Under certain circumstances the IRS allows a deduction for the payment of alimony. The deduction is granted, in part, because the recipient is taxed on alimony. The two spouses or former spouses end up paying less in taxes because alimony is deductible. The parties are shifting income from a higher to a lower tax bracket by transferring alimony from the higher income spouse to the lower income spouse. The high earner saves money that would otherwise be paid to the IRS. The recipient usually benefits because the payor is more generous because of the tax savings.
For example, if the higher earner makes $200,000 a year and pays the other spouse $80,000 a year, the higher earner is actually taxed on $120,000, not $200,000. The recipient might pay taxes of $16,000, but the payor would have paid $50,000 on $200,000 and now pays only $24,000 on $120,000. Between the two spouses, they are paying a total of $40,000, or $10,000 less, than the higher earner would have paid before deducting the alimony payments.
Not all payments qualify as deductions. The IRS imposes seven requirements upon taxpayers seeking a deduction:
1. Dollars. Do make payments in cash or by check to or for the benefit of a spouse or former spouse.
2. Documents. Do make payments in accordance with a divorce document, such as a marital settlement agreement, separation agreement, court order, or divorce judgment. Payments made pursuant to a temporary order or order pendente lite also qualify under Section 71 of the Internal Revenue Code.
3. Designation. Do include a statement in the divorce document labeling the payments as deductible by the payor and taxable to the recipient. Spouses sometimes intentionally make such payments nondeductible and nontaxable if they have not had a chance to analyze the tax consequences.
4. Distance. Do live apart. Payments must be made after a physical separation.
5. Death. Do terminate payments on the death of the recipient and include that condition in the divorce document. Most payors also have the right to terminate alimony on the recipient’s remarriage or upon the death of the payor.
6. Dependents. Do maintain a clear division between alimony and child-related events. If you terminate alimony upon the emancipation of a child, you run the risk of the IRS reclassifying past alimony as nondeductible child support. Your past alimony deductions would be disallowed, and back taxes would then be owed.
7. Declining. Do follow IRS rules against front-loading. Alimony should not be excessively high or front-loaded in the first three post-separation years. Excessive payments are subject to recapture or being taxed to the payor in the third post-separation year.