Tax for Litigators

State Bar Annual Meeting (Colorado Springs, CO) New Mexico State Bar • Thursday, October 1, 2015

Oscar Javier Ornelas CPA JD LLM

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Agenda• Taxation of Awards

• Tax Treatment of Legal Fees and Damages

• Tax Issues in Divorce

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Taxation of Awards

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Taxation of Awards• Type of Recovery

• Physical injury/sickness• Emotional Distress• Punitive Damages• Restitution

• Particular Causes of Action• Workplace Injuries• Antitrust Violations

• Drafting Considerations• Proving The Amount of a Tax-Exempt Recovery• Jury Charges

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Taxation of AwardsTypes of Recovery – Physical Injury/Sickness

• Generally not taxable income IRC §104(a); Treas. Reg. § 1.104-1(a), (c) (as amended in 2012

• Exemption does not depend on manner in which recovery is awarded Treas. Reg. §1.104-1(c)(1)

• Defined as “direct unwanted or uninvited physical contacts resulting in observable bodily harms such as bruises, cuts, swelling, and bleeding. PLR 200041022 (Oct. 13, 2000)

• Only those portions of the individual’s recovery that were awarded to compensate the individual for his/her physical injury or sickness are exempt from federal income tax. Commissioner v. Schleier, 515 US 323, 329-330 (1995).

• The recovery must be awarded “because of” the physical injury or sickness suffered by the individual, not merely because the individual’s claim arose because of the physical injury or sickness (i.e., “but for” causation). O’gilvie v. US, 519 US 79, 83 (1996)

• To qualify for exemption, the origin of the individual’s claim (on which a judgment or settlement was awarded) must be based on a physical injury or sickness. US v. Burke, 504 US 229, 237 (1992).

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Taxation of AwardsTypes of Recovery – Physical Injury/Sickness (cont’d)

• If an individual’s cause of action is based on a physical injury or sickness, then the entire award (excluding punitive damages) is exempt from federal income tax: “If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. For example, damages (other than punitive damages) received by an individual on account of a claim for loss of consortium due to the physical injury or physical sickness of such individual’s spouse are excludable from gross income.” H.R. Conf. Rep. 104-737 at 301.

• What portions are generally tax exempt:• medical expenses incurred by the individual (but only to the extent he/she

has not previously claimed such amounts as deductions for federal income tax purposes) IRC § 104(a); Comm’r v. Schleier, 515 US at 329.

• pain, suffering, and emotional distress the individual suffered as a result of the personal injury/sickness Comm’r v. Schleier, 515 US at 329; IRM § 5.18.1.10.2.3.30(6)(G) (as amended 1/28/2010).

• back pay and wages the individual lost because of his/her personal injury/sickness Comm’r v. Schleier, 515 US at 329; IRM § 5.18.1.10.2.3.30(6)(B))

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Taxation of AwardsTypes of Recovery – Physical Injury/Sickness (cont’d)

• Portions that are generally taxable:• interest income (prejudgment or post-judgment) that accrues on the award

IRM § 5.18.1.10.2.3.30(6)(A)

• wages or business profits that the individual lost for reasons other than his/her sickness/injury IRM § 5.18.1.10.2.3.30(6)(B)

• punitive damages (unless awarded in a wrongful-death case or under a state statute that only allows punitive recoveries) IRC § 104(c); IRM § 5.18.1.10.2.3.30(6)(C))

• amounts received to settle pension rights (but only to the extent the award exceeds the individual’s contributions to the pension plan) IRM § 5.18.1.10.2.3.30(6)(D)

• economic recoveries intended to replace an individual’s ordinary income IRM § 5.18.1.10.2.3.30(6)(E)

• recoveries for emotional distress that are unrelated to the individual’s physical injury or sickness (e.g., civil rights claims, employment discrimination, injury to reputation, etc.) IRM § 5.18.1.10.2.3.30(6)(F), (G)

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Taxation of AwardsTypes of Recovery – Emotional Distress

• Not generally considered a physical injury or sickness – so awards to compensate an individual for emotional distress are generally taxable. IRC § 104(a) (flush language); Treas. Reg. § 1.104-1(c)(1).

