Non-Traditional Settlements and the IRS

There are as many ways of settling marital estates as there are creative attorneys and divorcing couples. Each permutation brings its own complications, including tax burdens to be allocated (and avoided). When the assets are to be paid out by one party to the other over time rather than in lump-sum amount, the tax consequences of the arrangement must be carefully considered.

Case in point: Your client, a divorcing husband (Husband would like to enter into a settlement agreement with his wife (Wife). Under the agreement, Husband proposes to pay Wife $Y million dollars (plus interest) over a 10-year period commencing on the date of the signing of the settlement agreement in consideration for her release of her claims under the equitable distribution law. Husband's obligation to make these payments will not cease upon Wife's death – thus, the payments will not constitute “alimony” under Section 71 of the Internal Revenue Code of 1986, as amended (Code). Husband's obligation to Wife will be evidenced by a note. The note will be secured by a pledge of his interest in various of his assets. (Although payments of the Note may be funded by distributions from Husband's business entities, Husband is not transferring any business interest to Wife nor is any particular business entity redeeming any interest from her.) You must determine whether payments to Wife of principal or interest under the note will be subject to income tax.