April 16, 2019 Articles

How the Tax Cuts and Jobs Act Affects Matrimonial Matters

Among the many changes to the tax laws are the deductibility of alimony payments and several tax provisions that will affect the valuation of a privately held business.

By Louis Panariello

Introduced in the House of Representatives by Congressman Kevin Brady (R-TX) on November 2, 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) was officially signed into law by President Donald Trump on December 22, 2017. The TCJA will be effective for divorce or settlement agreements executed after December 31, 2018. 

As is true of any new law, the TCJA contains, in part, language to be deciphered and interpreted by tax professionals, attorneys, courts, and other professionals. Over the years to come, rulings by the supreme courts and appellate divisions will create precedent for the sections of the TCJA that are less rigid and ambiguous. Nonetheless, during the final months of 2018, lawyers were tasked with navigating the new tax bill and determining whether or not the provisions of the TCJA would be beneficial to their clients. The operative question was: Should the divorce agreement effectuate prior to year-end under the old provisions of the tax law, or is it more advantageous for the divorce agreement post-2018? The operative question forging forward will be: How does the TCJA affect divorce and settlement agreements entered into starting January 1, 2019?

The TCJA and Alimony

Among the many changes to the tax laws is the deductibility of alimony payments. Prior to the TCJA, paying spouses were able to deduct the alimony payments from their tax returns and the receiving spouses were required to include the alimony payments as income on their tax returns. This was preferential because, presumably, the paying spouse was in a higher tax bracket. By “handing over” the tax liability to the receiving spouse in the lower tax bracket, the net tax on that income would be lower and the parties collectively would benefit.

However, as we rang in the new year of 2019, we also said goodbye to the alimony deduction for the paying spouse (and inclusion of alimony on the receiving taxpayer’s tax return). Effective for divorces entered after December 31, 2018, a taxpayer paying alimony to a former spouse will no longer be able to deduct such payments in determining adjusted gross income (AGI). Further, a taxpayer who is receiving alimony will no longer be required to include such amounts in AGI. (Some states, such as New York, have decided to deviate from the federal tax law and have not changed how alimony is treated, which makes it important that attorneys check with a tax professional in their state to see what rules are to be followed in connection with alimony.)

As a result, attorneys will attempt to fashion alimony to account for the non-deductibility to the paying spouse. Because of the varying tax brackets, it will be difficult to create a scenario such that the end result will be the same as under the prior tax laws. As an example, let’s assume Spouse A was ordered to pay $40,000 per year in alimony to Spouse B. Spouse A’s federal tax rate is 40 percent and Spouse B’s federal tax rate is 25 percent. Under the old tax laws,

  • Spouse A deducts the $40,000 from AGI, and after considering tax savings of $16,000 ($40,000 x 40 percent), Spouse A effectively pays $24,000 in alimony;
  • Spouse B declares the $40,000 as income, and after paying $10,000 of federal tax ($40,000 x 25 percent), Spouse B effectively receives $30,000 in alimony. 

As seen in the illustration, Spouse A effectively paid $24,000 in order for Spouse B to effectively receive $30,000, representing a benefit of $6,000. Under the TCJA, to get Spouse B to the same amount of net alimony, Spouse A will have to pay $30,000, or $6,000 more than under the old tax laws. One way to mitigate the difference ($6,000 in this example) would be to split the additional amount between the spouses. In this instance, that would equate to an alimony award of $27,000. Spouse A pays an additional $3,000 and Spouse B receives $3,000 less, therefore equally bearing the burden of the $6,000 increase. Lawyers will work to determine what methodology best suits their clients’ specific positions.

The TCJA and Standard Deduction

The TCJA also increased the standard deduction for a taxpayer filing “single” to $12,000. This increase was offset with the elimination of certain itemized expenses such as miscellaneous deductions (i.e., deduction from AGI subject to the 2 percent AGI floor), medical expenses, and casualty losses, and the reduction of state and local taxes (commonly known as “SALT” taxes, which include real estate taxes on personal residences) to $10,000. (On this subject too, attorneys should check with a local tax professional to see if their state has deviated from the federal rules.) These changes should be considered in concert with the effect of the changes to alimony deductibility for each individual client. Given the complicated nature of the laws, a tax professional would prove valuable during settlement discussions.

