I. Head of Household Filing Status
One of the TCJA’s changes that impacts single parents who itemize their deductions is the elimination of special tax brackets for single parents with custody of children filing as head of household5 as soon as taxable income exceeds $51,800, pursuant to new Code § 1(j)(2)(B). In general, a spouse may file as head of household if:
1. the spouse is unmarried on the last day of the year6 or is “considered unmarried”—that is, there is a legally binding separation agreement, or the spouses have not lived together during the past six months of the tax year;7
2. the spouse’s home was the main home for a qualifying person8 for more than half the year;9
3. the spouse paid more than half the cost of maintaining the home for at least half the year10—these costs include rent, mortgage interest, real estate taxes, insurance repairs, utilities, and food eaten in the home, but do not include clothes, education, medical, vacations, life insurance, or transportation;11 and
4. the spouse can claim the dependency exemptions or child tax credits for the qualifying persons12—even if the spouse does not actually claim the dependency exemptions or child tax credits.13
In previous years, filing status as head of household allowed single parents taking care of children to take advantage of tax brackets that were significantly better than filing as single.14 The purpose of the additional tax benefit for filing as head of household was to provide additional financial assistance to single parents who had primary custody of their children. While it is possible that there were single parents who only wanted custody of their children in order to obtain the preferential tax treatment for head of household status, it is more likely that single parents were willing to endure the additional responsibility of primary custody because they loved their children or because they needed to take custody of their children when the other parent was unwilling or unable to take care of the children. However, starting on January 1, 2018, the TCJA has eliminated the preferential tax treatment for head of household status for any single parent who makes more than $51,800 and itemizes deductions.15 In other words, the maximum benefit from the new 2018 tax brackets that a single parent can get from having primary custody of the kids would be $1,391.50 per year if itemizing deductions.16 As a comparison, prior to the TCJA, the inflation-adjusted tax brackets for the 2017 tax year provided up to a $4,910.65 benefit for a head of household parent versus a single parent without primary custody.17
In order to ameliorate the economic impact on a single parent filing as a head of household, section 11021 of the TCJA amends Code § 63(c)(7) to provide head of household taxpayers with a standard deduction of $18,000 versus $12,000 for filing as single.18 However, single parents who itemize deductions—such as deductions for state income taxes, state property taxes, mortgage interest, and charitable contributions—will not receive any benefit from the higher standard deduction. It also is interesting to note that even though the TCJA eliminated the preference for head of household for ordinary income (e.g., wages) above $51,800, the TCJA did include a relatively small preference for long-term capital gains and qualified dividends—that is, a head of household is subject to a zero percent rate up to $51,700 of taxable income versus $38,600 for single, and a head of household is subject to a fifteen percent rate up to $452,400 of taxable income versus $425,800 for single.19 The good news for single parents with primary custody of their children is that the tax bracket preference for head of household status reappears in 2026 pursuant to the sunset provision in the TCJA20 provided by new Code § 1(j)(1).
Consider the following example. Amy and Bob have three children under the age of five and are getting a divorce.21 Amy is a college professor and Bob is an airplane pilot. Because of their schedules, they have agreed that Amy will be granted primary custody of their children. Amy and Bob each earn taxable income of $100,000 per year, after taking the following deductions: (1) $10,000 for state and local taxes (the maximum amount allowable under the TCJA);22 (2) $7,000 for mortgage interest on a $200,000 loan;23 and (3) $1,000 for charitable contributions.24 Accordingly, they each will be in the 24-percent tax bracket—the head of household preference for Amy only will have an impact on the first $51,800 of taxable income. To put the TCJA changes into perspective, Amy and Bob each will pay taxes at a higher federal income tax rate of 24 percent from earning $100,000 than a private equity manager earning $100,000,000—the private equity manager only will need to pay a long-term capital gains rate of 23.8 percent on the carried interest received for working on a private equity fund.25 Moreover, the preferential long-term capital gains tax treatment for private equity managers was extended indefinitely by the TCJA pursuant to new Code § 1061, which means that it does not sunset after 2025 like many of the other TCJA provisions that apply to individuals.26
II. Elimination of Itemized Deductions
In general, fees and expenses related to a divorce are considered nondeductible personal expenses. However, prior to January 1, 2018, certain divorce-related fees were deductible pursuant to Code § 212 as a miscellaneous itemized deduction subject to the two-percent floor under Code § 67, including expenses that were: “(1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax.”27 For example, fees and costs for attorneys, accountants, appraisers, actuaries, and vocational counselors related to obtaining alimony—but not paying alimony—were deductible.28 These included costs and fees were those incurred in: (1) the determination and collection of alimony amounts; (2) the recovery of alimony arrearages—that is, delinquent support; and (3) a claim for an increase in alimony payments.29 In addition, deductible fees and costs incident to a divorce included: (1) structuring a settlement or property division to produce desired tax effects; (2) creating a support trust as an alternative to alimony; (3) estate planning to mitigate estate and gift tax consequences of support or property division; and (4) preparing, submitting, and enforcing a qualified domestic relations order.30
Pursuant to new Code § 67(g) as enacted by the TCJA,31 divorcing spouses were no longer entitled to the deduction of any fees or expenses related to divorce as of January 1, 2018. As a result, the after-tax cost of getting a divorce after December 31, 2017, may be much higher than in previous years. The good news for spouses who divorce on or after January 1, 2026, is that the elimination of miscellaneous itemized deductions by the TCJA sunsets after 2025.32
The following example is illustrative. In 2017, Carl and Dolores went through the marital dissolution process. Carl’s adjusted gross income in 2017 was $100,000, and he had $20,000 of fees and expenses related to his divorce that qualified as miscellaneous itemized deductions under Code § 212. Pursuant to Code § 67, Carl is able to deduct those costs only to the extent that they exceed two percent of his adjusted gross income, which would be $2,000. Accordingly, Carl would have been entitled to deduct $18,000 in 2017. If Carl incurred the expenses in 2018 as opposed to 2017, he would not be entitled to deduct any of the fees and costs as a result of TCJA § 11045. In other words, divorces in 2018 through 2025 could be substantially more expensive due to the elimination of the deduction for miscellaneous itemized expenses.
