(A) the amount of the alimony or separate maintenance payments paid by the payor spouse during the 1st post-separation year, over (B) the sum of- (i) the average of- (I) the alimony or separate maintenance payments paid by the payor spouse during the 2nd post-separation year, reduced by the excess payments for the 2nd postseparation year, and (II) the alimony or separate maintenance payments paid by the payor spouse during the 3rd post-separation year, plus ii) $15,000. (4) EXCESS PAYMENTS FOR 2ND POST-SEPARATION YEAR.--For purposes of this subsection, the amount of the excess payments for the 2nd post-separation year is the excess (if any) of- (A) the amount of the alimony or separate maintenance payments paid by the payor spouse during the 2nd post-separation year, over (B) the sum of- i) the amount of the alimony or separate maintenance payments paid by the payor spouse during the 3rd post-separation year, plus ii) $15,000. (5) Exceptions.- (A) Where Payment Ceases by Reason of Death or Remarriage.--Paragraph (1) shall not apply if- (i) either spouse dies before the close of the 3rd post-separation year, or the payee spouse remarries before the close of the 3rd post-separation year, and remarriage. (ii) the alimony or separate maintenance payments cease by reason of such death or (B) Support Payments.--For purposes of this subsection, the term "alimony or separate maintenance payment" shall not include any payment received under a decree described in subsection (b)(2)(C). (C) Fluctuating Payments Not Within Control of Payor Spouse.--For purposes of this subsection, the term "alimony or separate maintenance payment" shall not include any payment to the extent it is made pursuant to a continuing liability (over a period of not less than 3 years) proposed in the original House bill in 1983.168 It also repealed the requirement that the divorce or separation instrument itself must explicitly provide that the obligation to make payments to pay a fixed portion or portions of the income from a business or property or from compensation for employment or self-employment. "1st post (6) POST-SEPARATION YEARS.--For purposes of this subsection, the term separation year" means the 1st calendar year in which the payor spouse paid to the payee spouse alimony or separate maintenance payments to which this section applies. The 2nd and 3rd postseparation years shall be the 1st and 2nd succeeding calendar years, respectively. The following example, taken from Dodge, Fleming, and Geier, supra note 10, at 202-03, provides an illustration of the current rule. Suppose that a divorce decree requires Burt to pay Loni a total of $200,000, scheduled as follows: $100,000 in year 1, $70,000 in year 2, and $30,000 in year 3. Assume that each payment meets all the requirements of I.R.C. § 71(b). The payments are includable by Loni under I.R.C. § 71(a) and deductible by Burt under I.R.C. § 215 in each of the three years. In year 3, however, I.R.C. § 71(f) also requires an inclusion by Burt and a deduction by Loni in an amount equal to the "excess alimony payment" as defined in I.R.C. § 71(f)(2): the sum of the excess payments for the first post-separation year and the excess payments for the second post-separation year. You must begin by computing the excess payments for the second year under I.R.C. § 71(f)(4), because you must have that number in order to compute the excess payments for the first year under I.R.C. § 71(f)(3). $25,000 Step 1: The excess payment for the second year = 2d year alimony - (3d year alimony + $15,000) = $70,000 - ($30,000 + $15,000) = = Step 2: The excess payment for the first year = 1st year alimony - (1⁄2[(2d year alimony less 2d year excess payment) + 3d year alimony] + $15,000) = $100,000 - (1⁄2[($70,000 $25,000) + $30,000] + $15,000 = $100,000 - (1⁄2[$75,000] + $15,000) = $100,000 - ($37,500+ $15,000) = $47,500 Step 3: Thus, the excess alimony payment includable by Burt and deductible by Loni in year 3 equals $72,500 ($25,000 + $47,500). Section 71(f) can produce unhappy results for taxpayers by creating a large year-3 income item for the payor, pushing the payor into a higher tax bracket, and by creating a large year-3 deduction item for the payee, which can exceed her year-3 income after all other deductions are taken into account. That excess portion of the payee's § 71(f) deduction cannot be carried to other taxable years and deducted, and thus it is lost for tax purposes if it cannot be used entirely in year 3. 