Abstract
Agreements between husbands and wives incident to their separation or divorce are affected by numerous income tax considerations. Thus, if a mediator is intelligently to assist a couple to conclude an agreement between themselves that will give effect to their intentions, these income tax provisions will have to be kept in mind. While it is possible that a taxpayer may be subject to three separate income tax liabilities (for example, residents of New York City are subject to federal, state, and city income taxes) the following discussion will be limited to federal income taxes (see Table 22.1).
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Notes
I.R.C. ∫ 215 (West 1988 Supp.).
I.R.C. ∫ 71 (West 1988 Supp.).
I.R.C. ∫ 215(a) (West 1988 Supp.).
I.R.C. ∫ 71(b)(1) (West 1988 Supp.). Payments made by check or money order will qualify as well. Temp. Treas. Regs. ∫ 1.71-lT(b)Q-5 (1984).
I.R.C. ∫ 71(b)(l)(A) (West 1988 Supp.).
Id.
I.R.C. ∫ 71(b)(l)(D) (West 1988 Supp.).
It is only the payments that are to be made following the wife’s death that will fail to qualify, not all of the payments. This will also apply to a substitute payment to be made after the death of the recipient spouse. If it is the intention of the parties to make a payment in a fixed amount, payable over a stated period, that will nevertheless qualify and be deductible by the husband, it is possible to achieve this by means of a life insurance policy (perhaps declining term) on the wife’s life that will insure that she (and her estate) will receive the full amount bargained for, despite her death. The House Ways and Means Committee Report which was issued in connection with the 1984 Act suggests that the proceeds of the policy of insurance will not be considered a substitute for any such violative payment and that it would be permissible for the husband to pay the premiums on that policy. H.R. Rep. No. 98-432, Part 2, 98th cong., 2d Sess. 1496 (1984).
I.R.C. ∫ 71(b)(l)(C) (West 1988 Supp.); Temp. Treas. Regs. ∫ 1.71-lT(b)Q-9 (1984).
I.R.C. ∫ 71(b)(l)(B) (West 1988 Supp.).
The Code also includes payments made to third parties on behalf of the spouse. Thus, if the agreement requires the husband to maintain medical insurance for his wife’s benefit, premiums paid by the husband will be deemed alimony taxable to the wife and deductible by the husband. If the parties do not intend that result, it is again important that the agreement specifically provide that those payments will not be treated as alimony. I.R.C. ∫ 71(b)(l)(B) (West 1988 Supp.).
The 1984 Act contained the requirement that if payments were to be made in excess of $10,000 in any calendar year, then no portion of such payments in excess of $10,000 paid in any year will be treated as alimony unless the agreement or decree contained provision that payments (not necessarily in excess of $10,000 a year) would be made in each of the six post-separation years, unless the payments would otherwise terminate within the six year period by reason of the death of either of the parties, or by reason of the remarriage of the party receiving the payments. (If none of the payments in the first six post-separation years exceeded $10,000, there was no requirement that payments be made in each of the first six post-separation years.) This requirement was eliminated by the 1986 Act with respect to all instruments signed after December 31, 1986.
The 1984 Act related to payments made within the first six post-separation years. The 1986 Act, which applies to payments made under instruments executed after December 31, 1986, replaced this with a three-year recapture rule. I.R.C. ∫ (71)(f) (West 1988 Supp.).
I.R.C. ∫ 71(f)(3), (4) (West 1988 Supp.). The application of the recapture rules are rather complicated, and it is not very important that a mediator know how to apply them. What the mediator must know, however, is that the rule may be violated if there is a reduction in the payments within the first three post-separation years. Rarely will it be important for either the parties or the mediator to know what the penalty will be for violating the rules. After all, the point is to avoid the penalty, not to determine it. Therefore, if the proposed payment contains a reduction within the first three post-separation years, then, and unless the mediator is an attorney familiar with the application of the rules, the parties should be referred to either a qualified attorney or accountant for a determination as to whether or not the rule will be violated.
I.R.C. ∫ 71(f)(6) (West 1988 Supp.).
I.R.C. ∫ 71(f)(5)(C) (West 1988 Supp.).