III. Elimination of Alimony Deduction
One of the biggest changes for divorce pursuant to the TCJA is the elimination of the deduction for payments of “alimony” starting on January 1, 2019. Alimony refers to spousal support payments—sometimes called spousal maintenance payments—that meet the requirements for “alimony or separate maintenance payment” under Code § 71.33
A. Background
The deduction for alimony payments came into law more than seventy-five years ago pursuant to the Revenue Act of 1942.34 The original Income Tax Act of 191335 did not directly address spousal support payments; however, the U.S. Supreme Court in 1917 in the case of Gould v. Gould36 held that spousal support payments made directly to a divorced wife by her former husband pursuant to a court decree were not taxable as “income” to her under the Income Tax Act of 1913.37 With the Revenue Act of 1942, Congress intended to establish a uniform rule for the taxation of any and all payments received by a divorced wife in the nature of or in lieu of alimony, and, generally, “to treat such payments as income to the spouse actually receiving or actually entitled to receive them.”38 In other words, Congress in 1942 completely reversed the result of Gould so that alimony payments made to a divorced spouse would be taxable as income to that spouse and deductible by the payor spouse. Congress’s legislative fix allowed higher income earning husbands—who typically would be in a higher-income tax bracket than their ex-wives after divorce—to increase the amount of spousal support that they could pay to their ex-wives who earned less income, or even no income, on their own and who typically would be in a lower-income tax bracket after divorce. While the original 1942 provision was a bit sexist by only mentioning husbands supporting their ex-wives, the rules have since been amended to also apply to wives supporting ex-husbands and to same-sex divorces.39 Even though the old patriarchal rules have been updated, women still represent the vast majority of taxpayers receiving alimony payments. In fact, recent U.S. Census Bureau statistics show that approximately ninety-eight percent of people who receive alimony payments are women.40
In short, the alimony deduction is an exception to the assignment of income doctrine first addressed by the U.S. Supreme Court decision in Lucas v. Earl,41 in which the court used the metaphor that “the fruits cannot be attributed to a different tree from that on which they grew.” In other words, taxpayers generally must pay income taxes on the income that they receive, and they are not allowed to gift—or shift—their income to other people who might be in a lower tax bracket. In contrast to spouses giving gratuitous gifts, most spouses who are divorcing would prefer not to have any of their income go to ex-spouses, and the Code addressed that fact prior to January 1, 2019, by allowing the payor of alimony to deduct the payments and requiring ex-spouses receiving the payments to include the payments in income.42
B. Taxation of Alimony
Unlike child support payments, alimony traditionally has been tax deductible for the spouse making the payments as an above-the-line deduction,43 which means that the paying spouse does not need to itemize in order to benefit from the tax advantage, and the alimony is taxable in the year received for the spouse receiving the payments.44 Family law attorneys and judges often use the terms spousal support, spousal maintenance, and alimony interchangeably. However, spousal support and spousal maintenance do not automatically qualify as alimony, and they must meet certain strict requirements under Code § 71 in order to qualify, such as:
1. the payments must be required under a divorce or separate maintenance decree or written separation agreement;
2. the payments must be paid in cash;
3. there must be no liability for payment after the death of the recipient;
4. the spouses may not live in same household; and
5. the divorce or separate maintenance decree may not designate the payment as anything other than alimony—for example, child support.45
Pursuant to section 11051 of the TCJA, the alimony deduction is eliminated for any divorce or separation instrument entered into after December 31, 2018, and the ex-spouse receiving the support payments is no longer be required to include the support payments in income.46 Any divorce or separation instrument finalized before January 1, 2019, was grandfathered—meaning that the old rules under Code §§ 71 and 215 for alimony will continue to apply, even if the divorce or separation instrument is modified in the future (unless the modification expressly provides that the TCJA amendments apply to such modification).47 New Code § 121(d)(3)(C) is similar to Code § 71(b)(2) and defines a divorce or separation instrument as: “(I) a decree of divorce or separate maintenance or a written instrument incident to such a decree, (ii) a written separation agreement, or (iii) a decree (not described in clause (a)) requiring a spouse to make payments for the support or maintenance of the other spouse.”48 Since “written instrument incident to such a decree” is not defined in either the Code or U.S. Treasury Regulations, a written instrument should be referred to, incorporated into, or approved by the court entering the decree of divorce or legal separation to confirm that it is the intention of parties.
A major cause of concern with the TCJA’s elimination of the alimony deduction is that pre- and post-marital agreements entered into prior to January 1, 2019, may not qualify as a written separation agreement under the TCJA for purposes of grandfathered treatment under the alimony deduction rules. For spouses who entered into a pre- or post-marital agreement requiring spousal support after a divorce, those payments may no longer qualify for the alimony deduction if those spouses divorce after December 31, 2018—even if the spouses entered into such agreements before January 1, 2019, and intended the payments to qualify under the alimony deduction rules of Code §§ 71 and 215. Without a technical correction or other guidance from the Internal Revenue Service (Service) or Department of Treasury, a substantial number of pre- and post-marital agreements may need to be updated or modified to take into account the new TCJA rules.
Due to the loss of the alimony deduction after December 31, 2018, there was a substantial rush to finalize divorces in 2018. Beginning in 2019, it became significantly more difficult to settle divorce cases when both spouses might be worse off financially due to the loss of the alimony deduction. Moreover, unlike many of the TCJA provisions that impact individuals and expire after 2025, the elimination of the alimony deduction does not expire after 2025.49
Some spouses who may be entitled to receive spousal support after a divorce might have believed that it would be an advantage to intentionally delay a divorce until January 1, 2019, or later so that the receipt of support payments in the future would not be included in that spouse’s income. However, the alimony rules under Code § 71 already allow spouses to structure their support payments as nondeductible alimony—the divorce or separation agreement simply needs to state that the support payments are not alimony. Beginning in 2019, spouses will no longer have both options for the income taxation of spousal support payments, and it is likely that both spouses will share the financial detriment of the loss of the alimony deduction.
