In California divorce cases parties often overlook the tax treatment of their proposed actions when negotiating settlement agreements. A husband might say, “I will pay you more spousal support than child support because our child is turning eighteen (18) soon and child support will terminate.” A wife might say, “I will pay you $100,000.00 if you just waive your right to spousal support.” In order to compromise an attorney might propose, “Let’s start with a high spousal support amount for the first year and step the amount down as time goes on.” However, family law litigants should think carefully about these proposals because they all contain hidden tax consequences.
In a recent post-judgment modification case, Alice requested an increase in the amount of monthly spousal support she received from her former husband, John. The parties reached an out of court settlement and John agreed to pay Alice a lump sum payment of $350,000 in exchange for her agreement to waive any future right to spousal support. After the parties formalized their agreement, John paid Alice $350,000. As John was used to deducting his monthly spousal support payments on his tax returns, he deducted the $350,000 spousal support payment on his return the following year. The IRS disallowed all but one month’s worth of spousal support as a deduction for John. On appeal, the tax court held that a lump sum settlement of future spousal support was non-deductible because the obligation to make the payment would not have expired in the event of Alice’s death.
Generally, Congress draws a clear line between child support, spousal support, and property settlements in order to ensure that parties can only deduct payment of spousal support. Further, Congress has structured the law to ensure parties cannot structure property settlements that are disguised as spousal support. As is evident in this dramatic example, the ability to deduct $350,000 of spousal support versus being barred from such a deduction results in a radically different amount of money paid out-of-pocket. On the other side of this case, Alice received $350,000 in non-taxable spousal support which otherwise would have been taxed to her at her normal rate. Alice received substantially more net income than she otherwise would have.In sum, taxation and family law is a complicated crossover of two different areas of law. Your property and support agreements may involve serious tax implications and therefore, it is always advisable to consult with a knowledgeable family law attorney regarding your divorce issues.