Child Support vs
Support vs. Spousal Support: Tax Benefits and Tax Traps
By: Jerry Style
Support payments pursuant to
divorce receive different tax treatment depending upon whether they are
characterized as child support or spousal support (referred to also as
maintenance or alimony). This is a
potential tax planning opportunity, but there are important pitfalls that need
to be addressed in the tax planning process.
Payments classified as child
support are not taxable to the payee spouse and not tax
deductible by the payor spouse. Payments
classified as spousal support are taxable to the payee
spouse and tax deductible by the payor.
These payments are not only tax deductible, but “above the line”
adjustments to income, meaning that the payor spouse does not have to itemize
deductions to get the tax break. In
theory, divorcing spouses may be able to save money in taxes by taking advantage
of this difference, but must be careful in how they do this.
Let’s go through a simple
example. John and Mary are divorcing, and their ten-year-old son
Matthew will be living with Mary. John
has a good job and makes $125,000 per year.
As a single individual, he is in a 30% marginal tax bracket.
Mary’s income is $25,000, and she will claim Matthew as a dependent. As
Head of Household, Mary is in a 15% marginal tax bracket. Let’s assume that an agreement is reached whereby John will
pay Mary $1,500 per month in child support and $1,000 per month in spousal
support, for a total of $2,500 per month in support.
The spousal support portion will be tax deductible to John and taxable to
John has a bright idea.
Why not call ALL payments alimony? John
would pay $2,500 per month in spousal maintenance until Matthew reached age 21
and $1,000 per month thereafter. Since John is in a higher tax bracket than Mary, this can
reduce the total amount of taxes that will be paid, putting more money in their
pockets and less in Uncle Sam’s. They
go to an accountant who tells them that such an arrangement would save John
about an additional $6,700 per year in Federal and New York State income tax,
but would only cost Mary $4,500. John
offers to pay Mary the additional $4,500 and offers to split the remaining
$2,200 in tax savings.
Pretty good, right?
By changing a few words, they reduce their tax by $2,200 per year and
each saves $1,100 per year in taxes, for a total tax savings of over $20,000
over the next eleven years.
You bet! The IRS has some
pretty smart people who work for them too, and they are very much aware that the
difference in tax treatment of support payments is a potential area of abuse.
They have thus created a revenue code called the “Child Contingency
Rule” that says that if payment of spousal maintenance is reduced as a result
of a contingency relating to a child, the amount of the reduction is considered
to be child support from the beginning.
Furthermore, if no specific child contingencies are mentioned, BUT the
reduction in spousal support occurs within six months of a dependent child’s
18th or 21st birthday, the rule also applies.
The Child Contingency Rule would nullify the “creative” arrangement
made between John and Mary and would disallow the attempt to deduct the child
support as alimony.
Always seek the advice of an
expert who knows the intricacies of these complex IRS rules.
Allocating support payments
between child support and spousal support is one of many tax-planning
opportunities in divorce, but tax planning must be done with great care.
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