By Justin T. Miller, J.D., LL.M., TEP, AEP®, CFP®
This is the second in a three-part series focusing on tax issues in divorce before and after tax reform. To view the first part, please click here. Stay tuned for the concluding piece in the March issue, which will be discussing retirement accounts, property transfers and division of property and support trusts in lieu of alimony.
The TCJA eliminated dependency exemptions for 2018 through 2025, however, it increased the child tax credit for 2018 through 2025 from $1,000 to $2,000 per child, and it significantly increased the phase-out limit for the child tax credit during that same time period.[1] As of 2018, the phase-out for the child tax credit begins for married taxpayers at $400,000 and the phase-out begins for all other taxpayers at $200,000.[2]
Prior to 2018 and after 2025 taxpayers are permitted to claim one exemption for each person claimed as a dependent—that is, the “dependency exemption.”[3] Only one taxpayer may claim a dependency exemption for a child for a tax year.[4] The dependency exemption for a child may not be split between two or more taxpayers.[5] The dependency exemption, similar to a tax deduction, reduces taxable income resulting in the payment of less income tax.[6] The exemption amount is adjusted each year for inflation; the exemption amount is $4,050 in 2017.[7] The child tax credit applies to a “qualifying child,” who must be under 17 years old as of the last day of the taxable year, and must be related to the parent, based on a broad definition— including biological and adopted children, stepchildren, foster children living in the parent’s care, siblings, stepsiblings, or a child of any of such individuals.[8] Beginning in 2018 through 2025, the T.C.J.A. also provides that a parent may be able to claim an additional $500 family credit for each non-child dependent, and all the old rules for claiming adult dependents on a tax return still apply—which generally are the same as they are for qualifying child dependents, but who do not meet the age requirement.[9]
For the dependency exemption, child tax credit or family credit, the dependent generally must meet the following six requirements:
The IRS presumes that the custodial parent is entitled to the exemption or credit for children.[16] Generally, the custodial parent is considered to be the parent who has physical custody of the child for most of the year.[17] Custody typically is determined by the number of nights spent with each parent, although there is an exception for parents who work at night.[18] If the child spends an equal amount of time with each parent, then the parent with highest adjusted gross income is considered the custodial parent.[19] Even if the custody decree grants physical custody to one parent, the tax court has held that “this parent is not entitled to a dependency exemption when the children did not live with this parent for most of the year.”[20]
There are certain instances where it may make more sense for the noncustodial parent to claim the dependency exemption or child tax credit—for example, where the custodial parent makes too much to benefit from the exemption. In such circumstances, a custodial spouse may be able to give the dependency exemption or child tax credit to the non-custodial spouse— treating the child as the qualifying child or qualifying relative of the noncustodial parent.[21]
Example 1. Grace and Henry are divorced and have two minor children. Grace, who is the custodial parent, makes $500,000 per year as a senior executive of a successful technology company. Henry is a school teacher who makes $60,000 per year and receives $75,000 per year of alimony. For 2017, Grace will not be able to take advantage of the two dependency exemptions for tax purposes due to the phase out of personal exemptions pursuant to the American Taxpayer Relief Act of 2012,[22] which fully phases out in 2017 at $384,000 if filing as single and $410,150 if filing as head of household.[23] Rather than waste the dependency exemptions in 2017, Grace could give the dependency exemptions to Henry, the noncustodial parent. For 2018 through 2025, Grace and Henry could agree (or a court could order) that Grace will give the child tax credit to Henry—who may have a greater need for the financial benefit— especially since dependency exemptions were eliminated by the T.C.J.A. for that time period.
