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“Til’ Debt Do Us Part”…Bankruptcy and Alimony Settlements

Davidson v. Comm’r, T.C. Memo. 2018-38, 2018 WL 1611811 (2018)

 

(a) Facts: The parties were divorced by an Arkansas court, and the divorce decree divided the parties’ debt.  Within a few days after the decree was entered the judge sent the parties a letter, which stated:

 

When I made my ruling from the bench last Thursday, I failed to mention the following issues that should be included in the Decree of Divorce:

 

  1. The division of debt ordered from the bench shall be considered as support for Mrs. Davidson [Kelley] and shall not be dischargeable in bankruptcy[.]

 

2018 WL 1611811, at *1.  The court then entered a modified decree, which stated:

 

  1. ALIMONY: In light of the foregoing division of the debts, and real and personal property, and having reviewed all the primary and secondary factors of alimony the Court recited, the Court finds that it is not appropriate to award the Plaintiff [Kelley] alimony in this case. Further, given this Court’s division of the marital property and debt between the parties and because Mr. Davidson’s future income is too speculative to set any kind of time frame on when his income would have to improve for it to inure to the benefit of the Plaintiff [Kelley], the issue of alimony will not be held open to allow Plaintiff [Kelley] to reopen this case and file a petition for alimony in the future.

 

  1. BANKRUPTCY: The division of the debt ordered from the bench shall be considered as support for Mrs. Davidson [Kelley] and therefore shall not be dischargeable in bankruptcy.

 

Id. at *4.

The husband’s CPA told him that he could take an alimony deduction for the payment of certain debts, and the husband did so.  The IRS disallowed the deficiency, and the husband sought relief in the Tax Court.

 

(b) Issue: Was the husband entitled to an alimony deduction?

 

(c) Answer to Issue: No.

 

(d) Summary of Rationale: The payments met the first three requirements in § 71(b)(1).  They were made under a divorce instrument, the instrument did not say that the payments were not includible in gross income, and the parties were not members of the same household.

 

The disputed point was the fourth requirement, which requires that the payments cease upon the payee’s death.  The divorce decree was silent on this point, so the court looked to Arkansas state law.  The court held that the payments were not alimony:

Petitioner has not shown that the payments at issue are alimony under Arkansas law or otherwise terminable at Kelley’s death. For one, Arkansas law distinguishes alimony from debt allocations; the latter are generally considered property settlements rather than alimony payments. . . . Second, petitioner has not shown that the allocation of his and Kelley’s marital debt was based on the primary and secondary factors considered for an alimony award. In fact, in the alimony section of the amended divorce decree, the circuit court referenced the alimony factors and stated that an alimony award was not appropriate.

 

Id. at *11-12.  Because the payments did not cease upon the payee’s death, the husband was not entitled to an alimony deduction.

 

The husband was not liable for the accuracy-related penalty since he provided all relevant facts to his CPA and relied upon the CPA’s advice.

 

Observations:

 

  1. The federal courts know the difference between a property settlement and an award of alimony.

 

  1. The federal courts know quite well that a payment is not alimony for federal tax purposes unless liability ends upon the payee’s death.

 

  1. An obligation to pay a marital debt looks a lot like a property settlement. The federal courts will be reluctant to treat a debt payment as alimony unless there is extremely clear evidence that liability for the debt does not survive the payee’s death. In other words, there must be strong evidence that the payor would not be liable for the debt at all if the other spouse were to die before the debt was paid.

 

  1. Most debt provisions require that the payor assume liability for the debt unconditionally. The death of the other spouse is therefore not a defense to liability, and the obligation is not alimony for federal tax purposes.

 

  1. If you take a questionable alimony deduction, you may at least be able to avoid the accuracy-related penalty if you relied in good faith upon the advice of a tax expert.