In the case of Wells v. Commissioner, T.C. Memo. 1998-2, the United States Tax Court ruled that family support, which under California law is defined as an "unallocated combination of child support and spousal support", is not "alimony" for purposes of Internal Revenue Code (hereinafter "IRC") 71(b), and is therefore not deductible to the payor under IRC 215. This is contrary to the commonly held belief of many family law practitioners, and is also contrary to another, earlier, Tax Court case. As proper reporting of alimony (both by the payor deducting it, and the payee required to include it in income) has recently been a major compliance project at the Internal Revenue Service ("IRS"), the issue clearly merits a careful analysis.
A problem generally arises where the payor claims a deduction and the payee fails to include the amounts in income. The IRS will select their tax returns for further examination. The IRS is able to track these returns down by reference to the social security numbers of both the payor and payee. In the typical audit, the tax returns of both the payor and payee will be examined. If no settlement is reached, both returns may be litigated before the United States Tax Court. This will require the divorced parties to once again face each other in court. The IRS is allowed to sit back and watch the divorced parties do battle.
Under the version of 71 existing prior to enactment of the Deficit Reduction Act of 1984, the general rule as set forth in the case of Lester v. Commissioner, 366 U.S. 299 (1961), now codified in IRC 71(c)(1) was that a support payment, so long as it did not specifically fix an amount payable for support of children, was "alimony" which would be deductible in its entirety. Conversely stated, if any payment was specifically fixed in amount and character as child support, it was treated as such and was therefore non-deductible to the payor, and excluded from the payee's income. The rule of Lester created an incentive to combine child and spousal support together in a single payment. So long as none of it was specifically fixed in amount and character as child support, it was deductible in its entirety.
The higher income payor benefits from the greater deduction, while the lower income payee is in a sufficiently low tax bracket not to be troubled by the greater income. From this principle arose what is known today as "family support," which under California Family Code 92 is defined as an unallocated combination of child support and spousal support.
One of the principal benefits of the so called Lester agreement/order or "family support" agreement/order was that contingencies could be drafted into the support scheme. These contingencies could call for reduction of the amount of the payment by specific amounts on the happening of certain contingencies relating to the children without affecting the deductibility of the entire amount.
This benefit, however, has been eliminated by the enactment of 71(c)(2) in 1984. See, In re Marriage of Leathers, 175 Cal.App.3d 783, 221 Cal.Rptr. 78, 81 n.6 (Cal.App. 3d Dist. 1985).
The 1984 Act also changed 71(b) and 215. Section 215 of the IRC allows a deduction to the payor of an amount equal to the alimony or separate maintenance payments paid during the payor's taxable year. For the definition of alimony or separate maintenance payment, 215(b) refers to 71(b).
Section 71(b)(1) sets forth the requirements which a spousal support order must meet in order to qualify as alimony. Section 71(b) provides that "alimony or separate maintenance payment" means any payment in cash if : (A) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument; (B) the divorce or separation instrument does not designate such payment as a payment which is not includable in gross income under 71 and not allowable as a deduction under 215; (C) in the case of an individual legally separated from his or her spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made; and (D) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.
If any of the payments made by the payor fails to meet any one of the four enumerated criteria, that portion is not "alimony" and thus is not deductible by the payor.
In the typical case of the family support order, the first three of the above-enumerated criteria are satisfied, and the issue is whether the fourth element applies; that there is no liability to make the payments after the death of the payee. Unfortunately, in most instances that fourth element set forth in 71(b)(1)(D) is not satisfied.
Obligation After Death
As originally enacted in 1984, 71(b)(1)(D) required that the decree or agreement specify that the payor's liability to continue making payments cease upon the payee's death. The Treasury Department promulgated regulations affirming this requirement. In 1986, however, this express provision requirement was repealed retroactively. Thus, if local law requires that spousal support payments terminate upon the death of the payee spouse, and the decree or agreement is silent as to termination, 71(b)(1)(D) is satisfied, and the payments may be deductible alimony. If, however, under the agreement, the payor spouse continues to be liable to make even one otherwise qualifying payment after the death of the payee spouse, none of the payments required before the payee spouse's death will be alimony. See, Cunningham v. Commissioner, T.C. Memo. 1994-474; Treas. Reg. 1.71-1T(b) Q&A-10.
California Family Code 4337 states "Except as otherwise agreed by the parties in writing, the obligation of a party under an order for the support of the other party terminates upon the death of either party or the remarriage of the other party." This statute appears clear on its face operating to terminate an obligation of a party under an order for the support of the other party upon either party's death. It clearly applies to spousal support orders thereby satisfying the 71(b)(1)(D) requirement that the payor have no obligation to pay upon the payee's death should there be no language in the spousal support order itself saying this. In fact, in the case of Ambrose v. Commissioner, T.C. Memo. 1996-128, the United States Tax Court held that this statute applies to family support orders thereby satisfying this requirement and resulting in full deductibility for family support payments.