168 See supra notes 150-51 and accompanying text. The example given there from the 1983 House Report is precisely the example given in the 1986 Conference Report regarding how the amended provision would work. otherwise qualifying as "alimony" for tax purposes ends on the payee's death. The obligation to continue making payments must itself end, but it is sufficient if state law would automatically require the payments to stop, even if the governing document is silent in this respect. It retained, however, the repeal of the Lester Rule, as well as all other aspects of the amended alimony definition adopted in 1984. A. Cash Payments III. THE GOOD, THE BAD, AND THE UGLY So where are we today? While I think the law was, on balance, improved in 1984, it continues to generate an overabundance of confusion and resulting litigation, as briefly described in subpart 1 below, an unfortunate and unnecessary cost to both the government and divorcing couples. This is particularly true since, as the discussion below will show, these disputes result not from law that is premised on firm theoretical foundations and the resulting necessary complexity required to successfully differentiate "alimony" from "child support" from cash "property settlements." Rather, the discussion will show that it is not possible to differentiate successfully among these payments, and state courts and divorcing parties tend not to think in terms of those rigid categories anymore; only the drafters of the Internal Revenue Code continue to insist on compartmentalizing the world in this fashion. Moreover, the huge costs as well as frustrations incurred in the effort are incurred only to determine which person's marginal tax rate will apply to cash payments transferred between the parties as a result of divorce or child support obligations outside divorce. Very little revenue is likely at stake here. Finally, the misunderstanding and litigation is due chiefly to the Code's insistence on making the parties' flexibility to decide to whom cash payments should be taxed dependent on the transactional form for the payment chosen by the parties. As a result of the 1980s legislation, the flexibility to decide to whom cash payments should be taxed flip-flopped by category. Prior to the legislation, there was great flexibility (so long as one knew the magic words) to decide to whom amounts paid out as “child support" would be taxed and little flexibility to determine to whom "alimony"--as defined for Federal tax purposes--would be taxed. After the 1980s legislation, in contrast, there was little flexibility to decide to whom "child support" should be taxed and greater (albeit still limited) flexibility to decide to whom "alimony" should be taxed. 170 Prior to the 1980s legislation, the parties could choose to tax the payor on child support payments by explicitly labeling the payments as "child support," which would then be excludable by the payee and not deductible by the payor. The parties could, in contrast, choose to tax the payee by designating the payment a "family support payment," unallocated between "alimony” and “child support." Such an unallocated family support payment would be taxed to the payee because-since no amount was explicitly "fixed" as child support in the 169 The Act accomplished this result by deleting the final parenthetical in I.R.C. § 71(b)(1)(D), quoted supra note 158. agreement-it would be includable as "alimony" and deductible to the payor (so long as the remaining requirements pertaining to "alimony" were satisfied). Under Lester, this would remain true even if the unallocated family support payment was scheduled to be reduced upon events clearly linked to the emancipation or death of the children, which would seem to indicate that a portion of the payment was intended by the parties all along to be, in fact, child support. There was, thus, great flexibility to determine to whom child support payments would be taxed, albeit only for the well-advised. At the same time, there was much less flexibility regarding "alimony" within the "tax” definition of that term. If a payment satisfied the tax definition of alimony, it was includable by the payee and not deductible by the payor, even if they tried to avoid this result and transform the payment into a tax-neutral "property settlement" by calling the payment a cash property settlement in the divorce agreement. If the court was convinced that the payment satisfied a support obligation, rather than a division of property, then the court could rule that the payment was includable/deductible "alimony," regardless of the labels attached to the payments by the parties or even by state law, so long as the other statutory requirements were satisfied. 171 As a result of the 1980s legislation, the Lester Rule was repealed, which meant (on the face of the statute, at least) that the parties should have no flexibility to determine to whom child support payments should be taxed. With the introduction of the rule that amounts should be considered "fixed" as child support if the payments are reduced upon a contingency directly related to one or more of the children, the drafters seemed to have intended that even "disguised" child support should be subject to a strict rule of exclusion on the part of the payee and nondeduction on the part of the payor, regardless of the wishes of the parties. 