Alimony is often one of the most important provisions in a divorce settlement. Normally, the person paying alimony (“payor”) expects to be able to deduct the payments for tax purposes, and the person receiving alimony (“payee”) expects to report the alimony payments as income. Unfortunately, poor drafting and lack of knowledge of the Internal Revenue Code results in tax consequences that were not anticipated by either party. The term for the unintended tax consequence is “recapture.” It results from what is typically referred to as “front-loading” of the alimony payments.
An explanation of the recapture rules is beyond the scope of this blog. However, a simple example will illustrate how the expectations of the parties and the actual tax treatment by the Internal Revenue Service can be significantly different.
Assume for this hypothetical that payee was in need of more alimony initially, but less in subsequent years. Therefore, the parties negotiate a settlement that requires payor to pay alimony as follows: In year #1, the alimony payments are $60,000 ($5,000 monthly), in year #2 the alimony payments are $48,000 ($4,000 monthly), and in year #3 the alimony payments are $12,000 ($1,000 monthly). Under this arrangement, payor expects to be able to deduct on his or her income tax return, over the course of three years, $120,000. Assuming the payor has an effective tax rate of 35% (Federal and State taxes), the payor expects a tax savings on these alimony payments of approximately $42,000 over the three-year period. Unfortunately, because of the manner the payments were structured, there will be a total “recapture” of approximately $46,500 that will apply to the payor. This means that in year #3, payor will be required to include in his or her income $46,500 that he or she expected would not be taxed. Applying the payor’s effective tax rate of 35%, results in an unanticipated tax of approximately $16,275.
As this example illustrates, it is very important that you have knowledgeable counsel advising you during the divorce process.
As with any other issues arising from your separation or divorce, you should consult with a North Carolina Family Law Specialist. Feel free to contact me, Monty Beck, Western North Carolina Family Law Specialist to discuss your separation or divorce.