By Jennifer M. Paine
This rule forces the alimony payer to report as income the alimony payments he previously deducted, which means the payee spouse is entitled to reduce from income the alimony payments previously received.
So how do you avoid the recapture rule and the subsequent tax nightmare? Discuss these five tips with your attorney and your CPA:
1. No Front Loading
Front loading refers to paying a large amount of alimony in the first few years of your support obligation, maybe while you feel like you have the money and/or when your children are minors and you want to pay family support.
The problem with front loading is if you reduce the payment substantially in the second year, you trigger recapture. If you do not, but then in the third year the payment is as little as $15,000 less than the second, you also trigger recapture.
Instead, consider extending the front loaded payments over more than three years or transferring an asset or assuming a debt in lieu of front loading the payments altogether.
2. Section 71 Payments
You could skip the deductibility problem altogether by making payments under IRC 71, referred to as “section 71 payments.” Under this rule, you are entitled to make a series of payments to your ex without tax consequence. The downside is the payments are not tax deductible to you.
3. Tied to Variable Uncontrolled Income
If your income is variable, and those variables are not within your control, then clearly state so in your divorce decree, and be prepared to provide proof to the IRS if an audit comes your way.
In your divorce decree, consider stating why your income varies, what factors cause your income to vary, that both you and your ex understand that your income varies and why, and that your ex will confirm the same to the IRS.
This will keep your ex from disagreeing with you – in an effort to deduct the alimony she previously reported as income – in the future if you are faced with an audit.
4. Longer Schedule
Extend your payments over more than three years, and be sure the amounts you are ordered to pay, and ideally do pay, do not decrease substantially from the first year to the second year and the third year or by more than $15,000 in the third year from the second year.
5. Increasing Schedule
Rather than decease your payments over time, consider increasing them. This may make sense, for example, as your ex approaches retirement age, provided you are financially able to make the payments.
Be cautious, however, of linking the increase to a loss of child support for your children. The IRS can decide that your “alimony” payments were actually child support because the amount you pay changed when your child support obligation changed. If so, then you will have to report that “child support” as recaptured income, too.
Remember, you should always talk to your divorce attorney and your CPA about the best alimony, child support, and tax planning strategy for your case.
If you do not have this conversation early and often, you may find yourself, three years after your divorce, recapturing all of those payments you deducted and hating the fact of paying alimony even more than you already had.
Note: Nothing in this article should be construed as recommending a particular course of action intended to avoid paying taxes.
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Jennifer M. Paine is a Michigan Divorce Lawyer with Cordell & Cordell. She is licensed to practice in Michigan, and has been admitted pro hac vice in Illinois, Ohio, and the United States Court of Federal Claims.
Ms. Paine received her BA in English and Mathematics from Albion College and graduated Summa Cum Laude. She received her Juris Doctorate from MSU College of Law and graduated Summa Cum Laude.