Don’t Overlook Estate Tax Consequences in Divorces

A couple in the midst of divorce negotiations concerning financial matters usually don’t think about the estate tax consequences that may develop if either party dies unexpectedly before the full implementation of the resulting agreements. There are two important possibilities: Will alimony payments that must continue after death of a payor be deductible by the payor’s estate? And, will the value of property transfers that are in process be included in the payor’s estate? The answers depend upon whether or not the payments and distributions were founded upon a promise or agreement between the parties, or imposed by an involuntary court order.

A claim against the payor’s estate that is based upon an agreement between the parties is deductible from the gross estate only if there was an exchange of adequate consideration. The IRS treats satisfaction of an obligation to provide support, such as alimony, as adequate consideration. Thus, an alimony obligation decreases the taxable estate of the payor.

A property settlement obligation is not adequate consideration under the estate tax rules. It is only treated as adequate consideration if the agreement establishing the obligation was made within two years before or one year after a final decree of divorce. The reason for this rule is to prevent spouses from circumventing the estate tax through private agreements. As long as the spouses are divorced and the property settlement agreements meet the time frame indicated above, any unpaid property obligation will be excluded from the payor’s estate.

When the parties are unable to reach agreement about support and property settlements, and the court makes a determination as part of its decree, then the obligations are created by the court and not by the parties. Any subsequent claims against the estate of the payor for unfulfilled obligations would be deductible from the payor’s gross estate without regard to whether or not the payor received adequate consideration.

The payor’s estate is not entitled to an income tax deduction on its fiduciary’s tax return for alimony paid after the payor’s death. All such payments are treated as distributions from an estate to an estate’s beneficiary. Payments of alimony from any income received by the estate are taxable to the former spouse and deductible to the estate but only to the extent that the estate has taxable income.

Frequently, the payor spouse owns a life insurance policy on his or her life and is required as part of the settlement agreement to maintain the policy, which names his minor children as the beneficiaries. If the parent dies while the children are minors, then the parent no longer has an obligation under state law to provide support and the value of the life insurance is not deductible from the payor’s gross estate even if the maintenance of insurance is required by a court’s decree.


The following example illustrates some estate consequences arising from divorces:

Husband voluntarily agrees to pay child support equaling $3,000 per month until his two children reach maturity, and to pay his wife $5,000 a month in alimony for 5 years plus $500,000 in five equal annual installments of $100,000 as a property settlement. The child support is funded by assignment of death benefits under a policy which the husband owns on his life. The husband dies after making 12 child support and alimony payments, and one property installment.

In the subsequent year, the husband’s executor distributes all the estate’s assets to the husband’s beneficiaries and reports $25,000 of net income (earned after the husband’s death) in the fiduciary tax return for the estate.

The former wife has an enforceable claim against the husband’s estate for the remaining 48 alimony payments. The executor makes 12 alimony payments of $5,000 a month to the
wife in the subsequent year while the estate is being settled. However, only $25,000 of such alimony can be deducted from the husband’s gross estate because that was the extent
of the estate’s distributable income. The former wife recognizes $25,000 of taxable income.

The husband’s executor is obligated to pay the remaining four installments of the property settlement to the former wife. If the voluntary agreement between the husband and wife was not made within two years before or one year after a divorce, the executor cannot deduct the remaining property settlement from the husband’s gross estate. If a court had imposed the settlement in a final decree or the agreement was made two years before or one year after divorce, then the present value of the remaining installments could have been deducted from the husband’s gross estate.

The life insurance proceeds that are paid to the two children are included in the husband's estate (unless a life insurance trust was established). The life insurance is considered to be a testamentary distribution.