In order to “trade” the dependency exemption, both of the following conditions must be met: (1) the custodial parent signs IRS Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent,[24] or a substantially similar statement; and (2) the noncustodial parent attaches the Form 8332 or the statement to his or her return.[25] While the T.C.J.A. is not clear, a custodial spouse should be able to give the benefit of the child tax credit to the non-custodial spouse in the same manner as a dependency exemption.[26]
Spouses also may be able to structure the use of dependency exemptions or child tax credits as part of a creative settlement solution. For instance, each spouse could alternate who claims the child from year to year in order to share the tax benefit—for example, one spouse gets the dependency exemption or child tax credit in even years and the other spouse gets the dependency exemption or child tax credit in odd years.[27] If there is more than one child, spouses can split the exemption or credit for each child between them, which is allowed even if both children spend the same amount of time with each parent.[28]
A state divorce court often orders in its divorce decree that the custodial parent must give the dependency exemption to the noncustodial parent.[29] It may be less common for a divorce decree or written separation agreement to address the release of the child tax credit due to the lower phaseout limits prior to the T.C.J.A., and it is unclear whether an existing order or written separation agreement to release a dependency exemption also would apply to a child tax credit due to the T.C.J.A. changes. Regardless of the foregoing, such a state court order or agreement generally has no effect on the Service or the tax court because federal law determines who may claim a dependency exemption or child tax credit—meaning, the Service and the tax court likely will not pay any attention to such an order or agreement.[30] Consequently, if the spouses agree that it would be more efficient for tax purposes to have the noncustodial parent claim a dependency exemption or child tax credit, then a signed IRS Form 8332 should be required as part of the final divorce agreement.[31] The only purpose of the IRS Form 8332 or similar statement is to release the custodial parent’s claim to the child’s exemption or credit.[32] Moreover, the IRS Form 8332 or similar statement must release the custodial parent’s claim to the child without imposing any conditions—for example, the release must not depend on the noncustodial parent paying support.[33]
If the noncustodial parent fails to make the required child support payments, then the custodial parent can revoke the IRS Form 8332 release.[34] The custodial parent can use Part III of IRS Form 8332 for this purpose and must attach a copy of the revocation to his or her return for each tax year he or she claims the child as a dependent as a result of such revocation.[35] The custodial parent also must give—or make a reasonable effort to give—written notice of the revocation to the noncustodial parent.[36]
If the custodial parent releases a claim to the dependency exemption or child tax credit for a child for a specific year, the custodial parent may not claim the exemption or credit for that child.[37] However, certain tax benefits for a qualifying child may not be “traded” to the other parent—meaning the benefits are available to only the custodial parent—such as: (1) head of household filing status; (2) dependent care credit; (3) exclusion from income for dependent care benefits; (4) Hope scholarship credit; (5) lifetime learning credit; and (6) earned income credit.[38]
In general, spouses may exclude from taxable income a substantial amount of capital gains on the sale of their principal residence if they have owned and used the home as a principal residence for two of the last five years, and they have not taken advantage of the principal residence exclusion within the last two years.[39] The exclusion amount from capital gains is $250,000 if single or $500,000 if married.[40] In order to take advantage of the $500,000 exclusion amount, the following must apply:
For purposes of the ownership test, a spouse’s period of ownership is attributable— imputed—to the other spouse.[42] For instance, if the spouse who owns the home transfers it to the other spouse pursuant to the divorce, the transferring spouse’s period of ownership is attributed to the other spouse’s ownership; thus, the transferring spouse’s holding period becomes part of the other spouse’s ownership period.[43]
Example 1. Kathy and Larry are getting a divorce this year. Kathy purchased a home five years ago, and both Kathy and Larry have occupied the home as their principal residence for the past two years. Pursuant to the divorce decree, Kathy will be transferring ownership of the home to Larry. If Larry sells the home next year, he still will be entitled to the $250,000 exclusion (filing as single) because Kathy’s ownership period is treated as his ownership period. Thus, Larry satisfies both the use and ownership requirements.[44]
Note also that a spouse owning a home is treated for tax purposes as using the home as a principal residence during any period the other spouse is granted use of the home under a divorce or separation agreement—the other spouse’s use of the home is attributed to the spouse who left the home.[45] Therefore, if a spouse moved out of the house before the divorce was final but then ended up getting the house in the proceedings anyway, that spouse still may claim the house as a primary residence.[46]
Example 2. Melissa and Nick are getting a divorce. They have used their home as a principal residence for one year. The spouses both agreed that Melissa will be granted sole use of the home for one more year, and that Nick—who owns the home—will move out of the house into a nearby apartment. When the home is sold a year later, Melissa’s use of the home is attributed to Nick.[47] Accordingly, Nick still will be able to claim the full $250,000 exclusion (filing as single) based on Melissa’s use of the home, even though he only used the home as a principal residence for one year. [48]
To qualify for the home sale exclusion, a spouse does not need to reside in the house at the time he or she sells it.[49] The two years of ownership and use may occur anytime during the five years prior to the date of the sale.[50] For instance, a spouse can move out of the house for up to three years and still qualify for the exclusion, or a spouse may rent out the home for up to three years prior to the sale and still qualify for the exclusion.[51] It is important to track such time periods in order to take advantage of the exclusion.
Example 3. Olivia and Peter purchased a home four years ago for $500,000, and it is now worth $1,000,000. They used the home as their principal residence for two years, but they have been living in separate apartments and renting the house out for the past two years. If Olivia and Peter sell the house this year, while they are married filing jointly, they could exclude the entire $500,000 of capital gains from the sale. If, on the other hand, Peter transfers his half of the residence to Olivia and she sells it next year after the divorce when she is filing as single, then Olivia only would be able to exclude $250,000 of the capital gains (filing as single) and would be subject to taxation on $250,000 of capital gains—potentially subject to federal income tax at a rate as high as 23.8%, including the net investment income tax,[52] as well as state income tax at rates as high as 13.3%.[53] Accordingly, it may be prudent for Olivia and Peter to sell the home prior to finalizing the divorce in order to benefit from the entire $500,000 capital gain exclusion.
