Since 1943, alimony has been deductible by the payor and included in the gross income of the payee. That all changed on January 1, 2019, when, under the new Tax Cuts and Jobs Act (TCJA), alimony payments made in accordance with a post-2018 divorce decree or separation agreement became nondeductible. The TCJA repealed I.R.C. § 71(a), which included alimony in a recipient’s gross income, and § 215(a), which provided the payor with a dollar-for-dollar, above-the-line deduction for the alimony paid. As the death of the alimony deduction approached on January 1, 2019, some anxious parties and practitioners anticipated the event with about as much enthusiasm as one would have for a zombie apocalypse. Moreover, unlike other Tax Code provisions impacted by the TCJA, the repeal of § 71(a) and § 215(a) is not set to expire in 2026. Thus, practitioners and clients alike will be adjusting to the new tax reality for the foreseeable future. But, with a little creativity and effort, everyone should survive.
What Is Alimony?
Alimony is, in its simplest form, a payment to or for a spouse, or former spouse, under a divorce or separation instrument that meets all of the following conditions:
- the spouses must not file a joint return with each other;
- the payment must be in cash, which includes checks or money orders, made to the spouse or for the spouse;
- the divorce or separation instrument must not specifically say that the payment is not alimony;
- the spouses must not be members of the same household at the time the payments are made if the spouses are legally separated under a decree of divorce or separate maintenance instrument;
- there must not be any liability to make any payment (in cash or property) after the death of the recipient spouse; and
- the payment must not be treated as child support.
Alimony does not include any of the following:
- child support;
- noncash property settlements;
- payments that are a spouse’s part of community income; or
- use of the payor’s property.
Many states have implemented guidelines for alimony calculation that are similar to child support guidelines requiring application of a statutory formula. The Santa Clara formula, for example, is used widely in California. Illinois, Mississippi, and many other states also apply such guidelines to determine how much a spouse will pay. Some states provide for permanent alimony for the rest of the life of the payor, regardless of the remarriage of the payee. The various alimony guidelines, formulae, and regulations promulgated on the state level are as diverse as the many states that have enacted them. The one constant, however, at least for the past seventy-five years, is that they have all largely developed against the backdrop of alimony being an adjustment to the gross income of the payor and reportable as income by the payee. The person receiving the money paid the taxes on it. That is no longer the case.
Alimony in the IRS Crosshairs
Under the pre-TCJA system, the payor would deduct the amount of the alimony payments from his or her gross income, and the payee would report them as income on his or her return. In 2015, 361,000 tax payors reported paying $9.6 billion in alimony. However, only 178,000 payee spouses reported the alimony income they received. While this gap may be explained by the occasional payor who marries multiple times and pays multiple ex-spouses alimony, it isn’t likely that that type of scenario is seen outside of Hollywood, and so this situation would not account for the discrepancy. The more likely reality is that payee spouses simply were not reporting the income, which resulted in great loss of revenue to the IRS. This may have put the alimony deduction in the crosshairs of tax reformers.
Another often maligned result of the alimony deduction was what has been pejoratively called the “divorce subsidy” or divorce “tax arbitrage.” Alimony is virtually universally paid by the spouse with higher income. The higher-earning payor spouse also typically has a higher effective tax rate. This means that, assuming honest reporting by both spouses, the payor spouse’s deduction will be at a rate higher than the payee spouse’s tax rate. For example, say ex-husband Paul pays his ex-wife Katie $40,000 a year in alimony, and Paul is subject to a 33-percent effective tax rate. Paul would realize a tax savings of $13,200 that he would not have to pay to the IRS. Katie, who has in this scenario an effective tax rate of 15 percent, would pay the IRS, out of that $40,000, a comparatively low $6,000. The difference between the two, $7,200, is the “divorce subsidy.” Pre-TCJA, Paul was able to effectively give Katie an additional $7,200 from what would ordinarily have been paid by Paul to the IRS. And Katie would have counted on that additional $7,200 to pay the monthly bills. As of January 1, 2019, the IRS is taking that money back. If Paul and Katie were divorced on January 1, 2019, Paul would have to report as income all $40,000 of the alimony he pays Katie and pay taxes on it at his effective tax rate of 33 percent. Katie will not pay any taxes on the alimony she receives. Obviously, Paul is not going to agree to pay $40,000 anymore.
