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Tax Aspects of Child Support

The Taxpayer Relief Act of 1997 has provided significant changes to the income tax map for individuals and businesses. Some changes which affect the arena of separation and divorce are as follows:

  • The sale of a home is easier due to a new exclusion for capital gains.
  • The dependency exemption is more valuable because three new credits and a deduction are tied to it.
  • The lower capital gains income tax makes property with a low basis more valuable.
  • New IRA rules can make it easier to utilize IRA funds for alimony and equitable distribution.
  • The foregoing changes are incorporated in the following materials.

Child Support

General Principles

  • Child support payments made by payor are not deductible pursuant to Section 71. These payments are treated as family expenses under Section 262(a) and are not deductible. See IRC 261.

  • Alimony tax treatment does not apply to any payments or portions thereof in the nature of support for minor children. However, where a property settlement agreement, divorce decree or order of court does not allocate a specific portion of a periodic payment as child support, then generally no portion of the payments thereunder will be considered to be child support.

  • Direct expenses paid by an obligor pursuant to a child support order are not deductible as business expenses even if non-payment would subject payor to incarceration for contempt, rendering payor unable to work.

  • The Pennsylvania support court and the parties may allocate child support and alimony. Some considerations are as follows:

    • Generally, an unallocated spousal and child support order will be favored by the payor because the payor will be eligible to deduct the entire monthly amount paid for federal income tax purposes.

    • Generally, an allocated spousal and child support order will be favored by the payee because the recipient will not be required to claim as income that portion designated as child support. Only the spousal support amount shall be taxable to payee.

    • In some instances the payee may find it advantageous to withdraw the claim for spousal support and/or alimony pendente lite to receive only child support, because this amount will be nontaxable to the payee. For example, assume the obligee is earning $2,000.00 per month and obligor is earning $3,000.00 per month and there is an action pending for spouse and two children. The Pennsylvania Supreme Court Guidelines dictate an award for two children in the amount of $696.00, all of which would be nontaxable to the payee or an award for spouse and two children in the amount of $787.00 which, if unallocated, would be entirely taxable income to payee. Therefore, it may be in the best interest of payee to withdraw his or her claim for spousal support and only proceed with the child support claim, to avoid the $787.00 per month from being income taxable ($787.00 x 12 = $9,444.00 x .15% = $1,416.60 income tax; $9,444.00 - $1,416.60 = $8,027.40 net support compared to $696.00 x 12 = $8,352.00 support).

    • In the situation where the payee has no income it may be advantageous to both parties to enter an unallocated spousal support and child support order. The payee will most likely be in a substantially lower tax bracket than the payor and will therefore pay lesser taxes on amounts received.

    • In certain instances it may benefit both parties to designate an additional payment to payee as spousal support, enabling the payee to pay income taxes with the additional amount. The payor may deduct fully the entire amount paid.

    • In certain instances it may be to the benefit of both parties to reach an agreement wherein payor, in addition to paying spousal support and child support on an unallocated basis, agrees to pay payee's taxes incurred in regard to the unallocated Order.

  • The IRS federal income tax refund intercept procedure is effective for a court order for child support only or for unallocated child and spousal support/alimony pendente lite where arrears are due to nonpayment of the order.

  • Pre-1985 rules. Payments under former Section 71(b) [now Section 71(c)] were also required to meet two additional requirements to be deemed child support:

    • The decree, instrument or agreement had to "fix" the amount of child support.

    • The payments were for the support of the transferor's minor children.

  • Under pre-1985 rules, if the periodic payments were received by the payee for the support and maintenance of himself or herself and the minor children, but the decree failed to designate a specific portion of the payment as child support, and provides for no automatic reductions, then the entire payment was includable in the obligee's gross income (and is deductible by the obligor). IRC Reg 1.71-1(e).

  • In an attempt to finally resolve the uncertainty promulgated by the vast number of conflicting cases, the United States Supreme Court defined the term "fix" in the case of Comm. v. Lester, 366 U.S. 299 (1961). Pursuant to a written agreement, Mr. Lester was required to make payments for spousal and child support. While the agreement did not allocate spousal and child support payments, there was an automatic reduction in the amount of the payments as each child died, became emancipated or married. Further, the entire payment terminated on wife's remarriage. The Commissioner ruled that the terms of the agreement were sufficiently clear to fix a portion of the total payment as child support. The Supreme Court, disagreeing with the Commissioner, held that payments would not be treated as child support payments unless they were expressly designated as such in the agreement. The statutory requirement is strict and carefully worded. The Court determined that "a sufficiently clear purpose" on the part of the parties was not sufficient to shift the tax. Finally, the Court reasoned that the agreement did not curb the recipient's absolute discretion as to how to utilize the support payments, notwithstanding strong hints in the agreement concerning the portion of the total payment which was allocable to child support. The Internal Revenue Service acquiesced to the Supreme Court's holding in the Lester case and adopted the Court's position in Revenue Ruling 62-53, 1962-1, C.B. 41.

  • The case law made it clear that the payment would be considered to be alimony unless the decree, instrument or agreement expressly specifies the portion or amount of the payments intended as child support. Additionally, the case provided as follows:

    • An interference from the document does not "fix" a child support obligation. Consequently, reductions that depend on future contingencies, from which the amount of child support can be inferred, were not sufficient to fix the child support.

    • State laws that designate a portion of unallocated payments as child support did not operate to fix a portion as child support under Section 71.

The Tax Reform Act of 1984: A Repeal of Lester.

