Alimony Recapture

alimony

What is Alimony Recapture?

Alimony Recapture is an effort by the IRS to block the disguise of a property settlement in divorce as tax deductible alimony.

Internal Revenue Code requires recapture of deductions taken for alimony payments into the income of the payer spouse if alimony decreases too fast in the first three calendar years of permanent support. The amount to be recaptured is determined by recomputation of the payer’s tax deductible payments.

  • Recomputation occurs once in the third post separation year.
  • The recaptured amount is includable in the income of the payer spouse in the third post separation year and the same amount is an above the line deduction to the recipient spouse in the same year.
  • The amount that must be recaptured in the third post-separation year is the sum of the excess payments made in the first post-separation year plus the excess payments made in the second post-separation year.

Exceptions

Alimony Recapture DOES NOT APPLY where:

  1. The payments fluctuate outside of the payer’s control because of a continuing liability to pay a fixed percentage of income from the earnings of a business or property or from compensation from employment or self-employment.
  2. The alimony payments terminate due to death of either party or remarriage of the recipient before the end of the third post-separation year
  3.  Payments are pursuant to a temporary order.

If alimony or separate maintenance payments decline or cease during a post-separation year for any reason other than one contemplated by these exceptions (including a failure by the payer to make timely payments, a modification of the divorce or separation instrument, a reduction in the support needs of the payee, or a reduction in the ability of the payer to provide support), excess amounts will be subject to recapture.

AS A GENERAL RULE OF THUMB, FRONT-LOADING CAN BE AVOIDED IF, WITHIN THE FIRST THREE CALENDAR YEARS AFTER THE DIVORCE, THERE IS NO MORE THAN A $15,000 VARIATION IN ALIMONY FROM YEAR TO YEAR.            

Sound complicated? It is. Get an expert to help you avoid costly errors and don’t assume your attorney is looking out for this kind of financial blunder. 

Family Support Risks and Rewards

family support

What is Family Support?

Family Support is the common term for what courts refer to as “unallocated alimony and child support” and a tool for maximizing the after tax cash flow for both households after divorce.

In cases where the divorcing parties have minor children and disparities in their incomes it is likely a judge will order alimony and child support as two separate payments in two separate amounts with different duration.

  • Alimony (spousal support) is intended to provide for continuation of the lower earning party’s standard of living and training if necessary to reenter the work force. Alimony can last for a number of years or a lifetime depending on the circumstances and the jurisdiction where the divorce is being completed. Alimony is taxable to the recipient and tax deductible for the payer.
  • Child support is intended to provide for basic needs of minor children from the marriage and ensure they have a similar standard of living in both new households. Child Support usually ends when the minor child turns 18 years old or graduates from high school, whichever comes last. Child support carries no tax liability for the recipient and is not deductible to the payer.

In some cases it makes sense financially to play with the allocation between these two payment amounts in order to provide the best bang for the buck and maximum cash flow to the newly formed separate households. Family Support can be a powerful tool for maximizing the after cash flow for both households but it comes with complications.

First an example using a single income household then we will talk about the risks and rewards:

Meet Sue and Dave

 

Facts

  • live in California
  • have been married for 17 years,
  • have two minor children aged 10 and 13
  • Dave makes $360,000 per year
  • Sue has been a full time mother and homemaker since the birth of their oldest child and has no earned income
  • Child sharing agreements have been reached with Sue remaining the main caregiver with 60% and Dave with 40% time share

Traditional Results

  • Child support is determined to be $3,983 per month
  • Spousal Support (alimony) is determined to be $5,845 per month
  • Sue’s Net (after tax) Disposable Income = $9,375
  • Dave’s Net (after tax) Disposable Income = $10,743
  • Total Net (after tax) Disposable Income = $20,118

Family Support Results

  • Child Support is set at $0 per month
  • Family Support is determined to be $12,527 per month
  • Sue’s Net (after tax) Disposable Income = $9,600 (+$225 per month)
  • Dave’s Net (after tax) Disposable Income = $11,000 (+$257 per month)
  • Total Net (after tax) Disposable Income = $20,600 (+$482 per month)

Rewards

  • If used appropriately Family Support allows the parties to achieve a higher net transfer of cash flow from the payer to the recipient by moving the income from the payer’s high income tax bracket to the recipient’s lower bracket.
  • The payer, Dave, simply has a larger tax deductible payment which increases his after tax funds available to pay support. Sue pays taxes on the family support in her bracket at a lower rate. The net benefit to the family cash flow is $482 per month, $5,784 per year or $57,840 over ten years.
  • The benefit of the cash flow increase is shared almost equally between the parties. $225 per month to Sue and $257 per month to Dave.