• Taxable even if the individual’s emotional distress manifested itself through physical symptoms – such as insomnia, headaches, and stomach disorders. H.R. Conf. Rep. 104-737 at 301, n. 56.

• However, recoveries for an individual’s emotional distress that was caused by the physical injury or sickness do qualify for tax exemption. Treas. Reg. § 1.104-1(c)(1).

• Further, emotional distress recoveries may qualify for limited exemption if the physical symptoms caused by such emotional distress required medical care (the exempt amount is limited to the cost of such medical care). IRC § 104(a) (flush language); Treas. Reg. § 1.104-1(c)(1).

• But see Chief Counsel Advice 200809001 (11/27/07): • The IRS held that proceeds from a settlement award were not taxable

where the settlement arose from a sexual molestation case when the award recipient (an adult at the time of the settlement) was a child.

• Even though the IRS conceded that the victim “may have difficulty establishing the extent of his physical injuries[, u]nder these circumstances [] it is reasonable for the [IRS] to presume that the settlement compensated [the victim] for personal physical injuries, and that all damages for emotional distress were attributable to the physical injuries.” 9

Taxation of AwardsTypes of Recovery – Punitive Damages

• As a general rule, punitive damages are taxable as income to the recipient even if the underlying cause of action was based on a physical injury or sickness. IRC § 104(a)(2); Treas. Reg. § 1.104-1(c)(1); H.R. Conf. Rep. 104-737 at 301.

• “Private fines levied by civil juries to punish reprehensible conduct and to deter its future occurrence.” Gertz v. Robert Welch, Inc., 418 US 323, 350 (1974).

• Liquidated damages fall within the definition of “punitive damages” and are generally taxable. Commissioner v. Schleier, 515 US at 331-332; Trans World Airlines, Inc. v. Thurston, 469 US 111, 125 (1985).

• Exception for Wrongful Death• While punitive damages are generally taxable, such damages are exempt if

awarded in a wrongful death claim. IRC § 104(c); H.R. Conf. Rep. 104-737 at 301.

• Where the wrongful death claim is brought under state law, the punitive damages are not taxable if the applicable state statute (as of September 13, 1995) continues to provide (or is interpreted as providing) that punitive damages are a claimant’s the sole remedy. IRC § 104(c)(2).

• No such qualification appears to apply, however, when the wrongful death claim is based on federal law. For example, the IRS determined as not taxable damages that a widow received from her wrongful death claim after her husband died while serving on board a US naval ship. Rev. Rul. 68-649, 1968-2 Cum. Bull. 52 10

Taxation of AwardsTypes of Recovery – Restitution

• Restitution paid by the US government and awarded under federal law may be exempt from federal income tax, but tax exemption must by specified by statute:• Certain payments made by US government to individuals affected by the

settling of international boundary dispute between the US and Mexico 22 USC § 277D-23

• Certain payments made by US government to individuals harmed by radiation exposure caused by US nuclear weapons program H. Rept. No. 101-463 at 10

• Restitution awarded under a federal law that penalized criminal acts of human trafficking Notice 2012-12, 2012-6 IRB 365

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Taxation of AwardsCauses of Action – Workplace Injuries

• Recoveries for personal injuries/sickness are exempt if awarded under a under workmen’s compensation statute or statute that is “in the nature of” a workman’s compensation statute (i.e., limits benefits to injuries, disabilities or sickness suffered in the course of employment ). IRC § 104(a)(1); Treas. Reg. § 1.104-1(b)

• Injury for which recovery is awarded must be job related• Where a statute provides benefits for both workplace and non-occupational

injuries (“dual-purpose statute”), the recovery is exempt if granted pursuant to the workman’s compensation portion of the statute. Craft v. US, 879 F. Supp. 925, 931-932 (S.D. IN, 1995).

