By Brandon Mourges
One of the many changes contained within the Tax Cuts and Job Act of 2017 (“the Act”) may prove to be a boon for divorce (and tax) attorneys in 2018. As explained in more detail below, section 11051 of the Act does away with the long-standing provision that allowed for the deductibility of alimony payments. Consequently, beginning in 2019, one of the most effective tax planning tools for divorcing spouses will lose much of its significance. Those considering divorce should finalize any agreement on alimony in 2018 in order to be grandfathered under existing law, effectively transfer post-divorce income, and minimize overall taxes of the divorced spouses.
Background. Currently, any qualifying alimony payments are treated as a deduction (or reduction) to the payor’s income and, correspondingly, as additional taxable income (or addition) to the payee. See I.R.C. § 215 (stating that a deduction is allowed in an amount equal to alimony paid during the tax year); I.R.C. § 61(a)(8) (stating that alimony payments received are includible as income). For instance, if a payor spouse, who had gross income of $200,000 in a given year, was required to make $60,000 in annual alimony payments to the other spouse (i.e., the payee), who had other income of $40,000 in that same year, their adjusted gross income for tax purposes would be $140,000 and $100,000 respectively. Effectively, this tax treatment was a way to transfer or allocate income amongst the divorced couple for tax purposes. As a result of progressive income tax rates, in scenarios where the payor had significantly higher gross income than the payee, structuring alimony was useful in reducing the combined tax burden of the divorcing couple.
Change to Deductibility of Alimony Payments. Beginning in 2019, the tax treatment of alimony will change significantly. The definition of an “alimony or separate maintenance payment” is retained in section 11051(a) of the Act; however, I.R.C. § 215 is stricken and is effective for any “divorce of separation instrument” executed after December 31, 2018. That means that alimony payments are no longer deductible by the payor and are correspondingly not treated as income to the payee. Alimony payments paid pursuant to divorce and separation agreements executed prior to 2019 will still qualify for the current treatment (i.e., deduction to payor and income to payee) provided that (1) the terms are not modified after 2018 and (2) the modification does not specifically provide that the new treatment will apply. The Act also clarifies that, once effective, alimony shall not be treated as a payment for support of a dependent and, in the case of remarriage, “support of a child received from the parent’s spouse shall be treated as received from the parent.”
Hypothetical. For those advising separated or divorcing couples, the economics of divorce are about to change as a result of this legislative change. Alimony will no longer be as useful as a tax planning strategy.[1] In situations where one spouse earns substantially more income than the other spouse, alimony payments will not be an effective means to transfer income and/or wealth.
Setting aside changes to tax rates, exemptions, and other proposals, a comparison[2] of the outcomes both before and after the change to the taxation of alimony payments is illustrative[3]:
Pre-Divorce
Gross Income: $220,000
Adj. Gross Inc.: $194,350
Federal Tax: $ 41,289
State Tax: $ 16,000
Net After Tax: $162,711
Post-Divorce (Through 2018)
Gross Income: $140,000 Gross Income: $80,000
Adj. Gross Inc.: $124,750 Adj. Gross Inc.: $69,550
Federal Tax: $ 27,912 Federal Tax: $13,126
State Tax: $ 11,200 State Tax: $ 6,400
Net After Tax: $100,888 Net After Tax: $60,474
Net After Tax (Total): $161,362
Post-Divorce (After 2018)
Gross Income: $200,000 Gross Income: $20,000
Adj. Gross Inc.: $179,950 Adj. Gross Inc.: $ 9,600
Federal Tax: $ 43,368 Federal Tax: $ 974
State Tax: $ 16,000 State Tax: $ 1,600
Net After Tax: $140,632 Net After Tax: $17,426
Net After Tax (Total): $158,058
This hypothetical shows that, due to progressive tax rates, the elimination of the alimony deduction will cause an increase to total taxes paid where the payor spouse generates higher income than the payee spouse. In situations where the discrepancy in income levels is greater and more of the payor’s income is subject to a higher rate, the effect of the tax change will be even greater. Moreover, in situations where alimony payments are greater, the effect of the inability to claim the deduction will be increased as well.
Planning Opportunities. Since it is in the mutual interest of divorcing spouses to retain the greatest possible amount of after-tax funds (even if they disagree on how they should be split amongst themselves), couples considering divorce will need to re-evaluate their options. First and foremost, it may be preferential to finalize a divorce or separation agreement prior to 2019 in order to preserve the potential tax benefits and flexibility of existing law – particularly if there is any provision on the payment of alimony. To the extent not all terms are able to be agreed upon in the divorce instrument, it may make sense to finalize an agreement on alimony with an opportunity to modify certain terms later. (It is not clear if or how the regulations implementing section 11051(c) may affect the ability to make such modifications.) For those re-negotiating the terms of a divorce agreement after 2018, special attention must be paid to alimony provisions so that current deductibility rules can be retained, if desired.
Aside from fast-forwarding a divorce agreement, divorcing spouses should consider the effective allocation of other credits, deductions, and exemptions to help to minimize the tax burden of the higher-income spouse and retain more after-tax funds. These items will become incrementally more important given the elimination of the alimony deduction. Further, divorcing spouses should consider other potential planning opportunities to achieve similar financial results – such as by property settlement or transfers incident to divorce. For instance, spouses may place more emphasis on transferring property with yet unrecognized gains or losses prior to divorce. All of these considerations may become more or less significant depending upon the effective tax rates of the spouses in a given scenario.
With the reduced ability to use alimony as a tax planning tool after 2018, those currently in the process of divorce, considering divorce, or with a pre-nuptial agreement containing alimony provisions, should consult a tax adviser. It is likely in the mutual interest of divorcing spouses to finalize an agreement governed by current law.
These descriptions are intended for informational purposes only and should not be taken as legal advice on any particular set of facts or circumstances. Rosenberg Martin Greenberg, LLP is experienced in all aspects of federal and state tax laws, including tax planning for divorce, audits of divorced spouses and payments related to divorce, addressing prior compliance issues, white collar criminal litigation, and more. Please contact Brandon Mourges at 410.951.1149 or bmourges@rosenbergmartin.com for a free consultation.
[1] The ability to shift income through alimony, as well as the difficulty faced by tax administrators in identifying differences between alimony, property settlements, and child support, are some of the main reasons why this provision is being changed.
[2] Assumptions: The payor spouse has an income of $200,000 and the payee spouse has an income of $20,000. Taxpayers have agreed to monthly alimony payments of $5,000. Taxpayers have no dependent children and, aside from state and local income taxes, have no other itemized deductions. State and local taxes are approximated at a flat 8% of gross income for purposes of this analysis. Tax rates, exemption amounts, and other computations based on those effective for 2017. Pre-divorce amounts based on married filing jointly.
[3] Note: This example has been intentionally simplified and is for illustration purposes only.