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New alimony audit project is underway

Pilot project reveals 40 percent noncompliance rate

Your clients who receive or pay alimony need to be aware of a new audit project examining alimony payments. The alimony audit project was initiated by a pilot study that indicated a 40 percent noncompliance rate, affecting multiple years in most cases.

Alimony payments are only deductible by the payer spouse under Internal Revenue Code (IRC) Section 215 (California Revenue and Taxation Code (R&TC) Section17201) if they are taxable to the recipient spouse under the provisions of IRC Section 71 (California R&TC Section 17081). If the divorce or separation agreement designates such payments as not includable in the recipient’s income, then the ex-spouse making the payments cannot deduct them. For example, property settlements are not includable as alimony income and are not deductible.

Generally, alimony deductions appear on line 31 of the federal Form 1040. Analysis of the pilot’s results revealed a 40 percent adjustment rate (the amount of alimony deduction or alimony income stated on the tax return was either increased or decreased), generating an average of $5,800 in added tax per return. Analysis also revealed that when there was an adjustment, it involved multiple years. The results were nearly equally divided between those paying alimony, and those receiving alimony.

Our analysis of divorce decrees shows that many taxpayers mistakenly consider all payments made to their ex-spouses as deductible alimony payments. For example, taxpayers frequently include non-deductible child support payments as alimony deductions. On the other hand, many alimony recipients do not consider the payments from their ex-spouses as taxable income, and do not report it. Some recipients make the common mistake of not reporting income designated as "family support" by the divorce decree. This type of support is considered alimony income in most cases.

If the support payments are taxable, the recipient must report them on the tax return for the year received. Alimony income is reported on line 11 of the federal Form 1040, and carries through to the California return. If we propose an audit adjustment, we will mail a “Tax Liability Discrepancy” letter to the taxpayer instead of conducting a complete and time-consuming audit. If the taxpayer agrees with our audit determination, the taxpayer can pay the tax and interest, and be finished with the process. If the taxpayer disagrees, we will request substantiation from the taxpayer supporting the taxpayer’s position.

The pilot program showed that sending a letter to the taxpayer regarding the understatement is cost-effective and efficient. Taxpayers agreeing with the letter typically paid within one week of receipt.

In Phase Two of the alimony project, we plan to develop a Frequently Asked Questions (FAQ) brochure, which would be included in the letters sent to taxpayers with alimony issues. The FAQs will help taxpayers more clearly understand what is and what is not alimony, as well as address applicable penalties.