Lump Sum Alimony: Potential Tax Trap

Alimony payments are taxable to the recipient spouse if they are cash payments received under a divorce or separation instrument not otherwise specifically excluded from taxable income. The payments must stop upon the death of the recipient, and if the spouses are legally divorced, they must not be members of the same household. A single lump sum payment in cash will often meet the definition of taxable alimony and can result in a significant tax trap.

An Example

Assume that a jury orders a husband to pay his ex-wife a cash payment of lump sum alimony of $250,000 followed by annual payments of $10,000. The award does not specifically exclude the lump sum payment from taxable income. The wife will be required to include the $250,000 payment in taxable income while the husband will receive a tax deduction for such payment. Of the $250,000 payment, $225,000 will be subject to recapture (which will occur two years later).

If the wife has no other taxable income, her federal tax during the year of divorce as a single taxpayer will be $71,906 under current tax rates. Two years later she will have a recapture deduction of $225,000 which will save her $615 in federal tax. The alimony recapture deduction is a nonbusiness deduction and cannot be carried back to offset the alimony income in the earlier year. This results in a net tax cost to the wife of $71,291.

If the husband has $100,000 of other taxable income, the alimony deduction in the first year will save him, at most, $26,522 in federal tax at the current rate. The additional $150,000 deduction ($250,000 alimony less $100,000 taxable income) is a nonbusiness deduction and cannot be carried backward or forward. Two years later he will have alimony recapture income of $225,000 which will generate $69,750 of tax. This results in a net tax cost to the husband of $43,228 ($69,750 - $26,522). In total, the husband and wife will pay $114,519 of federal tax on the $250,000 of lump sum alimony.

Avoiding the Trap

Internal Revenue Code Section 71(b)(1)(B) provides that a divorce or separation instrument may specifically exclude an otherwise taxable alimony payment from taxable income. In the example above, had the jury specified the lump sum alimony payment as being non-taxable, both husband and wife would have saved substantial amounts of income taxes.