Spousal Support Deductibility
Posted on June 6, 2013
Tax consequences – an opportunities – are always lurking in the background of family law disputes. Our San Francisco divorce and family law office can help you navigate the murky waters of family law disputes by giving you an understanding of how these issues affect your case. One of the most important issues is the deductibility of spousal support. We assist our clients in structuring settlements and litigating issues regarding spousal support. For this reason, an understanding of the rules regarding spousal support’s deductibility is necessary.
Spousal support that meets certain criteria can be – but doesn’t have to be – taxable to the recipient and deductible by the payor. Parties can structure spousal support payments so that they are nontaxable and nondeductible. However, most cases deal with parties who are in different tax brackets. This leads to a scenario where it will cost less to the payor to pay more in spousal support. This benefits the recipient (and likely the children as well) as well as the payor. For example, let’s suppose that the payor proposes to pay $3,000 per month in spousal support and that payor is in a 35% tax bracket. Let’s also suppose that the recipient is in a 20% tax bracket. If the parties structure this payment as a nontaxable / nondeductible payment, the payor pays $3,000 and gets no deduction for that payment while the recipient receives $3,000 and pays no taxes on it. Let’s then suppose that the payor proposes to increase her payment to the recipient to $4,000, so long as she gets a tax deduction on it. It will cost the payor $2,600 to make a payment worth $3,200 to the recipient. Spousal support is an above the line deduction, meaning that it reduces your gross income in calculating your adjusted gross income. If you make $200,000 per year and have to pay $20,000 of that in spousal support, your adjusted gross income goes down to $180,000.
Deductible spousal support payments have to meet many requirements, and this article will only cover the major ones. For a broader exposition, see Internal Revenue Code § 71. The first major requirement is that spousal support payments cannot be payments to support a child. In other words, child support is neither taxable to the recipient nor deductible by the payor. Furthermore, if the spousal support payments are reduced on a contingency regarding a child, then there is a presumption that the payment is child support rather than spousal support. If there is a reduction in support within six months of a child turning 18, there is a presumption that this payment is a child support payment. Likewise, if there are two or more reductions in spousal support with one year of when the children turned 18 and 24, there is a rebuttable presumption that the payment was child, rather than spousal, support and therefore nondeductible to the payor. However, if the custodial parent receives an increase in child support and spousal support is therefore reduced, there is no presumption that the spousal support payments were child support.
Another very important requirement for payments of spousal support to be deductible is that the payments have to terminate upon the death of the supported spouse. If payments are projected to continue to the heirs of the supported spouse, then the payments are not deductible spousal support. The default in California is set by Family Code § 4337, which says that, unless a written agreement says otherwise, spousal support ends upon the death of either party or remarriage of the supported party.
Spousal support payments must be received in cash, not in property. They must be provided for in a divorce or separation instrument, and that includes Marital Settlement Agreements and court orders. Before the divorce is final, spousal support payments can be deductible, if the rest of the requirements are met. However, as soon as the divorce is final, if the parties continue living together, spousal support is not deductible. In addition, although it might be beneficial for the parties to file a joint tax return for other reasons, spousal support is not deductible if they do file jointly.
Finally, and most complicatedly, there is a three-year recapture rule where, if the payments drop by certain specified amounts in the years after separation, the IRS can recompute the payor’s income to include the amounts that were previously deducted. The purpose of the recapture rule is to discourage “front-loading” of spousal support payments, which then drop precipitously. Congress did not want to provide spouses with a reduction to their adjusted gross income by permitting them to disguise property settlements as spousal support. There are some exceptions to the recapture / front-loading rule, including when payments stop because one party died or remarried, where payments were made under a temporary support order, or where the payments were fluctuating payments lasting at least three years under an agreement to pay a fixed portion of income from a business or from self-employment. If you need assistance determining whether your spousal support payments avoid the recapture rules, contact our San Francisco family law office for a consultation.