Taxation of Alimony – Part 3

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Alimony, also known as Spousal Support in California, is GENERALLY deductible to the payor and taxable income to the payee. I highlighted the word generally because the mere use of the term Alimony or Spousal Support in a settlement agreement does not affect the tax consequences of payments. Internal Revenue Code Section 71 contains eight requirements that must be met for a payment to be considered taxable to the recipient and tax deductible to the payor. I will review all eight in the coming weeks.

 

REQUIREMENT # 3 – PAYMENTS MUST BE MADE PURSUANT TO A DIVORCE OR SEPARATION INSTRUMENT

I.R.C. § 71(b)(1) provides that the “term alimony or separate maintenance payment” means any payment in cash if such payment is received by (or on behalf of) a spouse under a divorce or separation instrument.

I.R.C. § 71(b)(2) provides that the term “divorce or separation instrument” means —

(A) a decree of divorce or separate maintenance or a written instrument incident to such a decree,

(B) a written separation agreement, or

(C) a decree (not described in subparagraph (A)) requiring a spouse to make payments for the support or maintenance of the other spouse.

“While the instrument does not have to be part of the divorce decree itself, some written agreement must exist that creates a legally enforceable right to the support payments.” Anderson v. Commissioner, T.C. Memo 1999-53 (1999) (citing Prince v. Commissioner, 66 T.C. 1058, 1066-1067, 1976 WL 3686 (1976).

 

California Divorce Dictionary: Bifurcation

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Bifurcation refers to splitting of a main body into two parts or division into two branches. In a legal context it refers to the division of a trial or legal proceeding into two parts. California Family Code Section 2337 (a) states “In a proceeding for dissolution of marriage, the court, upon noticed motion, may sever and grant an early and separate trial on the issue of the dissolution of the status of the marriage apart from other issues.”

In other words, you can get be legally divorced and take status as a single person without reaching agreement on all issues in your divorce proceedings. This is common in very long litigation that may last years due to complicated financial issues. It is also common when one party wishes to re-marry which they obviously cannot do if still legally married to another.

Caution must be taken as bifurcation has very great ramifications on finances including Retirement plans, Taxes, Social Security benefits, Estate Planning and Life and Health Insurance coverage. Significant financial rules and procedures are laid out in Family Code Section 2337 to protect the status quo. Interim orders and temporary agreements such as joinder of retirement plans and indemnification agreements protecting the other party from taxes and other adverse affects of the change in marital status are often required.

 

Life Insurance as Security for Support

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It is common for a divorce decree or Marital Settlement Agreement to require a providing spouse maintain a life insurance policy on his/her life during the period spousal and child support payments are being made. This is called Life Insurance as Security for Support. Spousal Support terminates at the death of either party. Life Insurance can protect the supported party in the event the support payor were to pass away un-expectedly.

What type of insurance should be used?

  • The shorter the obligation the more likely some form of term insurance will be advisable. Longer time frames may call for some form of permanent life insurance. When lifetime alimony payments are required, permanent insurance will be preferred.

How can the recipient spouse be assured the life insurance policy is placed and remains in force?

  • The ideal policy would be fully paid but is not likely to be financially viable. The next best option is to require annual premium payments necessitating one check per year rather than 12 and limiting the logistic problems. The recipient spouse should be the owner of the policy meaning they will be notified if a premium payment is missed before the policy lapses