By Dan Branch, CPA/ABV, ASA
The Tax Law Changed?
Uh, yes it did! Hopefully, by now, you have noticed that there was a significant change to the federal tax law at the end of 2017. In fact, right before the end of the year, on Dec. 22, 2017, Congress enacted sweeping tax changes with the passing of the bill known as the Tax Cuts and Jobs Act (“TCJA”). TCJA went into effect Jan. 1, 2018.
Impact on Family Law Matters
The changes to the federal tax law will impact family law matters both in (1) how you will structure tax-related issues in settlement discussions (e.g., alimony) and (2) how much your clients will pay in taxes going forward. In this article, I will focus on the personal tax changes that will impact your cases. Changes to business taxes, which can also impact your cases, are not covered in this article but will be covered in a future article.
Tax-related Issues – Alimony
For the tax-related components, the most significant change is in the treatment of alimony. Alimony, as treated under the old tax law, was deductible by the payer (a benefit to the payer) and the recipient paid income tax on it. Though the recipient had to pay income tax on the alimony (not an ideal prospect for the recipient), the tax deduction to the payer typically helped increase the amount of alimony the payer was willing to pay, which provided a benefit to the recipient (and that offset the fact he or she had to pay taxes on it). In the context of settlement negotiations, the impact of the tax benefit to the payer has been an important piece that typically helped the parties move toward a mutually agreeable settlement. The tax benefit to the payer was considered a “sweetener” that helped make the payer willing to pay more in alimony.
With the changes to the TCJA, for agreements entered into after Dec. 31, 2018, alimony will not be deductible by the payer and taxes will not be paid on it by the recipient. This is a permanent change.
An example to demonstrate the impact is helpful. Under the old tax law, the payer is typically at a higher tax rate while the receiver was typically at a lower one. For this example, we’ll assume the payer was at a 40 percent tax rate and the recipient was at a 25 percent rate. In the real world, payers are usually limited in the amount of alimony they can afford to pay. In our example, we are assuming that the payer can afford to pay a net of $60,000 in alimony.
As shown in Figure 1, due to the advantageous impact of the tax deduction for the payer, the payer can “pay” gross alimony of $100,000 per year. The payer would receive $40,000 in tax deductions while the recipient would have to pay $25,000 in taxes. Overall, the payer would pay a net of $60,000 in alimony (the amount that the payer can afford to pay) while the recipient would receive a net of $75,000 in alimony.
In essence, under the old tax law, due to the typically different tax brackets of the payer and the receiver, the U.S. government was subsidizing some of the alimony burden, which ultimately was beneficial to the couple overall. In this example, the receiver is getting $15,000 more than the payer is paying; this was the “subsidy” provided by Uncle Sam.
One could suppose that with the change to the treatment of alimony (i.e., that the payer will not get a deduction and the receiver will not pay taxes on amounts received) this would be a boon to the receiver. As shown in Figure 2, if everything in our example stayed the same except for the taxes paid or saved, that would be true. In this case, the recipient actually “gains” $25,000 compared to the treatment in Figure 1, as they would not have to pay any taxes on the alimony received. The payer, with the loss of the tax deduction, would ultimately pay the total $100,000 of alimony, far beyond what the payer can realistically pay.
As already mentioned, in the real world, payers are usually limited in the amount of alimony they can afford to pay. As such, the more likely scenario is presented in Figure 3, whereby the payer can only afford to pay $60,000 in alimony. Without the tax deduction, the payer is on the hook for the total $60,000. The receiver, even though they do not pay any tax on the amount received, is receiving $15,000 less than they received under the old tax treatment (Figure 1).
With the loss of the carrot (i.e., the tax deduction for the payer), will we see more cases turn to the Court to resolve alimony issues? Some experts believe it will.
Additionally, since contributions to retirement accounts are from taxed income (and since the alimony to the receiver will not be taxed), alimony receivers will likely contribute less to retirement accounts after the new alimony treatment is in effect, especially if this is their sole source of income.
Let’s get technical for a moment about the specifics of the timing of the alimony changes.1 Per the TCJA, the changes to alimony shall apply to:
- Any divorce or separation instrument executed after Dec. 31, 2018, and
- Any divorce or separation instrument executed on or before Dec. 31, 2018, and modified after such date if the modification expressly provides that the amendments made by the TCJA apply to such modification.