However, in Wells v. Commissioner, the United States Tax Court explicitly held that this statute applies only to spousal orders and not to family support orders. It thus appears that family support, unless there is explicit language in the order/agreement terminating the obligation to pay on the death of the payee, will NOT be deductible as alimony under 215 and 71.
Facts of Wells
In Wells, the parties entered into a marital termination agreement (hereinafter "MTA") on February 5, 1990, which became the order of the court. In the MTA, Petitioner/husband agreed to make payments as and for family support of $2,000 per month (with subsequent increases) "and continuing thereafter until further Order of the Court or until the child marries, dies, is emancipated, reaches 19 or reaches 18 and is not a full-time high school student residing with a parent, whichever first occurs." On September 19, 1990, the parties modified the MTA so that, commencing October 15, 1990, the petitioner was to pay "family support" in the amount of $2,600 per month payable in the sum of $2,600 payable half on the first and half on the 15th of each month.
The IRS argued that this payment was not deductible alimony for two reasons. First, the payments were not set to terminate on the death of the payee (Ms. Wells) thereby failing to satisfy the definition of alimony. See, IRC 71(b)(1)(D). Second, that the payments were nondeductible child support payments, because the parties' agreements made cessation of payments contingent upon events which are associated with petitioner's children. Thus, those sums were child support pursuant to IRC 71(c)(2). This was because the parties intended the payments to terminate on a pro rata basis as each child "marries, dies, is emancipated" etc. Husband argued that California Family Code 4337 applied to his payments thereby qualifying them as alimony.
The Tax Court analyzed Family Code 4337 and held that it does not apply to family support orders. The Court stated: "Petitioner argues that because family support is an unallocated combination of child support and spousal support, he must prevail since spousal support terminates at the death of payee. We believe that the converse argument is equally persuasive (i.e., that the payments are not alimony because child support survives the death of the custodial parent), and refuse to accept his conclusion."
The Court held that with respect to modification of the original MTA, the parties had "otherwise agreed," within meaning of 4337, to terminate the family support payments at some point other than the death of the payee spouse. They had agreed that the payments were to continue until one or more specified events occurred with respect to their children. With respect to the modified MTA, the Court held that even if it could not conclude that the parties "otherwise agreed in writing" within the meaning of 4337, petitioner would still not prevail because 4337 does not apply to family support payments.
Focusing on the statutory language stating that "the obligation of a party under an order for the support of the other party terminates upon the death of either party . . . ," the Court stated that "California Family Code 4337 pertains only to spousal support orders and, in our estimation, does not address family support payments. Assuming a "worst case scenario" (i.e., custodial parent dies and custody is awarded to someone other than the surviving spouse), we cannot believe that California law would permit the surviving parent to avoid any further support obligations." Thus, because 4337 did not apply to the family support payments at issue, these payments were not alimony, and therefore were not deductible to the payor-petitioner.
This holding potentially invalidates all family support orders currently in effect insofar as deductibility of payments and correlative inclusion in income of those payments is concerned. Orders or agreements currently in effect providing for family support payments which rely on this state statute for federal income tax deductibility purposes may not have created an obligation, the payment of which is deductible to the payor. Take note: practitioners who have advised their clients to enter into these family support orders may find themselves receiving angry telephone calls from their clients upon their federal income tax returns being audited.
Also, this holding contradicts another holding by the Tax Court in the case of Ambrose v. Commissioner, T.C. Memo. 1996-128, in which the Court held that California Family Code 4337 did apply to family support orders thereby satisfying IRC 71(b)(1)(D). Because of the difference, there is now both confusion and uncertainty in the current state of federal tax law as it pertains to this issue.
This confusion will have to be remedied either by Treasury regulations or further litigated decisions. Neither the Wells case nor the Ambrose case were appealed to the Ninth Circuit. Until the United States Tax Court issues an opinion on this issue, and/or the issue is decided by the Ninth Circuit, the tax advisor and family practitioner cannot know which case will prevail.
It is the opinion and suggestion of this author that family law practitioners and their clients take the safe approach, and not enter into family support orders or agreements. Separate spousal support provisions complying with the Internal Revenue Code, and separate child support provisions, should be employed.
Should a client dismiss the risks and choose to engage in "audit roulette", the family support order may still be the way to maximize tax benefits. Perhaps drafting a provision in the order terminating payments upon the death of the payee is the answer. It is doubtful, though, that this proposed solution will pass a trial court's review.
Another possible solution could be drafting a provision whereby the payee specifically agrees to include all payments in income so that if the payee fails to do so, and the payor's return is audited disallowing the deduction, the payor could still have a contempt action against the payee. The problem with this approach, however, is that the IRS is not bound. Either way, however, is not a substitute for the safe approach of employing separate spousal and child support provisions.