  • The Tax Reform Act of 1984 amended Section 71 to significantly expand the treatment of a payment as alimony by radically redefining what payments are considered "fixed" as child support. The rules under the Tax Reform Act of 1984 apply to all agreements or decrees entered after January 1, 1985 and to certain pre-1985 agreements or decrees whose alimony or support terms were modified after January 1, 1985.

  • A contractual payment is "fixed" as child support if the payment is one of the following:

    • Subject to reduction on happening of a contingency "relating to" the child such as attaining specific age or income level, marrying, dying, leaving school, leaving spouse's household or obtaining employment.

    • Subject to reduction at a time which can be "associated with" a contingency related to the child.

  • A specified contingency may "relate to" a child regardless of whether the event triggering the contingency is certain or likely to occur.

  • There are two specific situations where a reduction in payment will be presumed to be "associated with" a contingency relating to a child:

    • Reduction to payments not more than six months before or after the date the child is to attain age of 18, 21 or the local age of majority. Any time there is a reduction at a future calendar date, each reduction must be examined separately with regard to each child's age. Close attention must be paid to these "trigger dates" when representing the payor spouse otherwise a portion of the payment may not be deductible.

    • Reduction of payments on two or more occasions which occur not more than one year before or after a different child attains a certain age between the ages of 18 and 24 inclusive, with the measuring age the same for each child. The latter provision applies where the parties have more than one child and there are two or more separate reductions involving two or more of the payor's children, and is discussed further herein. See Temp. Regs. 1.71-1T(c) Q&A-18.

  • These two date-based tests in the Regulations to Section 71(c) operate independently of each other. Consequently, if a reduction in payment falls within the purview of either test, it is presumed that the reduction is "associated with" a contingency related to a child and will be treated as child support.

  • Since it is possible for a reduction in payment to fall within the second test and yet avoid the first, the Regulations effectively impose a more rigorous "clearly associated" test upon taxpayers with more than one child.

  • The second test is more complicated than the first test, as the IRS will look to whether the cessation or reduction of all or a portion of support occurs one year before or after a child attains a certain age between 18 and 24 inclusive on two or more occasions. Temporary Regulation 1.71-1T(c), Q-18 sets forth the following example as an illustration of when payments are reduced on two or more occasions which occur not more than one year before or after a different child of the payor spouse attains a certain age between the age of 18 and 24, inclusive:
  • Albert and Betty are divorced on July 1, 1985. Their two children, Carl (born on July 16, 1970) and David (born on September 23, 1972), are 14 and 12 respectively. Albert must pay Betty $2,000.00 alimony per month. The divorce agreement provides that the alimony payments are to be reduced by $500.00 on each of two dates, January 1, 1991 and January 1, 1995. On the first reduction date, January 1, 1991, Carl is 20 years, 5 months and David is age 18 years, 3 months. On the second reduction date, January 1, 1995, Carl is 24 years, 5 months and David is age 22 years and 3 months. The regulations prohibit reduction on occasions that occur not more than one year before or after Carl and David attain a certain age between 18 and 24 inclusive. Each occasion of a reduction occurs less than one year before or after a different child attains the age of 21 years, 4 months. The first reduction date occurs less than one year before Carl turns 21 years, 5 months and the second reduction date occurs less than one year after David turns 21 years, 3 months. Thus, each reduction date occurs within one year from the date Carl and David reach age 21 years, 4 months.

    By arranging the reduction dates side by side, the "clearly associate" date becomes more apparent:

    1st Reduction Date
    2nd Reduction Date
    Carl 20 years 5 months 24 years 5 months
    David 18 years 3 months 22 years 3 months

    1 Year Prior
    1 Year After
    Carl 19 years 5 months 21 years 5 months
    David 17 years 3 months 19 years 3 months

    1 Year Prior
    1 Year After
    Carl 23 years 5 months 25 years 5 months
    David 21 years 3 months 23 years 3 months

    Less than one year apart for each; Midpoint = 21 years, 4 months

    The presumed "trigger" age of 21 years, 4 months is within one year of the age of a different child at both reduction dates. Therefore, both of the reductions would be presumed to be "clearly associated" with the children. Payments under the divorce decree totaling the amount of the reductions ($1,000.00) would not qualify as alimony payments, and would be treated as nondeductible child support paid by Albert.

  • The Temporary Regulations do not require that the parties intended that the reductions be related to the children. The second date related test can inadvertently cause a disallowance of an alimony deduction.

  • These tests, as delineated by the Temporary Regulations, create a "rebuttable presumption" that the "trigger age" was intended by the parties or the court to trigger a reduction of the child support portion of the periodic payment. Either the Internal Revenue Service or the taxpayer may rebut the presumption by showing that the time for the reductions was determined independently of the contingencies relating to a child of the taxpayer. Thus, in the instance of the six- month test, former spouses can conclusively rebut the presumption by showing that the reduction in support payments will result in the complete elimination of alimony "during the sixth post-separation year or the expiration of a seventy-two month period" Temp. Reg. 1.71-1T(c), A-18.

  • Additionally, the presumption can be rebutted if the local custom is to cease alimony payments after a certain period, such as a period equal to one-half the duration of the marriage. Temp. Reg. 171-1T(c), A-18.

  • Although former spouses can elect not to classify alimony as tax deductible to obligor and tax includable to obligee for federal income tax purposes, they cannot make a similar election that will classify child support as tax deductible/tax includable alimony.

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