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August 01, 2020 Feature

Divorce Tax Reform Two Years After Passage: What Hath Congress Wrought?

Mark Ashton

History has taught both accountants and lawyers that changes in the law come slowly and are more often the product of evolution than revolution. Students of federal income tax history in this country can look back 90 years or more to the instructions attached to the first tax returns and find many common principles and methods to determine what income is taxable and how.

Alimony Dies a Sudden Death

The tax deduction for alimony has a similar history. It began with tax laws adopted by Congress in the 1920s that permitted men to assign assets to the “use” of their spouses for their support. Men had long been obligated to support their wives both in life and following death. A husband who failed to do so risked a claim for spousal support or a claim against his will if he did not provide adequately for a surviving spouse. To address this, trusts were created to make those provisions without actually parting with ownership of the trust assets on a permanent basis. The question then became whether the income used to provide for a wife or widow’s needs was income taxable to her or not. The U.S. Supreme Court addressed that question with some frequency in the 1920s and 1930s.

If funds set aside for the support of a spouse could have a tax-efficient aspect by moving the tax burden from Mr. Bigbucks to his dependent spouse or widow, would it not make sense that direct payments from him to the same spouse from current income should also be deductible by him and taxable to her? In 1942 the Internal Revenue Code adopted the concept that payments of alimony could be deductible without regard to whether they were from a trust or remitted from the payor’s own current income. This evolution had a fiscal impact for those who project government revenues. Then and now, relatively few Americans have sufficient income-producing assets to create trusts to fulfill support obligations to family members. And the idea that a man would have to pay tax on income destined to go to his wife seemed inequitable. By 1965 the IRS instructions made explicit reference to “alimony” as “other income” subject to tax by the recipient. A decade later, as divorce became more prevalent, alimony was assigned its own line on the Form 1040.

What made the fiscal aspect somewhat alarming in those days was the fact that income was routinely taxed at rates ranging as high as 50–70 percent. A taxpayer with taxable income of $108,300 in 1980 paid 70 cents on every dollar over that amount. It meant his effective cost of his alimony was 30–50 percent of the amount paid. Bear in mind that the recipient spouse was also facing rates that rose quickly, but the alimony game has always been premised on getting the Treasury Department to effectively subsidize a portion of the alimony payments by reducing the payor’s taxes.

The Reagan Revolution brought a tax reform package that eventually dropped marginal rates by half. But, recognizing that fiscal problems persisted, the 1984 Tax Reform Law brought about a fairly complete amendment of alimony law. Before that date, alimony either came from a trust or had to be paid for 10 or more years to be deductible. The 1984 Tax Code eliminated that lengthy term and substituted a three-year look back to prevent the alimony from being “front loaded.” Under the 1984 regime, alimony had to be paid over three separate tax years to qualify for deduction. And, to the extent the reduction from one year over the other exceeded $15,000, the deduction could be reversed. This is a vast oversimplification of what were two alimony deduction tests made part of the IRS regulations. The regulations were published in one of my favorite magazines, The Federal Register: 49 Fed. Reg. 34,451 (Aug. 31, 1984). For people like me, who are math averse, the Rosen Law Firm in Raleigh, North Carolina, created an algorithm that does it for you.

Life was quiet from 1984 until fall 2017. Incoming President Trump had promised tax reform, but every presidential candidate does that, right? But in fall 2017 the winds of tax reform began to collect in the Senate and articles began to appear stating that while there would be lots of new tax incentives, the lawmakers were looking to identify some revenue “enhancers.” As we have noted, when a taxpayer peels off a $1,000 alimony payment to his/her unworthy ex, there was a tax deduction for the payment assuming it met the tests of Section 215 of Title 26. If the payor had taxable income exceeding $200,000, the effective cost was $1,000 × .66 ($660) because the payor was in a 33 percent marginal rate. Meanwhile, if the unworthy recipient of the $1,000 had taxable income (including that nasty alimony) under $50,000, the alimony was only being taxed at 15 percent. So, it cost the payor only $660 to pay $1,000 and the payee got to keep $850 after paying tax on this income shift. What happened to what economists like to call the “delta” of $190? Uncle Sam didn’t get revenue he might otherwise have collected. That kind of revenue loss adds up over time. In addition, the Inspector General at Treasury found in 2014 that $2.3 billion of alimony income was deducted for which there was no corresponding income reported by the unworthy recipients. So, Congress decided it would reform alimony by getting rid of it. Almost.

