Over the years, we have seen cases in which separation or divorce instruments violate the requirements for structuring alimony payments correctly. These situations often produce a negative financial impact for the individual that is paying the alimony and can lead to additional lawsuits and ill feelings. In order to avoid this potential mess, it is important to understand the requirements that we spell out below and structure a proper alimony agreement.
Divorce or separation agreements usually call for multiple payment streams (i.e. child support, alimony, cash settlements) to be paid to each of the spouses for several years after the divorce occurs. Each payment stream must be tested separately when applying the requirements to determine if the payment is alimony or not. If one payment stream between the parties does not qualify as alimony, it will not disqualify the other payment streams from being considered alimony.
Financial and Tax Impact
Let’s assume that you are required to pay alimony of $12,000 per year to your former spouse. If you have a properly structured alimony agreement spelled out in the divorce instruments, your potential tax savings for year could be significant. Let’s assume your income level puts you in the 28% tax bracket, your tax savings for the year would amount to $3,360 ($12,000 X .28). If you are the one required to make alimony payments, you realize the importance of meeting the requirements explained below based on the tax savings that you can achieve if you structure the payments accordingly.
The following is a list of requirements for payments to qualify as alimony for tax purposes:
- The payment must be made in cash or cash equivalent (checks, money orders or payroll tax withholdings)
- The payment must be made under a divorce or separation instrument that does not designate the payment as not alimony – you can have qualifying payments that occur both before and after the couple is legally separated or divorced. Payments can also be made to third parties on behalf of your former spouse if properly structured.
- The spouses are not members of the same household at the time the payments are made and a joint tax return is not filed.
- There is no liability to make any payment (in cash or property) after the death of the recipient spouse. The obligation to pay ceases when the recipient spouse is deceased.
- The payment is not treated as child support (child support is non-deductible to the payer and is considered tax free income to the recipient)
If your payments qualify as alimony, you will be able to deduct the payments you make as an adjustment to income. You are not required to itemize deductions to take advantage of this tax break. You will need to file a 1040 individual tax return (not a 1040EZ or 1040NR) and you will be required to provide the social security number for whom the alimony payments were made. If you do not provide the social security number, you may have to pay a $50 penalty and your deduction may be disallowed. If you are receiving alimony payments, you will need to report the payments as income and report the social security number of the individual from whom you received the alimony payments from.