APPEAL from the Circuit Court of Cook County; the Hon. WILLARD
J. LASSERS, Judge, presiding.
JUSTICE LINN DELIVERED THE OPINION OF THE COURT:
Respondent, Carolee Eichelman, appeals from an order entered in the circuit court of Cook County which, in effect, lowered the amount of support payments being made to her by petitioner, Alfredo Mass. Alfredo cross-appeals from the same order which denied his petition for modification of the support payments.
After 19 years of marriage, Alfredo and Carolee Mass. (now Carolee Eichelman) were divorced by a decree entered in the circuit court of Lake County on September 26, 1973. At the time of the divorce, Alfredo was earning $110,000 per year as a pathologist employed by a hospital. Carolee was a homemaker with no income of her own. There were six children ages 18, 17, 14, 13, 11, and eight.
Two weeks prior to the entry of the decree of divorce, Alfredo and Carolee entered into a "Property Settlement Agreement." The agreement provided for an equal division of the couple's family home which was to be sold upon divorce, and provided for Alfredo's keeping in force, for the benefit of Carolee, all life insurance policies held on his life (the policies had a face value of $195,000). Except for the foregoing, it does not appear that either of the parties had any other significant interests in property or otherwise.
The agreement provided that Alfredo was to assume the custody and support of the two older children and Carolee the custody and support of the four younger children. Both parties agreed to assume such custody and support until the children had completed their "Post-Graduate College studies." The most significant term of the agreement, and the one that has caused the controversy here, was the following:
To pay to the wife for her maintenance and support during her lifetime and over a period of twenty years, regular monthly installments according to the following schedule, commencing JANUARY 1, 1974:
$4,583.33 x 144 months (12 years) $659,999.52 $3,783.33 x 24 months ( 2 years) 90,799.92 $2,983.33 x 24 months ( 2 years) 71,599.92 $2,183.33 x 24 months ( 2 years) 52,399.92 $ 800.00 x 24 months ( 2 years) 19,200.00 __________ ___________ TOTALS: (20 years) $893,999.28
At the end of the twentieth year, or by agreement at the end of any calendar year, the monthly amount may be negotiated between the parties. However, the sum agreed to be paid the wife shall be subject to change in accordance with the changed circumstances of the parties, and in accordance with the needs of the wife and the earning capacity of the husband, and in the event either party desires a change of monthly payments and they are unable to agree on the amount to be thereafter paid, either party may thereupon submit the question to be determined to the Circuit Court of Lake County or other court having jurisdiction of the parties, and each party agrees to be bound by the determination and judgment of such court."
The agreement also contained a clause which stated that Carolee accepted all of the terms in the agreement as a final settlement of all of her rights, including her inheritance rights, rights to alimony, and any claims to property held in Alfredo's name.
The agreement was submitted to the Lake County court for approval, and the court found it to be fair and reasonable and adopted the agreement as a part of the divorce decree.
At the time the decree was entered, on September 23, 1973, and at the time Alfredo entered into the agreement, two weeks before the entry of the decree, Alfredo knew Carolee was planning to remarry shortly after the divorce decree was entered. Carolee married her present husband, John Eichelman, in December 1973, two months after the divorce decree and one month after the "maintenance and support" payments were to begin. Alfredo learned of Carolee's marriage in December 1973. Alfredo himself remarried in February 1974. Shortly after the divorce, both parties moved to residences in Chicago and have lived there since.
On January 1, 1974, Alfredo began making the monthly payments called for in the agreement and continued to make them until April 19, 1979, when he filed his petition for modification in the present case. For the tax years 1974 through 1976, Carolee, on her Federal income tax returns, declared the $55,000 per year she was receiving from Alfredo as "alimony" taxable to her. (See 26 U.S.C. § 71 (1976).) For the same years, Alfredo declared the payments as an itemized deduction. See 26 U.S.C. § 215 (1976).
Sometime in 1977, Carolee informed Alfredo that she could no longer support herself and the four younger children on the $55,000 per year less taxes. She asked Alfredo for more money. Alfredo refused.