Bismarck is credited with saying that legislation is made in much the same way as sausage. Many ingredients are employed without any regard to consistency. As the Tax Cuts and Jobs Act of 2017 rocketed through Congress without hearings, legislators realized that many constituents would not be pleased to see that the $1,000 alimony payment was going to actually cost the payor $1,000. And the whole point of the TCJA was to make people happy with tax cuts. So, as the law was being crammed into the sausage press, a provision was added that existing agreements crafted back in the days before the new act would still have the same tax effect. One can only imagine the response of Treasury department regulation writers and enforcers. “Wait, we will have two systems of taxation for alimony for an indefinite period of time?” Well, why not? The public will think better of the legislators who adopt that. Then Congress added another twist. The new tax law will otherwise go into effect in 2018, but the new nondeductible alimony provision will be deferred for a year so that any agreement signed before midnight on December 31, 2018, will be grandfathered into the 1984 tax regime. Then came the coup de grace. The law adopted by Congress and signed by the president on December 21, 2017, effectively says that any amendment to an alimony agreement or order in place as of December 31, 2018, will also keep the old 1984 tax treatment unless they foolishly should decide they want to give up the tax benefit by agreement. Thus, if you formed a lifetime alimony agreement for a 45-year-old couple while crews were elevating the 2019 New Year’s ball above Times Square, you could continue to amend that agreement for decades and still claim the benefits of a tax scheme Congress abandoned in 2017. The statute passed says there is a presumption that any amendment to a pre-2019 agreement or order is intended to retain deductibility by the payor and to tax the recipient.

Thus, having decided that allowing alimony to be deductible was a bad fiscal policy, Congress renounced and abandoned the policy, while granting taxpayers a year extension to make as many deals as possible taking advantage of the bad fiscal policy and allowing those people to amend agreements based on the bad policy forever. We are left with two systems, which means that family law attorneys and the public will have to resign themselves to a world where alimony is nondeductible, except for the alimony that remains deductible, including amendments to deductible alimony agreements formed on or before December 31, 2018. Simple, right?

As we learned in 2019, there are far broader repercussions to this legislative anomaly.

The author comes from a state that employs an income shares model when deciding child support. Alimony is income for purposes of determining child support in many states. We now have two forms of alimony: deductible and nondeductible. In Pennsylvania, this required a complete rewrite of the child support formula to accommodate what appears to be an indefinite two-tier system. For years to come, lawyers and judicial officers will have to pause in the process of calculating child support to ask whether there is alimony being paid and under which regime (1984 or 2019).

Property Transfers in Divorce

The 1984 Tax Code also changed tax aspects of how property was distributed. Under a 1962 Supreme Court case, United States v. Davis, 370 U.S. 65, when jointly held property was divided, the transaction was treated as a sale by the person conveying the interest and the seller had to pay tax on any capital gain associated with that transaction. So, when the husband ran away from home or got kicked out, if the ensuring divorce involved him transferring the house to the ex-wife, he had to report the transfer and pay tax on half of any gain that accrued during the marriage. The Domestic Relations Tax Reform Act of 1984 provided that divorce-related transfers were not a taxable event. The person getting jointly held property or even individually held property from a former spouse took on the transferor’s basis. In plain English, under the regime ancien, Mom and Pop bought the Homestead in 1963 for $20,000. When they broke up in 1983 and Pop was required to fork over the deed to the Homestead at a time when it was now worth $50,000, he needed to report that he effectively sold Mom his half of the ranch for $25,000 when his half of the basis was $10,000. So, capital gain of $15,000 taxed at 20% (then) meant Uncle Sam was in for $3,000. Effective in 1984, that problem disappeared for Pop. Mom just took over his basis and would have to square up with the Uncle only when she sold the Homestead and harvested the gain. Later, what was a small exclusion of capital gains was amped up so that $250,000 of gain was not taxed if the sale was a residence and the exclusion went to $500,000 if the couple sold the house while still married. Thus, the homeowners who paid $250,000 for their house in 1990 and sold it for $750,000 today pay no taxes on that gain. Had the same couple rented an apartment during the same timeframe and purchased a Honus Wagner baseball card for $250,000 in 1990, the sale of that card for $750,000 today would trigger a $30,000 tax obligation on the same gain.

The Personal Exemption: Another Casualty in the Name of Reform

Another victim of Tax Reform 2017 was the personal exemption. It was an old friend, as it could be found on tax returns as early as 1920. It was accompanied by another old friend who did survive 2017: the standard deduction. The death of the personal exemption had already occurred for high-income families as the deduction amount eroded as income rose in recent years. But now it is gone, kaput. Except it really isn’t. The dollar reduction in taxable income brought about by the personal exemption is no longer there. To be more precise, it has been reduced to -0- until 2025, when many of the 2017 reforms magically disappear.

In the meantime, there are still favorable tax rates if you can qualify as a head of household. For so long as anyone can remember, we have different tax rates for single people, married people, and heads of households. To be a head of a household, you need someone else living in it who qualifies as dependent. As most know, an adult family member can be your dependent, but we shall focus on children and college students. The 2018 Tax Form kept the list of dependents on its new half page tax format. The definition of who is a dependent did not change. If the child receives more than half of his/her support from the “combined” income of the parents, the right to claim the child as dependent belongs to the parent who had the child more than half the year. Treasury Regulation § 1.152-4 sets forth a “Nights Test” that counts how many nights a child is under roof. The level of detail in the “Nights Test” is breathtaking. It used to be that you could barter away your right to the dependency using IRS Form 8332. But the new form for Tax Year 2019 now explicitly says that signing the form will not affect earned income credit, dependent care credits, or household filing status. For those wanting to claim head of household rates, the night count might prove to be the knockout count if you aren’t careful. The IRS now even ropes in the tax preparer with a form where the preparer certifies that this issue was reviewed. See Form 8867. Accordingly, you may want to email your accountant every night after tucking your child into bed to confirm that the night is “yours.”