It is predicted that the amount of alimony paid under the divorce and separation instruments to which the TCJA now applies will be lowered by 10 to 15 percent to make up for the additional tax burdens on payors like Paul, who now have to pay a 33-percent tax on the $40,000 they pay to their ex-spouses. According to numbers published in Congressional Reports, this will effectively empty the pockets of alimony recipients like Katie by approximately $6.9 billion over the next ten years. Given the amount of news coverage the repeal of the alimony deduction has generated, practitioners will be fielding calls in the foreseeable future from clients on old and pending cases in a mad dash to determine how, or if, the TCJA affects them. While all clients are advised to consult a tax professional, the following summarizes for family law practitioners the important alimony-related tax provisions that went into effect January 1, 2019.
What Alimony Is Affected?
The TCJA went into effect, and alimony is no longer deductible by the payor or reportable as income by the payee on any divorce or separation instrument executed as of 12:01 a.m. on January 1, 2019. For any divorce or separation instrument that was executed by midnight on December 31, 2018, and for all prior divorce or separation agreements, § 71 and § 215 will continue to apply, and the alimony will continue to be deductible by the payor and reportable as income by the payee. Everyone who pays or receives alimony in accordance with a pre-January 1, 2019, decree or separation instrument is “grandfathered in” for purposes of alimony deductions.
What Constitutes a Divorce or Separation Agreement?
A divorce or separation agreement is:
- a decree of divorce or separate maintenance or a written instrument incident to that decree;
- a written separation agreement; or
- a decree or any type of court order requiring a spouse to make payments for the support or maintenance of the other spouse, including decrees that are temporary, interlocutory, or pendente lite.
This definition is broad enough to encompass the many different divorce and separation laws across the country. California has legal separation, while Texas does not. Parties can enter into separation agreements lasting decades and never actually be divorced. The Tax Code definition of what constitutes a divorce or separation agreement has not changed. The bottom line is that if a decree or order was signed or a separation agreement finalized by December 31, 2018, the alimony will be deductible by the payor and reportable by the payee.
Some interesting questions arise in the context of a decree signed by a court by December 31, 2018, but subsequently appealed. According to IRS Publication 504, so long as the decree itself is signed and entered, it is final until it is invalidated. It is unclear if a decree subsequently set aside on appeal after December 31, 2018, will be subject to the new tax regime, but, for as long as that appeal is pending and that decree stands, the alimony will be deductible. Additional guidance is needed from the IRS on this issue.
Temporary versus Final Orders
While temporary orders are specifically included in the definition of “divorce or separation agreements,” it appears that, even though pre-TCJA temporary-order alimony is deductible, if the final decree was not executed by December 31, 2018, alimony paid under the later 2019 decree that is merely a continuation of the same amount paid under the temporary orders may no longer be deductible. Additional guidance is needed on this issue from the IRS.
Warning: Prenuptial or Postnuptial Agreements Do Not Count
Prenuptial or postnuptial agreements are not considered divorce or separation agreements. Therefore, parties who entered into such agreements decades ago assuming that § 71 and § 215 would apply to their alimony payments but who do not divorce or enter into a separation agreement until after January 1, 2019, may be in for a big surprise. Additionally, spouses who rushed to enter into marital property agreements just before January 1, 2019, for the purpose of avoiding the TCJA deadline are out of luck as well. There’s no way to contract your way out of the TCJA.
What About Modifications of Pre-2019 Divorce and Separation Agreements?
If any “grandfathered in” divorce or separation agreement entered into prior to December 31, 2018, is modified on or after January 1, 2019, the new TCJA amendments apply only if the parties opt-in with specific language to that effect. Such language would include a statement that “In any subsequent modification of this Decree of Divorce/Separation Agreement, the TCJA will apply.” Without the opt-in language, subsequent modifications of a pre-2019 divorce or separation agreement or order will continue to enjoy the pre-TCJA tax deduction treatment, regardless of when the modification occurs. Thus, the repeal of the alimony deduction will not provide a basis, in and of itself, to modify a pre-2019 divorce or separation agreement or order.
If the opt-in langue is included in a pre-2019 divorce or separation agreement or order, the fact that alimony is no longer deductible at the time a modification is sought arguably may not be a basis for an alimony payor to seek a modification either, as the changes in tax treatment would have been clearly contemplated at the time the order or agreement was made.
