If you get married, there are plenty of documents to sign to establish and recognize the union. When seeking a divorce it takes an equal, if not greater, amount of signed paperwork to undo all that has been done. Through it all, one thing is certain—nothing is final until it is signed by both parties. And, making financial commitments without a signed agreement can be costly. Just ask James Faylor.
In the case of James J. Faylor, the Tax Court has held that $20,000 in temporary support payments made by an individual to his spouse did not qualify as alimony. The spouses were divorcing and the payments were made under a temporary support agreement that was being negotiated by their attorneys but was never finalized. The Tax Court concluded that the payments did not qualify as alimony because they were not made under a divorce or separation instrument, but it refused to impose an accuracy-related penalty as IRS had sought.
Tax Laws Relating to Alimony: You may claim an above-the-line deduction for alimony or separate maintenance payments you make during the year. An alimony or separate maintenance payment is one that meets the following requirements:
- the payment must be made under a divorce or separation instrument;
- the instrument must not designate that the payment is not includable in your spouse's gross income and not deductible by you;
- legally separated spouses under a decree of divorce or separate maintenance must not be members of the same household when the payments are made; and
- your obligation to make the payment must end at the death of your spouse.
Here is What Happened to the Faylors: James and Mary Faylor separated in May 2007. On July 20, 2007, Ms. Faylor filed a motion for temporary support in a Nebraska divorce court. Subsequently, the parties attorneys exchanged correspondence regarding the terms of a temporary support agreement.
Ms. Faylor's attorney proposed that Mr. Faylor pay $6,000 per month in temporary support so that Ms. Faylor could maintain the household. Mr. Faylor's attorney countered with an offer of $4,000 per month and a request about Ms. Faylor's daughter's tuition. Later, Mr. Faylor's attorney proposed temporary support of $5,000 per month and requested Ms. Faylor's attorney to draft the proposed temporary support order.
On Sept. 1, 2007, while the parties were still discussing the terms of a temporary support order, Mr. Faylor began making monthly transfers of $5,000 to a joint checking account he shared with Ms. Faylor. After that, two proposed temporary support orders were exchanged between the parties but were never finalized. Neither spouse signed either of the two proposed temporary support orders. Even though there was no temporary support order in place, Mr. Faylor continued making the monthly $5,000 transfers into the joint account through April 2008.
On May 23, 2008, the divorce court entered a divorce decree dissolving the marriage. The divorce decree awarded alimony to Ms. Faylor of $2,500 a month for 6 months and then $1,500 a month for 66 months thereafter.
Mr. Faylor timely filed a 2008 Form 1040 in which he claimed a deduction of $36,500 for alimony paid. Of that amount, $16,500 represented payments Mr. Faylor made to Ms. Faylor pursuant to the divorce decree. The remaining $20,000, which IRS disallowed, represented the transfers to the joint account that Mr. Faylor made before the divorce decree, in accordance with the temporary support order that was never finalized.
The IRS argued that the $20,000 did not qualify as alimony because it was not paid under a divorce or separation instrument. Mr. Faylor conceded that the deposits he made to the joint account were not paid under a decree. He argued, however, that the letters between the attorneys constituted a "meeting of the minds," forming the basis of a written separation agreement between him and Ms. Faylor under the law.
The Tax Court found that the letters between the attorneys did not establish the existence of a written separation agreement. The letters showed there was no meeting of the minds between the spouses. Furthermore, Ms. Faylor and her attorney both credibly testified at trial that the spouses did not come to an agreement. Ms. Faylor credibly testified that she did not sign either of the proposed temporary support orders because she did not agree to all of the terms. Her attorney credibly testified that he had discussed with the husband's attorney the amount and terms of the temporary support, but a complete agreement was not reached. The Tax Court thus found that Ms. Faylor did not receive the $20,000 under a divorce or separation instrument, as required under the Internal Revenue Code. It held that Mr. Faylor couldn't deduct the $20,000 as alimony. Accordingly, Ms. Faylor did not have to pick up the $20,000 as taxable alimony income in 2008.
There was one significant bright spot for the paying spouse that may help other taxpayers in similar cases. The IRS sought to impose an accuracy-related penalty but the Court declined to do so. It found that Mr. Faylor had reasonable cause for the position taken on his return and acted in good faith. The Court said he mistakenly believed that he was entitled to deduct the $20,000 he transferred before the divorce decree as alimony. Although the Court ultimately disagreed with him, it was reasonable for him to believe the money he transferred while negotiating a temporary support order was alimony. Therefore, the Court refused to impose an accuracy-related penalty.
Tax Warrior Tip: Do not make alimony payments to a joint account if it can be avoided. This will prevent a later argument that you still had access amd control of the funds.
Divorce proceedings rarely go smoothly and money is almost always a major factor in both sides seeking to level the playing field, and/or get a step ahead of the other. Many of the decisions made in this process may seem like they are in your immediate best interest, but may have hidden tax consequences that can sting you in the end. If you are going through a separation or divorce, make sure your tax advisor is part of the process. The advice given by divorce or family attorneys relating to the tax impact of certain decisions, while made with good intentions, may not be correct since taxation is not their area of specialization.
At Drucker & Scaccetti, we are always prepared to help you and your attorney navigate challenging times and avoid good-intentioned, yet ill-advised, actions--such as those by James Faylor. You or your attorney can contact our Philadelphia office at 215.665.3960 or our Scranton office at 267.765.0205. Our experienced and tax-focused professionals are ready to help mitigate the tax impact of divorce proceedings in a respectful and thoughtful way.