A partial exclusion of gain may be available for a spouse who does not meet the ownership and use requirements or who has already used the section 121 exclusion within the prior two years[54] if the sale results from (1) a change in place of employment; (2) health reasons; or (3) unforeseen circumstances. Fortunately for divorcing spouses, an unforeseen circumstance includes divorce or legal separation under a decree of divorce or separate maintenance.[55] The formula for determining the partial exclusion is the following: days of ownership and use, or, if less, days between dates of sale of previous and current home; divided by 730 days; times $250,000 or $500,000—whichever exclusion is applicable.[56]
Example 4. Rebecca and Steve purchased a home as their principal residence one year ago for $250,000. They are now in the process of getting divorced and are selling the home for $750,000. If they had owned and used the home as principal residence for two years, they would have been entitled to a $500,000 capital gain exclusion.[57] Even though they only owned and used the home for half of the required period, they still are allowed to claim half the benefit of the exclusion due to the unforeseen circumstance of divorce—that is, 365 days divided by 730 days times $500,000 (filing as married filing jointly). Accordingly, Rebecca and Steve would be able to exclude $250,000 of the capital gains—half of the $500,000 married filing jointly amount—and would be subject to taxation on the remaining $250,000 of capital gains.
If a spouse qualifies for the exclusion, that spouse may do anything with the proceeds from the sale; the spouse is not required to reinvest or rollover the money into another house— whereas prior law was different.[58] If a spouse buys another home, that spouse can qualify for the principal residence exclusion again if the subsequent sale occurs at least two years later.[59]
Pursuant to the T.C.J.A., single individuals and married spouses have a deductible interest limitation on $750,000 of acquisition indebtedness, if the debt was incurred after December 15, 2017.[60]
If the debt was incurred on or before December 15, 2017 (or incurred to buy a residence under a binding contract that was in effect prior to December 16, 2017, if the transaction closed before April 1, 2018), there is a $1,000,000 deductible interest limitation on acquisition indebtedness.[61] There also used to be deduction for interest up to an additional $100,000 on home equity indebtedness prior to 2018, however, that deduction was eliminated by the T.C.J.A. for all home equity indebtedness after 2018, even if the home equity indebtedness was incurred before 2018.[62] For the home mortgage interest deduction, the debt must be secured by a qualified home, which means a main home or a second home.[63] A “home” includes a house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities.[64] The home must be used by the taxpayer as a residence—meaning the taxpayer uses it for fourteen days within the year or for 10% of the time it is rented, whichever is greater.[65] The taxpayer is deemed to have used the unit to the extent that the taxpayer or “any member of the family of the taxpayer” uses it, which likely does not include a former spouse.[66] A mortgage secured by a qualified home may be treated as home acquisition debt, even if a taxpayer does not actually use the proceeds to buy, build, or substantially improve the home.[67] This applies in the following situations:
Traditionally, the Service has applied the indebtedness limitation[69] on a per-residence basis as opposed to a per-taxpayer basis—meaning that unmarried owners were required to allocate the limitation amounts amongst themselves.[70] However, in August 2015, the United States Court of Appeals for the Ninth Circuit in Voss v. Commissioner of Internal Revenue[71]—in reversing a tax court decision—ruled that each unmarried taxpayer was allowed to individually apply the $1,000,000 limitation (i.e., the limit prior to December 15, 2017).[72] Moreover, in August 2016, the Service acquiesced to the decision in Voss.[73] Accordingly, to the extent former spouses are sharing ownership and use of a main home or second home—which typically is not recommended for emotional and psychological reasons—each former spouse should be entitled to a deductible interest limitation of $1,000,000 (for indebtedness incurred on or before December 15, 2017) or $750,000 (for indebtedness incurred after December 15, 2017). For unmarried couples, the recent ruling also provides individuals who would prefer to stay unmarried with a good financial excuse not to get married—in addition to the marriage tax penalty, discussed above.
In general, fees and expenses related to a divorce are considered non-deductible personal expenses.[74] Except for 2018 through 2025—during which period the T.C.J.A. eliminated miscellaneous itemized deductions[75]—certain divorce-related fees that are attributable to the collection of income or tax advice are deductible, including, expenses that are:
As an example of the foregoing, fees and costs for attorneys, accountants, appraisers, actuaries, and vocational counselors related to obtaining alimony may be deductible.[77] This would include (1) the determination and collection of alimony; (2) the recovery of alimony arrearages—that is, delinquent support; and (3) a claim for an increase in alimony payments.[78] An example of deductible fees and costs for tax advice rendered incident to a divorce would include: (1) structuring a settlement or property division to produce desired tax effects; (2) creating a support trust as an alternative to alimony; (3) estate planning to mitigate estate and gift tax consequences of support or property division; and (4) preparing, submitting, and enforcing a qualified domestic relations order.[79] On the other hand, fees and costs that may not be deductible would include anything related to (1) the payment—as opposed to collection—of alimony;[80] (2) a business, but originating with a divorce action—even if paid through a business and useful for protecting a family business;[81] and (3) property transfers—other than tax advice related to a property division.[82]
Ultimately, the taxpayer has the burden of proving the amount of deductible expenses.[83] To assist the taxpayer, family law attorneys should maintain careful records and separately itemize billings related to tax advice or to income production or collection, which could help clients save thousands of dollars, potentially.[84] Because determining deductibility is dependent on an individual’s particular facts and circumstances, family law practitioners should advise taxpayers to consult with their tax advisors for specific tax advice.
