Divorce Has Tax Traps - Get Some Advice

This post was originally published on Forbes Jul 24, 2015

When Christina Mehriary entered into a marital settlement agreement with Bradley Williams, the agreement included language that advised the parties to seek the opinion of a tax professional as to the tax ramifications of the agreement.  Talk about closing the barn door after the horse has left.  At any rate the $4,000 per month for 60 months that Ms. Mehriary was required to pay Mr. Williams as non-modifiable alimony, does appear to pass muster as deductible to the payor and taxable to the payee and lasts long enough to not trigger the alimony recapture rule.

Then, they decided to make a change, apparently without tax advice.  Ms. Mehriary ended up stumbling into Reilly's Third Law of Tax Planning - "Any clever idea that pops into your head probably has a corresponding rule that makes it not work"       In the marital settlement, Mr. Williams had received the marital residence and Ms. Mehiary had received another residence.  She transferred the second residence to Mr. Williams in lieu of $80,000 in alimony payments.

Unscrambling An Egg

I'm sure glad she wasn't my client, because I still have a headache trying to figure out the right way to account for that transaction.  Ms. Mehriary took an $80,000 deduction on Schedule A, because the insurance company had indicated that the property was an investment property.  Not only is that clearly not the right answer, it is not even the most beneficial answer.  If you were going with that sort of theory, you would need to consider the basis in the property, but of course this is in conjunction with a marital dissolution, so no gain or loss is to be recognized.

Ms. Mehriary's fallback position was to take an alimony deduction for the $80,000.  I'm still getting a headache trying to do the debits and credits of that one, but Tax Court judges are not accountants and don't have to trouble themselves about such thing.  The reason that it does not work is simple. Alimony to be deductible has to be paid in cash or its equivalent and a house is not a cash equivalent.

Petitioner's argument that the transfer of $80,000 (the fair market value of the Sweet Briar property) was deductible as an alimony payment fails because it was not a payment in cash. Instead the transfer was a transfer of property and therefore does not constitute an alimony payment. Although petitioner and Mr. Williams agreed that petitioner's transfer of the Sweet Briar property would replace $80,000 of petitioner's alimony obligation, the intent of the parties does not determine the deductibility of a payment as alimony under section 71. See Okerson v. Commissioner, 123 T.C. 258, 264-265 (2004). Instead the test for [*7] whether a payment is deductible as alimony is a straightforward, objective test that rests entirely on the fulfillment of explicit requirements set forth in section 71, including that the payment be made in cash or a cash equivalent.

The bottom line ends up being a property transfer incident to the divorce.  No deduction for Ms. Mehriary and no income pickup for Mr. Williams.  Of course, we don't know how Mr. Williams accounted for the transaction.  Hopefully the taxpayers did not get whipsawed.

Insult To Injury

The IRS asserted the accuracy penalty and the Tax Court backed them up.

Petitioner set forth no specific facts to show that she acted with reasonable cause and in good faith. Petitioner was advised to seek the opinion of a tax professional when she signed her marital settlement agreement, but she did not offer any testimony or other evidence to show that she relied on professional tax advice. See sec. 1.6664-4(b)(1), Income Tax Regs. Petitioner merely testified that [*9] she relied on her insurance company's characterization of the Sweet Briar property as investment property. The insurance company did not provide tax advice, and the record does not reflect that it ever represented itself as a competent professional.

 Thoughts On Return Presentation

The AICPA standards of tax practice prohibit me from giving audit lottery advice, but you are not my client, so I think I am safe in making this observation.  If Ms. Mehriary had taken an alimony deduction on her originally filed return, there is a very good chance she would have slid through even if Mr. Williams had not picked up income equal to her deduction.  The IRS computers match up the alimony deductions to the income pickups, but the Service cannot  just send out a bill for a mismatch, since it doesn't know who is right.  According to a TIGTA report, in 2010 there were over a quarter million mismatches and the IRS opened examination in just over 10,000 cases.

On the other hand, a nice round $80,000 deduction on Schedule A sticks out like a sore thumb.  Ms. Merhriary represented herself in Tax Court, which makes me suspect that she prepared her own return.  I think that almost any preparer, even one who is technically weak, would not have gone with Schedule A.  I have to admit that I'm not sure where I would have ended up.  I do think the Tax Court has it right, but I am curious as to how another preparer might have handled this situation if Ms. Mehriary had plopped it on his or her desk.

You've Come A Long Way Baby

You youngsters will have to forgive me for this observation.  You have to remember that I am old enough to remember the "Want Ads" being divided into three section - "Help Wanted Male", "Help Wanted Female" and a generally smaller gender neutral section.  At any rate for many years I have at least looked at every single Tax Court decision and those concerning divorce have been of particular interest to me.  This is the first time I have noted a decision about a woman paying alimony and being denied a deduction .  I'd have to do more research than I am inclined to do to determine whether this is an actual milestone, so I will leave it at that.

 Other Coverage

Prof. James Maule mentioned the case titling his post "Be Careful With Divorce Tax Planning", which is pretty much the moral.

"Debt And Taxes" had a piece by J Wade in which he, like Professor Maule, noted another recently decided case in which the taxpayer was denied an alimony deduction because amount would have been payable even in the event of death. First time I have noticed this blog.