The spouses had entered into a separation agreement (MSA) before 1985 which was incorporated into a final judgment of divorce, although not merged into the judgment.
The MSA provided that the husband would pay to the wife as alimony a percentage of his annual net income, under a specified formula, not in any event to be less than a stated minimum amount. Should wife’s net income exceed another stated amount, husband, under the agreement, was to receive a credit against his alimony obligation. The alimony obligation was to terminate on the earlier of husband’s death, wife’s remarriage or wife’s death. There were no alimony arrearages and wife has not remarried.
Subsequent to the entry of the final judgment and after 1984, the former husband (FH) and former wife (FW) entered into a Modification Agreement (MA) under which FH is to pay to FW a lump sum amount in full settlement of his obligation under the MSA and continue to pay monthly alimony to the FW for a period of months following the entry by the state court of an Amended Divorce Judgment which the parties stipulate is obtainable under law of the state involved. The MA also provides that section 71 of the IRC, as amended by the Tax Reform Act of 1984, shall apply to the MA and that t the lump-sum payment shall not be taxable to the former wife or deductible to the former husband. Further, that the monthly alimony to be paid shall be taxable to FW and deductible to FH. The lump sum settlement payment was determined by a professional actuary taking into account the present value of future alimony payments under the MSA and former wife’s vested right to share in husband’s estate which former wife may release under state law. The MA was necessary in part because the parties disagreed about how FH’s net estate would be calculated.
The MA was contingent upon obtaining the Amended Divorce Judgment and an opinion from IRS that there would not be certain adverse tax consequences from the MA. If IRS ruled adversely or if an Amended Divorce Judgment could not be obtained, the MA would cease to be effective although either or both of the parties could elect to waive the nullification caused by an adverse IRS ruling.
The IRS Private Letter Ruling (PLR 201206005) ruled as follows:
- The lump sum settlement amount is not taxable to the former wife because:
- Treas. Reg. 1.71-1T(e), Q&A-26 provides that Sec. 71 (as amended by the Tax Reform Act of 1984) applies to any post 1984 modification of a pre-1985 divorce or separation agreement, if the MA expressly provided that Sec. 71, as amended, shall apply to the MA.(not so uncommon with more people living into their 90s)
- The deductibility of alimony under the MA is governed by the terms of the MA but payments under the MA will be treated as alimony, regardless of its terms, to the extent, arrearages under the original agreement are being satisfied. Thus, characterization of only future payments under the MA will be determined with reference to the terms of the MA.
- The MA, viewed under in the light of Sec. 71, states that the lump sum payment is to be non-taxable/ non-deductible. Thus, under Sec. 71 that statement characterizes the payment as stated.
- There are no arrearages in alimony that the lump sum payment will satisfy.
- The monthly alimony provided for under the MA will be taxable to the FW and deductible by the FH. No statement of taxability serves to create taxability for payments made under a marital agreement. The monthly payments must meet the definition in Sec. 71(b)(1) and in this case are taxable because:
- They will be paid in cash to the FW, under the MA
- Incorporated into an Amended Divorce Judgment
- Are not designated in the MA as non-taxable/ non-deductible,
- Will end on the death of the FW, and,
- The FH and FW live apart (Sec. 71(b) (1)).
- No gain or loss will arise from the transfers to occur the MA even thought Sec. 1041 had not been enacted when the MSA was executed and incorporated into the spouse’s divorce decree. Section 1041(a) nonetheless applies because the transfers contemplated will occur pursuant to a post 1984 agreement. Thus, 1041(c) (2) is relevant to determine if the transfers are related to the cessation of the marriage. In the instant case the transfers will occur beyond the one-year and six-year periods deemed incident to a divorce under Treas. Reg. 1.1041-1T (b), A-7. Because the MA, modifies the term of payments under the MSA and will be incorporated into an Amended Divorce Judgment, however, IRS opined that the MA is “incident to” the divorce. The MA will be incorporated into an Amended Divorce Judgment that will be necessarily related to the cessation of the marriage even though beyond the six-year period. A state divorce court judgment modifying an earlier MSA will always be related to the cessation of the marriage and Q&A 7 explicitly recognizes that presumably obvious fact.
- The PLR also opined that no taxable gift resulted from the original MSA nor would result from the transfers under the MA.
- Lastly, the PLR opined that, should FH die before completing his obligations under the MA, the unpaid claim would be deductible from his gross estate for estate tax purposes.
The PLR is not precedent for taxpayers other than those who obtained this ruling. Yet, it does emphasize that an Amended Divorce Judgment should be sought when former spouses are seeking to modify the terms of an earlier divorce judgment, especially when beyond the safe harbor one-year and six-year periods. It remains to be seen if IRS would respect a post six-year transaction that is completely unconnected to the original MSA or Final Judgment of divorce even if the parties somehow convinced a state court judge to enter such an order. For example, where one former spouse, 15 years following the divorce, offers to buy property listed for sale in the market, by the other former spouse. Section 1041(a) should not apply to such a transaction.
© By Robert S. Steinberg, Esquire
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