Even if certain divorce-related fees are deductible, those deductions still might be subject to other limitations. For instance, the deductions will be itemized deductions subject to the two percent floor for miscellaneous itemized deductions—which means the deductions will be lost if the individual uses the standard deduction.[85] The deductions also could be lost if the individual is subject to the alternative minimum tax.[86]
Tax carryovers—such as capital loss carryovers, charitable contribution carryovers, net operating loss carryovers, and passive loss carryovers—are property rights that have inherent value and must be considered in a divorce proceeding. Tax carryovers sometimes are overlooked or ignored by family law attorneys and courts. In addition, there is different tax treatment for tax carryovers related to separate property versus marital assets.
Charitable contribution carryovers should be divided post-marriage in accordance with the ratio of amounts that would have carried forward if separate returns were filed in the year of contribution.[87] The Service has ruled that the allocation of excess charitable contribution between spouses cannot be made by agreement between the parties but must be in accordance with the method set forth in the Treasury Regulations.[88]
Capital loss carryovers should be divided post-marriage in accordance with the individual net losses that gave rise to carryover.[89] In other words, the capital loss carryover typically is allocated to the spouse who actually suffered the capital loss.[90] In certain states, capital loss carryovers are treated as marital assets subject to equitable division.[91] For example, the appellate division of the New York Supreme Court in Finkelstein v. Finkelstein[92] held that a capital loss carryover was a marital asset subject to equitable distribution.[93] The court in Finkelstein determined that a capital loss carryover constituted marital property based on the reasoning that marital property should be broadly construed and consist of “things of value arising out of the marital relationship.”[94] Similarly, the Missouri Court of Appeals in Mills v. Mills[95] sustained the trial court’s finding that a long-term capital loss carryover was marital property.[96] In Mills, the trial court made an equal allocation of the loss carryforwards even though the losses were generated by the husband’s capital losses.[97] The ruling in Mills appears to contradict Treasury Regulation section 1.1212-1(c), which provides that if spouses file a joint return for a year in which a net capital loss arises and separate returns are filed for the following year, the carryover is allocated to each spouse on the basis of their individual net capital losses for the preceding year.[98] However, the court in Mills stated:
Husband further asserts that the court’s order awarding wife one-half of the loss carry forward violates Treasury Reg. § 1.1212-1(c). It is well settled that a state court cannot override federal income tax regulations. Calia v. Calia, 624 S.W.2d 870, 873 (Mo. App. 1981). We have examined the regulation and do not find that the trial court’s order violates the regulation in any manner.[99]
Passive loss carryovers may be treated similar to capital loss carryovers. The Missouri Court of Appeals in Silverstein v. Silverstein[100] held that a passive loss carryforward generated during the marriage was a marital asset and that the trial court should have divided it.[101] The court cited Mills to support its decision.[102]
To calculate the appropriate amounts for carryovers, spouses may need to go back and prepare married filing separately returns in the year when the tax loss was generated—solely for calculation purposes—and then prorate the loss between the spouses accordingly going forward.
