or would like to discuss this topic further, please don’t hesitate contact a member of our Business Valuation and Litigation Support Team.