Take-Away: The tax consequences of a divorce settlement agreement are much more difficult than they were prior to 2018. It is much more difficult to negotiate provisions in those agreements to shift the tax burden, or ‘create’ and income tax deduction.

Background: As part of the 2017 Tax Act,  Congress ended the tax deduction for alimony that is paid to a spouse or former spouse. It ‘grandfathered’ alimony payments made pursuant to a divorce or a separation agreement made on or before December 31, 2018. And in doing so, Congress slightly modified the definition of alimony.

Pre-2017: Under the former rule, payments had to meet four basic requirements in order to constitute tax deductible alimony:

(i) payments had to be paid in cash, or cash equivalents[ IRC 71(b)(1);]

(ii) payments had to be made ‘under a divorce or separation agreement’ [IRC 71(b)(1)(A);]

(iii) the paying spouse must have had no obligation to continue to make the payments after the death of the recipient-former spouse [IRC 71(b)(1)(D);] and

(iv) the divorce or separation document must not have designated the payments as non-alimony- just that ‘the substance of such a designation is reflected in the instrument.’ 

For this last requirement. (iv), the words need not have specifically referred to IRC 71 or IRC 215 to designated the payment as non-alimony. This last requirement thus enabled spouses some flexibility to decide for themselves whether and when payments would constitute tax deductible alimony. 

Post- 2017 Tax Act: Congress changed the definition of alimony in 2017. The first 3 [(i)-(iii)] requirements noted above were moved from IRC 71(b)(1) over to IRC 152(d)(5)(b), and it dropped the fourth [(iv] requirement.

Consequently, if the issue is whether payments made are alimony or child support, the ability of the divorcing individuals to specifically designate payments as non-alimony was removed. Congress did not make any changes to the definition of ‘divorce or separation instrument’ but it did  move the definition from IRC 71(b)(2) to IRC 121(did)(3)(C) which deals with the exclusion of gain on the sale of a principal residence.

How these changes play out in the ‘real world’ was on display in a recent Tax Court decision.

Jihad Y. Ibrahim v. Commissioner, Tax Court Summary Opinion, 2022-7 (May 16, 2022)

Facts: Dr. Ibrahim, an MD, married Cheryl, a nurse. Each of them had three children from prior marriages. The couple separated in 2016. They then executed a Marital Separation Agreement.

That Agreement expressly provided that neither spouse would pay   maintenance to the other (Missouri calls alimony maintenance.]Their Agreement went on to state that “each will be forever precluded from requesting maintenance as part of the decree of dissolution. Their Judgment of Divorce provided that “neither party shall receive maintenance from the other, and that this judgment with respect to maintenance is not modifiable.” 

Their Agreement went on to provide that Dr. Ibrahim was to pay Cheryl $10,000 “to assist in Wife’s relocation and legal fees” which was to be paid in monthly installments of $300 with the balance due in a lump sum when the divorce became final. The $10,000 amount was later increased to $50,000 in a formal amendment to the Agreement. The divorce became final in 2017, almost a year after the Agreement was signed.

Dr. Ibrahim paid Cheryl $300 a month, so that by the time the divorce was final he had paid $1,200 in 2016 and $2,000 in 2017. Once the divorce was final, Dr. Ibrahim then paid Cheryl the balance of the $50,000, or $46,800.

Issue: Dr. Ibrahim tried to deduct the full $50,000 on his 2017 tax return (including the $1,200 that he had paid in 2016.) The IRS disallowed the entire deduction claimed by Dr. Ibrahim, and it also sought penalties.

Tax Court: The first two conditions of the pre-2017 Tax Act were satisfied- the amounts were paid in cash and they were paid pursuant to the Marital Separation Agreement. The third condition was indirectly satisfied by Missouri’s divorce statutes that directs that maintenance obligations terminate on the death of either party- thus providing the missing condition [(iii)]in the Marital Separation Agreement.

Not Otherwise Designated Condition: The Agreement did not meet this condition. The Tax Court Judge noted: “the Agreement, the Amended Agreement, and the judgment each contain statements indicating that neither Dr. Ibrahim nor Ms. Edington [Cheryl] would pay maintenance to the other. We find these statements provide clear, explicit and express direction that neither party shall receive maintenance payments from the other.”

Implicit Alimony Argument: Dr. Ibrahim also tried to argue that the payments he made were implicit maintenance, aka alimony, i.e. by default, claiming that the payments were not a part of the property division, nor were they child support, so by default they must have been for Cheryl’s maintenance (alimony) since they were labeled to assist Cheryl with her relocation and attorney’s fees. The Judge rejected this default argument noting that: (i) the rules are explicit for what constitutes alimony (see (i)-(iv) above); (ii) the rules for what constitutes child support are similarly explicit [IRC 152(d)(5); Treasury Regulation 1.71-1T(c).] Since the rules to determine alimony and child support are both explicit, then by default any other payments would fall under the property division category.

Penalties: The Tax Court judge also upheld the imposition of penalties for a substantial understatement of Dr. Ibrahim’s income tax liabilities.[IRC 6662(a)and (b)(2).]

Conclusion: The words chosen by the parties themselves will control, regardless of whatever secret reasons the parties have for agreement to the words. The judge refused to allow extrinsic evidence to alter what the plain language of the Marital Separation Agreement provided. The ability of the parties in a divorce settlement to shift income tax burdens became substantially much more difficult after the 2017 Tax Act.