As a general rule, child support payments are not tax deductible for the parent paying the support and not taxable income for the parent receiving the support.[103] In other words, if a spouse pays child support, that spouse cannot deduct it on a tax return.[104] If a spouse receives child support, the amount that spouse receives is not taxable.[105] While alimony, discussed below, is considered a taxable event,[106] child support is always tax-neutral, meaning it does not affect the spouses’ taxes in any way.[107]
To the extent there is a divorce or separation agreement before 2019—at which point the T.C.J.A. permanently repeals the existing alimony rules—alimony refers to spousal support payments (sometimes called spousal maintenance payments) that meet the requirements for “alimony or separate maintenance payment” under section 71.[108] Unlike child support payments, alimony payments are tax deductible for the spouse making the payments,[109] and the payments are taxable for the spouse receiving the payments.[110]
In order to qualify as alimony, the support payments must meet all of the following strict requirements:
If a spouse makes payments under a divorce decree, separate maintenance decree, or written separation agreement, that spouse may be able to deduct the payments as alimony, provided the payments qualify as alimony for federal tax purposes.[121] If the decree or agreement does not require the payments, then the payments do not qualify as alimony.[122] In most cases, alimony will lower the tax bill of the spouse making the payments. Alimony is an above-the-line deduction, which means the paying spouse does not need to itemize in order to benefit from the tax advantage.[123]
If a spouse receives alimony from a former spouse, the alimony is taxable in the year received.[124] Alimony is not subject to tax withholding, so the receiving spouse may need to increase the payment of taxes during the year to avoid potential penalties.[125] The alimony recipient can accomplish this by either making estimated tax payments or increasing the amount of tax withheld from his or her wages—that is, file a new Form W-4, Employee’s Withholding Allowance Certificate, with his or her employer.[126]
The tax treatment of alimony payments makes it tempting for some divorcing spouses to want to disguise property settlements and child support as alimony. Consequently, the Service has strict rules about what may be treated as alimony for tax purposes.[127] Excessively high or front-loaded payments in the first three post-separation calendar years—starting with the first calendar year that an alimony payment has been made—are subject to recapture or being taxed to the payor in the third post-separation year.[128] In other words, if there is a significantly large payment within a short period of time after the divorce, the Service may consider the payment to be a property settlement (which is not deductible) as opposed to alimony (which is deductible).[129] Exceptions to the recapture rules include (1) payments that cease due to death of either party or remarriage of payee spouse; (2) payments that are pursuant to a temporary order for support; or (3) payments that fluctuate outside of the payor’s control because the payments are based on a percentage or fixed portion of the payor’s income or compensation.[130]
In addition, payments do not qualify as alimony if reductions in such payments are tied to certain childhood events.[131] The “Anti-Lester Rules”[132] under section 71(c)(2) were implemented so that these types of payments would be treated like child support payments, which are not deductible by the payor spouse and not taxable to the payee spouse.[133]
Example 1. Ursula and Victor are getting a divorce, and they have one minor child, Charlotte. Ursula is in a very low tax bracket and Victor is in the highest bracket for tax purposes. Ursula and Victor have agreed that he needs to help support Charlotte until she finishes high school. However, Victor would like to structure the support payments so that he could deduct them as alimony at his high rates, and Ursula would include the payments as income at her lower rates. So, Victor proposes that his monthly payments to Ursula be called “spousal support” and that the requirement to make the payments end six months after Charlotte’s 18th birthday. Under the “Anti-Lester Rules” in section 71, the payments likely will be treated as disguised child support, which do not qualify as alimony.
For any year after 2018, the T.C.J.A.[134] permanently repeals the alimony rules that have been in effect since 1942.[135] Pursuant to section 11051 of the T.C.J.A., the alimony deduction is eliminated for any divorce or separation instrument entered into after December 31, 2018, in which case the ex-spouse receiving the support payments would no longer be required to include the support payments in income. Any divorce or separation instrument finalized before January 1, 2019, will be grandfathered—meaning that the old rules under sections 71 and 215 for alimony will continue to apply, even if the divorce or separation instrument is modified in the future (unless the modification expressly provides that the T.C.J.A. amendments apply to such modification).[136] New section 121(d)(3)(C) is similar to section 71(b)(2) and defines a divorce or separation instrument as: “(i) a decree of divorce or separate maintenance or a written instrument incident to such a decree, (ii) a written separation agreement, or (iii) a decree (not described in clause (i)) requiring a spouse to make payments for the support or maintenance of the other spouse.”[137] Since “written instrument incident to such a decree” is not defined in either the Code or Regulations, a written instrument should be referred to, incorporated into, or approved by the court entering the decree of divorce or legal separation to confirm it is the intention of parties.
A major cause of concern with the T.C.J.A.’s elimination of the alimony deduction is that pre- and post-marital agreements entered into prior to January 1, 2019, may not qualify as a written separation agreement under the T.C.J.A. for purposes of grandfathered treatment under the alimony deduction rules. For spouses who entered into a pre- or post-marital agreement requiring spousal support after a divorce, those payments may no longer qualify for the alimony deduction if those spouses divorce after December 31, 2018—even if the spouses entered into such agreements before January 1, 2019, and intended the payments to qualify under the alimony deduction rules of sections 71 and 215. Without a technical correction or other guidance from the Service or Department of Treasury, a substantial number of pre- and post-marital agreements may need to be updated or modified to take into account the new T.C.J.A. rules.
Life insurance commonly is used in a divorce context to ensure payment of alimony or child support.[138] Life insurance also may be necessary to provide liquidity at death—for example, estate taxes may be due, but the estate may consist mainly of illiquid real estate investments.[139]
In general, the proceeds of a life insurance policy received at the death of the insured are excluded from gross income for income tax purposes, assuming no transfer for value;[140] however, there could be estate tax consequences if the insured retains any incidents of ownership in the policy.[141] Moreover, unless the insured states otherwise in a will, the executor will be entitled to recover from the insurance beneficiary the estate tax attributable to the insurance proceeds—in which case, the divorce agreement should clearly state whether any estate taxes on the policy proceeds are to be paid from the insured spouse’s assets or from the insurance policy proceeds.[142]
To avoid inclusion for estate tax purposes, the insured may be able to transfer ownership to his or her spouse without income or estate tax consequences.[143] However, even with a spousal transfer, there is a “three-year rule” in which the amount of life insurance proceeds may be included in the insured’s estate if the insured dies within three years of transfer.[144] Accordingly, if practical, it may be more efficient for the insured’s spouse to purchase a new policy.