The holy grail you seek is head of household rates as they are better than those for single taxpayers. Thus, a single parent with a child or children in house making $60,000 a year gets to deduct $6,150 more than the single parent who cannot through the standard deduction. Then that reduced income is subject to a lower rate table.

Income  | Single: 60,000 | Head of Household: 60,000

Standard deduction Single: 12,200 | Head of Household: 18,350

Taxable Income Single: 47,800 | Head of Household: 41,650

Tax | Single: 6,380 | Head of Household: 4,724

So, having little Stella at home that 183rd night saved the taxpayer $138 a month in income taxes. Trouble is that if Stella has three siblings who are also dependent, the adjustment is no greater because the $4,150 exemption per child was rolled back to -0-. For now, anyway.

The Child Tax Credit

We are told that the increase in the child tax credit and the revision of tax rates have been built to substitute for the lost personal exemption. But one does have to ask, why did we do this? The tax credit is now $2,000 per child but not adjusted for inflation. Then there is the “Additional Child Tax Credit,” which is inflation-adjusted. Are you feeling better about how this law “simplified” your income tax filing? If the answer to that question is affirmative, don’t forget that this credit phases out after $200,000 in household income, $400,000 for joint filers.

The “Additional Credit” comes into play if the sum of your child tax credits exceeds your tax obligation. Using our example above, if little Stella is an only child, that $4,724 tax obligation will be reduced by a $2,000 credit. Recall that a credit is a deduction from the tax obligation, whereas a deduction or a personal exemption is just a subtraction from taxable income. So, if Stella has those three siblings we mentioned above, that’s 4 kids × a $2,000 credit. The $8,000 is subtracted from the $4,724 to produce a negative balance. So, Stella’s mom now has a $3,226 credit that the IRS owes her. But to claim it, her custodial parent will need to have at least $2,500 of earned income. We are to take the earned income and reduce it by $2,500 and then multiply the result by 15 percent. (($60,000–2,500) × 0.15) That yields a credit of $8,625. The parent can claim this such that she ends up paying negative income tax; she gets a subsidy. But not so fast: the remittance to the parent cannot exceed $1,400 per eligible child even though the credit is $2,000 a head. This means Stella’s mom will get $3,901. No matter what other deductions she took, her cap on what she could receive as a credit is $5,600 ($1,400 × 4). The worksheet is Schedule 8812 in case the New York Times crossword puzzle wasn’t challenging enough.

There are only seven requirements to claim a child tax credit. Some of them are easy. It must be your child (stepchild or foster child). The child can’t have reached age 17 during the tax year (before December 31). You have to have provided more than half of the child’s support and the child has to have lived with you for more than half the year. The child must qualify as a dependent, although many of those requirements are embodied in this seven-part test. The child must be a U.S. citizen or a resident alien. I have omitted the section about citizens of American Samoa or the Northern Mariana Islands, not out of disrespect, but in the interest of brevity.

If you are feeling blue about the fact that your kid celebrated her 17th birthday on December 30, 2019, and aged out of the big tax credit, the government does have a consolation prize. If the child meets the six other requirements, there is still a $500 tax credit available. That one is at If that child hankers to live in a foreign country, be certain to rule out any move to Canada or Mexico because qualifying adult children resident in those countries become unqualified by law. That will limit the child to 193 other countries that so far have eluded Congress’s ire.

Once you have absorbed these tax simplifications, I think it prudent to remind the reader that the personal exemption now suspended may return in 2025 unless Congress passes a law to exile it longer. If you read IRS Publication 5307 that has been gathering dust on your nightstand, you will note that many tax changes are referred to as “suspended,” while others are “modified.” Suspended means until 2025. As I conclude, I feel sympathy for the lawyer or tax preparer who has recently graduated. They have a malpractice risk of not knowing the 1984 law coupled with the possibility that in 2025 the old law will be the new law after eight short years of tax reform. In the meantime, we should probably dust off IRS Publication 5307. It’s the one that features a young mother contentedly staring at her computer screen while taking the two-hour IRS tutorial on child tax credit eligibility. She is holding her one-year-old child, who seems somewhat bewildered by the same screenshot. I count myself with the child. Bewildered, if not dazed and confused.

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Mark Ashton is a partner with Fox Rothschild in Exton, Pennsylviania, and practices in the area of civil litigation with a particular emphasis on family law. Mark served as the Pennsylvania Bar Association Family Law Section chair in 2016.