Redleaf v. Commissioner – Cash Payments are Property Settlement, Not Deductible Alimony
In Redleaf v. Commissioner, the U.S. Court of Appeals for the Eighth Circuit recently held that $51 million in deferred cash payments made by a husband to his ex-wife pursuant to a marital termination agreement (MTA) weren’t deductible as alimony. At the time the payments were made, the federal tax code provided that alimony was deductible by the payor spouse and includable in the recipient spouse’s income. This provision was repealed under the Tax Cuts and Jobs Act (TCJA), effective for divorce or separation instruments executed after 2018.
Sizable Property Settlement
Executed in 2008, the MTA provided that the wife would receive the family’s principal residence and vacation home, as well as most furnishings and artwork in the homes and four of their five vehicles. The husband received a piano, some art, his personal effects, the fifth vehicle and his 84.5% interest in a hedge fund asset management firm.
To account for the wife’s interest in the firm as a marital asset, the MTA provided for the husband to pay her approximately $140 million in cash over the next five years. This included around $51 million in payments in 2012 and 2013, which the husband deducted as alimony on his tax returns for those years. The wife treated the payments as nontaxable transfers of property incident to divorce.
The IRS issued separate deficiency notices, informing the husband that the payments weren’t deductible as alimony and informing the wife that they were includable in her income as alimony. Both parties petitioned the U.S. Tax Court for redetermination.
The IRS took the position that the payments weren’t alimony and, therefore, weren’t deductible by the husband or includable in the wife’s income. The court agreed, granting summary judgments reversing the wife’s deficiency and upholding the husband’s deficiency.
The Eighth Circuit affirmed the Tax Court’s decision, noting that, to constitute alimony, cash payments must satisfy the following four requirements:
- The payment is received by or on behalf of a spouse under a divorce or separation instrument,
- The instrument doesn’t designate the payment as excludable from the payee’s gross income and nondeductible by the payor,
- In the case of legal separation, the payor and payee aren’t members of the same household, and
- There’s no liability to make any such payment after the payee spouse’s death.
The MTA didn’t contain a provision specifying whether the payments were includable in the wife’s income or deductible by the husband. However, while the MTA didn’t expressly state whether the payments would have survived the wife’s death, they clearly would have under applicable state law (Minnesota in this case).
The MTA stated that the wife had “adequate income and financial resources from the property settlement to meet her needs,” and that each party “waives any right to receive temporary and/or permanent spousal maintenance . . . now or in the future.” The Eighth Circuit found that Minnesota law unambiguously established that the MTA was a contractual division of marital property rather than a spousal maintenance agreement. As such, Minnesota law unambiguously provided that the husband’s obligation to make the payments would survive the wife’s death and, therefore, weren’t deductible.
Factor Taxes into Settlements
As Redleaf demonstrates, it’s important to discuss tax issues with a financial professional when executing a divorce or separation agreement. Although the TCJA eliminated the above-the-line deduction for alimony payments, some pre-2019 cases are still making their way through the court system and there are other divorce-related tax pitfalls — for example, related to retirement plans and built-in capital gains tax — that need to be addressed when splitting up the parties’ assets.