Practice Limited to Taxation


Posted on 07/27/2013

The following question was recently posted on the American Bar Association Tax Law and Practice Discussion Board:

A taxpayer who we shall describe as the Former Husband (FH) agrees to settle alimony arrearages owed to his Former Wife (FW) by having a Qualified Domestic Relations Order (QDRO) entered by the state family law court. The QDRO transfers to FW a lump sum interest in his qualified 401(k) plan. The QDRO requires the Plan Administrator to create a separate account for the FW Alternative Payee. The Former Wife receives the 401(k) funds as a direct transfer into her newly created Individual Retirement Account (IRA). Neither FW nor FH is taxed on the 401(k) transfer made pursuant to the QDRO; and, Former Wife is not taxed on the rollover of the 401(k) funds into her IRA account. Rather, she will pay tax as withdrawals are made from the IRA account. The state of residence and age of the taxpayers was not mentioned.

The CPA who posed the question asked whether Former Husband could take an alimony deduction for the 401(k) transfer to the Former Wife.

Some responses incorrectly pegged denying the deduction to FH solely on the fact that FW did not pay tax currently on the distribution from the 4010(k) plan of FH. . Those responders were looking at IRC section 215 which in part, ties the deduction for alimony to the recipient including the amount paid in income. That FW did or did not pay tax currently, however, is not the linchpin to why FH gets no alimony deduction.

Structurally, it is not Section 215 that defines taxable alimony. Rather it is Section 71. The QDRO and IRA inclusion rules are not relevant to this question. The transfer under the QDRO is not a payment in cash as required by Section 71, but rather is a transfer of an interest in a qualified plan. Thus the transfer fails to meet the definition of alimony and that is why there is no deduction under Section 215. It matters not how the spouse takes the distributions from the plan, whether she rolls over into an IRA or how she reports the IRA distributions. We don’t get past the “payment in cash” requirement.

Section 215(b) provides in pertinent part:

For purposes of this section, the term “alimony or separate maintenance payment means any alimony or separate maintenance payment as defined in section 71(b) which is includible in the gross income of the recipient under section 71.

Thus, to be deductible, the payment must be alimony as defined by Section 71(b) and includible in the income of Former Spouse.

Section 71(b) provides in part:

For purposes of this section

(1) in general: The term “alimony or separate maintenance payment” means any payments in cash (emphasis added).”

The cash payment must also meet other section 71(b) (1) requirements, namely:

  1. The payment must be made pursuant to a divorce or separation instrument which is defined in Section 71(b) (2) to mean:
    1. i. A Decree of divorce or separate maintenance or a written instrument incident to such a decree.
    2. ii. A written separation agreement, or,
    3. iii. A decree not described above requiring a spouse to make support or maintenance payments to the other spouse.
  2. The qualifying instrument must not designate the payments as non-taxable / non-deductible; and,
  3. There is no liability to make the payments for “any period after the death of the recipient spouse, and no liability to make substitute payments (in cash or property) for alimony after the recipient’s death.”

Another factor not discussed in the ABA board posting is whether the QDRO provided that payments shall continue after the death of the payee spouse. Usually QDRO’s provide that an Alternate Payee shall be treated as a surviving spouse under the plan if the Former Husband dies after the QDRO is entered by the court. There is no protection, however, if the Former Husband dies before the QDRO is entered by the court. Thus, the payment may or may not be deemed by a court to continue beyond the death of the payee spouse. (See post of July 21, “Alimony or Not: That is the Question,” for an example in Nye v. Commissioner of the Tax Court looking to state law to determine if a lump sum payment for alimony arrears satisfies the “end on death” requirement of section 71(b)(1)).

In the situation posed above, however, we don’t need to go that far because the payment is not made in cash and for that reason alone flunks the “payment in cash” requirement of section 71(b).

Finally, another question raised by the Commissioner (IRS) in Nye v. Commissioner but not discussed by the court (or my post of July 21), whether an agreement or court order (in this hypothetical a QDRO) for lump sum payments of alimony arrearages is a decree or separation agreement as described in section 71(b (1) (A). It may not hyper-technically be a divorce decree, separation agreement or other decree requiring a spouse to make support payments. One may argue that the QDRO satisfying alimony arrearages is a support payment but a QDRO is more accurately a property transfer of FH’s interest in an asset, i.e., the 401(k) plan. In Nye the lump sum was not paid under a QDRO, but under a Mediated Settlement Agreement incorporated into the court’s Final Judgment on Modification. We shall watch to see if IRS argues this position in other cases.

Had the Former Husband in our hypothetical taken a distribution from his 401(k) plan (assuming the plan so permitted) and then paid the funds to Former Wife both FH and FW would have been taxed and FH might have been able to deduct the payment as alimony if he did not run afoul of the “ends on death” requirement. He still might have run into trouble with the alimony front loading rules that require recapture during the first three post-divorce or separation years of bunched alimony payments.

The posting on the ABA Tax Law and Practice Discussion Board illustrates the importance of reading the Internal Revenue Code and other primary sources of law in attempting to decipher a solution to tax questions. Reading secondary sources like newspaper articles or CCH’s “Master Tax Guide,” may be helpful but does not substitute for reading the actual law. Even simple questions of tax law can be very puzzling. Also, be mindful that this posting is a discussion of a hypothetical situation and thus simply reflects the author’s opinion. Others might have other opinions and a court might rule differently.

© 2013 by Robert S. Steinberg, Esquire
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