The TCJA and Child Support

The tax treatment of child support has remained unchanged, such that it is not deductible from the paying spouse’s tax return and not includable in the receiving spouse’s tax return. However, under the TCJA, dependency exemptions have been eliminated.

The TCJA and Business Valuations

The TCJA introduced several tax provisions that will affect the valuation of a privately held business. The TCJA reduced the corporate tax rate for C corporations. C corporations are taxed at the entity level, and dividends from C corporations are taxed at the personal level, a practice known as double taxation. Under the TCJA, federal corporate tax rates are reduced to a 21 percent flat rate.

Subchapter S corporations and partnerships are pass-through entities whereby the owners report their pro rata portion of the income (or loss) from the entity on Schedule E of the owner’s personal tax returns. The TCJA introduced a deduction of up to 20 percent for qualified business income (QBI) earned from a business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. The QBI deduction is subject to many limitations and many restrictions, with interpretations still to be solidified during the present tax-reporting season.

As a result of the reduced 21 percent flat corporate tax rate and the QBI deduction on pass-through income and sole proprietorship income, business values are reasonably expected to increase. Although there is still much debate as to the magnitude of the effect on business values, applying lower tax rates to business valuation models will inevitably result in higher values. As an example, under the income approach, capitalization of earnings/cash flow method, the entity’s normalized cash flow is first tax impacted before a capitalization rate (which translates to a multiple) is applied. The application of a lower tax rate to the entity’s cash flows under the TCJA will result in the use of higher after-tax cash flows in the valuation model. This results in a higher value for the entity.

Attorneys may attempt to mitigate higher business values by arguing for lower entitlement percentages. However, providing the non-titled spouse with a smaller piece of a larger asset may not be the most equitable approach. Given the TCJA, business owners may likely find themselves owning a more valuable asset. That newfound “value” should not be ignored in a divorce settlement.

The TJCA presents some unknowns for what is commonly deemed to be the preferred valuation approach: the market approach. Under the market approach, the business evaluator uses transactions of privately held entities and key metrics of publicly traded companies similar to the subject company to derive multiples of various factors (multiple of earnings before interest, taxes, depreciation and amortization, multiple of revenue, multiple of sellers’ discretionary cash flow, etc.). Given the introductory stages of the TCJA, the effect of the new tax laws on valuation multiples remains to be seen. However, it seems logical that applying multiples derived from transactions that took place when less favorable tax laws were in effect would not provide an apples-to-apples comparison to the subject entity operating under current tax laws. With that in mind, business valuation experts will have to determine the most effective way to compensate for the TCJA when deriving valuation multiples.

In addition to affecting tax rates used in business valuation models, the QBI deduction can also have an impact on a spouse’s after-tax income or cash flow. The QBI deduction does not apply to taxpayers whose income is in excess of $415,000 if married filing jointly, and $207,500 for all other tax-filing statuses, and is earned from a specified service trade or business (SSTB). SSTB is defined as

any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of the owners or employees.

As can be seen, the fields offered by the statute are broad and vague. Application of the QBI deduction should be taken on a business-by-business basis.

If a spouse qualifies for the QBI deduction in 2018 and forward, the spouse will recognize an increased amount of after-tax income and cash flow. Accordingly, when determining a spouse’s after-tax income and cash flow for purposes of maintenance, spousal support, or child support, relying on the spouse’s historical tax returns does not provide an accurate proxy for future expected after-tax income and cash flow. The paying spouse’s tax accountant should be consulted to ascertain the effect of the QBI deduction.

Conclusion

The TCJA presents many challenges, obstacles, and unknowns for the array of professionals who contribute to any single matrimonial matter. In its infantile state, the TCJA is a conundrum of new law and new tax principles. Over time, interpretations will be tried and court decisions will solidify the impact of the TCJA on matrimonial law.
 

Louis Panariello is a senior associate with Klein Liebman & Gresen, LLC, with four locations in the New York, New York, area.


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