• Also exempt is compensation which is paid under a workmen's compensation act to the survivor(s) of a deceased employee. Treas. Reg. § 1.104-1(b)

• Not exempt:• Retirement pension or annuity if determined by reference to the employee's

age, length of service, prior contributions to such pension/annuity – even if employee was forced to retirement because of occupational injury or sickness. Treas. Reg. § 1.104-1(b)

• Where a workman’s compensation statute allows for compensation for occupational disability and length-of-service benefits, only those benefits for occupational disability are exempt. Recoveries must be separable under the statute. Rev. Rul. 80-44, 1980-1 Cum. Bull. 34.

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Taxation of AwardsCauses of Action – Workplace Injuries (cont’d)

• Not exempt (cont’d):• Recoveries for a non-occupational injury or sickness (although these may

be exempt under § 104(a)(2)) Treas. Reg. § 1.104-1(b)

• Portion of recovery is for an occupational injury or sickness in excess of the amount provided in the applicable workmen's compensation act(s) Treas. Reg. §1.104-1(b)

• Disability payments received while employee was performing light-duty work or participated in retraining program. Morris v. Comm’r, TC Memo 1987-7; Albertini v. Comm’r, TC Memo 1981-619

• Benefits that an employee receives from an accident or health insurance policy for personal injuries or sickness are generally taxable to the extent the premiums for such policy were (a) paid by the employer, or (b) excluded from the employee’s gross income. IRC §§ 104(a)(3), 105(a); Treas. Regs. §§ 1.104-1(d), 1.105-1(a) (as amended in 1964).

• Benefits that would be taxable under the preceding rule may be exempt if:• The taxable benefits are paid directly or indirectly to the taxpayer to

reimburse him for medical care of the taxpayer, his spouse or his dependents. IRC § 105(b); Treas. Reg. § 1.105-2 (as adopted in 1956).

• Payments (a) compensate taxpayer for loss (or loss of use) of a or function of the body, or the permanent disfigurement, of the taxpayer, his spouse, or a dependent, and (b) are calculated without reference to amount of time taxpayer is absent from work. IRC § 105(c); Treas. Reg. § 1.105-3 (as adopted in 1956).

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Taxation of AwardsCauses of Action –Anti-Trust Violations

• Tax exemption for “compensable injuries” is equal to the lesser of (a) amount of recovery or (b) unrecovered loss resulting from the compensable injury. IRC §186(a); Treas. Reg. § 1.186-1(a) (as adopted in 1972)

• Tax exempt amount of a recovery is limited to the amount of actual economic damages claimed by taxpayer. Punitive damages and interest awarded on the recovery are taxable. Treas. Reg. § 1.186-1(c)(1), (2).

• Amounts received pursuant to a settlement agreement are exempt only if (a) taxpayer filed suit with respect to the compensable injury, and (b) allocation of recovery for compensable injuries under the agreement is supported by facts and circumstances. Treas. Reg. § 1.186-1(c)(3).

• This exemption is based on the tax benefit rule: losses attributable to these economic injuries may not have resulted in a tax benefit (i.e., deductible loss) to the taxpayer in the year they occurred because the taxpayer may not have had enough income (loss limitation). Reducing taxpayer’s income by the amount of the recovery received restores tax benefit lost in prior year. Explanation of Pub. L. 91-172, JCS-16-70 (1970) at 237.

• Definitions• “Compensable injury” means injuries sustained (a) from infringement of a

patent issued under 35 USC 153 (whether the injured party or another was issued the patent), (b) from breach of fiduciary duty or relationship (including third-party beneficiaries), and (c) to business/property by conduct forbidden under anti-trust laws of the Clayton Act (15 USC 15). IRC § 186(b); Treas. Reg. § 1.186-1(b)

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Taxation of AwardsCauses of Action –Anti-Trust Violations (cont’d)

• Definitions (cont’d)• “Compensable amount” means amount recovered for a compensable injury

(whether by jury award or settlement agreement) in civil action net of amounts paid to secure the recovery. IRC § 186(c); Treas. Reg. § 1.186-1(c)(1)

• “Amounts paid to secure recovery” legal expenses such as attorney's fees, witness fees, accountant fees, and court costs. Treas. Reg. § 1.186-1(c)(4).

• Costs are allocated between actual economic damages and other damages based on ratio of each type of damages to total damages.Treas. Reg. § 1.186-1(c)(4).

