In Andrew Dean Shelton v. Commissioner, T.C. memo 2011-266, the Tax Court considered whether a $25,000 cash payment made pursuant to a marital settlement agreement (MSA) was alimony deductible by the petitioner.  The petitioner was divorced from his former spouse in 2007.  The former spouses had entered into a MSA incorporated into the final judgment of divorce that provided in part that former wife was to be paid $25,000 “representing her share of his separation pay from the military, in addition to any interest she claims, in the real estate and furniture still in the marital home.” Further, that the payment, “constitutes full and final settlement of any additional claims to a share of assets,” and that each party waived any claim for maintenance from the other party.  The divorce decree entered in 2007 by an Illinois Circuit Court stated that each party was barred from asserting any claim “for maintenance, formerly known as alimony.”  The petitioner paid the $25,000 in 2007 and deducted the full amount as alimony.  The IRS issued a statutory notice disallowing the deduction and asserted the accuracy –related penalty under section 6662(a).

 The court ruled that the payment was not deducible alimony under Section 215(a) which defines deductible alimony by reference to the amount included in income under Section 71.  Section 71(b) generally treats as alimony income a cash payment made under a divorce or separation instrument to a former spouse, ending on death of the former spouse, if the instrument “does not designate such payment as a payment which is not includible in gross income under this section and not allowable as a deduction under section 215.” (See section 71(b) (1) (B)).

 The MSA and divorce decree in this case do not state the magic words “non-taxable / non-deductible” or any similar words that expressly state the payment, otherwise satisfying Section 71(b), was not to be deductible by the paying spouse or includible in the income of the payee spouse.  The court, nonetheless, held that the payment did not meet the requirements of Section 71(b) (1) (B) finding that the Illinois divorce court did designate the payments as non-deductible/ non-taxable by stating in its order that each party was barred from asserting any claim “for maintenance, formerly known as alimony.”

The Illinois court order states only that no claim for maintenance under state law may be asserted and does not address tax consequences to the spouses.  Section 71 was intended to end controversies about whether state court orders for periodic payments are alimony under federal tax law by substituting an objective standard and providing a roadmap that the divorcing spouses can follow to make certain the desired tax consequences of cash payments made incident to a divorce (Amended by the Deficit Reduction Act of 1984).  In this case the payment of $25,000 was made, in part, in exchange for the former wife releasing claims to petitioner’s taxable military separation pay.  The court should have addressed the question: Under Illinois law, would the obligation to make the $25,000 payment have been a claim against the petitioner’s estate had the former wife died before the payment was made?  Section 71(b)(1)(D) requires that there be no obligation to make a  payment, otherwise representing taxable alimony, after the death of the payee spouse.  Having decided the case under Section 71(b) (1) (B), however, the court did not consider the other requirements of section 71(b).  In so holding, the court injects an element of uncertainty into the definition of taxable/deductible alimony payments. 

The court cites Estate of Goldman v. Commissioner, 112 T.C. 317 (1999), aff’d. without published opinion sub nom. Schutter v. Commissioner, 242 F. 3d 390 (10th Cir. 2000), but in that case the state divorce court order incorporated a Property Settlement Agreement that specifically addressed income taxes making clear an intent that payments made under the property division clause of the agreement be non-taxable to the payee spouse.  The agreement stated that all transfers under the property division clause would be treated as a non-taxable event.  The agreement also contained clause 7, Spousal Support Waiver, which included an express waiver of spousal support.  The Tenth Circuit upheld the decision of the Tax Court and examined Hawaii law to interpret how the contractual provisions in the agreement reflect the intent of the parties.    

The Tax Court in Shelton also upheld the accuracy-related penalty asserted under section 6662(a) for negligence or intentional disregard of the rules or regulations.  The court found based on the evidence that petitioner did not act with reasonable cause and in good faith.   The court based is finding on the fact that the Illinois court explicitly stated that neither party was entitled to alimony, yet petitioner “proceeded to claim an alimony deduction.” 

Despite this case and Estate of Goldman, I strongly suggest that all marital settlement agreements included a catch-all clause, “Except as otherwise expressly provided in clause number ___ relating to spousal support payments, all other cash payments to be made to a spouse or cash payments to be made to others on behalf of a spouse, shall be non-taxable to the recipient spouse and non-deductible to the paying spouse.”  Using this or similar language will make clear that cash payments not intended as taxable support will be treated as non-taxable transfers.

Copyright 2011 by Robert S. Steinberg, Esquire
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