Paul L. Caron

Monday, August 22, 2022

Lesson From The Tax Court: State Law Label Did Not Control Federal Tax Consequences

Camp (2021)Some things never change:  people get married, people get divorced.  Sure, the divorce rate has fallen somewhat, as this thoughtful 2018 Time Magazine analysis explains.  But people continue to marry, and some non-trivial percentage of those marriages will end in divorce.  Plenty of work for family lawyers.

Other things constantly change:  tax law, for example!  While divorce is primarily a matter of state law, good family lawyers need to keep an eye out for the tax consequences of divorce.  They need the tax lesson we learn today.  Despite recent changes in taxation of certain divorce payments, it's a lesson that never gets old: state law cannot trump federal tax law.

In Alejandro J. Rojas and Elena G. Rojas v. Commissioner, T.C. Memo. 2022-77 (July 18, 2022) (Judge Thornton), the taxpayer was obligated to pay his ex-wife what the divorce decree labeled “family support” under California law.  Under state law, none of those payments were for child support.  Alejandro decided that the state law label entitled him to deduct those payments in 2016 as alimony under former §215.  The Tax Court decided otherwise, finding that all the payments were child support for federal tax purposes, despite the state law label.  State law did not control federal tax consequences.  Details below the fold.

Before 2019, I taught students that federal tax law treated payments between ex-spouses as falling into one of three mutually exclusive buckets: (1) the alimony bucket; (2) the child support bucket; (3) the property settlement bucket. I approached the subject that way because, for divorces occurring before December 31, 2018, now-repealed §215 permitted taxpayers to deduct alimony and now-repealed §71 required the ex-spouse to report alimony as gross income.  In contrast, child support was neither deductible to the payor spouse or includible to the payee spouse.  The third was sort of the residual: if a payment did not qualify as either alimony or child support it would be considered part of the couples’ property settlement.  So putting the payments into the correct bucket was important.

Before 2019, the first two buckets were well-defined by statute and case law.  Specifically, the definition of alimony excluded payments that were child support payments under §71(c)(1).  Section 71(c)(2) gave what I call the child contingency test.  It provided that “if any amount specified in the instrument will be reduced (A) on the happening of a contingency specified in the instrument relating to a child (such as attaining a specified age, marrying, dying, leaving school, or a similar contingency), or (B) at a time which can clearly be associated with a contingency of a kind specified in subparagraph (A), an amount equal to the amount of such reduction will be treated as an amount fixed as payable for the support of children of the payor spouse.” (emphasis supplied).

For divorces after 2018, Congress eliminated the deduction for alimony.  So now the tax consequences are the same for payments regardless of whether they are alimony or child support.  No deduction to the payor spouse and no inclusion for the payee spouse (at least so far).  But I still use the three-bucket approach because I think distinguishing alimony from child support might still play an important role in determining which of two divorced parents can claim a child as a Qualifying Relative under §152.  I discussed that in Lesson From The Tax Court: Distinguishing Child Support From Alimony, TaxProf Blog (Apr. 20, 2020).

Today's lesson, however, involves the old rules so buckets matter for the traditional reasons.

State law creates legal buckets, too, but they may be different from federal tax law.  Most states have a concept of alimony, although they may use different labels.  Some states use the same term as federal tax law.  My own state of Texas uses the label “Maintenance.”  See Tex. Fam. Code § 8.001(1).  California uses the label “Spousal Support.” See CA Fam. Code §4330.  Those different labels neither prevent nor ensure that payments from one spouse to another will be treated as alimony for federal tax purposes.  See  Lesson From The Tax Court: Distinguishing Property Settlement From (Indirect) Alimony, TaxProf Blog (Sept. 17, 2018).

California state law not only has buckets for alimony and buckets for child support, it also has an additional bucket that it labels “Family Support.”  CA Fam. Code §4066 provides that “Orders and stipulations otherwise in compliance with the statewide uniform guideline may designate as “family support” an unallocated total sum for support of the spouse and any children without specifically labeling all or any portion as “child support” as long as the amount is adjusted to reflect the effect of additional deductibility. The amount of the order shall be adjusted to maximize the tax benefits for both parents.”