• “Unrecovered losses” means net operating losses (NOLs) within the “injury period” attributable to the compensable injury net of (a) any NOLs carried back or forward to another taxable year, and (b) any recoveries received in prior taxable years for the same compensable injury. IRC § 186(d)(1); Treas. Reg. § 1.186-1(d)(1).

• “Injury period” generally means the period of time during which the compensable injury occurred. IRC § 186(d)(2); Treas. Reg. 1.186-1(d)(2)

• An NOL is “attributable to” a compensable injury to the extent of the loss caused by the compensable injury during a taxable year within the injury period. IRC § 186(d)(3); Treas. Reg. § 1.186-1(d)(3), (4). 15

Taxation of AwardsDrafting Considerations

• Courts interpret tax exemptions are narrowly. Comm’r v. Schleier, 515 US 323, 328 (1995).

• Verdicts - Whether damages awarded by a jury are tax exempt depend on the basis for the award as evidenced in the verdict, the taxpayer’s pleadings, the remedies provided under the law pursuant to which the taxpayer filed suit, and the underlying harm the taxpayer seeks to redress. O’gilvie v. US, 519 US 79, 83 (1996); Comm’r v. Schleier, 515 US 323, 329-330 (1995).

• Settlement Agreements• The taxpayer bears the burden of proving that the settlement award was in

lieu of damages for physical injuries or physical sickness. Green v. Comm’r, 507 F.3d 857, 867 (5th Cir., 2007).

• Entire settlement award may be subject to tax if taxpayer fails to establish the portion of the award attributable to tax exempt damages. Pipitone v. US, 180 F.3d 859, 865 (7th Cir. 1999).

• The nature of the claim that was the actual basis for settlement controls whether damages awarded pursuant to a settlement agreement are tax exempt. US v. Burke, 504 US 229, 237 (1992).

• The determination of the nature of the underlying claim is factual, and is usually made by reference to the settlement agreement. Bagley v. Comm’r, 105 T.C. 396, 406 (1995); Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965).

• Whether the settlement payment is excludable from gross income depends on the nature and character of the claim asserted, and not upon the validity of that claim. Bent v. Comm’r, 87 T.C. 236, 244 (1986), aff’d., 835 F.2d 67 (3rd Cir. 1987).

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Taxation of AwardsDrafting Considerations (cont’d)

• Settlement Agreements (cont’d)• A court is not bound by the allocation of damages in settlement, particularly

when it appears that one party may not have had a strong motivation to negotiate at arm's length as to the characterization and/or division of the settlement amounts. Dotson v. US, 87 F.3d 682, 687 (5th Cir. 1996).

• Factors to be considered in making the allocation include the allegations contained in the complaint, the defenses asserted, the background of the litigation, the amount paid, the evidence adduced at trial and other facts pertinent to the controversy giving rise to the settlement. Estate of Morgan v. Comm’r, 332 F.2d 144, 151 (5th Cir. 1964); Green v. Comm’r, 507 F.3d 857, 867 (5th Cir. 2007).

• The intent of the payor in agreeing to the settlement agreement is critical to determining what the agreement was to settle if the settlement agreement lacks express language. Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965).

• Although the belief of the payee is relevant to determining the nature of the claim settled by agreement, the character of the settlement payment hinges ultimately on the dominant reason of the payor in making the payment. Agar v. Commissioner, 290 F.2d 283, 284 (2d Cir. 1961).

• A jury's verdict is the best evidence in determining a payor's intent in a post-verdict settlement. US v. Burke, 504 U.S. 229, 234 (1992). 17

Taxation of AwardsDrafting Considerations (cont’d)

• Settlement Agreements (cont’d)• Specificity as to claims settled and allocation of damages matter

• Sole reference to “personal injuries” in boilerplate provision of settlement agreement or standardized settlement form insufficient to qualify award as exempt. Ahmed v. Comm’r, TC Memo 2011-295; Dorroh v. Comm’r, TC Summary Opinion 2003-93; Brennan v. Comm’r, TC Memo 1997-317.

