Alimony must be reported as taxable income by the person receiving it. Conversely, it is deductible by the payer (child support is not tax deductible). Unfortunately, many people are unaware that they must pay taxes on the alimony and they are hit with a huge tax bill at the end of the year. Make sure you discuss this issue with you or accountant or tax preparer.
It is possible that a dispute may arise as to how much alimony was paid or received – the amounts claimed on the respective tax returns of the payor or payee might not match. This raises serious red flags with the IRS. Therefore, it is very important to keep good records.
If paying alimony, make sure you keep the following records:
1. Copies of the checks (originals are best). In the memo section, indicate that the check is for alimony and the month that the payment is for.
2. If you pay cash (which is not recommended) make sure you received a signed receipt.
3. A list showing the date, check number, amount and address where payment was made.
If you’re receiving alimony, make sure you keep the following records:
1. Keep a copy of the check received.
2. A list showing the date, check number, amount and bank and account against which the check is drawn on.
3. Copy of any receipts for cash payments.
You can be creative in negotiating settlements by considering the deductibility of alimony payments. Alimony results in tax savings since the higher income individual is able to deduct payments at a high tax rate while the spouse who has little earnings pays taxes at a much lower tax rate. However, it is very important to be aware that certain conditions must be met to make sure that the tax benefits of alimony are not revoked by the IRS. There are several key rules.
1. Paid in Cash. The payments must be paid by check or cash.
2. Written agreement. The payments must be made pursuant to an agreement such as a settlement agreement, court order or divorce judgment. The document should clearly state that the payments are deductible by the payer in taxable to the recipient.
3. Separation. The recipient must live in a separate residence.
4. Termination on death. The payments must terminate on the death of the recipient – this must be stated in the document.
5. No front loading. Alimony cannot be excessively high in the first three years after separation – for example, larger amounts paid in the first year compared to years two and three.