C. State Spousal-Support Guidelines Often Assume an Alimony Deduction
Currently, forty-five states provide statutory laws that enumerate a total of sixty factors for the courts to consider in spousal support determinations.50 Moreover, attorneys and judges in many states use certain guidelines and software to help calculate spousal support payments using the assumption that such payments will qualify as alimony under the Code § 71,51 and the repeal of alimony by the TCJA may render many such systems unusable. For instance, the Uniform Law Commission adopted the Uniform Marriage and Divorce Act (UMDA), section 308 of which provides the following with respect to spousal support:
§ 308. [Maintenance]
(a) In a proceeding for dissolution of marriage, legal separation, or maintenance following a decree of dissolution of the marriage by a court which lacked personal jurisdiction over the absent spouse, the court may grant a maintenance order for either spouse only if it finds that the spouse seeking maintenance:
(1) lacks sufficient property to provide for his reasonable needs; and
(2) is unable to support himself through appropriate employment or is the custodian of a child whose condition or circumstances make it appropriate that the custodian not be required to seek employment outside the home.
(b) The maintenance order shall be in amounts and for periods of time the court deems just, without regard to marital misconduct, and after considering all relevant factors including:
(1) the financial resources of the party seeking maintenance, including marital property apportioned to him, his ability to meet his needs independently, and the extent to which a provision for support of a child living with the party includes a sum for that party as custodian;
(2) the time necessary to acquire sufficient education or training to enable the party seeking maintenance to find appropriate employment;
(3) the standard of living established during the marriage;
(4) the duration of the marriage;
(5) the age and the physical and emotional condition of the spouse seeking maintenance; and
(6) the ability of the spouse from whom maintenance is sought to meet his needs while meeting those of the spouse seeking maintenance.52
Noticeably absent from the UMDA and many state statues is an additional statutory factor that takes into account the tax treatment and consequences to both parties of any alimony award, including the designation of all or a portion of the payment as a nontaxable, nondeductible payment.53 Many state guidelines and related software programs, thus, need to be updated to reflect the fact that the elimination of the TCJA’s alimony deduction after December 31, 2018, could cause both spouses to be financially worse off than in previous years. In sum, divorces on or after January 1, 2019, may be a more challenging, lengthy, and expensive proposition given current inconsistencies with standard state guidelines and software assumptions and without the availability of an alimony deduction to help encourage settlement negotiations and avoid the necessity of going to court.
Consider the following example. Elliott, a wealthy doctor, and Fran, a stay-at-home mother, live in California and are getting a divorce. In 2018, Elliott and Fran agreed that Elliott would pay Fran spousal support of $10,000 per month ($120,000 per year) for the rest of her life. With the alimony deduction, Elliott will not be taxed on the $120,000, and Fran will be subject to tax on the $120,000. Fran will be in the 24-percent tax bracket for federal income tax purposes (whether filing as single or head of household) and the nine-percent tax bracket for California state income tax purposes54—without taking into account any potential deductions that still are allowed after the enactment of the TCJA (e.g., $10,000 of state and local taxes, mortgage interest, and charitable contributions). If Elliott and Fran did not finalize a divorce or separation instrument in 2018, Elliott would no longer be entitled to deduct the support payments he is required to pay to Fran each year, and Fran would not be required to include the payments in income. However, without the alimony deduction, Elliott would need to earn approximately $240,000 in order to pay Fran the same $120,000 support, assuming Elliott is in the highest 37-percent tax bracket for federal income tax purposes and the 9.3-percent tax bracket for California income tax purposes.55 Accordingly, Elliott only may be willing to pay Fran spousal support of $5,000 per month ($60,000) per year if they get a divorce in 2019, which would be approximately the same—on an after-tax basis without the alimony deduction—as the $120,000 he was willing to pay in 2018. As a result, it is likely that Elliott and Fran would have a substantially more difficult time settling their divorce in 2019 without the alimony deduction, and they had an extra incentive to finalize a divorce or separation instrument in 2018 in order to avoid the TCJA’s negative financial impact on divorcing spouses.
IV. Policy Reasons for Alimony Changes
Given the extra financial burden and hardship that can be caused by divorce—especially for middle- and lower-income taxpayers trying to support two households on an amount that may have been barely sufficient to support one household—many taxpayers might question why Congress included provisions in the TCJA that make divorce even more expensive. Four main policy reasons have been used to support the elimination of the alimony deduction.
