by Milandria King, LL.M of Cordell & Cordell, PC
TIP #4: Avoid the Child Support Issue of I.R.C. Section 71
Section 71 of the tax code provides that no portion of a maintenance payment can be fixed as child support. The definition of the word “fix” means that a reader would be able to precisely determine what portion of the payment constitutes alimony and which part of the payment may be labeled as child support. There need not be reference to a certain dollar amount in the document for a payment to be fixed as child support. See Sperling v. Commissioner, 726 F.2d 948 (2nd Cir. 1984).
The Internal Revenue Service recognizes that the laws of most states allow for payments that are a combination of maintenance and child support. In some jurisdictions, these payments are labeled as family support. With the introduction of child support percentages in some jurisdictions, over the years practitioners have heard frequent rumblings from the IRS as to whether these percentages would be imputed in the family support payments, making such portion of the payment nondeductible, as that portion is for child support. If the instrument does not specifically provide a mechanism for determining what portion of each payment is actually child support, the entire payment will be treated as alimony. See Neu-Karemer v. Commissioner, 52 T.C.M. (CCH) 363 (1986).
No portion of the payment may be identified as “child support” for purposes of this provision. However, even if the instrument does not identify a portion as child support, if it does require that the payment is to be reduced upon an event related to a child (i.e., death of the child, marriage of the child, child leaving school, child attaining a specific age, etc.) or at a time that could be associated with such contingency, the IRS will treat that payment as child support. This treatment dictates that the payment will not qualify as alimony and will not be deductible to the payor. This provision presents a unique challenge when interpreting family support agreements and parenting plans that provide for automatic step downs and departures as each child reaches the age of majority.
There exist two situations in which the reduction of payments will be presumed to be associated with events relating to a child even when the payments would otherwise qualify as alimony and the instrument does not expressly provide for a reduction in the payment contingent upon an event related to a child. A brief description of those situations follows:
(1) The payments shall not be reduced more than six months before or after a child is to attain the age of 18, 21 or the jurisdictional age of majority.
(2) The payments are reduced on two or more instances that occur not more than one year before or one year after a different child of the payor spouse attains a certain age between the ages of eighteen and twenty four. See I.R.C. Treasury Regulation 1.71-1T with supporting examples.
TIP #5: Avoid the Recapture Rules of I.R.C. Section 71
The recapture rules in section 71 were drafted to discourage front-end loading and, thus, discourage camouflaging property divisions as deductible alimony payments. The recapture rules should be avoided unless you are utilizing the services of a strategic tax planner to assist in properly navigating this section.
The 1986 recapture rules apply to instruments executed after December 31, 1986, and provide for (1) a three-year look back, (2) recapture occurs only in the third year, and (3) the reduction cushion is $15,000. In year three, recapture occurs if: (1) alimony paid in year two exceeds payments in year three by more than $15,000 or (2) alimony remitted in year one exceeds the average annual alimony paid in years two and three by more than $15,000. In these scenarios, the excess will be recaptured.
As with most tax provisions, there are exceptions to this rule. For instance, when the payment ceases upon the death of either spouse, remarriage of the payee spouse, or when the payments begin to fluctuate and are not within the control of the payor spouse, the rules will not apply.
TIP #6: Tax Free Transfers of Property Between Spouses
Property transfers between spouses are governed by I.R.C. section 1041. The general rule is that no gain or loss is recognized on a transfer of property from an individual to a spouse or former spouse; however, in the case of a former spouse, no gain or loss is recognized only if the transfer is incident to a divorce. A transfer of property may be classified as incident to a divorce if the transfer (1) occurs within one year after the date on which the marriage is dissolved or (2) is related to the cessation of the marital relationship. Internal Revenue Code regulations provide that transfers related to the cessation of marriage must be pursuant to the divorce or separation instrument (including modifications) and must occur within six years of the date the marriage ends.
Transfers of property prior to marriage are not addressed by section 1041. Further, premarital transfers of property pursuant to the terms of a prenuptial agreement will result in the recognition of gain or loss.
The transfer or sale of the marital home, however, requires special considerations. The parties may save significant taxes and benefits simply based on the timing of the sale. Several sections of the tax code address deferment of recognition if the proceeds are reinvested in a new residence within two years. Other provisions cover the exclusion of gain under I.R.C. section 121. For more information on these and other tax tips, consult with the many articles addressing this subject and enlist the advice of a tax attorney or accountant familiar with these provisions.
Milandria King is a Senior Attorney in the Memphis, Tennessee office for Cordell & Cordell, P.C., admitted to practice law in the state of Tennessee. Additionally, Ms. King is admitted to practice before the Sixth Circuit Court of Appeals and before the United States District Court for the Western District of Tennessee. Her memberships include the American Bar Association, the Memphis Bar Association, the Tennessee Bar Association, as well as the Association for Women Attorneys.