How To Use Tax Laws To Maximize Income in Divorce: Unallocated Family Support

Frequently in divorce cases, one spouse makes a claim against the other for the payment of alimony and/or child support, arguing that he/she needs money from the other to maintain his/her standard of living and that of the children. Where it is likely that one spouse will have to pay spousal support and/or child support to the other, and the claim will go to court, a court in North Carolina is required to enter separate provisions or orders for child support and alimony. When this occurs, there is no opportunity to take advantage of the possibility of characterizing the payments as unallocated child support and alimony, more commonly known as “ Family Support.”

Characterizing alimony and child support payments, collectively, as Family Support enables the total payment to be tax deductible by the payor spouse and taxable to the recipient spouse, just as alimony is treated. Because generally the payor spouse is in a higher tax bracket, the deductibility of payments classified as alimony or family support result in a higher percentage deduction because of the higher tax rate of the payor spouse. This results in the payor spouse having a higher net income than if part of the payments were classified as child support which is a not deductible from the payor spouse’s income and not taxable to the recipient spouse.

Conversely, because the recipient spouse is generally in a lower tax bracket, the tax rate on the payments classified as alimony or Family Support are at a lower rate resulting in greater net income. Thus both parties benefit from characterizing the payments as Family Support. Since, in North Carolina a court cannot order Family Support , the parties will have to agree to the payment of child support and alimony being classified as Family Support and the agreement will have to be set out in a written support agreement or a consent order.

Often the bitterness and hostility between spouses in a divorce situation prevent one or both of them from looking at the financial situation realistically and with the purposes of maximizing the income of both parties. The parties’ attorneys must help feuding parties understand that the tax laws can provide a mutual benefit.

In order to take advantage of the classification of alimony and child support payments as Family Support , the following criteria must be met pursuant to the provisions of Internal Revenue Code § 71: (1) the payments must be cash (e.g. checks or money order) received by or on behalf of a spouse; and (2) must be pursuant to a divorce or separation instrument (as defined in I.R.C. § 71(b)(2)) ; and (3) the payments must not be designated as not includible in gross income under § 71 and not allowable as a deduction under Internal Revenue Code §215; and (4) the spouses or former spouses are not members of the same household at the time payments are to be made; and (5) there is no liability to make a payment after the death of the payee spouse.

In addition, the spouses must file separate tax returns. In other words, in order for payments of Family Support to be deductible by the payor spouse and taxable to the recipient spouse, the payments must meet all the requirements under the Internal Revenue Code § 71 for the payment of alimony.

Because Family Support payments classify as alimony, for tax purposes, what would ordinarily be child support payments, there is always a concern about a reduction in the amount of Family Support to reflect that a child or children age out and the recipient spouse would – but for the designation of the payments as Family Support – no longer be entitled to child support payments. I. R. C. §71C (1)(2) specifically address this issue and any agreement or consent order must be drafted carefully . I.R.C. § 71C (2) generally prohibits the reduction in the amount of unallocated support being reduced by a child related contingency such as a child reaching a certain age, dying or leaving school or at a time related to such a child related contingency.

If a reduction based on a child related contingency were to occur, the amount of the reduction will be treated as child support. The effect is that the amount, treated in prior years as deductible by the payor spouse would lose its deductibility and be taxed, possibly including interest and penalties in arrears. This is why a Family Support provision or agreement must be carefully drafted to avoid any appearance of a reduction based on a child related contingency. (more…)