In early 1978, Carolee filed her Federal income tax return for the tax year 1977. In this return, Carolee failed to declare the $55,000 per year as income taxable to her. She notified the IRS that the payments were for support of the minor children, making the payments exempt from her income. (See 26 U.S.C. § 71(b) (1976).) Carolee also filed amended returns for the tax years 1974 through 1976, seeking a refund of all taxes she had previously paid on the $55,000 per year.
In April 1978, Alfredo filed his Federal income tax return for tax year 1977 and claimed the payments as a deduction. Shortly thereafter, the IRS sent Alfredo notice that he was to be audited to determine whether he could claim the payments as a deduction and to determine whether he should pay back taxes with interest and penalties for the tax years 1974 through 1976.
After several months of dispute with the IRS, Alfredo was told the IRS had decided to deny him a tax deduction on the annual payments and had decided that he would have to pay back taxes with interest and penalties on the $55,000 per year he had paid to Carolee. Moreover, the IRS informed Carolee that she would be required to include all the payments made by Alfredo as income taxable to her.
To understand this dual-taxation decision of the IRS requires a basic understanding of the applicable tax law. As a general rule, "alimony" payments made by a divorced husband to a divorced wife are taxable to the wife and deductible by the husband. (26 U.S.C. §§ 71, 215 (1976).) In practice, this rule should be considered only as a guide to further analysis. In actuality, the divorced wife must declare payments made to her by a divorced husband as "alimony" taxable to her under section 71 of the Internal Revenue Code (26 U.S.C. § 71 (1976)), and the husband may deduct the payments under section 215 of the Code (26 U.S.C. § 215 (1976)), if and only if all of the following requirements are met:
(1) the payments are "periodic";
(2) the payments are made in recognition of the husband's duty to support the wife, and thus are not made to the wife for her relinquishment of ascertainable property rights and not made to the wife exclusively for the support of the minor children in her custody;
(3) the husband makes the payments because a divorce decree has ordered him to do so or because he has agreed to do so in a written agreement entered into with the wife; and
(4) if the payments are made pursuant to a divorce decree, the husband must have a "legal obligation" to make the payments under the applicable law of the State in which the decree was entered; however, if the payments are made pursuant to a written agreement, the husband need have no "legal obligation" under local law to make them, and thus even if the agreement is unenforceable under local law, the payments are still taxable to the wife as "alimony" and deductible by the husband as long as the other three requirements listed above are met.
See 26 U.S.C. §§ 71, 215 (1976); Treas. Reg. § 1.71-1; United States v. Davis (1962), 370 U.S. 65, 8 L.Ed.2d 335, 82 S.Ct. 1190; Commissioner v. Lester (1961), 366 U.S. 299, 6 L.Ed.2d 306, 81 S.Ct. 1343; Wright v. Commissioner (7th Cir. 1976), 543 F.2d 593; Hoffman v. Commissioner (7th Cir. 1972), 455 F.2d 161; Taylor v. Campbell (5th Cir. 1964), 335 F.2d 841; see generally II Illinois Family Law § 14 (Ill. Inst. Cont'g Legal Educ. 1978); Harris, The Federal Income Tax Treatment of Alimony Payments — The "Support" Requirement of the Regulations, 22 Hastings L.J. 53 (1970); Note, Alimony: Income Taxation of Installment Payments, 24 U. Fla. L. Rev. 499 (1972).
The absence of any one of the requirements means the husband cannot deduct the payments. However, it does not necessarily mean the wife escapes taxes on the payments. It simply means she does not have to declare the payments as "alimony" taxable to her under section 71 of the Code (26 U.S.C. § 71 (1976)). (See Hoffman v. Commissioner (7th Cir. 1972), 455 F.2d 161.) She may still have to declare them as "gross income" taxable to her under section 61 of the Code (26 U.S.C. § 61), unless she can show the payments are exempt or deductible under another section of the Code. See Rev. Rul. 81-8, 1981-82 I.R.B. 6; Joss v. Commissioner (1971), 56 T.C. 378.