Regarding timing and treatment of alimony, a helpful breakout is as follows:
- Current alimony payments—no change to tax treatment (i.e., tax deduction will continue to be taken by the payer and the receiver will continue to pay income tax).
- If agreement is executed before midnight Dec. 31, 2018, the tax treatment is the same as it is now (i.e., the tax deduction can be taken by the payer and the receiver will pay income tax). And,
- If such an agreement is later modified after Dec. 31, 2018, the tax treatment is the same as it is now (i.e., tax deduction can be taken by the payer and the receiver will pay income tax) if the modification does not provide that the amendments made by the TCJA apply to such modification.
- If such an agreement is later modified after Dec. 31, 2018, the tax treatment will be under TCJA (i.e., no deduction is allowed by the payer and the receiver will not pay income taxes on amounts received) if the modification expressly provides that the amendments made by the TCJA apply to such modification.
- If agreement is executed after Dec. 31, 2018, no deduction is allowed by the payer and the receiver will not pay income taxes on amounts received.
Let’s again get technical, but this time about the definition of “executed.” Though this may be a legal issue, the tax code does provide some guidance. Relating to the effective date of the change, the TCJA includes language about “any divorce or separation instrument executed…” (emphasis added) Let’s first define “divorce or separation instrument.” Per § 71(b)(2) of the Internal Revenue Code of 1986, the definition pointed to in the TCJA,2 this means:
- A decree of divorce or separate maintenance or a written instrument incident to such a decree,
- A written separation agreement, or
- A decree requiring a spouse to make support/ maintenance payments to the other spouse.
Though I do not claim to be a legal expert, in my lay- man’s reading, the first and third bullets appear to relate to decrees from the Court, i.e., a final judgment or post-divorce modification order. But does that mean that the final decree has to be entered into by the effective date of Dec. 31, 2018? What if the decree is technically issued after the effective date of Dec. 31, 2018, but all the details have been determined (i.e., the decree is just waiting final signature of the judge which doesn’t happen until Jan. 2, 2019)?
Again from a layman’s perspective, for the second bullet, “a written separation agreement” would appear to encompass settlement agreements executed by the parties. Could a prenuptial agreement be considered “a written separation agreement” and bind the couple to the traditional treatment of alimony even if they divorce after Dec. 31, 2018? Even if this makes sense in a legal context, would the IRS, who will ultimately be reviewing both party’s treatment of alimony, consider that as meeting the timing deadline? Going down that road may be problematic and costly for the taxpayers who file taxes long after the divorce is finalized.
Another question develops—what happens to temporary orders providing alimony that are entered into prior to Dec. 31, 2018? Will the alimony tax deduction for the payer be preserved after Dec. 31, 2018? Likely, the tax treatment will continue in the traditional manner under the temporary order since it would have been issued before Dec. 31, 2018 (though there is no guarantee of how the IRS will treat it!). It is uncertain whether modifications to temporary orders (i.e., by a final order or agreement) will allow for the traditional tax treatment for alimony even after Dec. 31, 2018; therefore, attorneys may want to consider including language that covers situations where the traditional tax treatment is disallowed.
Another impact from the change to the tax treatment of alimony relates to the deduction for legal fees. Because alimony (after Dec. 31, 2018) will no longer be taxable to the recipient, the payer will likely not be able to deduct legal fees related to obtaining alimony (i.e., the portion of legal fees related to that effort).
The personal and dependency exemptions would have been $4,150 for each person for 2018, which would have been worth about $1,245 to someone with an effective rate of 30 percent. These exemptions are typically negotiated as part of settlement discussions, as they can have a real impact on the taxes each parent owes. However, under the TCJA, the personal and dependency exemptions were reduced to $0.4 Unlike the alimony change, this change is not permanent and is set to sunset in 2025 (meaning that if Congress does not act to extend the TCJA, the personal and dependency exemptions will revert to their treatment under the old tax law). As such, parties with young children should consider allocating dependency exemptions in agreements with included qualifying language (e.g., “the father gets the exemption, if the exemption is available”). Another reason to consider allocating dependency exemptions—the child tax credit, which was increased from $1,000 to $2,000 per child (and is actually more “valuable” when it comes to taxes because it is applied directly against taxes), can still be allocated to the parent with the dependency exemption. Lastly, including such qualifying language even if children are not young may be a good idea because the TCJA could be repealed at any time (though this is probably unlikely).