If the former spouse of the insured is both the owner and the beneficiary of the policy, the policy should not be included in the insured spouse’s estate, and the payment of premiums by the insured spouse may be deductible as alimony—if there is a divorce or separation agreement prior to 2019.[145] However, the premium payments would not be deductible if the insured spouse retains policy ownership, even if the policy names the former spouse as beneficiary.[146]
Example 1. Wilma and Zeke are getting a divorce, and have agreed that Wilma will be entitled to $200,000 per year of alimony for the next ten years. To protect such support payments in the event of Zeke’s untimely death, a $2,000,000 life insurance policy could be purchased with Zeke as the insured and Wilma as the beneficiary. If Zeke is the owner of the life insurance policy and the size of his estate at death exceeds the lifetime exclusion amount of $11,180,000 (in 2018),[147] then the insurance proceeds could be subject to a 40% estate tax, which would be $800,000 in estate taxes on a $2,000,000 life insurance death benefit. To avoid that result, Wilma could be both the owner and the beneficiary of the policy, and Zeke’s payments of life insurance premiums could be treated as alimony—taxable to Wilma and deductible by Zeke—provided that there is a divorce or separation agreement before 2019.
Another alternative planning strategy for divorcing spouses would be using an Irrevocable Life Insurance Trust (ILIT).[148] While premium payments would not be deductible as alimony, a properly structured ILIT may have additional gift, estate, and generation skipping transfer (GST) tax benefits.
Example 2. Allison and Ben are getting a divorce. Allison has no children and Ben has three adult children from a previous marriage. Allison and Ben have agreed that a $3,000,000 life insurance policy should be purchased to ensure that Allison continues to receive $150,000 of support payments every year for the next twenty years, even if Ben were to die. Allison and Ben do not want the life insurance proceeds to be subject to estate taxes upon Ben’s death. In addition, Ben does not want Allison to receive anything more than the required support payments on his death and would rather have his three children receive any excess death benefits from the insurance policy. In this case, Ben could create an ILIT to own the insurance policy, and the ILIT would pay Allison support payments for the remaining term after Ben’s death, with the remainder payable to Ben’s children. Ben could fund the life insurance premium payments without gift tax consequences by using his annual gift tax exclusion amount of $15,000 per individual beneficiary (in 2018),[149] and the death benefit would not be included in his estate for estate tax purposes because the ILIT—not Ben—would be the owner of the policy.[150] The ILIT approach could save up to $1,200,000 in estate taxes—that is, 40% of $3,000,000.
Adapted with permission from Justin T. Miller, Making Divorce Less Taxing: A Unique Opportunity for Income, Estate and Gift Tax Planning, 52 Real. Prop. Tr. & Est. L.J., no. 1 (2017). The comments contained in this Article are the individual views of the author who prepared them. The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, or tax advice. The reader should contact his or her legal or tax advisor prior to taking any action based on this information.
Justin T. Miller, J.D., LL.M., TEP, AEP®, CFP®, is a national wealth strategist at BNY Mellon, an adjunct professor at Golden Gate University School of Law, and a Fellow of The American College of Trust and Estate Counsel.
[1] See T.C.J.A. § 11022 and I.R.C. § 24(h).
[2] See id.
[3] I.R.C. § 151(c).
[4] See I.R.C. § 152.
[5] See I.R.C. § 151(d)(2).
[6] See I.R.C. § 151(a).
[7] See Rev. Proc. 2016-55, 2016-45 I.R.B. 707, 713.
[8] See I.R.C. § 15.
[9] See T.C.J.A. § 11022 and I.R.C. § 24(h).
[10] See I.R.C. § 152.
[11] See id.
[12] See id.
[13] See id.
[14] See id.
[15] See I.R.C. § 152(e)(1)(A).
[16] See I.R.C. § 152(c)(4)(B).
[17] See I.R.C. § 152(e)(4).
[18] See Treas. Reg. § 1.152-4(d)(1) – (5).
[19] See I.R.C. § 152(c)(4)(B)(ii).
[20] Maher v. Comm’r, 85 T.C.M. 2003-85 (CCH) 1053, 1056 (2003).
[21] See I.R.C. § 152(e).
[22] American Taxpayer Relief Act of 2012, Pub. L. No. 112–240, H.R. 8, 126 Stat. 2313 (Jan. 2, 2013).
[23] See Rev. Proc. 2016-55, 2016-45 I.R.B. 707, 713.
[24] I.R.S. FORM 8332, https://www.irs.gov/pub/irs-pdf/8332.pdf.
[25] See Treas. Reg. § 1.152-4.
[26] See INSTRUCTIONS TO I.R.S. FORM 8332, https://www.irs.gov/pub/irs-pdf/8332.pdf.