172 At the same time, the drafters introduced the rule that payments of “alimony" within the "tax" definition of that term could be designated by the parties as "not includable" and "not deductible," providing some flexibility for the parties to decide to whom "alimony" should be taxed. But the flexibility is constrained; the parties can elect out of the inclusion/deduction system, but they cannot elect into it. To qualify for the inclusion/deduction system, each of the requirements for tax “alimony” must be satisfied, including the requirement that the payments must stop or the payee's death, whether by agreement of the parties or under state law. This requirement was one means by which the drafters intended to disallow cash property settlements from qualifying as "alimony," the other means being the mechanical "recapture" rule that effectively recharacterizes, in the third year, a portion of prior payments otherwise satisfying the definition of "alimony" if the payments are excessively front-loaded. Thus, on balance, it seems that there was little change to the overall amount of flexibility granted to the parties to decide to whom cash payments should be taxed; only the locus of the flexibility was flip-flopped from child support to alimony. 171 172 See supra notes 50-57 and accompanying text. While there has not been significant litigation under this new “elect-out” option, a few cases have arisen, where the issue was whether the parties' language was sufficient to trigger the election. See, e.g., Schutter v. Comm'r, 2000 U.S. App. LEXIS 33324 (10th Cir. 2000); Jaffe v.Comm'r, 77 T.C.M. (CCH) 2167 (1999). Subpart 1, below, will review some of the litigation that evidences the continuing weaknesses of current law. In subpart 2, I shall discuss my recommendations for change regarding the taxation of cash payments in divorce. 1. The Tax Litigation Even a cursory review of the tax litigation that has occurred since the 1984 Act confirms that change is definitely needed. Family court judges and divorcing parties do not themselves extricate mixed payments and categorize them in the nice, tidy packages envisioned by the Federal tax rules. They see payment streams as mixed. It would almost be sheer coincidence if the labels attached in I.R.C. § 71 actually corresponded to reality. The reality is that no one except the drafters of the tax Code thinks that we can adequately distinguish these payments from one another. The cases also illustrate that real parties in the real world, even when represented by counsel, do not understand the current rules adequately and do not draft agreements that reflect them. It's obvious upon reading the cases that the parties are often taken by surprise when they find out that their assumptions regarding who will be liable for the tax obligation turn out to be wrong. While I cannot possibly cite every case decided since 1984 dealing with the problems under these provisions, several dozen representative cases are footnoted here. They represent th 173 173 See, e.g., Craven v. U.S., 2000-2 U.S.T.C. (CCH) ¶ 50,541 (11th Cir. 2000); Preston v. Comm'r, 209 F.3d 1281 (11" Cir. 2000); Schutter v. Comm'r, 2000 U.S. App. LEXIS 33324 (Dec. 19, 2000); Ribera v. Comm'r, 98-1 U.S.T.C. (CCH) ¶ 50,260 (9th Cir. 1998); Richardson v. Comm'r, 125 F.3d 551 (7th Cir. 1997); Walters v. Comm'r, 97-1 U.S.T.C. (CCH) ¶ 50,204 (9th Cir. 1997); Hoover v. Comm'r, 102 F.3d 842 (6th Cir. 1996); Murley v. Comm'r, 97-1 U.S.T.C. (CCH) ¶ 50,172 (6th Cir. 1996); Heller v. Comm'r, 97-1 U.S.T.C. (CCH) ¶ 50,193 (9th Cir. 1996); Barrett v. U.S., 74 F.3d 661 (5th Cir. 1996); Arnes v. Comm'r, 981 F.2d 456 (9th Cir. 1992); Kenfield v. U.S. 783 F.2d 966 (10th Cir. 1986); Pettet v. U.S., 97-2 U.S.T.C. (CCH) ¶ 50,948 (E.D.N.C. 1997); Votzmeyer v. U.S., 96-2 U.S.T.C. (CCH) ¶ 50,621 (S.D. Tex. 1996); Christoph v. U.S. 919 F. Supp. 1576 (S.D. Ga. 1995); Barrett v. U.S. 878 F. Supp. 892 (S.D. Miss. 1995); Smith v. Comm'r, 94-2 U.S.T.C. ¶ 50,503 (S.D.N.Y. 1994); Laird v. U.S., 89-1 U.S.T.C. (CCH) ¶ 9,225 (Cl. Ct. 1989); Goldman v. Comm'r, 112 T.C. 317 (1999); Balding v. Comm'r, 98 T.C. 368 (1992); Darby v. Comm'r, 97 T.C. 51 (1991); Zinsmeister v. Comm'r, 80 T.C.M. (CCH) 774 (2000); Berry v. Comm'r, 80 T.C.M. (CCH) 825 (2000); Maloney v. Comm'r, 80 T.C.M. (CCH) 53 (2000); Shepherd v. Comm'r, 79 T.C.M. (CCH) 2078 (2000); Baker v. Comm'r, 79 T.C.M. (CCH) 2050 (2000); Benham v. Comm'r, 79 T.C.M. (CCH) 2054 (2000); Leventhal v. Comm'r, 79 T.C.M. (CCH) 1670 (2000); Heckaman v. Comm'r, 79 T.C.M. (CCH) 1643 (2000); Gonzales v. Comm'r, 78 T.C.M. (CCH) 527 (1999); Miller v. Comm'r, 78 T.C.M. (CCH) 307 (1999); Simpson v. Comm'r, 78 T.C.M. (CCH) 191 (1999); Lawton v. Comm'r, 78 T.C.M. (CCH) 153 (1999); Jaffe v. Comm'r, 77 T.C.M. (CCH) 2167 (1999); Baxter v. Comm'r, 77 T.C.M. (CCH) 2137 (1999); Hopkinson v. Comm'r, 77 T.C.M. (CCH) 1968 (1999); Cologne v. Comm'r, 77 T.C.M. (CCH) 1728 (1999); Anderson v. Comm'r, 77 T.C.M. (CCH) 1447 (1999); Preston v. Comm'r, 77 T.C.M. (CCH) 1437 (1999); Megibow v. Comm'r, 76 T.C.M. 1072 (1998); Medlin v. Comm'r, 76 T.C.M. (CCH) 707 (1998); Ryan v. Comm'r, 76 |