• Inclusion of confidentiality, non-disclosure and anti-defamation provisions in settlement agreement indicated payor’s concern for such protections and portion of award allocated accordingly in the absence of an express allocation under the agreement. Amos v. Comm’s, TC Memo 2003-329.

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Taxation of Awards• Type of Recovery

• Physical injury/sickness• Emotional Distress• Punitive Damages• Restitution

• Particular Causes of Action• Workplace Injuries• Antitrust Violations

• Drafting Considerations

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Tax Treatment of Legal Fees & Damages

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Legal Fees and Damages• Deductibility of Legal Fees

• Deductibility of Damage Awards

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Legal Fees & DamagesDeductibility of Legal Fees

• Business v. Personal Expense• In general, ordinary and necessary expenses incurred or paid for business

purposes are deductible. IRC § 162(a); Treas. Reg. § 1.162-1(a) (as amended in 1993).

• On the other hand, neither personal living expenses nor expenses paid or incurred to acquire or defend title to property are generally deductible for tax purposes. IRC §§ 262(a), 263(a); Treas. Regs. §§ 1.262-1(a) (as amended in 1972), 1.263(a)-2(e)(1) (as amended in 2013).

• Whether legal fees are paid or incurred for business or personal reasons, and therefore deductible or not, depends on whether the claim for which the legal fee is paid or incurred arises from a profit-making activity (origin of the claim test) – not the ultimate effect the legal proceedings may have on the profit-making activity. US v. Gilmore, 372 US 39, 48 (1963).

• Even though civil fines and penalties may not be deducted, legal fees paid or incurred in defense or prosecution of the assessment of such civil fines and penalties may be deducted if the legal fees are otherwise ordinary and necessary business expenses. Treas. Reg. § 1.162-21(b)(2) (as amended in 1975).

• Legal fees paid or incurred to defend title to property are an addition to the basis of property and must be capitalized rather than deducted. Treas. Reg. § 1.263(a)-2(e)(1). 22

Legal Fees & DamagesDeductibility of Legal Fees (cont’d)

• Legal fees paid for certain personal matters are deductible• Legal fees paid in connection with divorces or legal separations are

generally non-deductible personal expenses. However, legal fees paid in connection with claims for alimony are deductible by the payor spouse for tax purposes as expenses incurred for the production of income. Treas. Reg. §1.262-2(d)(7).

• As a general rule, contingent attorney’s fees collected from a taxpayer’s recovery of damages are an anticipatory assignment of income from by the taxpayer to the attorney and must be included in the taxpayer’s income. Comm’r v. Banks, 543 US 426, 435 (2005).

• To the extent the damages recovered are not taxable the legal fees attributable to such tax exempt recoveries are not deductible. IRC § 265(1); Treas. Reg. § 1.265-1(a)(2) (as adopted in 1958).

• Legal fees paid or incurred to obtain damages that are taxable are deductible as miscellaneous itemized deductions because the expenses were incurred for the production of income. IRC § 212; Treas. Reg. §1.212-1(k) (as amended in 1975).

• Legal fees paid or incurred in connection with certain civil rights violations and whistleblower actions are deductible in full from a taxpayer’s taxable income. IRC § 62(a)(20), (21). 23

Legal Fees & DamagesDeductibility of Damage Awards

• Fines and Penalties• Civil fines and penalties assessed on a taxpayer are not deductible as a

matter of public policy. IRC § 162(f); Treas. Reg. § 1.162-21(a).

• A non-deductible fine/penalty is one that is paid to a sovereign or subdivision or instrumentality of government pursuant to a criminal conviction or guilty plea (including no contest), a civil penalty, a settlement of an actual or potential civil or criminal fine or penalty, or a forfeiture of collateral posted in a proceeding that could result in the imposition of such fine or penalty. Treas. Reg. § 1.162-21(a); (b)(1).

• Fines and penalties paid to private parties may be deducted. Allied Signal Inc. v. Comm’r, 54 F.3d 767 (3rd Cir. 1995).

• Compensatory Damages/Restitution• Compensatory damages paid to a government are not included within the

definition of a “fine or penalty” – so the same may be deducted if it is otherwise a valid business expense. Treas. Reg. § 1.162-21(b)(2).