[27] See I.R.S. Pub. 504 (2016).
[28] See id.
[29] See, e.g., Hughes v. Hughes, 518 N.E.2d 1213 (Ohio 1988).
[30] See, e.g., Rivas v. Comm’r, T.C.M. 2016-158 (2016); He v. Comm’r, T.C. Summ. 2016-4 (2016); Cappel v. Comm’r, 112 T.C.M. (CCH) 216 (Ohio 1988); I.R.S. C.C.A. 201602009 (Jan. 8, 2016).
[31] See I.R.S. Pub. 504 (2016).
[32] See id.
[33] See id.
[34] See id.
[35] See id.
[36] See id.
[37] See id.
[38] See id.
[39] See I.R.C. § 121.
[40] See I.R.C. § 121(b).
[41] I.R.C. § 121(b)(2); see also Treas. Reg. § 1.121-2(a)(3)(i).
[42] See I.R.C. § 121(b)(2).
[43] See I.R.C. § 121(d)(3)(A); see also Treas. Reg. § 1.121-4(b)(1).
[44] See id.
[45] See I.R.C. § 121(d)(3)(B); see also Treas. Reg. § 1.121-4(b)(2).
[46] See I.R.C. § 121(d)(3)(B).
[47] See id.
[48] See id.
[49] See Treas. Reg. § 1.121-1(c).
[50] See id.
[51] See id.
[52] See I.R.C. § 1411(a)(1).
[53] See Ca. Franchise Tax Bd., Ca. Tax Rates and Exemptions (2015), https://ftb.ca. gov/forms/2015-california-tax-rates-and-exemptions.shtml.
[54] See I.R.C. § 121(c)(2)(B); Treas. Reg. § 1.121-3(b).
[55] See I.R.C. § 121(c)(2)(B); see also Treas. Reg. § 1.121-3(e)(2).
[56] See Treas. Reg. § 1.121-3(g)(1).
[57] See I.R.C. § 121(b)(2)(A).
[58] See Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 312, 111 Stat. 788, 836-41.
[59] See I.R.C. § 121(b)(3).
[60] See T.C.J.A. § 11043 and I.R.C. § 163(h)(3).
[61] See id.
[62] See I.R.C. § 163(h)(3).
[63] See I.R.C. § 163(h)(4)(A).
[64] Treas. Reg. § 1.163-10T(p)(3)(ii).
[65] See I.R.C. § 280A(d)(1).
[66] I.R.C. § 280A(d)(2).
[67] See I.R.S. Pub. 936 (2016).
[68] See id.
[69] See I.R.C. § 163(h)(3).
[70] See id.
[71] 796 F.3d 1051 (9th Cir. 2015), rev’g Sophy v. Comm’r, 138 T.C. 204 (2012).
[72] See id. at 1068.
[73] A.O.D. 2016-2, 2016-31 I.R.B. 193.
[74] See United States v. Gilmore, 372 U.S. 39, 42 (1963).
[75] See T.C.J.A. § 11045 and I.R.C. § 67(g).
[76] I.R.C. § 212.
[77] See I.R.C. § 71.
[78] See I.R.C. §§ 71,212 and 71,215 (providing that a spouse’s payment of the other spouse’s legal fees may be deductible by the payor (as alimony), includible in income by the payee (as alimony), and also deductible by the payee (related to collection of alimony)).
[79] See Carpenter v. United States, 338 F.2d 366 (Ct. Cl. 1964); see also Rev. Rul. 72-545, 1972-2 C.B. 179.
[80] See I.R.C. § 71; see also United States v. Davis, 370 U.S. 65 (1962).
[81] See United States v. Gilmore, 372 U.S. 39 (1963); Dolese v. United States, 605 F.2d 1146 (10th Cir. 1979); Melat v. Comm’r, 65 T.C.M. (CCH) 247 1993.
[82] See I.R.C. §§ 1041, 2056, 2516, and 2523.
[83] See INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992).
[84] See Rev. Rul. 72-545, 1972-2 C.B. 179.
[85] See I.R.C. § 67(a)-(b).
[86] See, e.g., I.R.C. § 56(b)(1)(A) (disallowing miscellaneous itemized deductions in computing an individual’s alternative minimum tax).
[87] See Treas. Reg. § 1.AG170A-10(d)(4)(i)(b); see, e.g., Dombrowski v. Dombrowski, 559 A.2d 828 (N.H. 1989).
[88] See Rev. Rul. 76-267, 1976-2 C.B. 71.
[89] See Treas. Reg. § 1.1212-1(c)(1)(iii)
[90] See id.
[91] See Finkelstein v. Finkelstein, 701N.Y.S.2d.52 (2000).
[92] See id.
[93] See id. at 54.
