It seems like there are tax ramifications to practically everything. It is very rare to find a transaction where the Federal government leaves you alone—and says something is neither a gain nor a loss. That said, in some areas the IRS is somewhat charitable to divorcing spouses and in others they are the heartless brutes that you would expect them to be.
The Internal Revenue Code provision 26 USC § 1041 (A.K.A IRC 1041), states in pertinent part, “No gain or loss shall be recognized on a transfer of property from an individual to…a former spouse, but only if the transfer is incident to the divorce.” Great. You get divorced and when you receive your portion of community property, that transfer is not taxable. To anyone. At all. That’s great unless you are domestic partners. Then, even though as domestic partners you have community property, distributions of assets after terminating the partnership are taxable because you are not spouses under § 1041. DOMA hurts.
Spousal support is deductible for the payor and gross income (taxable) for the payee. See 26 USC § 71. Some families in which the payee is not employed and the payor is a high income earner may benefit from “Family Support,” where support is designated differently and the tax ramifications are reversed. However, family support is complicated, requires the agreement of both parties, and is rarely worth delving into instead of spousal support. Also, any amount claimed on taxes as spousal support may be re-characterized by the IRS if they believe there is hidden child support.
Child support, like a property transfer, is totally tax-neutral. No gain is attributed to the payee and no deduction is attributed to the payor. It is like nothing happened. See §71(c)(2).
Now, this is a bit complicated and more of a note for CPA’s and those attempting to draft their own marital settlement agreement, but the IRS can re-characterize spousal support payments under a rule called “front-loading recapturing” which is described in 26 USC § 71(f). If the amount of spousal support paid in years 1, 2, and 3 following a divorce are all within $15,000 of each other, there will be no recapture. If year three amounts paid are more than $15,000 lower than years one or two, the IRS can find that there was front-loading. Front-loading means that there was an attempt to disguise a property transfer as a deductible spousal support payment. So, that amount was taxed as a Payor deduction and a payee inclusion, but that portion was really a lump payment of property. So at year three, the recaptured portion becomes a Payor inclusion and a Payee deduction—having tax consequence to both parties. The lesson with front-load recapturing is that if you write your own settlement agreement or are trying to get really creative with support deductions—you need to do some research to make sure you aren’t shooting yourself in the foot.
Alimony trusts are ridiculous and infrequently used, but here are the basics. An alimony trust is when property is transferred to a former spouse as a source of support following a divorce or separation. The payor spouse transfers investments and other assets that generate income into an alimony trust for the recipient spouse or beneficiary. It should only be used when a paying party has the financial ability (big pockets) to set up a significant trust account and there is some concern about the paying party’s ability to keep paying. For instance if the paying party is elderly, terminally ill, has a high risk of insolvency, or has financial resources but takes high risks (think Donald Trump) it might be a good idea. The tax consequences follow, but you can see Alimony Trusts have the ability to make spousal support a tax neutral event, while characterizing child support as gross income for the beneficiary (payee). 26 USC § 682.
Alimony Trust Tax Consequences:
- Alimony Trust as Spousal Support:
- No deduction
- Payee not taxed on income.
- Alimony Trust as Child Support
- Payor: No tax consequence;
- Trustee: Amount is deductible expense; and
- Beneficiary: Amount counts as gross income.
For a discussion of other issues including the loss of exemptions and capital gains rates on the family home see my previous post here.