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…)

Under existing tax law, a parent is entitled to claim an exemption for any dependents they financially support. This exemption reduces taxable income so you pay less taxes. In 2008 the amount of the dependency exemption is $3,500 per child. This exemption however, is subject to a phase-out provision such that the taxpayer will lose some of their exemptions the higher their adjusted gross income. In effect, the more money you make, the less valuable the dependent exemptions may be.In North Carolina, if the issue of child support is not resolved by the parents between themselves, a judge will decide not only the amount of child support that each party must provide for the children, but how the child support dependency exemptions are to be allocated. However, in many cases, people with children separate and pay support without the existence of a court order for children living the majority of time with the other parent. Or, people enter into a voluntary child support agreement. Whatever the case, parents who are separated or divorced should know their rights with respect to claiming the children as dependents for tax purposes absent a court order allocating the dependency exemptions to one or both parents.

Pursuant to Internal revenue Code §152(e)(1)(B) the custodial parent is presumptively entitled to claim the children as dependents if: (1) the children receive over half of their support during the calendar year from their parents (a) who are divorced or legally separated under a decree of divorce or separate maintenance, or (b) who are separated under a written separation agreement, or (c) who live apart at all times during the last six (6) months of the calendar year and (2) the children are in the custody of one or both of their parents for more than one-half of the calendar year. Pursuant to treasury regulation 1.152-4, effective July 2, 2008, the custodial parent is defined as the parent with whom the child resides for the greater number of nights during the calendar year. The non-custodial parent (defined as the parent who is not the custodial parent) can claim the exemptions in two circumstances: (1) where the custodial parent releases the claim to the exemption for the year; or (2) the non-custodial parent contributed over one-half of the support for the dependent(s) during the calendar year. Where there is no agreement or waiver with respect to which parent gets the exemption and where a child resides with each parent an equal number of nights during the calendar year, the parent who has a higher adjusted gross income would be deemed to be the custodial parent and entitled to the exemption.

For the release or waiver by the custodial parent of the right to take the child dependency exemptions to be effective the custodial parent must sign a written declaration stating that he/she will not claim the children as a dependents for the specified calendar year. The non-custodial parent must then attach this form to his tax return for the year in which the dependency exemptions are claimed. The Internal Revenue Service provides a form to make this declaration known as Form 8332 which can be downloaded from the IRS website at http://www.irs.gov/pub/irs-pdf/f8332.pdf. A written declaration which is not on IRS Form 8332 must conform to the substance of the form and be a document executed for the sole purpose of making the declaration. A court order or settlement agreement will no longer suffice as a written declaration as of July 2, 2008.

In order for the non-custodial parent to claim the dependency exemptions without a waiver by the custodial parent, the non-custodial parent must prove that he/she contributed over one-half of the support for the children in the calendar year. To accomplish this objective the non-custodial parent must first show the total amount of support for the children from all sources including the other parent or income earned by the dependent (which cannot exceed the amount of the exemption). The term “support” includes food, shelter, clothing, medical, education and also such items as pets, toys, televisions and other entertainment costs. Expenses that are not directly related to any one member of a household, such as the cost of food for the household or rent payments, must be allocated among the members of the household in which the dependent resides. Records and receipts will be required. (more…)