Changes to Alimony Guidelines at the State Level
After seventy-five years of deductibility, the TCJA is an alimony paradigm shift. In response, some states are beginning to modify their alimony calculation guidelines for 2019 to take into account the TCJA changes.
Illinois, for example, has passed a law that lowers the alimony guidelines to account for the additional tax burdens on payors. It is expected that other states will follow suit. Practitioners should pay close attention to any such changes in their state’s law, particularly in the event that they have a client who seeks to modify a pre-2019 order that does not have the TCJA opt-in language. The client may find that the state’s alimony guidelines have changed and assume that there is no deduction, when, in fact, the pre-2019 order will continue to be eligible for the deduction. Most states will require some showing of a change in circumstances for the modification, but it is important to closely examine how any changes in your state’s alimony laws are impacted by the TCJA. As with any transition, unexpected results should be expected. It is also possible that permanent alimony, which is becoming increasingly rare across the country, will also be reexamined as a result of the shifting tax burden.
The Recapture Rule Hasn’t Changed
Another layer of complication that may arise as parties are reexamining, modifying, and entering into new alimony agreements and orders, is that the recapture rule was not changed by the TCJA. The recapture rule requires the payor to recapture (i.e. report as income) some amounts previously deducted. The rule is triggered when alimony paid in the third year of the first three-year period is more than $15,000 less than in the second year or if the alimony paid in the second and third years decreases by more than $15,000 per year from the amount paid in the first year. For some clients, the changes brought about by the TCJA may provide an opportunity to rethink and modify their current orders. Before doing that for them, don’t forget to examine how the recapture rule might impact the payments and deductions your clients are considering.
New Negotiating Strategies?
Now that alimony is no longer deductible, parties will have to look to alternative solutions to solve post-divorce income deficiencies without the “subsidy.” As parties are no longer chained to the definition of what constitutes alimony under the Tax Code in their quest to qualify for the deduction, they can be more creative about finding ways to support an ex-spouse. Periodic transfers of other assets or property over time can be a solution. For example, periodic transfers of stock, housing, transportation, and any of a number of other solutions can be explored.
In an effort to compromise, parties may consider agreeing to a “tax-effect” discount to the total amount of alimony paid. They could, for example, discount the total amount of alimony paid by an amount equivalent to the payee’s effective tax rate. Thus, in the scenario discussed above, if Katie needs $40,000 a year in alimony to get by post-divorce, she and Paul can agree to a discount on the amount of alimony paid in the amount of Katie’s effective tax rate of 15 percent. The parties could, alternatively, negotiate a discount somewhere in between the two effective tax rates, with the difference between Paul’s 33-percent tax rate and Katie’s 15-percent rate providing the negotiation delta. Parties have the opportunity get creative in finding solutions to the tax changes through a combination of tax-effect discounts and noncash payments.
Similarly, parties may also consider an alimony “buy-out” with a lump sum payment that is both tax effected and/or calculated based upon present value. Note however, that in many jurisdictions, lump sum alimony and alimony “buy-outs” are not modifiable.
The repeal of the alimony deduction may also impact negotiations to the extent that property divisions will no longer be subsidized by tax savings. In the past, alimony has frequently been used as an enticement in an otherwise unappealing overall property division. For example, not infrequently, the lipstick of alimony was put on the pig of a property division that awarded 100 percent of an undervalued business or other high-value assets to a moneyed spouse. This scenario frequently arose in community property states such as Texas. In that scenario, when the alimony-payor’s tax savings was added to the cash-flow outlay needed to offset the award of the business and other high-value assets, it could be argued that the IRS subsidized the wealthier spouses’ property award. Without the alimony deduction, the property division itself will be a more contentious battleground.
According to Census Bureau statistics, 243,000 people received alimony in 2016, 98 percent of whom were lower-income women. Alimony is frequently an essential component of divorce settlement negotiations, and its favored tax treatment for the past seventy-five years has helped enable many payors to contribute larger sums to their ex-spouses’ post-divorce income or to make division of illiquid assets manageable. Alimony payments that would have been affordable to the payor in 2018 may no longer be so under the TCJA. As the IRS is realizing billions of dollars in additional revenue, it will frequently be at the expense of lower-income spouses dependent on alimony to survive post-divorce. It will be essential for practitioners, state legislators, and parties to look to creative solutions for the future.