A simple method exists for shifting tax burdens from a high-tax bracket parent to a low-tax bracket parent in divorce cases. The result is the possibility for extra after-tax cash for both parents and a tangible reinforcement of the concept that divorced couples can and should work together for their mutual benefit.
To begin with the basics, it should be remembered that child support payments are tax neutral. They are neither deductible by the payer nor includable in income for the payee. Maintenance, on the other hand, is deductible by the payer and taxable to the payee. Unallocated family support is a label which can be applied to the combination of child support and maintenance payments which makes the entire payment deductible by the payer and taxable to the payee.
The benefit of this arrangement is that the payer, commonly the higher income party and breadwinner in the family, can often use the extra deductions and the recipient of the support funds can pay the tax on the funds at a lower rate of tax with a net benefit to the two parties.
The receiving parent can be expected to negotiate a sufficiently increased support amount to offset the tax burden of the unallocated family support. Generally, there will be a sufficient tax savings to allow each parent to increase his or her after-tax cash by a significant amount. To illustrate this point, assume that John and Mary Doe are divorcing. John has $150,000 per year gross income, and Mary is a stay-at-home mom with the parties’ three children. Child support payable by John to Mary is $31,762. Mary’s budget shows that she needs $4,000 per month, or $48,000 per year, to pay the household expenses. The shortfall in Mary’s budget on a monthly basis is $1,353. This can be made up by the payment of maintenance to her. This results in an alimony payment on an annual basis of $16,493. After tax cash for living expenses for Mary is $48,000 annually, and for John, $57,027.
While still meeting the requirements of the Internal Revenue Code and labeling the entire support payment as "unallocated family support," it is possible to increase Mary’s support so that she has more than the $4,000 per month that she needs. John’s tax burden is reduced significantly so that he has an extra $7,000 per year after tax cash. The benefit to the parties combined is $7,782 per year.
Additional benefits could be gained by switching the child dependency exemption from one party to the other, and this simple model does not include additional savings which might be gained by itemizing such deductions as mortgage interest, etc. Nonetheless, it illustrates the point that using unallocated family support can significantly benefit the more highly compensated spouse, and these tax savings can be funneled to the custodial parent in terms of greater after-tax cash.
The above example has been produced using the FinPlan software plan. (Any errors in the example are mine, not theirs). Attempting to work out these calculations without FinPlan is akin to performing dental surgery on oneself. With the software, it is easy. The software can be obtained by calling FinPlan at 800-777-2108.
For the parties’ agreement to qualify as fully deductible by the payer and includable in the payee’s taxable income, the agreement must provide the following:
1. Payments must be in cash (checks and money orders also permitted).
2. Payments must be made pursuant to a divorce or separation instrument, including a decree of divorce or separate maintenance, a written separation agreement, or a temporary support order.
3. The parties must be living in separate household when the alimony is pursuant to a decree of divorce or a decree of separate maintenance, but not where the payments are made under a written separation agreement or a temporary support order.
4. Payments must terminate upon the payee’s death.
5. Payments cannot be fixed for child support. See Family Law Tax Guide (CCH), Section 1005 et.seq. (1988). Also see Sections 71 and 215 of the Internal Revenue Code.
While the above requirements deal with whether a payment is taxable maintenance, there are further requirements regarding unallocated family support. The law presumes that changes in the amount of unallocated support at a time within six months before or six months after a child’s 18th or 21st birthday, pursuant to the written agreement will prevent such payments from being deductible by the payer. See IRS Regulations which interpret Section 71.
An additional requirement regards multiple changes of support for multiple children within a one-year period of time pegged to a certain age of the children between 18 and 24. This is one of those rules that is about as easy to explain as the rule against perpetuities. Commentators suggest that practitioners should use the benefits of unallocated family support with one change or an end date. That change or end date should be outside the six-month period of time before or after the child’s 18th or 21st birthday. Again, the agreement must call for payments to cease upon the death of the payee and must not be pegged to some child support provision. In other words, pegging the termination of unallocated family support to any child’s birthday or any other happening which is regulated by reference to a child probably runs afoul of the rules.
Because an element of the unallocated family support payment is child support, Illinois courts have found such payments to be always modifiable. The use of "federal tax gimmicks" will not be allowed to avoid child support modification provisions. See IRMO Steadman, 283 Ill.App. 3d 703, 219 Ill.Dec. 258, 670 N.E. 2d 1146 (3d Dist. 1996). While the use of unallocated family support may indeed be nothing more than a tax gimmick, it is, nonetheless, one of the few devices with which a family law practitioner can help his clients pay their bills. By showing our clients how to work together with their ex-spouses for their mutual financial benefit, we may in some small way be helping them toward greater cooperation in the parenting of their children and the resolving of other conflicts.
William J. Parkhurst is an associate with the Carol Stream law firm of Johnson, Westra, Broecker, Whittaker & Newitt, P.C., concentrating his practice in the area of family law.