A. Tax Subsidy
One policy argument for the elimination of the alimony deduction is that the deduction is an unfair tax subsidy that encourages divorce. In fact, the House Ways and Means Committee, the chief tax-writing committee of the U.S. House of Representatives, in its bill summary addressed the elimination of the alimony deduction by stating, “[t]he provision would eliminate what is effectively a ‘divorce subsidy’ under current law.”56
However, since a divorce typically requires spouses to support two households on a level of income that previously supported only one household, it is unlikely that there are many spouses who would be willing to go through the financial and emotional strain of divorce solely in order to take advantage of an alimony deduction and shift taxable income to someone in a lower bracket. Moreover, if Congress truly wanted to eliminate a divorce subsidy, it also could have eliminated the marriage tax penalty, which still applies to higher-income married spouses even after the TCJA’s enactment.57 In other words, two working spouses could be paying more federal income taxes as a married couple pursuant to the TCJA than if they were each filing as single or head of household as a nonmarried couple.58 In addition, the TCJA specifically creates a new divorce subsidy by amending Code § 104(b)(6) allowing every unmarried individual taxpayer to deduct up to $10,000 in state and local taxes but limiting married spouses to the same $10,000 deduction.59 Moreover, married taxpayers are limited to a deduction for mortgage interest up to $750,000 of principal acquisition indebtedness under Code § 163(h)(3)(F).60 However, unmarried taxpayers are each permitted to deduct interest up to $750,000 even if they live in the same principal residence.61
The following example is instructive. Gary and Helen are both prominent attorneys with taxable income of $500,000 per year. If they stay married, they will be in the highest federal income tax bracket of thirty seven percent as soon as their combined income exceeds $600,000—which means that $400,000 of their combined income will be subject to a thirty-seven-percent tax. If Gary and Helen would be willing to get divorced solely for tax reasons to take advantage of the “divorce subsidy” provided by the TCJA, they each would be in a lower thirty-five-percent bracket for single or head of household—which means that they would save $8,000 or more in taxes every year by not being married.62 Moreover, as an unmarried cohabitating couple, both Gary and Helen would be entitled to a $10,000 deduction for state and local taxes—double the amount to which they would be entitled as a married couple. In addition, they each would be entitled to deduct mortgage interest on principal-acquisition indebtedness up to $750,000 for a combined total amount of $1,500,000—double the amount they would be able to deduct as a married couple.
B. Cost of Alimony Deduction
The second policy reason advanced for repealing the alimony deduction is that it will result in more tax revenue for the U.S. government. However, the additional revenue would be relatively minimal, especially considering the overall cost of the TCJA. The nonpartisan Joint Committee on Taxation estimates that repealing the alimony deduction would add $6.9 billion in new tax revenue over ten years.63 That amount is equal to less than one-half of one percent of the $1.5-trillion increase in the federal deficit that the Joint Committee on Taxation estimates the TCJA will produce over the next ten years.64 In comparison, the TCJA’s new Code § 2010(c)(3)(C)65 almost doubled the estate tax exemption amount to benefit wealthy families—$11.18 million per person in 201866—which will increase the federal deficit more each year than the entire ten-year cost of repealing the alimony deduction.67
C. Compliance with Alimony Rules
The third policy reason put forth for repealing the alimony deduction is that there has been a mismatch in the number of taxpayers reporting the alimony deduction and the number of taxpayers reporting the inclusion of the alimony income, which has resulted in a compliance burden for the Service. Data provided by the Service for the 2015 tax year shows that 598,888 taxpayers claimed they paid a total of $12,345,177 in alimony on their Form 1040, although only 414,420 taxpayers reported receiving alimony of $10,077,086. In other words, there was a discrepancy of 184,468 returns and $2,268,091.68
Moreover, the Treasury Inspector General for Tax Administration (the “TIGTA”) in 2014 analyzed 567,887 tax returns with an alimony deduction claim for the 2010 tax year and identified 266,190 tax returns—47 percent of them—in which it appeared that individuals claimed alimony deductions for which income was not reported on a corresponding recipient’s tax return or the amount of alimony income report did not agree with the amount of the deduction taken.69 The TIGTA found a discrepancy of more than $2.3 billion in deductions claimed without corresponding income reported and estimated that the discrepancy could result in more than $1.7 billion in unreported tax over five years.70 The TIGTA concluded that, apart from examining a small number of tax returns, the Service “generally has no processes or procedures to address this substantial compliance gap.”71 The Service agreed with three of the four recommendations proposed by the TIGTA and stated that “it enhanced its examination filters and will continue to review and improve its strategy to reduce the compliance gap.”72
Regardless of the mismatch among taxpayers reporting the payment of alimony and taxpayers reporting the receipt of alimony, a lack of enforcement of the tax rules is not a strong policy reason for eliminating the rules. Payments of alimony and receipt of alimony should be relatively simple to match, as are, for example, (1) a business filing a Form 1099 and reporting a deduction for a payment to an independent contractor and (2) the independent contractor reporting the receipt of income. If there are taxpayers either falsely claiming an alimony deduction or fraudulently failing to include alimony payments in income, then those taxpayers should be subject to back taxes, penalties, and interest under the Code. Rather than eliminating the alimony deduction, a more practical solution could be for the Service to increase audits of mismatched returns and enforce the existing tax laws.
Moreover, the repeal of the alimony deduction by the TCJA actually will increase the ongoing burden on the Service from a compliance perspective. Not only will the Service continue to be responsible for reviewing tax returns based on the alimony deduction rules in effect for taxpayers who have a divorce or separation instrument prior to January 1, 2019, but in the future, the Service also will have the additional obligation to determine whether the TCJA’s repeal of the alimony deduction applies to taxpayers due to a divorce or separation instrument after December 31, 2018, or a modification of a pre-2019 divorce or separation instrument that expressly provides the TCJA amendments apply to such modification.73
D. Family-Friendly Tax Reform
The fourth proposed policy reason for repealing the alimony deduction is likely the most controversial. In proposing the initial tax reform bill, the chair of the House Ways and Means Committee stated that the TCJA changes were intended to be pro-family or “family-friendly.”74 Arguably, discouraging people from getting a divorce by making it substantially more expensive under the TCJA could be considered to be family-friendly. However, the vast majority of psychiatrists, psychologists, therapists, and counselors likely would argue that it is not a family-friendly policy to encourage spouses to stay in unhappy marriages, let alone mentally and physically abusive marriages.
V. Elimination of § 682
The TCJA also eliminated Code § 68275 beginning on January 1, 2019.76 In general, Code § 682 provided that if one spouse (the “moneyed spouse”) created an inter vivos irrevocable grantor trust (a “support trust”)77 for the benefit of the other spouse (the “non-moneyed spouse”), then the moneyed spouse was not required to pay taxes on income78 distributed from the support trust to the non-moneyed spouse after a divorce.79 Instead, Code § 682 required the non-moneyed spouse to pay taxes on the income he or she received from the support trust after a divorce. The elimination of Code § 682 may a huge impact on support trusts for spouses who finalized a divorce or separation instrument after December 31, 2018, even if the support trust was created before January 1, 2019. A moneyed spouse could be required to pay all of the taxes on a support trust’s net income if there is a divorce or separation instrument after December 31, 2018, even if the support trust was created twenty years ago and the support trust is required to make payments to an ex-spouse for the next fifty years.