• Punitive damages paid to the government, on the other hand are similar to government fines and penalties and are not deductible.

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Legal Fees & DamagesDeductibility of Damage Awards (cont’d)

• Compensatory Damages (cont’d)• Where a statute is unclear as to the type of damage paid to the

government, the purpose served by the statutory penalty controls rather than the conduct that caused the violation. Southern Pac. Transp. Co. v. Comm’r, 75 TC 497, 653 (1980).

• A government assessment is “compensatory” if imposed to encourage prompt compliance with a legal requirement, or as a remedial measure to compensate another party. Southern Pac. Transp. Co. v. Comm’r, 75 TC 497, 652 (1980).

• Compensatory damages or restitution paid to a private party may be deducted. Stephens v. Comm’r, 905 F.2d 667 (2nd Cir., 1990).

• Anti-Trust Damages – a taxpayer may deduct one third (1/3rd) of the judgment paid following their criminal conviction for a violation under the Clayton Act. IRC § 162(g); Treas. Reg. § 1.162-22(a) (as adopted in 1972).

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Legal Fees and Damages• Deductibility of Legal Fees

• Deductibility of Damage Awards

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Tax Issues in Divorce

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Tax Issues in Divorce• Alimony

• Child Support

• Property Settlements

• Claiming Children as Dependents

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Tax Issues in DivorceAlimony

• Prior to 1942, some states taxed alimony and others did not. Congress enacted the precursor of IRC Section 71 to standardize the tax treatment of alimony. While the constitutionality of the taxation of alimony has not been decided by the US Supreme Court, the Court of Claims held that alimony is “income” to the recipient for purposes of the 16th Amendment. Mahana v. US, 88 F.Supp. 285, 288 (Ct. Cl. 1950).

• Alimony payments are taxable to the recipient and deductible to the payor. IRC §§71(a), 215(a); Treas. Reg. § 1.215-1(a) (as adopted in 1957).

• To qualify as “alimony,” payments must meet all of the following conditions:• be made pursuant to a “written divorce or separation instrument” IRC § 71(b)(1)(A),

(B)

• divorce or separate maintenance decree or written instrument incident to the same IRC § 71(b)(2)(A)

• written separation agreement IRC § 71(b)(2)(B)

• any other type of decree requiring a spouse to make payments for the support or maintenance of the other spouse IRC § 71(b)(2)(C)

• be in cash (not property, in-kind payments, services, or use of property) IRC §71(b); Treas. Reg. § 1.71-1T, Q&A 5

• be received by (or on behalf of) a spouse IRC § 71(b)(1)(A)

• includes cash payments made to 3rd parties for the benefit of spouse (rent, mortgage, tax, or tuition liabilities) Treas. Reg. § 1.71-1T, Q&A 6

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Tax Issues in DivorceAlimony (cont’d)

• Requirements of payments to qualify as “alimony” (cont’d):• be received by (or on behalf of) a spouse (cont’d)

• also includes payment of premiums for term life insurance on payor’slife but owned by recipient Treas. Reg. § 1.71-1T, Q&A 6

• includes 3rd party payments requested, contented to, or ratified in writing by the recipient Treas. Reg. § 1.71-1T, Q&A 7

• does not include payments to maintain property that payor owns but used by recipient – even if so provided by agreement Treas. Reg. § 1.71-1T, Q&A 6.

• not be designated as payments that are excludible from recipient’s taxable gross income or for which a tax deduction is not allowable to payor IRC §71(b)(1)(B); Treas. Reg. § 1.71-1T, Q&A 8.

• designation of payment as not taxable/deductible as alimony is respected if made in any writing that makes reference to the parties’ divorce or separate maintenance decree Treas. Reg. § 1.71-1T, Q&A 8.

