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Ninth Circuit finds payments were alimony and not property settlement

June 13, 2018

The Court of Appeals for the Ninth Circuit, affirming the Tax Court, has concluded that payments by one spouse to another were alimony, deductible by the payor and includible in the recipient’s income.

Checkmark observation:  Under the Tax Cuts and Jobs Act (TCJA, P.L. 115-97, 12/22/2017), for any divorce or separation agreement executed after Dec. 31, 2018, or executed before that date but modified after it (if the modification expressly provides that the new rules apply), alimony and separate maintenance payments are not deductible by the payor spouse and are not included in the income of the payee spouse.

Background on alimony. Generally, property settlements (or transfers of property between spouses) incident to a divorce do not give rise to deductions or recognizable income. (Code Sec. 1041) On the other hand, for any divorce or separation agreement executed before 2019 (i.e., for the years at issue here), amounts received as alimony or separate maintenance payments are included in gross income and taxable to the recipient (Code Sec. 71(a), before repealed by TCJA) and deductible by the payor in the year paid. (Code Sec. 215(a), before repealed by TCJA)

An alimony or separate maintenance payment is one that meets the following four requirements:

(1) the payment must be made under a “divorce or separation instrument”;

(2) the instrument must not designate the payment as not includible in the recipient spouse’s gross income under Code Sec. 71 and not deductible by the payor spouse under Code Sec. 215;

(3) the payor and payee spouses must not be members of the same household at the time the payments are made; and

(4) the payor’s obligation to make the payment must end at the death of the payee spouse. (Code Sec. 71(b)(1))

Background on constructive receipt. Income not actually received is constructively received and reportable if it’s within the recipient’s control. Cash basis taxpayers must report money unconditionally subject to their demand as income, even if they haven’t received it. However, there’s no constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it. (Reg § 1.451-2(a))

Facts. After Maria Leslie’s marriage to Byron Georgiou came to an end, marital separation negotiations began in 2003 and continued for three or four years. A major reason for their length was the division of fees that Georgiou, an attorney, hoped to get from certain litigation (the Enron litigation) in which he would receive a substantial referral fee.

Under the marital separation agreement (MSA), Leslie received $7,000 per month in spousal support which would end with either party’s death. Under a separate section of the MSA entitled “Division of Community and Co-owned Property,” Leslie was awarded nine rental properties. She was also awarded 10% of whatever fee Georgiou received as a result of the Enron litigation as spousal support taxable to her; the MSA did not say whether this payment would terminate in the event of either party’s death. In addition, under the same section of the MSA, Georgiou was to pay, contingent on his receiving his split of the Enron fees, an additional $355,000 lump sum to Leslie as spousal support. The MSA expressly specified that the obligation to make the $335,000 payment would terminate upon Leslie’s death.

Georgiou received a referral fee of $55 million from the Enron litigation spread out from 2008 to 2010. He paid the $355,000 to Leslie in 16 separate payments from 2006 to 2007. He deposited the 2009 Enron payment to Leslie into a bank account that had both his name and Leslie’s on it. But Leslie credibly testified that she had no control over the account: she wasn’t given any checks to sign from the account, and her impression of the payment was that it wasn’t yet legally hers. In January of 2010, she filed a petition in state court to gain control of the account, which Georgiou opposed, and the state court at first refused to grant. The Tax Court noted that it was not clear from the record when or if Leslie ever gained control over the account containing the 2009 payment.

On her 2009 tax return, Leslie excluded from taxable income the 2009 Enron litigation payment from Georgiou.

Parties’ positions. Leslie argued that the 2009 Enron litigation payment she received (which didn’t expressly terminate on her death under the MSA) didn’t qualify as alimony and was therefore a nontaxable property settlement. As a fallback position, she argued that even if the amount was taxable, she didn’t receive it in 2009: she did not have control over the bank account; she did not have access to it; and did not even know it existed.

On the other hand, IRS argued that the 2009 payment qualified as alimony under Code Sec. 71 and was thus taxable to Leslie. And, even if Leslie didn’t have knowledge or control over the trust, Georgiou should be considered Leslie’s agent, thus giving her constructive receipt over the funds.

Tax Court decision. The Tax Court held that the 2009 payment qualified as alimony under Code Sec. 71. While nowhere in the MSA was there a condition that terminated Georgiou’s obligation to pay the contingent referral fee upon Leslie’s death, state law could supply the missing termination-on-death-of-payee condition for alimony under Code Sec. 71(b)(1)(D).

Under then-applicable California law, except as otherwise agreed by the parties in writing, the obligation of a party under an order for the support of the other party terminates upon the death of either party or the remarriage of the other party. The mere failure to include language terminating support upon death was not enough to constitute a waiver. (Cal. Fam Code §4337 (West 2013)) Accordingly, the Tax Court found that by operation of California law, the payments from the Enron settlement would have terminated upon Leslie’s death. (Leslie, TC Memo 2016-171, see “Tax Court rules on alimony and theft loss deduction”)

However, the Tax Court also concluded that there was no constructive receipt and that Leslie did not receive the 2009 Enron payment in the 2009 tax year. The Tax Court noted that it has held that knowledge of funds (something Leslie didn’t have) was necessary for constructive receipt. (Furstenberg, (1984) 83 TC 755) And the fact of her unsuccessful petition to state court to gain control indicated that, even after Leslie became aware that the funds were in an account, she still had no power to get them. Further, there was no evidence suggesting that Georgiou had any authority to act as Leslie’s agent; Georgiou’s interest was adverse to Leslie’s, as shown by his opposition to her state court petition to gain access to the account.

Appellate decision. The Ninth Circuit, affirming the Tax Court, rejected Leslie’s contention that the payments should have been treated as a lump-sum payment not subject to federal income tax under Code Sec. 1041(a).

The Ninth Circuit found that Code Sec. 71(b) plainly applied to the payments at issue:

…The payments were received “under a…separation instrument.” (Code Sec. 71(b)(1)(A))

…The separation instrument designated the payments as “taxable to Ms. Leslie and deductible to Mr. Georgiou as spousal support.” (Code Sec. 71(b)(1)(B))

…Leslie and Georgiou were “not members of the same household at the time such payment[s] [were] made.” (Code Sec 71(b)(1)(C))

…By operation of California law, the liability to make the payments would have ended upon Georgiou’s death. (Code Sec. 71(b)(1)(D); Cal. Fam. Code §4337)

The Ninth Circuit noted that Leslie conceded that Code Sec. 71(b) provided the applicable definition of alimony and that the payments in question met the statutory definition of Code Sec. 71(b).

The Court declined Leslie’s invitation to reject the statute’s plain meaning, stating that when a statute has a plain meaning, it is that meaning that the Court applies. (Hughes Aircraft Co. v. Jacobson (S Ct 1999) 525 U.S. 432) Further, the Ninth Circuit stated that courts “do not resort to legislative history to cloud a statutory text that is clear.” (Ratzlaf v. U.S., (S Ct 1994) 510 U.S. 135)

References: For pre-2019 alimony payments includible in gross income, see FTC 2d/FIN ¶J-1413United States Tax Reporter ¶714.01.

Leslie v. Comm., (CA 9 6/6/2018) 121 AFTR 2d ¶2018-828

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