Getting a divorce and negotiating a settlement that both parties find acceptable is difficult enough. Even spouses that remain friendly with one another may find themselves at bitter odds as they fight over their home, children, and other issues.
Taxes further complicate matters. Some aspects of a settlement may carry tax implications that can lead to severe consequences if neglected. Knowing how to navigate the IRS’s rules will help you to make better decisions and prevent being surprised by a huge tax bill at the end of the year.
Two items that should be considered in light of how they influence each spouse’s taxes are child support and alimony (spousal maintenance). They’re treated differently by the IRS. The good news is that with upfront planning, you and your soon-to-be ex can tailor your settlement so that both of you come out ahead.
Below, we’ll explain how the IRS regards child support and spousal maintenance payments. Note that the following information should not take the place of a professional tax preparer or accountant’s advice. But it should provide a starting point from which you can adjust your settlement to lower your end-of-year tax liability.
How The IRS Treats Child Support Payments
Child support is paid to the spouse who has been granted legal custody of the couple’s children. The amount and duration of the payments vary. The amount is heavily influenced by the spouses’ incomes in relation to each other. The duration is usually based on when the children reach the age of majority (18 in most states).
The payments are neither considered taxable income for the receiving party nor tax-deductible for the paying party. Thus, they have no direct effect on either spouse’s taxes. Having said that, child support can play an indirect role in reducing those taxes – a point we’ll demonstrate below.
How The IRS Treats Alimony Payments
Alimony is financial support paid by one spouse to the other. It is a common component of a settlement when marriages last for several years and one party stays home while the other party works. This is often the case when the divorcing couple has kids.
The amount and duration of the payments are based on a number of factors. The amount is influenced by the parties’ respective incomes, the ability of the receiving party to make a living, and how long the marriage lasted. The standard of living the couple enjoyed during their marriage is also taken into account.
The duration is affected by whether the receiving spouse remarries and how much time the receiving party needs to become self-sufficient. The presence of underage children in the household is also considered since their care might preclude the custodial parent from seeking full-time employment.
Unlike child support payments, the IRS considers alimony payments to be taxable income for the receiving spouse. At the same time, it allows the party paying child support to deduct the payments from his or her gross income.
Failure To Report The Receipt Of Alimony
The spouse who receives alimony is responsible for reporting the payments to the IRS. If she fails to do so, it is highly likely that she will be audited by the IRS at some point in the future.
A common assumption is that the IRS will never learn about the payments, and hence a failure to report them will have few consequences. This is incorrect. Assuming the paying party deducts the amount paid from his or her gross income at the end of the year, the IRS will be notified. The paying party is required to include the Social Security Number of the receiving party on his or her tax documents.
Child Support Vs. Alimony: Which Is Better To Receive?
Depending on the couple’s circumstances, it may be advantageous for both parties to adjust the settlement terms so the paying spouse can reduce his or her tax liability. Doing so usually entails that individual paying less in child support and more in alimony.
As noted earlier, the receiving spouse must report alimony payments to the IRS and pay taxes on the money as if it were normal income. However, both parties can still come out ahead if the paying spouse is in a higher tax bracket than the receiving spouse. Significantly reducing the tax burden imposed on the paying party – even if doing so slightly increases the tax burden imposed on the receiving party – can result in a more generous settlement.
It is critical to consult a qualified divorce attorney or a tax advisor if you have questions about the matters discussed above. Tax rules are often complex and confusing. Worse, if violated, they can open the door to stiff IRS penalties.