Risks and Complications

  • Family Support is typically a temporary agreement used to help maximize cash flow during the months or years divorce negotiations are pending and can help facilitate economic transition into two separate households. Opinions are mixed on how the IRS or state taxing authorities would look at longer term payments characterized this way and if they may try to “recapture” a portion of the tax deduction taken by the payer.
  • Click here for information from the State of California taxing authority which does recognize Family Support as fully tax deductible.
  • At least one federal court has invalidated a family support order in terms of deductibility to the payer (Wells v. Commissioner)
    • In order for family support to be deductible at the federal level it cannot be disguised child support so cessation of payments should not be contingent on child related events such as attaining the age of 18. Notice the example of Dave and Sue uses a ten year duration for payments for that exact reason.
    • The payments must also terminate upon the death of the recipient. This is a requirement for any alimony payment to be deductible.
    • With careful drafting by an experienced attorney we think Family Support can pass muster for long-term deductibility.
  • Both parties must fully understand the tax consequences before agreeing to Family Support. Sue will now have to make large estimated tax payments or face penalties and interest on unpaid taxes.
  • Courts do not typically order Family Support because the law requires them to maintain jurisdiction over child support as a matter of public policy.
  • Even if Sue and Dave chose to write Family Support into their agreement, either party could walk into court a week later, ask the judge for child support and expect to be granted the guideline amount effectively terminating their original agreement and potentially triggering tax trouble.

Help is out there.

Be sure to consult your Wellspring Divorce, tax and legal advisers about the risks of Family Support and applicability to your personal situation and stay out of the court system because a judge will never order Family Support for longer periods. Amounts and duration used in the hypothetical are not meant as advice or opinion for what you should expect in similar circumstances.

Spousal Support IS Modifiable

spousal support

Can Spousal Support be Changed?

YES! The amount and duration of Spousal Support may be modifiable. You can go to court and ask the judge to increase, decrease, or stop spousal support any time during the period when court has jurisdiction unless you agree otherwise in your settlement.

In most states the court will retain jurisdiction over spousal support for different periods of time based on factors in the case. The main factors include:

  • Length of marriage
  • Age of the parties
  • Each party’s ability to support themselves by earning a living and or living off of the assets they own after the divorce.

Here’s an example.

A couple in their mid 50’s who has been married for 25 years with one party having been a full time parent would likely see the court retain jurisdiction over modification of spousal support forever in California. The length of marriage and ages of the parties would likely classify the example as a long-term marriage.

The working and paying spouse would be allowed to retire at normal retirement age, 65 or 67 depending on who you ask, at which point the amount of support could be modified to reflect the decreased income of the payer. If the payer continues to work past their normal retirement age they may be required to continue paying support at the same level. This has become more common as many baby boomers work past normal retirement age. Laws vary from state to state so be sure to consult experts in your home state.

During the court’s jurisdiction either party may petition the court for a modification based on a change of circumstances. A change of circumstances may include:

  • job loss by no fault of the worker
  • disability
  • decrease in earnings of a small business owner due to economic circumstances
  • retirement at an appropriate retirement age
  • many other factors.

What other life changes apply?

It can also go the other direction where a payer has a large increase in income, a one time financial windfall through bonus or stock compensation. In this case the payee could seek to modify the support amount upwards. We often work with the payee spouse to determine whether they should seek an upwards modification of support. In order to do so we may ask for the payer to provide annual income disclosures so we can be aware of any factors suggesting an upwards modification may be appropriate.

In some cases it makes sense for the parties to agree to a non-modifiable spousal support order. This so called non-modifiable spousal support can stipulate duration of the payment and or dollar amount or both. Non-modifiable spousal support comes with risks and rewards for both the payer and the recipient but can make sense for both parties in the right circumstances.

Some cases build modifications into the original agreement corresponding with the recipient reentering the work force or some change in financial circumstances in the future. These are often called step down orders.

 

Spousal Support After Remarriage

Spousal Support

Will I receive spousal support after remarriage?

It may depend on who is getting remarried. The payer or the recipient?

The remarriage of the payer has no affect on spousal support orders. Most divorce settlements do terminate spousal support after remarriage of the recipient. This is not a legal requirement just an assumption made in most cases and the family law code of many states. Some states even see co-habitation with a member of the opposite sex as grounds for modification of spousal support.

Get the facts.

Make sure you understand the financial ramifications of your new romantic interest before you dive into a new marriage. It is not abnormal for recipients of spousal support to postpone remarriage in order to maintain their spousal support payments. If you are still negotiating your divorce settlement but have designs on getting remarried soon here are some thoughts.

How Wellspring Divorce Advisors can help.

