Child support and spousal support (alimony) are treated differently for tax purposes and they can result in significant tax consequences for both parties.
Child support is “tax free” to the custodial parent receiving the payments. They are not required to pay taxes on these payments even though they are similar to receiving “income” payments. The spouse who is making the payments will be responsible for paying taxes and cannot deduct the payments from their income.
Alimony, on the other hand, is deductible by the person who is paying it. The payment is included in the taxable income of the person who is receiving it and therefore treated as taxable income.
Since the parties may have substantially different tax brackets post-decree, it is critical to understand the different categorizations of payments and how they will affect each spouse’s post-decree tax returns.
The IRS has specific definitions of child support and alimony and it is important to discuss them with your tax advisor and your attorney before finalizing any marital settlement agreement. There are specific guidelines that tie deductions in maintenance to IRS Recapture Rules (which are based on periods of time that are similar to the expected periods for reductions in child support). There are many divorce agreements that overlook these IRS rules, but it is important for you to make informed decisions regarding these matters since they could have substantial tax penalty repercussions.
Brandi Ruffalo is a financial divorce advisor with Valuation & Forensic Partners, LLC in Chicago and Schaumburg in Illinois. She specializes in basic lifestyle and financial analyses to the valuation of private businesses or stock option.