April 1, 2017
Alimony is often a necessary component of a divorce settlement but there are always cases in which the payor spouse doesn’t want to face years of monthly payments. In a sense these payments still tie the two parties together, and this is a situation the payor doesn’t want to be in. So the question arises, can the entire sum of alimony payments be satisfied with one lump-sum “alimony” payment?
Alimony is structured so that the payor receives a tax-deduction for the payments, which are instead taxable to the payee. To qualify as alimony the payments must adhere to some strict IRS rules: the payments must be made in cash, must end at the payee’s death, remarriage or cohabitation, must be outlined in the divorce decree and designated as tax-deductible, and the parties must live apart.
But there is one alimony rule that is often overlooked and we don’t often see it listed among the others above. This is also an IRS rule that describes how payments must be structured so that they are tax-deductible. The IRS says that if alimony payments decrease by more than $15,000 per year between years 1 and 2, or years 2 and 3, then part of the payments will not qualify for a tax deduction to the payor (and hence will not be taxable to the payee.) In other words, if alimony payments total more than $15,000 per year then they must last more than one year and cannot be reduced too quickly. Why? Because the IRS sees this as a property settlement, not alimony. Because of this rule replacing all monthly payments with a lump sum “alimony” payment that is paid all in one year will often cause a trigger of this recapture rule, since alimony will go down to $0 in year 2.
There may be circumstances when a lump sum settlement makes sense:
The benefits of a one-time payment for the payor include getting rid of the obligation to carry life insurance to insure the payments, and being able to reduce payments by applying a present-value calculation to them.
The downside of a one-time payment for the payor include giving up the tax deduction as well as the potential that payments would have stopped if the payee remarried or died during the alimony period.
In general when you and your client are considering replacing alimony with a payoff, remember that, among other possible outcomes, they are losing a tax-deduction. This must be weighed in the decision process.
