Payments Were Alimony Despite Missing Language Agreement

Payments Made to Ex-Spouse Were Alimony Despite Missing Language in Divorce Agreement

Tax issues are often the last thing that spouses consider when going through a divorce. In other cases, one spouse plans for the tax issues and the other does not. This appears to have been the situation in Leslie v. Commissioner, T.C. Memo. 2016-171.

Facts and Procedural History

The taxpayer’s husband was an attorney. He was friends with the general counsel to the Regents of the University of California. This friendship lead to him representing the University of California as lead plaintiffs in a class action suit against Enron.

The Enron class action ended with a favorable settlement for the University and the other plaintiffs. The court awarded $688 million in legal fees. The taxpayer’s husband received a percentage of the legal fees. This amounted to $55 million in payments to the taxpayer’s ex-husband, which were received in 2008 through 2010.

Just prior to the time the Enron litigation settled, the taxpayer and her husband were finally divorced. The terms of the divorce settlement were set out in a Marital Settlement Agreement (“MSA”).

In the “Spousal Support” section of the MSA, the taxpayer was awarded 10% of whatever fee her ex-husband received as a result of the Enron litigation. The MSA went on to say that the taxpayer’s ex-husband “shall receive ninety percent (90%) as his sole and separate property and Ms. Leslie shall receive ten percent (10%) of all net fees distributed to” her ex-husband. It also said that the “ten percent (10%) distribution to Ms. Leslie is taxable to Ms. Leslie and deductible to Mr. Georgiou as spousal support.”

Given the timing of the Enron litigation settlement, the taxpayer started receiving payments shortly after the MSA was finalized. The payments totaled nearly $6 million.

The IRS concluded that the payments were alimony deductible by the taxpayer’s then ex-husband and income subject to tax for the taxpayer. The taxpayer argued that the payments were not taxable as alimony but rather a property settlement and, therefore, were not taxable income to her.

The Alimony Rules

Congress has provided specific rules that describe what payments are considered to be alimony for income tax purposes. Specifically, alimony is defined in Section 71 to include any cash payment if:

1. such payment is received by (or on behalf of) a spouse under a divorce or separation instrument,
2. the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under Section 71 and not allowable as a deduction under Section 215,
3. in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made, and
4. there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.

In the Leslie case, the taxpayer only challenged the last point. She argued that her ex-husband’s obligation to make the payments did not end upon her death. The MSA did not expressly address this issue.

Given that the MSA was silent on the issue, the court looked to state law to conclude that the ex-husband’s obligation would in fact end upon the taxpayer’s death by operation of state law. So the court concluded that the payments were alimony, which was considered to be taxable income for the taxpayer.

Planning for Divorce

The facts in Leslie demonstrate, these tax rules can shift the tax burden to one spouse of the other. This can be significant. In Leslie, it ended up being a $6 million in taxable income at issue. The amount could have even been larger had the Enron ligation settlement resulted in an even higher payout.

The Leslie case shows why it is important for taxpayers to factor taxes into their divorce settlement agreements. Tax planning is key. This is particularly true for taxpayers who own hard to value assets or where there is an unequal distribution of assets.

Given this case and that the MSA was silent on whether the payments terminated on death, one is left wondering whether the taxpayer knew of this looming tax issue at the time of her divorce and just did not want to pay the taxes when the time came to pay, or if she did not understand or missed the issue altogether.