The purpose of this family support bucket is well described by one California family lawyer, Mr. Thurman W. Arnold III, in this 2010 blog post:

“In theory family support allows parties, by agreement, to characterize both child support and spousal support together. The spousal and child support components are unallocated, and the total sum is a combined number. The purpose of family support is to create a deductibility for child support for federal and state income tax purposes that otherwise does not exist. ***  However, as mentioned at the bottom of this blog, there is some uncertainty whether the IRS will in fact allow this deduction.  (emphasis supplied).

Too true!  That 2010 blog post does a good job in explaining the federal tax law traps when using family support.  That’s because federal tax law does not care what labels California law puts on payments.  Mr. Arnold could well update his 2010 post with today’s case.

Let’s take a look.

Alejandro Rojas married Christina in 1995 and they divorced in 2012.  They had two kids, both minors in 2012.  The stipulated divorce decree ordered Alejandro to pay $4,500/month to Christina.  But it explicitly said that “neither party shall pay child support...”  Op. at 2.  It also specifically said that “neither party shall pay spousal support....”  Id.  Instead, the divorce decree dumped Alejandro’s payment obligation into the “family support” bucket.  That obligation would continue “until both minor children emancipate or [Christina] remarries.  If [Christina] remarries, the family support obligation shall be modified to $2,500 per month until each minor child emancipates....” Id.

Ok. At first blush this looks like spousal support of $2,500 per month and child support of $2,000 per month.  But noooooo.  Under California law, it seems it was all “family support” and could not be modified.  Thus, when Alejandro later went back to state court to ask for a reduction in the child support portion, the state Court explicitly found that “there is no current child support order.”  Op. at 3.  The state Court then noted that Alejandro had provided no legal authority to support a request to modify “family support.”  Ouch.

By 2016 (when Alejandro had remarried), he was apparently paying Christina about $5,800 per month.  Judge Thornton drops a footnote that the increase was a mystery, but appears to assume that the payments represented the mandated “family support.”  On their 2016 return, Mr. and Ms. Rojas took an almost $70,000 deduction for those payments, characterizing them as alimony.

On audit, the IRS disallowed the entire deduction.  Even though it seems that the family support payments were partially alimony and partially child support, the Tax Court sustained the total disallowance, not even giving Alejandro half-a-loaf: it was all non-deductible child support, even though none of it was child-support under state law.  The reason why forms our lesson.

Lesson: State Law Labels Cannot Trump Federal Tax Rules
In Tax Court, Alejandro argued that his payments to his ex-wife could not be child support because, hey, the California state court had explicitly said there was no child support obligation!  The obligation was all in the family support bucket.

Judge Thornton patiently explains that the label only matters for state law purposes, because “family support...under California law represents combined, but unallocated, child support and spousal support.”  Op. at 5.  But for federal tax law purposes, the state law label could not control: the proper analysis was whether “any amount specified in the instrument will be reduced...on the happening of a contingency specified in the instrument relating to a child (such as attaining a specified age, marrying, dying, leaving school, or a similar contingency)...” Former 71(c)(2)(A).  And when you properly apply that analysis, none of the payments were alimony because they were all contingent on events relating to their children.

Take a look again at the specific language used in Alejandro’s divorce decree.  Notice that it says his obligation to pay support would continue until one of two events occurred: (1) both minor children became emancipated, or (2) Christina remarried.  Under the first condition, Alejandro’s payment obligation would be reduced to zero.  Under the second condition, his payment obligation would be reduced by $2,000.

If you just focus on the second condition, you could make an argument that the $2,000 was child support and $2,500 was alimony.  But when you put the two conditions together, it is inescapable that the entire payment obligation was tied to the children.  When both children became emancipated, that made the entire amount go away.  Well if that’s not a contingency relating to a child, nothing is!  Judge Thornton string-cites a bunch of cases so holding.

Bottom Line: Alejandro got the worst of both worlds.  Under California state law, none of his “family support” payments were child support.  So no reduction.  But under federal tax law, all of his family support payments were child support.  So no deduction.

This is pretty much what Mr. Arnold warned his readers about in 2010:

“In order for family support to be deductible for IRS purposes, it needs to not be disguised child support. This means its payment or continuing existence cannot be tied to any child related event — it will be disallowed if the Judgment or other support instrument links it cessation or modification to the children becoming majors, or dying, for instance.”

Yup.  It’s the substance of state law obligations, and not their labels, that controls their federal tax treatment.  A lesson worth passing on to your family law attorney friends. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday, if Monday is a federal holiday) for a new Lesson From The Tax Court (or, if not exactly new, at least a lesson that bears re-learning).

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