Parties often like – well no one really likes to pay alimony – to use alimony as a vehicle to settle issues in a case because usually, alimony is deductible to the payor and includible in the income of the recipient. Because of differences in tax brackets, proper structuring of alimony can create additional cash flow for the recipient and additional tax relief for the payor.
There are times, however, when alimony is paid in a lump sum. Sometimes an alimony obligation is bought out – prepaid if you will (though for the payor, one wonders whether this is a good deal because the recipient can go out and get married the very next day whereas alimony terminates upon remarriage typically (as well as death). Other times, people make a business decision to front load some of the alimony so that the monthly payments in the future are reduced.
However, lump sum alimony cannot be deducted nor is it includible in income. Because of this, consideration should be given to what the lump sum should be by perhaps tax effecting the number so that the recipient does not get the full amount, up front, without having to pay taxes on it.
What happens, however, when parties settle a case that includes the traditional periodic payment of alimony but then they decide to modify this agreement to pay a lump sum? Can this lump sum representing the conversion of a payment that was clearly deductible be deducted?
The IRS recently answered that question in Private Letter Ruling 201206005. While private letter rulings can only be used by the taxpayer submitting the request for a ruling from the IRS, and cannot be cited as precedent, this private letter ruling was interesting.
Therein, the taxpayers wanted to convert periodic payments into a lump sum, however, for some time prior to the lump sum, there would be periodic payment. The IRS determined:
The Modification Agreement expressly designates the lump-sum payment provided under the agreement as excludible from Wife’s income and non-deductible from Husband’s income for federal income tax purposes. Therefore, the lump-sum payment does not meet one of the factors of § 71(b)(1) of the Code that requires
no such designation of the payment in the divorce or separation instrument in order to meet the definition of alimony or separate maintenance payment for purposes of §§ 71 and 215. Further, there are no past due alimony payments involved in this case. Accordingly, we conclude that the payment of $F in a lump sum by Husband to Wife in return for the extinguishment of his liability to pay alimony to Wife is not alimony or separate maintenance payment as defined in § 71(b), and is not includible in Wife’s income under § 71 and not deductible by Husband under § 215. However, the Y month’s alimony payments made under the Modification Agreement satisfy all of the factors of § 71(b)(1) and qualify as alimony taxable to Wife under
§71 and deductible to Husband under § 215.
In any event, lump sum alimony can be a trap for the unwary. As such, it would be wise to discuss these issues with experienced and sophisticated counsel and tax professionals.
Eric Solotoff is the editor of the New Jersey Family Legal Blog and the Co-Chair of the Family Law Practice Group of Fox Rothschild LLP. Certified by the Supreme Court of New Jersey as a Matrimonial Lawyer and a Fellow of the American Academy of Matrimonial Attorneys, Eric practices in Fox Rothschild’s Roseland, New Jersey office though he practices throughout New Jersey. You can reach Eric at (973)994-7501, or firstname.lastname@example.org.