• if parties are under temporary support order, non-taxable/deductible designation must be incorporated into original or subsequent temporary support order and the same must be attached to recipient’s Form 1040 Treas. Reg. § 1.71-1T, Q&A 8

• not be treated as payments for child support Treas. Reg. § 1.71-1T, Q&A 1530

Tax Issues in DivorceAlimony (cont’d)

• Requirements of payments to qualify as “alimony” (cont’d):• not be required (as such or as substitute payments) for any period after

recipient dies – and the instrument must expressly so state. IRC § 71(b)(1)(D); Treas. Reg. § 1.71-1T, Q&A 10-12

• Alimony payments shall not be classified as such if payor and recipient either:• are members of the same household when the payments are made IRC § 71(b)(1)(C);

Treas. Reg. § 1.71-1T, Q&A 9

• parties must not be living under the dwelling unit Treas. Reg. § 1.71-1T, Q&A 9

• disqualification rule does not apply if recipient leaves dwelling occupied by payor within 1 month after payment is made (1 month grace period) Treas. Reg. § 1.71-1T, Q&A 9

• file a joint return IRC § 71(e)

• Restricting acceleration of alimony payments (“Frontloading”)• One of both parties may desire to pay more alimony than required by the

divorce or separation agreement. If the excess payments are large enough, then the payor’s deductions for excess payments are reversed and included in gross income beginning in the 3rd post-separation year, and recipient can deduct the excess payments beginning in the 3rd post-separation year. IRC § 71(f)(1); Treas. Reg. § 1.71-1T, Q&A 24. 31

Tax Issues in DivorceAlimony (cont’d)

• Restricting Frontloading (cont’d)• Frontloading is allowed in any of the following circumstances:

• Before end of 3rd post separation year, alimony payments end either because (a) payor or recipient dies, or (b) recipient remarries IRC § 71(f)(5)(A); Treas. Reg. § 1.71-1T, Q&A 25

• Payments were made pursuant to a decree other than a divorce or separate maintenance decree or written separation agreement IRC §71(f)(5)(B)

• Continuing liability requires alimony payments (over a period of at least 3 years) in amounts equal to a percentage of (a) business/property income or (b) employment or self-employment (i.e., payor did not intentionally frontload) IRC § 71(f)(5)(C)

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Tax Issues in DivorceChild Support

• Payments made under a divorce or separation instrument for the support of children of the payor spouse are not “alimony.” Thus, such amounts are not taxable to the recipient or deductible by the payor. IRC § 71(c)(1); Temp . Treas. Reg. § 1.71-1T(c), Q&A 15 (as issued in 1984).

• A payment will be treated as a “child support” payment if• It is expressly so designated in the divorce or separation instrument, or• An amount payable under the divorce or separation instrument will be

reduced (a) upon the occurrence of a contingency relating to a child, or (b) at a time clearly associated with such a contingency. IRC § 71(c)(2); Treas. Reg. § 1.71-1T(c), Q&A 16.

• A contingency “relates to a child” if it depends on any events relating to the child – regardless of the likelihood of the event occurring. Treas. Reg. §1.71-1T(c), Q&A 17.

• A reduction will be clearly associated with a similar contingency if the reduction is to occur (a) not more than 6 months before/after the child reaches the age of majority, or (b) 2 or more occasions not more than 1 year before or after payor’s different child attains a certain age between 18 and 24 years old. Treas. Reg. § 1.71-1T(c), Q&A 18.

• If less than the full amount of a child support payment (as stated in the instrument) is actually paid, then a portion of an alimony payment will be reclassified as child support to make up the difference. IRC § 72(c)(3).

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Tax Issues in DivorceProperty Settlement

• The transfer of property between spouses incident to a divorce is not a taxable event. IRC § 1041(a)(2); Temp . Treas. Reg. § 1.71-1T(c), Q&A 15 (as issued in 1984).

Transfer is treated as gift between spouses and transferee succeeds to transferor’s basis in the property transferred. IRC § 1041(b).

• Transfer takes place “incident to divorce” if the transfer occurs (a) within 1 year after marriage ceases, or (2) is related to the cessation of marriage. IRC § 1041(c).

• Marriages that are annulled or declared “void ab initio” still qualify as “divorces.” Temp. Treas. Reg. § 1.1041-1T(a), Q&A 8. (as amended in 2003).

