Question

Rick and Maria had been married for 20 years before their divorce in the current year. At that time, they made the usual property settlement: Maria got the house, the van, and the cat; Rick got the mortgage, the Ford, and the dog. Other property was divided equally with the exception of the following: At the time of their divorce, Maria had instituted a number of lawsuits against various fast-food chains for infringement of her patent on an automated burrito-stuffing machine. Maria had developed the machine in the early ’90s and patented it under her name. (Rick thought it was a silly idea and refused to have his name associated with it.) At that time, her efforts to license the machine to fast-food outlets were unsuccessful. Five years ago, she observed a similar machine in Tucker’s Tacos, a fast-food Mexican restaurant, and instituted her first claim against that chain. Subsequent research revealed that several other chains had stolen her idea without compensating her, and she sued them for patent infringement.

As part of the divorce decree, 20% of any net proceeds (1% for each year of marriage) that Maria ultimately receives from the lawsuits is to be paid to Rick. During the current year, Maria settles the initial suit with Tucker’s Tacos for $200,000. The proceeds are placed into an escrow account from which the costs of litigation are paid. Rick receives a check for $30,000 from the escrow agent for his share of the net proceeds. Maria receives the balance from the account. The remaining lawsuits are still being litigated. Rick would like to know if he must include the $30,000 in his gross income.

Write Rick a letter explaining the tax treatment of the $30,000 he received from the escrow account.

Answer 1

After a divorce is final, assets change hands. It is important to understand what part of the settlement is taxable and to what party. In the case of alimony, the amount is taxable to the person who receives the support. In return, the person paying the money receives a tax deduction. Certain requirements must be met for the money to be considered alimony. To begin, the exchange must be in cash or an equivalent, payment must be made under a court order, the parties must live separately, there are no requirements of payment after the receiving party dies and each party files tax returns separately.

When a divorcing couple has children, child support is often part of the settlement. This money is not deductible.

Besides alimony, divorce usually contains a property settlement as well. Many times, it is not recommended for a couple to equally divide marital assets. It is better to give one party a lump sum settlement for equity interest. For instance, when the couple has a home with a mortgage, it is common for one party to keep the house and pay the other spouse the equity as a property settlement. No taxable gain or loss is recognized.

Divorce lawyers will help couples understand what part of the settlement is taxable. The IRS has specific rules in place to prevent property settlements from qualifying for tax benefits. For instance, if a divorce decree orders the husband to pay his wife a large amount of alimony for one year with a lower amount to follow, the IRS uses the “recapture rule.” This requires the paying party to “recapture” some of the money as taxable income.

As if a divorce is not complicated enough, it is challenging to understand what part of a settlement is taxable. A divorce lawyer may be able to answer common tax questions.

Where as lump sum amoount is received, it will be treated as capital receipt., hence not taxable. if monthly payments received being revenue receipt it should be taxable However , important to note that if the settlement is as per court , the Revenue authorities will not raise question ..If the settlement is out of court, the Revenue authorities , as is the nature, may raise the question regarding the taxability of Lump sum payments. Therefore, it is better to get the stamp of Court in case of settlement.

Therefore $30,000 will be treated as capita receipt as received in lump sum therefore would not be taxable.