You might think that with the potential impending demise of the alimony deduction, a Tax Court case about that deduction would not teach a useful lesson. But note that it’s the House Bill that repeals the §71/§215 regime. The Senate Bill leaves those sections alone (at least I cannot find any repeal provisions searching for "alimony" with ctrl-f, but I also did not read all the handwritten stuff). Traditionally, it’s the House that caves in conference (for all the reasons you hear in long lingering lectures from political science folks). So there may be hope for payor spouses yet!
Even if the alimony deduction is repealed, however, I hope to convince you that the lesson in last week’s case of Gary A. Wolens v. Commissioner, T.C. Memo. 2017-236 (Nov. 27, 2017), is worth your time. I consider it a useful lesson for lawyers about the level of care one needs in drafting agreements, particularly those relating to divorce. It also has a neat choice-of-law lesson. More below the fold.
Mr. Wolens married Mrs. Wolens in 1986 in New York but moved to England a month later, where they apparently stayed until they called it quits in 2006 and went to the English courts to process the divorce. The English divorce decree required Mr. Wolen to make yearly payments to Mrs. Wolens as follows: 1 million pounds in 2006; 2.3 million pounds on the date he performed one of two acts with respect to their marital home (in England); 441,667 pounds in each of 2007, 2008, and 2009. Notice that adds up to a total of 1.325 pounds. Mr. Wolens had no obligation to made payments after 2009.
It’s the 2009 year that is at issue in the case. When Mr. Wolen made the payment that year it was the equivalent of just over $650,000. He took a §215 deduction for that amount. Section 215 allows deductions for payments that are alimony within the meaning of §71.
I bet Mr. Wolen did this for the earlier years too. But this time his return was selected for examination and the Service disallowed the deduction because it did not believe the payment was alimony within the meaning of §71. Unlucky! Mr. Wolens petitioned the Tax Court to contest the deficiency.
Drafting Lesson (Part 1)
The main reason the payments did not qualify for alimony was because of how the English divorce decree was drafted. The decree did not specify that the obligations it imposed on him would end on the death of Mrs. Wolen. If those payments had indeed been intended to be alimony that was a fatal drafting error. Section 71(b)(2)(D) says that in order to be “alimony” within the meaning of the §71/§215 regime, there must be “no liability to make any such payment for any period after the death of the payee spouse.”
The fact that payments may be a one-time obligation, or a fixed sum payable in installments, rather than a continuing obligation is not what separates “alimony” from “property settlement” payments. It used to (and it still does in England as the Tax Court here analyzes). Before the current definition of alimony came into the Code in 1984, there was lots of litigation about the common law requirement that alimony payments had to be periodic. See e.g. Bernatschke v. United States, 364 F2d 400, --- (Ct. Cl. 1966)(citing cases and finding that payments were not alimony in part because they were a “fixed sum” to be paid in installments).
Since 1984, however, §71 has replaced the old facts and circumstances test with a series of pretty bright-line rules, rules that require some care in drafting. The upside of these bright line rules is that parties have a more difficult time coming in after the fact and recharacterizing the payments. Here, if the attorneys really intended for these payments to be alimony, they could easily have drafted the decree to meet the requirements.
You see a similar drafting error in the case of Webb v. Commissioner, T.C. Memo 1990-540. There, Mr. Webb obligated himself to make a one-time payment to his wife. The payment of $215,000 was provided in their separation agreement to be due “on signing this Agreement.” Mr. Webb took an alimony deduction which was disallowed. The Tax Court held that because the separation agreement did not provide that his obligation to pay the $215,000 ended on the death of his ex-wife, it could not be alimony. Mr. Webb argued that this obligation would be satisfied “simultaneously” with the signing of the agreement that created the obligation. So he asked the Court to ignore the “not payable after death” requirement. The Court was not impressed: “We refuse to embrace such an incongruous, absurd position,” it said:
We think it significant that the statute speaks in terms of "liability." [Paragraph 3 of] the agreement...provides that "The Husband shall pay." [the $215,000]... Unquestionably, this created a liability which would have been enforceable by Rosalie J. Webb's estate had she died after the execution of the agreement but before the payments were actually made. Paragraph 4 of the agreement stands in sharp contrast; it specifically provides for termination of the $40,000 annual payments in the event of the "Death of the Wife."
Mr. Wolen’s attorney similarly failed to include the proper language to create an alimony deduction in the English divorce decree.
Drafting Lesson (Part 2) and Choice of Law Lesson
Courts have created a rescue rule for badly drafted documents. If the relevant state law provides that the obligation at issue would terminate on the death of the payee spouse, then courts have allowed such payments to qualify as alimony. Hoover v. Commissioner, 102 F3.d 842 (6th Cir. 1996).
Here, Mr. Wolen argued that the relevant “state” law had to be New York because, gosh darn it, England is a “country” and New York is a “state.” Judge Pugh had no trouble nuking that argument. Channeling the sainted Justice Holmes (Oliver Wendell Jr., sorry Mark), she pointed out that what matters is “whose power is being invoked.” (Holmes fussed about that in the context of what is called the “Erie Doctrine” in civil procedure---go read his dissent in the Black & White Taxicab case, 276 U.S. 518 (1928)). Citing a long line of cases, Judge Pugh showed how courts consistently use the law of the sovereign by whose power the obligation is created. Here, that was England.
So that’s the choice of law question. To determine whether there is a state rescue rule, the Tax Court will look to the law of whatever state (or country) issues the relevant decree that creates the obligation.
But that choice of law approach creates another drafting lesson here. Just as parties can specify in their contracts what state law (or national law) will apply in cases of disputes under the contract, so they can draft a separation agreement or other divorce document to agree on what law would cover disputes arising from the obligations it creates. In other words, Mr. Wolen’s attorney could have put something in the English divorce decree that the parties agreed that the law of New York would govern.
Looking at the facts of this case, however, why would the attorneys representing either of the Wolens have cared about U.S. law? This is couple that apparently lived in England for 20 years. I doubt anyone was thinking about U.S. tax law or New York state law when they decided to get divorced in England. This just looks like a post-hoc attempt to re-characterize what appear to be installment payments of a property settlement.