Congress eliminated the deduction for alimony in the December 2017 Reconciliation Act (informally called the Tax Cuts and Jobs Act). But the legislation grandfathered in alimony payments made pursuant to divorce or separation instruments executed on or before December 31, 2018. The question of whether a payment qualifies as alimony will thus still be important for many taxpayers for years to come. The short lesson from the recent decision in Jeremy Adam Vanderhal v. Commissioner, T.C. Sum. Op. 2018-41 (Sept. 5, 2018) is thus worth blogging about. Plus, it's nice to blog about one of those very rare wins for a pro se taxpayer.
This is mainly a drafting lesson: the tax effect of language in a divorce or separation instrument turns on what the language does more than what the language says it does. Here, Judge Carluzzo gives a very nice lesson on how not to be distracted by what the language says it is doing.
Mr. Vanderhal got divorced in 2011. Attached to the court’s divorce decree was an agreement between the divorcing couple on how they would split up their assets and debts. One section of the agreement deals with “Division of Community Debts” and obligates Mr. Vanderhal to pay off his ex-spouses’ student loan obligations. Another section of the agreement is titled “Tax Free Transfers” and says that the “parties believe and agree that the transfer of property between them...are tax free...pursuant to Section 1041...and are not taxable sales or exchanges of property or payments for alimony, except where this agreement specifically denotes payments as such.”
In 2013, Mr. Vanderhal deducted as alimony what he had paid on his ex-spouses’ student loan obligations. The IRS audited and disallowed the deduction.
The Law and Application
Section 215 permits a deduction for alimony payments by the payor if the payment would be includible in the gross income of the payee under the rules in §71.
Section 71 provides that payments received from a former spouse are includible in gross income as alimony when they pass the tests set out in §71(b). Of those tests, two are relevant to this case: (1) the receipt test and (2) the designation test. Mr. Vanherhal’s payments are a great example of how indirect payments can meet the receipt test. The difficult issue was the designation test.
The receipt test comes in §71(b)(1)(A): a payment will qualify as alimony so long as “such payment is received by (or on behalf of) a spouse....” The key language here is the parenthetical “or on behalf of.” Payments can qualify as alimony even if indirectly “received” by the payee spouse. The key test for indirect payments to meet the receipt test is that they be made in satisfaction of the payee spouse’s sole obligation. In this case Mr. Vandenhal’s payments of his ex-spouses’ student loans meet that test. Treas. Reg. 1.71-1T(b) at Q&A 6, specifically says that “payments of...tuition liabilities of the payee spouse made under the terms of the divorce or separation instrument will qualify as alimony....”
The designation test is the more problematic one in this case. Section 71(b)(1)(B) provides that a payment will qualify as alimony so long as the divorce or separation instrument “does not designate such payment as a payment which is not includible in gross income under this section and not allowable as a deduction under section 215.” The regulations give no further guidance.
Here, the IRS focused on the language in the divorcing couple’s agreement that “transfer[s] of property....are not taxable sales or exchanges of property or payments for alimony, except where this agreement specifically denotes payments as such.” The IRS then said that the provision for Mr. Vanderhal to pay his ex-spouses’ student loans was not designated as alimony and so could not be deductible. While Judge Carluzzo does not tell us the title of the couple's agreement, I would bet a dollar to a donut that it was titled something like “Property Settlement Agreement.” That sure would be distracting.
Judge Carluzzo rejected that reading of the agreement because it misreads the relevant language. The language relied upon by the IRS just says that transfers of “property” would not be treated as alimony unless specifically designated. Judge Carluzzo points out that “debt” is not “property” in the hands of the debtor. Nor does the agreement attempt to equate them: the provisions for debt allocations are dealt with in separate sections than the section with the language about property transfers. Thus, writes Judge Carluzzo, “the divorce decree and the agreement do not...specifically denote the division of debts as tax-free transfers of property made pursuant to section 1041” and he finds nothing else in the agreement that “clearly, explicitly, and expressly designates the Sallie Mae student loan payments as nonalimony payments.”
As a general rule, state divorce decrees or orders or associated agreements cannot just say what the federal tax consequences are of the transactions they contemplate. The tax consequences flow from the rights and obligations created by the agreements, not by what the agreements may claim to be the tax consequences. For example, in this case, the agreement attempts to designate certain property transfers as “tax-free” transfers under §1041. But just saying so does not make it so. Section 1041 gives non-recognition treatment only to transfers incident to divorce and that concept has statutory boundaries, as explicated by regulations. Those boundaries control, regardless of what the state court says in a decree or the parties say in their separate agreement.
In this case, for example, if §1041 applies it will be because of what the agreement requires the parties to do, not because of what the agreement says about the tax consequences of those requirements. If Mr. Vanderhal had acquired property after the divorce and transferred it within one year of the divorce then §1041 would apply even if his agreement had said “transfers of after-acquired property will not be subject to §1041.” Treas Reg. 1.1041-1T, Q&A 6 (“Thus a transfer of property occurring not more than one year after the date on which the marriage ceases need not be related to the cessation of the marriage to qualify for section 1041 treatment.”).
But sometimes tax statutes permit parties to modify tax consequences if the parties use the proper language. The designation test in §71(b)(1)(B) is one such tax statute. As Judge Carluzzo points out, however, the parties need to use language that clearly and expressly accomplishes the desired designation. That did not happen in this case. Consider, however, what would have happened if Mr. Vanderhal’s agreement had contained an opening or closing provision that said something like “all payments made pursuant to this agreement that are not specifically designated as alimony are hereby designated as non-alimony.” Now that would seem to be a clear designation, even though it was general. Something like that happened in in Steves v. Commissioner, T.C. Sum. Op. 2013-80, where the separate agreement had this catch-all language: “It is the intent of the parties that all transfers of assets and other monetary awards pursuant to this Agreement, except spousal support payments, are nontaxable transfers between the parties incident to their divorce.” The Court held that was a clear designation and disallowed deductions the taxpayer had made that were not spousal support payments as defined in another part of the agreement.
Coda: As usual, I am keenly aware of my abilities to commit error and I invite correction from those who have better knowledge than I do. If you catch error, all I can do is channel Tony Kornheiser from the show Pardon the Interruption and say: I promise to do better next time.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.