• A transfer is “incident to divorce” if it takes place no more than 6 years after the cessation of marriage. Temp. Treas. Reg. § 1.1041-1T(a), Q&A 7.

• The nonrecognition rule does not apply in situations where:• the recipient spouse is a nonresident alien, IRC § 1041(d); Temp. Treas. Reg. § 1.1041-

1T(a), Q&A 3.

• the adjusted basis of the property transferred is less than the liability to which it is subject, IRC § 1041(e).

• property other than real or tangible personal property is transferred, or Temp. Treas. Reg. § 1.1041-1T(a), Q&A 4.

• property that was acquired after the end of the marriage is transferred. Temp. Treas. Reg. § 1.1041-1T(a), Q&A 5. 34

Tax Issues in DivorceProperty Settlement (cont’d)

• Qualified Domestic Relations Orders (QDROs)• QDROs allow the division of tax-favored retirement assets between

spouses as a result of divorce without triggering income tax consequences to the retirement plan beneficiary. IRC § 414(p)(1)

• To qualify as a QDRO, the order must:• Specify the following: IRC § 414(p)(2)

• names and addresses of the plan participant and alternate payee (i.e., former spouse),

• amount or percentage of plan participant’s benefits to be paid to alternate payee or the manner of calculating same,

• number of payments or time period covered by the order• the plans the order covers.

• Avoid the following: IRC § 414(p)(3)

• require a plan to provide any type or form of benefit, or any option, not otherwise provided under the plan,

• require the plan to provide increased benefits,• require the alternate payee to receive benefits that must be paid to

another alternate payee.35

Tax Issues in DivorceClaiming Children as Dependents

• If a child’s parents do not file jointly, then the parent with whom the child resided the longest during the taxable year (i.e., “custodial parent”) can claim the child as a dependent. IRC § 152(c)(4)(B)(i); Treas. Reg. § 1.152-4(a) (as amended in 2008).

• If the child resided an equal amount of time with each parent, then the parent with the higher adjusted gross income (AGI) can claim the child as a dependent. IRC § 152(c)(4)(B)(ii); Treas. Reg. § 1.152-4(d)(4).

• A child “resides” with a parent if such child sleeps at the parent’s residence, in the parent’s company, or would have slept at a parent’s residence but for the child’s absence. Treas. Reg. § 1.152-4(d)(1), (d)(3)(i).

• These rules apply irrespective of whether the parents are divorced or separated; and a parent’s designation as a “custodial” or “noncustodial” parent depends solely on the length of time the child spent with such parent during the taxable year. IRC § 152(e)(4).

• In cases where the parents of a child are divorced or separated and the child is in the custody of at least one of the parents, the custodial parent can allow the noncustodial parent to claim their child as a dependent for tax purposes by signing a waiver to such effect (Form 8332). IRC § 152(e)(2); Treas. Reg. § 1.152-4(b)(2)(i), (3)(i).

• A parent has “custody” of a child if they have the right under state law to physical custody of the child for more than 50% of the taxable year. Treas. Reg. §1.152-4(d).

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Tax Issues in DivorceClaiming Children as Dependents (cont’d)

• Custodial parent’s waiver of right to claim child as dependent (cont’d)• The noncustodial parent must attach the waiver to their federal income tax

return when claiming their child as a dependent. IRC § 152(e)(2); Treas. Reg. § 1.152-4(b)(3)(i).

• This procedure is available to spouses who are not separated or divorced, so long as they lived apart at all times for the last 6 months of the taxable year. IRC § 152(e)(1).

• The noncustodial parent cannot claim their child as a dependent under this procedure, however, in cases where a multiple support arrangement (Form 2120) is in effect. IRC § 152(d)(5).

• A multiple support arrangement is an agreement in which all persons who provided at least 10% of the support to a child and would otherwise had been able to claim the child as a dependent for tax purposes (but none of whom provided at least 50% of the support to the child) agree to allow one persons amongst them to claim the child as a dependent for tax purposes. IRC §152(d)(3); Treas. Reg. § 1.152-3(a) (as amended in 2003).

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Tax Issues in Divorce• Alimony

• Child Support

• Property Settlements

• Claiming Children as Dependents

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