We have helped clients negotiate settlements to continue spousal support after remarriage of the recipient. Circumstances of the family financial picture or the health of the recipient party may support such a settlement. Like any negotiation each possible outcome comes with risks, rewards, costs and benefits. Wellspring Divorce Advisors can help you understand each angle and see if your circumstances may warrant continuing spousal support after remarriage.

Here are some examples of settlements we have helped craft.

1.The recipient party is permanently disabled and unable to earn a living for themselves.

In this case the recipient’s remarriage may have no effect on their financial circumstances due to their need for constant medical care. It may also be the payer simply wants to be sure their former spouse can live in comfort regardless of their circumstances and wishes to provide the minimum necessary to support medical expenses even after the recipient’s remarriage.

2. A non-modifiable order has been negotiated based upon other financial factors in the case.

Non-modifiable spousal support orders will include either a specified duration or dollar amount for the support payments regardless of other circumstances. For example if you negotiate a non-modifiable support duration of 10 years and get remarried in year 5 the spousal support would continue after the recipient’s marriage.

3. Some parties negotiate spousal support by agreeing to a total amount to be paid over the life of the order then work backward to determine the amount and duration.

In other words $1,000,000 over ten years which results in $8,333 per month for the life of the payment. Usually these types of settlements assume the continuance of spousal support after remarriage of the recipient in order to complete the full payment of the agreed upon $1,000,000.

 

If you are the payer the IRS makes one important distinction with regards to the termination of spousal support. Spousal support, alimony in their language, must terminate upon the death of the recipient for it to be tax deductible to the payer. They do not, to our knowledge, consider remarriage of the recipient to jeopardize the deductibility of the spousal support payments.

Social Security Statement in Divorce Financial Planning?

Social Security

An individual’s Social Security Statement can be a valuable resource in your divorce financial planning. Make sure to gather copies of the most recent statements available and we can help you uncover a wealth of financial knowledge.

1. Earnings and employment history.

The Social Security Statement is a great place to look for historical employment earnings. It is valuable to understand the earnings history and trajectory of both parties in a divorce. If tax returns and other documentation are being with-held by your spouse the Social Security statement can provide a valuable baseline.

2. Estimated retirement and disability benefits for long term, post divorce financial planning purposes.

Understanding the long term cash flow is very important when negotiating a financial settlement. Having details of the Social Security administration’s estimated benefits can help me understand your future cash flow and plan more effectively for the future.

3. If there is a public pension.

A worker who participates in California State Teacher’s Retirement System (STRS), California Public Employees Retirement System (PERS) and many other governmental retirement systems may not have paid into the Social Security system. Some may pay into Medicare but not Social Security. You can see this if the worker’s statement has wages in the Medicare taxed earnings column but not the Social Security column. Using the Social Security statement we can uncover the existence of a previously undisclosed pension.

4. Derivative benefits available to a former spouse.

In a marriage over ten years you can receive derivative benefits on the record of your former spouse. The derivative benefit is equal to one half of the former spouse’s benefit which can be found on their annual statement. This is useful for long term planning and can be important in long term spousal support negotiations.

5. Social Security and Medicare tax details.

We often need to estimate incomes for negotiation purposes. A common mistake occurs when the 6.2% Social Security tax is applied to the worker’s entire income. Instead the tax should be applied up to the maximum wage base for Social Security taxes. If you apply the tax to $300,000 of income the net, after tax income will be understated by over $10,000 per year.

6. Possible application of Government Pension Offset Provision (GPO) or Windfall Elimination Provision (WEP).

Those workers mentioned in #3 above may find themselves subject to the GPO or WEP and end up receiving less benefits than they expected if not careful. It is always important to understand how these government provisions affect an individual in divorce. The Social Security Statement even talks about them in the bottom right hand corner of page 2 in it’s current lay-out.

7. Existence of tax deferral vehicles such as deferred compensation plans and retirement accounts.

If the numbers reported under Medicare wages don’t match those reported in the Social Security earnings column there may be tax deferral vehicles like deferred compensation plans that are being used. The worker may also have simply hit the wage base maximum after which Social Security taxes are no longer incurred but Medicare taxes are.

8. Misreported income.

In California an individual involved in divorce proceedings must file a declaration of disclosure detailing their income and expenses and sign it for accuracy under penalty of perjury. This doesn’t keep people from reporting incorrect figures. If the Social Security Statement doesn’t match what is reported on the declaration there better be an explanation.

The Social Security Administration is provides an online version of taxpayers’ statements. The online version is now available at www.socialsecurity.gov/mystatement.

Your Wellspring Divorce advisor can uncover a lot from simple and easily available documentation. Imagine what we can find with a complete and accurate set of financial documents.