Support trusts generally are used for estate planning purposes, pre- and post-marital planning purposes, and divorce settlement purposes. For example:
1. Spouses may want to minimize their need for any future interaction after a divorce, which otherwise would be necessary with the payment of spousal support. With a support trust, an independent, neutral trustee is responsible for support payments outside of the control of both spouses.
2. The moneyed spouse may have limited liquidity and want to prevent the sale or transfer of a closely held business in a divorce, which otherwise might be necessary to fund spousal support payments. Distributions from the business could be paid by the trustee to the non-moneyed spouse for a specified term.
3. The non-moneyed spouse may want to ensure that support payments continue even in the case of the moneyed spouse’s financial insolvency or bankruptcy, especially if the moneyed spouse has a profession with a high risk of financial insolvency or bankruptcy, such as professional athlete,80 that might jeopardize payment of future spousal support.
4. The non-moneyed spouse may want to ensure continued support payments in the event of the moneyed spouse’s death, which may not be practical or possible with life insurance due to the health condition of the moneyed spouse or the cost of premiums.
5. Ongoing professional asset management may be necessary to protect a financially unsophisticated non-moneyed spouse, who might otherwise make poor investment decisions.
6. One or both spouses may want to protect assets for children and future descendants from creditors.
7. One or both spouses may want to take advantage of potential estate, gift, and generation-skipping transfer tax savings.81
The income generated by a support trust’s assets as well as trust principal—for example, a specified dollar amount or percentage of trust assets—could be distributed to the non-moneyed spouse for a specified length of time, such as a term of years or the life of the non-moneyed spouse.82 At the end of the trust term, the support trust’s assets could either revert back to the moneyed spouse or be distributed outright, or in trust, to the spouses’ children or future descendants.
The tax rules under Code §§ 671-679, subpart E of subchapter J (the “grantor trust rules”) typically applied to support trusts because the moneyed spouse or the non-moneyed spouse often retains certain interests in, or powers over, the trust. Under the usual grantor trust rules, the moneyed spouse would be subject to tax on the trust’s taxable income, regardless of whether the support trust distributed any income to the non-moneyed spouse. In other words, the moneyed spouse continued to be treated as the owner of the trust’s assets for income tax purposes, even after the spouses divorced or legally separated.83 Fortunately, if the spouses had a divorce or separation instrument prior to January 1, 2019, Code § 682 provided a special exception to the usual grantor trust rules,84 requiring the non-moneyed spouse—not the moneyed spouse—to include the income he or she was entitled to receive from the support trust in his or her gross income. Code § 682(a) provided that if the spouses were divorced from each other or separated under a decree of separate maintenance or under a written separation agreement, the non-moneyed spouse was required to include in gross income:
[t]he amount of the income of any trust which such wife is entitled to receive and which, except for this section, would be includible in the gross income of her husband, and such amount shall not, despite any other provision of this subtitle, be includible in the gross income of such husband.85
In other words, under Code § 682, the moneyed spouse did not get an income tax deduction, as with alimony, but the moneyed spouse was not taxed on any of the support trust’s income payable to the former spouse.86 Instead, the non-moneyed spouse was taxed on that income as if he or she received it directly.87
With the elimination of Code § 682 by the TCJA beginning on January 1, 2019, a moneyed spouse continues to be liable for all the taxes on a support trust—even after a divorce—if a divorce or separation instrument was not finalized before 2019. In other words, a support trust may not qualify as a written separation agreement under the TCJA for purposes of grandfathered treatment under Code § 682. Moreover, the repeal of Code § 682 is not set to expire—or sunset—at the end of 2025, like the provisions providing for the elimination of alimony and unlike a multitude of other provisions that apply to individuals under the TCJA. It is likely that Congress eliminated § 682 in order to prevent spouses from creating a trust after December 31, 2018, that allows a moneyed spouse to shift income to a former spouse in a lower tax bracket, which would not otherwise be possible with the elimination of the alimony deduction. However, without a technical correction or other guidance from the Service or Department of Treasury, a substantial number of pre-existing support trusts may need to be updated or modified—which may be challenging under state law due to the irrevocability of support trusts—to take into account the new TCJA rules.88
The following is an example of how the elimination of § 682 may affect divorcing couples. Iris and John got married in January 1988 and had one child, Kyle, born in January 1989. Iris was an extremely successful software engineer and agreed to create a trust in January 2008 for post-marital planning purposes for the benefit of John and estate planning purposes for the benefit of Kyle (the “John and Kyle Trust”). Iris funded the John and Kyle Trust with $2 million.89 The trust agreement for the John and Kyle Trust provided that John would be entitled to receive a unitrust distribution every year equal to four percent of the value of trust’s assets at the end of each year. In other words, John would be entitled to approximately $80,000—four percent of $2 million—in the first year, and the amount of the distribution would increase each year if the trust assets grew by an amount greater than four percent. The trust agreement also provided that all of the assets remaining in the John and Kyle Trust after John’s death would be distributed to Kyle. Regardless of how much the assets in the trust appreciate, Kyle would be entitled to receive the trust’s remaining assets completely free of gift and estate tax after John’s death. If Iris and John divorced in 2018, John would have been subject to tax on the future distributions from the John and Kyle Trust to the extent of the trust’s net income pursuant to Code § 682. However, if Iris and John divorce after 2018, Iris will continue to be subject to tax on all of the trust’s net income regardless of the amount of the trust’s distributions to John for the remainder of John’s lifetime. In other words, in the wake of a post-2018 divorce, John would continue to receive $80,000 or more from the John and Kyle Trust completely free of any income, estate, or gift taxes and Iris would be subject to tax on all of the John and Kyle Trust’s net income for the remainder of her lifetime. As a result, Iris and John likely would need to consider the following three options, subject to applicable state law and the trust agreement: (1) remove John as a beneficiary by amendment power in the trust agreement or by decanting; (2) dissolve the trust with an outright distribution of trust property to John; or (3) maintain John as a beneficiary but have a marital settlement agreement requiring John to reimburse Iris for income taxes attributable to the trust income that John is entitled to receive.
