When Divorce Settlement Tax Optimization Goes Wrong

Tax optimization is an important aspect of a comprehensive divorce settlement. Easy Soft’s CIS software easily interfaces with Divorce Financials, our more general divorce product, to give New Jersey family law attorneys options to help them find the best settlement for both parties in a divorce. However, as shown in a recent case, tax optimization can go too far.

Why Optimize?

The IRS considers child support and alimony to be different. Child support is considered a natural part of caring for children and is not considered income any more than buying your kid a pair of shoes or paying his tuition. Since it is not income it is not taxed on either the child’s or the custodial parent’s return, nor is it deductible on the payor’s return.

However alimony is considered income. Since the two parents no longer have a legal relationship and don’t share assets, money paid from one to the other is income. The recipient must declare the alimony on taxes and the payor can deduct alimony payments.

In light of this relationship many divorce practices use family attorney software to trade alimony and child support dollar for dollar to create an optimized tax situation for one or both parties. This is completely legal and acceptable…except when it’s not.

When Is A Deduction Not A Deduction

Recently in the case of Johnson v. Commissioner of Internal Revenue, the U.S. Tax Court ruled against the deductibility of the husband’s “alimony” payments because they said that the payments were really child support in disguise. Why was this case different from the countless other cases where child support and alimony are openly exchanged?

In the agreement the alimony was specifically tied to the youngest child’s graduation from high school. The court ruled that since the payments were tied to an event related to the child, they were clearly child support and not alimony and therefore not tax deductible to the father.

The important factor here is the court didn’t specifically object to the tradeoff. It objected to tying the alimony payments to the child. Family law attorneys should be careful when wording a divorce agreement not to link alimony payments to events in the children’s lives.

CIS may not be able to help you word your settlements, but it does make it easy to complete the CIS statement NJ divorces require. If you are using CIS be sure to look at Divorce Financials as well so you can create tax optimized settlements.