I.R.C. ∫ 71(f)(5)(A) (West 1988 Supp.). There is another exception to the recapture rule but it is not one which will normally concern mediators. That is that the rule does not apply when the support payments have been fixed by court order rather than by an agreement between the parties. I.R.C. ∫ (f)(5)(B).
I.R.C. ∫ 71(c) (West 1988 Supp.).
Commissioner v. Lester, 366 U.S. 299 (1961).
I.R.C. ∫ 71(c)(2) (West 1988 Supp.).
I.R.C. ∫ 71(c)(2)(B) (West 1988 Supp.).
Temp. Treas. Regs. ∫ 1.71-lT(c)Q-18 (1984).
Id.
Id.
Id.
Id. (emphasis added). While it will not be difficult for an experienced mediator, even one who is not an attorney, to fashion an agreement that will not violate the contingency test when there is only one child involved, in no event should he attempt to meet the requirement of the multiple reduction test on his own. In fact, the test is a very complicated one, and its applications are so much narrower and its benefits so much smaller, that it is almost never employed by attorneys who negotiate agreements for separating and divorcing couples.
I.R.C. ∫ 7703(a)(l) (West 1988 Supp.).
I.R.C. ∫ 2(b)(l) (West 1988 Supp.).
I.R.C. ∫ 7703(b) (West 1988 Supp.).
I.R.C. ∫ 2(b)(l)(A) (West 1988 Supp.).
Id.
Treas. Regs. ∫ 1.2-2(b)(6)(d) (1984).
Id.
Temp. Treas. Regs. ∫ 1.71-lT(c) (1984).
I.R.C. ∫ 2(b)(l)(A)(i) (West 1988 Supp.).
If they are still legally married at the close of the tax year in question, however, she must be entitled to claim the child as an exemption for that year. I.R.C. ∫ 7703(b)(l) (West 1988 Supp.).
I.R.C. ∫ 21 (West 1988 Supp.).
Id.
I.R.C. ∫ 21(a)(2) (West 1988 Supp.).
I.R.C. ∫ 21(d)(l) (West 1988 Supp.).
I.R.C. ∫ 21(c) (West 1988 Supp.).
I.R.C. ∫ 151(a), (b), (c). A dependent is generally defined as an individual who receives over half his support during the taxable year from the taxpayer, and who is related to the taxpayer in one of the following ways
A son or daughter of the taxpayer, or a descendant of either
A stepson or stepdaughter of the taxpayer
A brother, sister, stepbrother, or stepsister of the taxpayer
The father or mother of the taxpayer, or an ancestor of either
A stepfather or stepmother of the taxpayer
A son or daughter of a brother or sister of the taxpayer
A brother or sister of the mother or father of the taxpayer
A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law of the taxpayer, or
An individual (other than an individual who at any time during the taxable year was the spouse, determined without regard to section 7703, of the taxpayer) who, for the taxable year of the taxpayer, has as his principal place of abode the home of the taxpayer and is a member of the taxpayer’s household.” I.R.C. ∫ 152 (West 1988 Supp.).
I.R.C. ∫ 151(d)(3) (West 1988 Supp.).
I.R.C. ∫ 152(e)(l) (West 1988 Supp.).
I.R.C. ∫ 152(e)(2) (West 1988 Supp.).