VI. Conclusion
After December 31, 2017, due to the TCJA’s reduction in the preference for head of household status and the elimination of deductions for certain expenses related to divorce, divorce may have become much more expensive. With the elimination of the alimony deduction and elimination of Code § 682 for trusts after December 31, 2018, beginning on January 1, 2019, divorce may be even more costly. Furthermore, married spouses who have previously entered into pre- or post-marital agreements or created inter vivos trusts for the benefit of a spouse may need to speak with their legal and tax advisors regarding the potential need for changes based on the new TCJA rules.
Endnotes
1. Pub. L. No. 115-97, 131 Stat 2054, (codified in scattered sections of 26 U.S.C. (the Internal Revenue Code “(I.R.C.”) and other titles of the U.S. Code). “Public law no. 115-97, an Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” was originally introduced in Congress as the “Tax Cuts and Jobs Act.” The official name of the bill was changed prior to the final vote, but it is commonly referred to as the Tax Cuts and Jobs Act (or “TCJA”).
2. For purposes of this Article, the terms divorce and marital dissolution are assumed to be synonymous, which is not always the case under the laws of certain states.
3. Any references to “I.R.C.” or the “Code” refer to the Internal Revenue Code of 1986, as amended, Title 26, U.S.C.; any reference to the Regulations refers to the Treasury Regulations promulgated thereunder. All statutory citations in this Article refer to the current statute unless otherwise indicated.
4. I.R.C. § 682 (2017).
5. TCJA § 11001(a) (2017); I.R.C. §§ 1(j)(2)(B)–1(j)(2)(C) (2018).
6. I.R.C. § 2(b)(1) (2018).
7. Reg. § 1.2-2(b)(5) (2018).
8. I.R.C. § 152(a) (2018).
9. I.R.C. § 2(b)(1)(A)-(B) (2018).
10. I.R.C. § 2(b)(1) (2018).
11. I.R.S. Pub. 501 (2016).
12. I.R.C. § 152(a) (2018).
13. I.R.C. § 2(b)(1) (2018).
14. I.R.C. § 152(a) (2018).
15. See TCJA § 11001(a) (2017); I.R.C. §§ 1(j)(2)(B)–1(j)(2)(C) (2018).
16. Id.
17. Rev. Proc. 2016-55, 2016-40 I.R.B. 432.
18. The Tax Policy Center of the Urban Institute and Brookings Institution estimates that the TCJA will reduce the total number of itemizers by about 21 million in 2018, mainly due to the increased standard deduction. Urban-Brookings Tax Policy Center, Impact on the Number of Itemizers of H.R.1, The Tax Cuts and Jobs Act (TCJA) By Filing Status and Expanded Cash Income Level, Table T18-0001 (Jan. 2018), https://www.taxpolicycenter.org/file/174796/download?token=Jd7LLBiG.
19. TCJA § 11001(a) (2017); I.R.C. § 1(j)(5) (2018).
20. Id.
21. Unless otherwise provided, the names, characters, businesses, places, and events discussed in the hypothetical examples in this paper are fictitious. Any resemblance to actual persons, living or dead, or actual events is purely coincidental.
22. See TCJA § 11042 (2017); I.R.C. § 164(b)(6) (2018).
23. Assumes a 3.5 percent interest rate on a $200,000 mortgage. See I.R.C. § 163 (2018).
24. See I.R.C. § 170 (2018).
25. The 2018 rates reflect a 20-percent tax rate on long-term capital gains pursuant to TCJA §§ 11001(a) and 13309 and I.R.C. § 1061, and a 3.8 percent tax on net investment income pursuant to the Patient Protection and Affordable Care Act of 2010, as amended by the Health Care and Education Reconciliation Act of 2010.
26. See TCJA § 13309 (2017); I.R.C. § 1061 (2018).
27. I.R.C. § 212 (2018).
28. See I.R.C. § 71 (2018).
29. I.R.C. §§ 71, 212, 215 (2018) (providing that a spouse’s payment of the other spouse’s legal fees may be deductible by the payor (as alimony), includible in income by the payee (as alimony), and also deductible by the payee (related to collection of alimony)).
30. See Carpenter v. United States, 338 F.2d 366 (Ct. Cl. 1964); see also Rev. Rul. 72-545, 1972-2 C.B. 179.
31. TCJA § 11045(a) (2017).
32. TCJA § 11045(b) (2017).
33. I.R.C. § 71(b)(1) (2018).
34. Pub. L. No. 753, ch. 619, 56 Stat. 798 (1942). The provisions were adopted as section 120 of the Revenue Act of 1942, 56 Stat. 816 (codified as amended at 26 U. S. C. §§ 22(b)(2), 22(k), 23(u), 25(b) (2) (A), 171(a) and (b), 3797(a) (1942)).
35. 38 Stat. 114, 166, c. 16 (1913).
36. Gould v. Gould, 245 U. S. 151 (1917).
37. For a more detailed discussion on the history of the alimony deduction, see Alan L. Gornick, Alimony and the Income Tax, 29 Cornell L. Rev. 28, 28–52 (Sept. 1943).