And what happens to existing agreements which include dependency exemption allocations (e.g., “father gets dependency exemption for two children every year”)? Especially if those tax benefits were negotiated and the agreed- to-allocations were a trade- off for other concessions. Would the fact that the dependency exemptions are worth $0 (at least through 2025) be grounds for modification?
Taxes Going Forward
If you consider the permanent change to alimony to be bad news, rest assured that there is good news in the TCJA, much of which will impact taxpayers directly—though it should be noted that the changes that are “good news” are all temporary and scheduled to sunset after 2025. For one, generally tax rates for individuals decreased, whether filing as an individual or jointly.5 That means less of your client’s money will be going toward income taxes.
Other good changes include:
- An increase in the standard deductions, which nearly doubled (from $6,350 to $12,000 for individuals; from
- $9,350 to $18,000 for head of household).
- The child tax credit increased to $2,000 per child (generally under age 17 at the end of the year). Plus, an additional $500 tax credit is available for other dependents (e.g., dependent children age 17 and older). The income phase-outs related to the child tax credit were increased to $200,000 for individuals and
- $400,000 for married or joint filers (a sizable increase), which will allow more individuals and married couples to take advantage of the credit.
- The alternative minimum tax (AMT) remains in the TCJA but the exemption was increased, which should result in fewer taxpayers owing AMT.
- Under TCJA, the AGI limitation was increased from 50 percent to 60 percent for charitable contributions to qualified charities.
- The popular 529 college-related accounts became more flexible. Under TCJA, distributions of up to $10,000 per student are allowed for tuition at public, private, or religious elementary or secondary schools. Additionally, TCJA also changed the definition of higher education expenses so that it now includes certain expenses related to homeschooling.
- The threshold for medical expense deduction was reduced, but only for 2018.
However, there are other changes to the tax law that may offset some of the good news items mentioned above. One highly publicized change was the introduction of a limit on deductions for state and local taxes, which are now capped at an aggregate total of $10,000 (this includes state/local income or sales taxes and local property taxes). Taxpayers with high property taxes will see this impact them the hardest.
Other not-so-good changes include:
- Mortgage interest on primary residence was limited to interest on up to $750,000 of the mortgaged amount (previously at $1 million)—this will likely only impact very high net worth individuals with very large mortgages.
- Interest on home equity lines of credit is no longer deductible, which may limit your client’s plans to use such debt going forward.
- Job expenses and miscellaneous deductions, which had previously been subject to 2 percent AGI limitation, were eliminated.
Summing it Up
The federal tax law changes enacted in the TCJA should have you thinking how those changes will impact your settlement discussions and your client’s future.6 Understanding the tax changes that will impact your clients going forward after your engagement concludes will allow you to best prepare them for the road ahead.
Dan Branch is a partner with IAG Forensics & Valuation. He specializes in all aspects of forensic accounting for family law matters, including business valuation, and has over fifteen years experience. Prior to his work in forensic accounting, Dan was an officer in the U.S. Navy. You can learn more about Dan’s background and IAG by visiting www.iagforensics.com. Feel free to contact him with any questions about the tax law changes. Dan@IAGForensics.com
1 The specific language of §11051 (c) of the TCJA which relates to the effective date states that the change “shall apply to:
1. any divorce or separation instrument (as defined in section 71(b)(2) of the Internal Revenue Code of 1986 as in effect before the date of the enactment of this Act) executed after Dec. 31, 2018, and
2. any divorce or separation instrument (as so defined) executed on or before such date and modified after such date if the modification expressly provides that the amendments made by this section apply to such modification.”
2 Note, the definition in the TCJA has not changed from that presented in §71(b)(2) of the 1986 Code; however, the location of the definition did change to §121(d)(3)(C) under the TCJA.
3 This is based on the assumption that a signed, final written separation agreement between them suffices as meeting the requirement of having an executed divorce or separation agreement.
4 Note, the exemptions are not technically eliminated in the law; however, making them $0 effectively eliminates them.
5 Note, the actual change depends on the income bracket of the individual. For instance, an individual making $150,000 will see a tax rate decrease of 4 percent. While an individual making $175,000 will see a tax rate increase of 4 percent. However, overall, rates have decreased about 2 percent.
6 It should be noted that several changes in the TCJA were not covered in this article (e.g., changes related to the qualified business income tax deduction for pass-through entities, corporate tax rates, estate and gift issues, etc.). These changes may impact other aspects of your client’s case and the diligent attorney will familiarize themself with those changes as well.