Alfredo's and Carolee's problems with the IRS were caused by the fact of Carolee's remarriage in December 1973. The payments in the settlement agreement were designated as having been for Carolee's "maintenance and support." Because of all the conditions attached to the making of the payments, especially that they could change at any time due to a change in circumstances of the husband or wife, the contract term had every appearance of being a term that required Alfredo to pay "periodic alimony" to Carolee. (See Adler v. Adler (1940), 373 Ill. 361, 26 N.E.2d 504, cert. denied (1940), 311 U.S. 670, 85 L.Ed. 430, 61 S.Ct. 29; Roberts v. Roberts (1967), 90 Ill. App.2d 184, 234 N.E.2d 372.) Illinois divorce law in effect at the time of the parties' divorce provided, "A party shall not be entitled to alimony and maintenance after remarriage * * *." (Ill. Rev. Stat. 1973, ch. 40, par. 19 (repealed 1977).) Because of this prohibition against payments of alimony after the receiving spouse's remarriage, one could conclude, as the IRS apparently did, that Alfredo was not "legally obligated" under Illinois law to make any of the payments he made to Carolee because all of the payments were made after her remarriage.
Because of this lack of a "legal obligation," the deductibility of the payments made by Alfredo depended on whether the fourth requirement of Federal law, listed above, for such deductibility, was met. If the payments could have been deemed to have been made pursuant to a written agreement, Alfredo could have still deducted them because the "legal obligation" requirement did not have to be met. However, if the payments could have been deemed to have been made pursuant to the parties' divorce decree, Alfredo could not have deducted them because of the "legal obligation" requirement.
Though one could conclude Alfredo made the payments pursuant to the settlement agreement, Alfredo was faced with another rule of the Federal courts> which apparently prevented Alfredo's deduction. If the State law applicable to the divorce holds that a predivorce written agreement when incorporated in a decree becomes "merged" in the decree and loses its independent legal significance as a result, then any payments made after the entry of the decree will be deemed to have been made pursuant to the decree and not pursuant to the written agreement. (Hoffman v. Commissioner (7th Cir. 1972), 455 F.2d 161.) In Alfredo's case, since the settlement agreement was adopted by the court as a part of the divorce decree, there is support for the conclusion that the agreement thereby became "merged" in the decree. (E.g., Herrick v. Herrick (1925), 319 Ill. 146, 149 N.E. 820.) Consequently, the IRS could have concluded Alfredo was not entitled to a deduction because the payments were made pursuant to the divorce decree and he had no "legal obligation" under Illinois law to make them.
Carolee's problems with the IRS were somewhat different. She attempted to exempt the payments from her income as child support. (See 26 U.S.C. § 71(b) (1976).) The difficulty with her assertion was that the agreement clearly designated the payments to be for her support and not the children's. Also, the payments were to extend well beyond the 21st birthday of the youngest child (the cut-off age for the exemption under Federal law). Thus, she faced a difficult, if not impossible task, of proving the payments were exempt as support for the minor children.
It is an established principle of Federal income tax law that all transfers of anything of value from one party to a taxpayer are presumed to result in "gross income" to the taxpayer, on which the taxpayer must pay an income tax, unless the taxpayer can show the transfer is exempt or deductible under a specific section of the Internal Revenue Code. (See 26 U.S.C. § 61 (1976); Commissioner v. Lo Bue (1956), 351 U.S. 243, 100 L.Ed. 1142, 76 S.Ct. 800.) Since Carolee could not show that the payments were exempt as child support, then even though she did not have to declare them as "alimony" income under section 71 of the Internal Revenue Code (26 U.S.C. § 71 (1976); see Hoffman v. Commissioner (7th Cir. 1972), 455 F.2d 161), she still had to declare them as "gross income" taxable to her under section 61 of the Code (26 U.S.C. § 61 (1976); see Rev. Rul. 81-8, 1981-82 I.R.B. 6; Joss v. Commissioner (1971), 56 T.C. 378).
Thus, the IRS found that both Alfredo and Carolee were obligated to pay taxes on the payments. At the present time, both parties apparently are challenging the IRS's decision in Federal tax court, and as yet no final ruling has been made at that level.
When Alfredo learned that he could not deduct the payments and owed back taxes with interests and penalties, he brought his present petition for modification in the circuit court of Cook County. At the trial level, Alfredo sought either ...