38. S. Rep. No. 1631, at 83, 77th Cong., 2d Sess. (1942); H. R. Rep. No. 2333, at 71, 77th Cong., 2d Sess. (1942).
39. See I.R.C. §§ 71 and 7701(a)(17); United States v. Windsor, 570 U.S. 744 (2013) (holding Section 3 of the Defense of Marriage Act unconstitutional because it violated principles of equal protection by treating relationships that had equal status under state law differently under federal law); Rev. Rul. 2013-17, 2013-38 I.R.B. 201.
40. See U.S. Census Bureau, Current Population Survey Alimony and Child Support Supplement (last updated July 18, 2019), https://catalog.data.gov/dataset/current-population-survey-alimony-and-child-support-supplement.
41. Lucas v. Earl, 281 U.S. 111 (1930).
42. I.R.C. §§ 71, 215 (2018).
43. I.R.C. § 215(a) (2018).
44. I.R.C. § 71(a) (2018).
45. Id.
46. TCJA § 11051(c) (2017).
47. Id.
48. TCJA § 11051(b)(3)(A) (2017).
49. Id. (emphasis added).
50. For a deeper discussion on alimony legislation, see Laura W. Morgan, A Nationwide Review of Alimony Legislation, 2007–2016, 51 Fam. L. Q. 39 ( 2017).
51. Two main goals of spousal support guidelines are predictability and consistency. The arithmetic method’s appeal lies in its replacement of a factor analysis with a numerical system designed to convert those factors into quantifiable numbers used to calculate alimony amounts. Proponents of statutorily defined calculations believe this framework achieves more consistent results, eliminates judicial unfairness, and provides equity to both parties. Both the American Law Institute’s guidelines and the American Academy of Matrimonial Lawyers offer numeric guidelines. See L. J. Jackson, Alimony Arithmetic: More States Are Looking at Formulas to Regulate Spousal Support, 98 A.B.A. J. 15, 16 (2012); Mary Kay Kisthardt, Re-thinking Alimony: The AAML’s Considerations for Calculating Alimony, Spousal Support or Maintenance, 21 J. Am. Acad. Matrim. L. 61, 62 (2008).
52. Unif. Marriage and Divorce Act § 308 (Unif. L. Comm’n 1974).
53. See, e.g., Fla. Stat. Ann. § 61.08(2) (2016).
54. See Cal. Franchise Tax Bd., Cal. Tax Rates and Exemptions (2017).
55. Id.
56. Staff of H. Comm. on Ways and Means, Tax Cuts and Jobs Act, H.R. 1, as Ordered Reported by the Committee, Section-by-Section Summary, 115th Cong., Rep. No. 115-409, at 17–18 (Nov. 13, 2017), https://republicans-waysandmeansforms.house.gov/uploadedfiles/tax_cuts_and_jobs_act_section_by_section_hr1.pdf. The full report is available at https://www.congress.gov/115/crpt/hrpt409/CRPT-115hrpt409.pdf.
57. See TCJA § 11001(a) (2017).
58. Id.
59. TCJA § 11042 (2017).
60. TCJA § 11043 (2017).
61. Action on Decision (“AOD”), 2016-31 I.R.B. 205. The Service acquiesced to the decision in Voss v. Commissioner, 796 F.3d 1051 (9th Cir. 2015), which reversed Sophy v. Commissioner, 138 T.C. 204 (2012).
62. Id.
63. See Joint Comm. on Taxation, U.S. Cong., Estimated Budget Effects of the Conference Agreement for H.R. 1, the “Tax Cuts and Jobs Act,” Fiscal Years 2018–2027, JCX-67-17 (Dec. 18, 2017), https://www.jct.gov/publications.html?func=startdown&id=5053.
64. Id.
65. See TCJA § 11061 (2017).
66. See Rev. Proc. 2018-18, 2018-10 I.R.B. 392.
67. Id.
68. See I.R.S., Statistics of Income—2015 Individual Income Tax Returns Line Item Estimates, Pub. 4801 (rev. Sept. 2017).
69. See Treas. Inspector Gen. for Tax Admin., Significant Discrepancies Exist Between Alimony Deductions Claimed by Payers and Income Reported by Recipients, (2014), https://www.treasury.gov/tigta/auditreports/2014reports/201440022fr.pdf.
70. Id.
71. Id.
72. Id.
73. See TCJA § 11051(c) (2017).
74. Rep. Kevin Brady (R-Texas), House Ways & Means Committee chair, answering questions on November 2, 2017, following the announcement of the Republican tax reform bill, stated, “This is a family-friendly tax code.” (CNBC broadcast Nov. 2, 2017), https://www.cnbc.com/video/2017/11/02/tax-reform-rep-kevin-brady-this-is-a-family-friendly-tax-code.html.
75. “Subpart F of part I of subchapter J of chapter 1 is amended by striking section 682 (and by striking the item relating to such section in the table of sections for such subpart).” TCJA § 11051(b)(1)(C) (2017).
76. TCJA § 11051(c) (2017).
77. Support trusts are sometimes referred to as “alimony trusts,” which is something of a misnomer since support trusts typically would be used in lieu of, or in addition to, alimony.
78. I.R.C. § 682 and the Regulations thereunder do not clarify whether income should be defined as “fiduciary accounting income” under I.R.C. § 643(b). Fiduciary accounting income is determined under the trust instrument and local law and typically would not include capital gains, or “income determined for tax purposes” under Reg. § 1.671-2(b), which would include capital gains. In other words, if a support trust has any capital gains, it is not clear whether the moneyed spouse or the non-moneyed spouse would be subject to tax on the capital gains, regardless of any amounts distributed to the non-moneyed spouse. In 2015, this issue was brought to the attention of the I.R.S. Office of Chief Counsel, Department of Treasury, U.S. Congress Joint Committee on Taxation, and Senate Finance Committee, which led to the Department of Treasury adding the issue to its 2016–2017 Priority Guidance Plan. Department of the Treasury 2016-2017 Priority Guidance Plan at 13 (Aug. 15, 2016). See Justin T. Miller, Taxation of Grantor Trusts After Divorce: A Need to Define “Income,” 25 Cal. Tax Law. 15, 19 (2015).