[94] Id.; see also Cerretani v. Cerretani, 634 N.Y.S.2d 228, 231–32 (1995) (examining N.Y. Domestic Relations Law § 236 (B) and finding that a capital loss carryforward was not the type of property that was contemplated by the statute and that tax consequences were a factor in equitable distribution, but only relating to the consequences of such distribution).
[95] 663 S.W.2d 369 (Mo. Ct. App. 1983).
[96] See id.
[97] See id. at 372.
[98] See Treas. Reg. § 1.1212-1(c)(iii).
[99] Mills, 663 S.W.2d at 372.
[100] Silverstein v. Silverstein, 943 S.W.2d 300 (Mo. Ct. App. 1997).
[101] See id.
[102] See id. at 302.
[103] See I.R.C. § 71(c)(1); Treas. Reg. § 1.71-1T.
[104] See Treas. Reg. § 1.71-1T(c).
[105] See I.R.C. § 71; Temp. Treas. Reg. § 1.71-1T(c).
[106] See I.R.C. § 71(a).
[107] See Temp Treas. Reg. § 1.71-1T(c).
[108] See I.R.C. § 71(b)(1).
[109] See I.R.C. § 71(a).
[110] See I.R.C. § 215(a).
[111] See I.R.C. § 71(b)(1)(A).
[112] See Larievy v. Comm’r, 104 T.C.M. (CCH) 241 (2012).
[113] See I.R.C. § 71(b)(1).
[114] See Temp. Treas. Reg. § 1.71-1T(b), Q&A (5).
[115] See I.R.C. § 71(b)(1)(D). Note that life insurance may be an acceptable method to ensure that the payee spouse’s successors will receive some, if not all, of the value of the payments had the payee survived. The House Ways and Means Committee Report on the Tax Reform Act of 1984 states that life insurance proceeds payable on the death of the payee spouse are not considered a substitute payment. H.R. REP. NO. 98-432, pt. 2, at 1391-1462 (1984).
[116] See Temp. Treas. Reg. § 1.71-1T(b), Q&A (10).
[117] See Hampers v. Comm’r, 109 T.C.M. (CCH) 1138 (2015); Crabtree v. Comm’r, 110 T.C.M. (CCH) 219 (2015);
Mukherjee v. Comm’r, 87 T.C.M. (CCH) 1224 (2004).
[118] See I.R.C. § 71(b)(1)(C).
[119] See Temp. Treas. Reg. § 1.71-1T(c), Q&A (15)(a).
[120] See I.R.C. § 71(b)(1)(B); see also Temp Treas. Reg. § 1.71-1T(c), Q&A (15)(a).
[121] See I.R.C. § 215(a).
[122] See I.R.S. Pub. 504, at 15 (2016).
[123] See id. at 13–14.
[124] See I.R.C. § 71(a); Treas. Reg. § 1.71-1(b)(5).
[125] See I.R.S. Pub. 504, at 23.
[126] See id.
[127] See I.R.C. § 71(b).
[128] See I.R.C. § 71(f).
[129] See id.
[130] See I.R.C. § 71(f)(5).
[131] 196 See I.R.C. § 71(c)(2).
[132] See id. Prior to the enactment of section 71(c)(2), as part of the Tax Reform Act of 1984, spousal support payments could be treated as alimony, as opposed to child support, even if reductions in the payments were tied to certain childhood events. See Comm’r v. Lester, 366 U.S. 299 (1961).
[133] See Temp. Treas. Reg. § 1.71-1T(c), Q&A (15)–(16).
[134] See T.C.J.A. § 11051.
[135] See The Revenue Act of 1942, Pub. L. 753, ch. 619, 56 Stat. 798 (Oct. 21, 1942). The provisions were adopted as section 120 of The Revenue Act of 1942, 56 Stat. 816 (codified as amended at 26 U. S. C. §§ 22(b)(2), 22(k), 23(u), 25(b) (2) (A), 171(a) and (b), 3797(a) (1942)).
[136] See T.C.J.A. § 11051(c).
[137] See T.C.J.A. § 11051(b)(3)(A).
[138] See Jani Maurer, Use and Disposition of Life Insurance in Dissolution of Marriage, 16 BARRY L. REV. 57, 58 (2011).
[139] See id. at 88.
[140] See I.R.C. § 101(a).
[141] See I.R.C. § 2042(2).
[142] See I.R.C. § 2206.
[143] See I.R.C. §§ 1041, 2516; see infra Part X.
[144] I.R.C. § 2035.
[145] See Rev. Rul. 70-218, 1970-1 CB 19.
[146] See id.
[147] See Rev. Proc. 2018-18, 2018-10 I.R.B. 392, 397.
[148] See, e.g., Donald O. Jansen, Giving Birth to, Caring for, and Feeding the Irrevocable Life Insurance Trust, 41 REAL PROP. PROB. & TR. J 571 (2006).
[149] See I.R.C. § 2503(b)-(c); see also Crummey v. Comm’r, 397 F.2d 82, 86–88 (9th Cir. 1968).
[150] See I.R.C. § 2042.