There is a problem that a mediator should expect in connection with the allocation of these exemptions. Many people who will come into mediation will know, or will have heard, that the law says that the custodial parent is entitled to claim the children as exemptions. Unfortunately, the custodial parent in this instance will tend to read more into the law than is appropriate. The rule established by the Code does not, and was not intended, to constitute a judgment by the Federal Government as to who should more appropriately be entitled to claim the children as exemptions. In fact, the former rule, which generally gave the exemption to the noncustodial parent if he or she made payments to the custodial parent for the support of the children, was far more appropriate (equitable), since the custodial parent received those payments without the obligation to pay taxes on them. The new rule was enacted simply for the convenience of the Internal Revenue Service, which did not want to be in the position of having to guess which of the parents was actually entitled to claim the children as exemptions. Thus, they wanted a simple rule that could be applied in all situations, namely, that the parent with whom the children principally resided (the custodial parent) was entitled to the exemption. More importantly, and rather than being dependent upon the couple’s agreement, or any other extraneous document not necessarily in their possession, the Internal Revenue Service wanted to have to look to but one document, namely, the written declaration that had to be signed by the custodial parent and filed by the noncustodial parent with his tax return if he were to be given credit for the exemption which he claimed for a child. In short, there is nothing in the change effectuated by the Tax Reform Act of 1984 which should change the presumption which previously prevailed, which was that the exemption for a child would be given to the party who was obligated to make child support payments to the other party. More importantly, there is nothing in the change that should be deemed to suggest that the law has made a determination that the custodial parent should be the one who has the right to claim the child as an exemption, and a court of law, like the parties themselves, has the power to ignore the direction made by the Code, grant the exemption to the noncustodial parent, and direct the custodial parent to sign the necessary written declaration. Cross v. Cross, 363 S.E.2d 449 (W. V. 1987). There is also a minority view which holds that the Tax Reform Act of 1984 divested state courts of jurisdiction over which party could take the exemption. Lorenz v. Lorenz, 166 Mich. App. 58, 419 N.W.2d 770 (1988). See also, Davis v. Fair, 707 S.W.2d 711 (Texas 1986).
U.S. v. Davis, 370 U.S. 65 (1962). However, after 1984, the husband would recognize no gain or loss on such transfer. I.R.C. ∫ 1041 (West 1988 Supp.); Temp. Treas. Regs. ∫ 1.1041T(d)Q-10 (1984).
I.R.C. ∫ 1041 (West 1988 Supp.).
Temp. Treas. Regs. ∫ 1.1041-lT(b), Q7 (1984). This is an issue that can arise very often in mediation. By the terms of the parties’ agreement, the wife is given the right to continue to live in the marital residence until either her remarriage or until the youngest child graduates from high school or college, whichever first occurs. At that time the home is to be sold, except that the wife is given an option to purchase the husband’s interest rather than having it sold to a third party. The youngest child will not graduate from high school for eight more years and, since it is their intention to be divorced immediately, the sale by the husband to the wife at that time will not be related to the cessation of their marriage. But suppose that the wife should remarry and exercise her option within the six-year period? In that instance the husband will receive the consideration for his interest in the home tax free (just as would have been the case had the wife bought out his interest presently, and at the time of the signing of their agreement) and the wife will receive no credit, in terms of an increase in her basis, by reason of the payment which she has made to the husband for his interest in the home. Quite obviously, in any discussions between the parties concerning the present or future transfer of property between them, they should be made aware of these tax implications. While the parties cannot obviously change the law in this respect (and the Internal Revenue Code represents one of the very few exceptions to the rule that the parties are free to make their own law as between themselves), there is nothing to say that their agreement cannot provide that the husband will share with the wife any tax obligation that she may later have in connection with her subsequent sale of the home.
Id.
I.R.C. ∫ 1034 (West 1988 Supp.). This will be discussed in the next section, entitled The Sale of the Parties’ Principal Residence.
I.R.C. ∫ 121 (West 1988 Supp.). This will be discussed in the next section, entitled The Sale of the Parties’ Principal Residence.
I.R.C. ∫ 1034 (West 1988 Supp.).
If they are not selling the home presently, and if one of them (for example, the wife) is going to have the exclusive right to use it until it is sold, then they will not both meet the requirements, and only the wife, whose principal residence it will be at the time of its sale, will be able to avail herself of the right to roll over her portion of the gain. I.R.C. ∫ 1034(a) (West 1988 Supp.).
I.R.C. ∫ 121(a), (b). This exclusion can only be taken once in a lifetime.
I.R.C. ∫ 121(d) (West 1988 Supp.).
However, if they are not both over 55, then to get the maximum exclusion of $125,000 they must file a joint return and both make the election. I.R.C. ∫ 121(c), (d) (West 1988 Supp.).
I.R.C. ∫ 121(b)(l) (West 1988 Supp.).
Id.
I.R.C. ∫ 121(b)(2), ∫ 121(d)(6) (West 1988 Supp.).
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Marlow, L., Sauber, S.R. (1990). Income Taxes. In: The Handbook of Divorce Mediation. Springer, Boston, MA. https://doi.org/10.1007/978-1-4899-2495-7_22
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