79. For more a more detailed discussion, see Justin T. Miller, Making Divorce Less Taxing: A Unique Opportunity for Income, Estate, and Gift Tax Planning, 52 Real Prop., Tr. & Est. L. J., 1 (Spring 2017); Justin T. Miller, Support Trusts in Lieu of Alimony: A Creative Settlement Solution, 30 Am. J. Fam. L. 92 (2016); Justin T. Miller, Taxation of Trusts After a Divorce or Marital Dissolution: A Need to Define “Income,” 25 Cal. Tax Law. 15 (2015); Justin T. Miller, Taxation of Grantor Trusts After Divorce: A Need to Define “Income,” 148 Tax Notes 1241 (Sept. 14, 2015); Alan S. Acker, Income Taxation of Trusts and Estates, Bloomberg Tax Mgmt. Portfolio No. 852-3d (2007); and Carlyn S. McCaffrey & Melissa G. Salten, Structuring the Tax Consequences of Marriage and Divorce (1995).
80. According to research provided by the National Basketball Players Association and National Football League Players Association, 60% of NBA players and 78% of NFL players are broke within two to five years into retirement. Pablo Torre, How (and Why) Athletes Go Broke, Sports Illustrated (Mar. 23, 2009), www.si.com/vault/2009/03/23/105789480/how-and-why-athletes-go-broke.
81. See Miller, Making Divorce Less Taxing: A Unique Opportunity for Income, Estate, and Gift Tax Planning, supra note 79; Miller, Support Trusts in Lieu of Alimony: A Creative Settlement Solution, supra note 79.
82. It should be noted that, without careful planning, I.R.C. § 2702 could cause a draconian gift-tax result—that is, a taxable gift equal to the full value of the transferred property—to the extent anyone other than the spouses will receive a current or remainder interest in a transfer to a trust for the support of a spouse. See I.R.C. § 2702(a)(2)(A). Treasury Regulation § 25.2702-1(c)(7) provides an exception to I.R.C. § 2702 “if the transfer of an interest to a spouse is deemed to be for full and adequate consideration by reason of section 2516 . . . and the remaining interests in the trust are retained by the other spouse.” It also is possible that a transfer could be treated as a recognition event, as opposed to a gift. For instance, if the primary purpose of the transfer to the trust is to discharge a spouse’s obligation to support children or is made to provide a reasonable allowance for the support of the spouses’ minor issue under § 2516, the transfer may be treated as a recognition event instead of a gift. Neither I.R.C. § 1041 nor the Treasury Regulations thereunder distinguish between trusts with a spouse as the sole beneficiary and trusts that have additional beneficiaries, nor do they specify the type or amount of interest that the spouse is required to have in order for I.R.C. § 1041 to apply. Fortunately, such a negative result may be minimized or even avoided with prudent planning that, for example, provided the beneficiary spouse with: (1) a qualifying income interest in an inter vivos, qualified, terminable-interest property (QTIP) trust that qualifies under I.R.C. § 2056; (2) a qualified annuity or income interest pursuant to I.R.C. § 2516; or (3) a power of appointment over the remainder of the trust limited to the spouses’ issue. See I.R.C. §§ 2056, 2516, and 2702; Treas. Reg. § 25.2702-3 (I.R.C. § 2702 does not apply if the spouse retains a “qualified interest”); and Priv. Ltr. Rul. 201116006 (Apr. 22, 2011).
83. It is not always clear whether a trust will continue to be treated as a grantor trust after a divorce based on certain triggers under the Grantor Trust Rules. In Notice 2018-37, 2018-18 I.R.B. 392, released on April 13, 2018, the Department of Treasury and Service requested comments—in light of the repeal of I.R.C. § 682—regarding whether the application of I.R.C. §§ 672(e)(1)(A), 674(d), and 677 to trusts for the benefit of a spouse causes a trust to remain a grantor trust following a divorce or legal separation. See, e.g., Treas. Reg. § 1.1361-1(k)(1), Example 10.
84. Note that I.R.C. § 682 is an exception to the Grantor Trust Rules, but it is not part of the Grantor Trust Rules under subpart E, subchapter J.
85. See Revenue Act of 1942, Pub. L. 753, ch. 619, 56 Stat. 798, 817–18 (Oct. 21, 1942). The predecessor to I.R.C. § 682 was § 171 of the Internal Revenue Code of 1939, as amended, which was adopted pursuant to § 120 of the Revenue Act of 1942. Section 171 of the Internal Revenue Code of 1939, as amended, became § 682 as part of the Internal Revenue Code of 1954. See ch. 736, 68A Stat. 1, 234 (codified as amended at I.R.C. § 682). Like the alimony rules, I.R.C. § 682 also applies to trusts created by wives for husbands and same-sex couples. See I.R.C. §§ 71 and 7701(a)(17) and United States v. Windsor, 570 U.S. 744 (2013) (holding section 3 of the Defense of Marriage Act unconstitutional because it violated principles of equal protection by treating relationships that had equal status under state law differently under federal law); and Rev. Rul. 2013-17, 2013-38 I.R.B. 201.
86. See I.R.C. § 682 (2018).
87. Id.
88. Changes in the Code applicable to irrevocable trusts traditionally have been applied on a prospective basis. See Estate of Gerson v. Comm’r, 507 F. 3d 435 (6th Cir. 2007) (Prospective application of tax law changes is intended “to protect those taxpayers who, on the basis of pre-existing rules, made arrangements from which they could not reasonably escape and which, in retrospect, had become singularly undesirable.”).
89. Note that the maximum estate tax exemption amount per person in 2008 was $2 million—significantly less than the $11.18 million estate tax exemption amount per person in 2018 pursuant to the TCJA. See TCJA § 11061 (2017); I.R.C. § 2010(c)(3)(C) (2018); Rev. Proc. 2018-18, 2018-10 I.R.B. 392.