Tax Court Allows Alimony Deduction for Health Insurance Purchased with Pre-Tax Earnings

(Parker Tax Publishing October 2021)

The Tax Court held that neither the double deduction common law principle nor Code Sec. 265 applies to prevent the deduction of alimony where a married couple separated and, pending a final decree of divorce, created an agreement that included continued health care coverage as provided by the payor spouse's employer, the premiums of which were properly excluded from the payor's gross income and included in the recipient spouse's gross income under pre-TCJA rules. Thus, a taxpayer who was paying alimony relating to a pre-2019 divorce decree was entitled to deduct an amount equal to the alimony payments from his gross income. Leyh v. Comm'r, 157 T.C. No. 7 (2021).

Background

In 2012, Charles Leyh filed for divorce in Pennsylvania from his then wife, Cynthia Leyh. The couple filed and signed an agreement in 2014 (i.e., the 2014 agreement) incident to their divorce proceedings in which Charles agreed to pay Cynthia alimony until the divorce was finalized. As part of the 2014 agreement, Charles said he would pay for Cynthia's health and vision insurance. Charles's employer offered a cafeteria plan under which employees could use pre-tax earnings to pay for health-related benefits, such as health and vision insurance. In 2015, under this cafeteria plan, Charles paid $10,683 for Cynthia's health insurance premiums as pretax payroll reductions from his wages (alimony payments).

On his 2015 Form 1040, Charles excluded from his gross income the total amount of health care coverage premiums he and Cynthia received through his employer's cafeteria plan (health insurance compensation) and also claimed an alimony deduction for the alimony payments. The IRS audited Charles's 2015 tax return and issued a notice of deficiency after disallowing Charles's deduction for the alimony payments and determining a Code Sec. 6662(a) accuracy-related penalty.

Observation: Generally, effective for any divorce or separation instrument executed before January 1, 2019, amounts received as alimony or separate maintenance payments are includible in income in the year received (pre-2019 Code Sec. 71) and are deductible by the payor in the same year (pre-2019 Code Sec. 215). The Tax Cut and Jobs Act of 2017 (TCJA) repealed Code Sec. 71 and Code Sec. 215. Thus, effective for any divorce or separation instrument executed after December 31, 2018, or for any divorce or separation instrument executed on or before December 31, 2018, and modified after that date (if the modification expressly provides that the TCJA changes apply to such modification), alimony and separate maintenance payments are excluded from the payee's income and no deduction is allowed to the payer.

Before the Tax Court, the IRS argued that permitting the alimony deduction in this instance created a "windfall" to Charles by granting him the practical equivalent of multiple deductions for the same economic outlay. The IRS also cited S. Rept. No. 77-1631, at 83 (1942), and a statement from the Senate Finance Committee describing the creation of the alimony deduction as an attempt by Congress to relieve a payor-spouse from the tax burden of whatever part of an alimony payment was "includible in the payor's gross income."

Analysis

The Tax Court held that Charles was entitled to deduct, as alimony, an amount equal to the premiums paid to provide health insurance coverage for Cynthia. The court noted that Charles received the health insurance compensation while Cynthia was still considered his spouse as Pennsylvania law recognizes only divorce, not legal separation, and a final decree of divorce was not granted until 2016.

The court observed that, as a married couple awaiting a final decree of divorce under Pennsylvania law, Charles and Cynthia could have chosen to file a joint return for 2015 and avoid the alimony regime altogether. If they had, the court said, they would have had an exclusion from gross income equal to the amount of the health insurance compensation, no alimony deduction for that amount, and no alimony income inclusion for that amount. Instead, the couple chose to file separately and treat the alimony payments as alimony. But for the alimony regime, Cynthia would not have been required to include any portion of the alimony payments in her gross income. It follows, the court said, that, per the general matching design of the alimony regime, if Cynthia was required to include the alimony payments in her income, then Charles should be permitted a corresponding deduction for those payments to preserve this equilibrium. In other words, Charles's alimony deduction should be properly viewed as being matched against Cynthia's alimony income, not against his excluded wage income.

In response to the IRS's argument that Charles would receive a windfall if the alimony deduction was allowed, the court noted that there was no such risk of a windfall to Charles because disallowing the alimony deduction in this circumstance would instead leave Charles with a greater tax burden and that would run counter to the intended purpose and operation of the general alimony regime as previously interpreted by the Tax Court.

With respect to the IRS's argument regarding comments in the alimony sections of the Senate Finance Committee Report, the Tax Court agreed that those sections clearly state that a payor of alimony may deduct such expenses to the extent they constitute alimony and are includible in the recipient's gross income. The court noted that the IRS recognized that these elements were present in Charles's case by conceding that the alimony payments met the Code Sec. 71(b) definition of alimony and would otherwise be deductible under Code Sec. 62 and Code Sec. 215 but for Charles's exclusion of the health insurance compensation from his gross income. However, with respect to the IRS's concern that Charles's situation might create an unanticipated statutory "loophole" (which the court did not believe was the case in Charles's situation), the court said it would be up to Congress, not the IRS or the Tax Court, to retroactively address this issue. This legislative history, the court said, cannot be read to override the plain text of Code Sec. 62, Code Sec. 215, and Code Sec. 71 by interpreting these comments as imposing a precondition not present in the statutes themselves. According to the court, these sections are clear that a payor of alimony may deduct such expenses to the extent they constitute alimony and are includible in the recipient's gross income.

Finally, the court noted that it was unaware of, and the IRS had not directed it to, any case in which an alimony deduction has been disallowed on the basis of the double deduction principle as codified in Code Sec. 265. This common law doctrine, the court observed, has been limited to instances in which a taxpayer has attempted to claim the practical equivalent of multiple deductions for the same expense but where Congress did not specifically intend such a result.

For a discussion of the tax treatment of alimony payments, see Parker Tax ¶14,220.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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