If you still don’t fully understand all the changes brought about by the new tax law, you’re not alone. The Tax Cuts and Jobs Act of 2017 made significant amendments to the Internal Revenue Code of 1986, and many of these amendments have a direct impact on financial issues commonly addressed in a divorce.
1. Many Changes Have Already Taken Effect
Many of the changes took effect on January 1, 2018. Take the time to understand these changes moving forward or consult with someone who does.
2. The Changes Are Temporary
All of the changes that affect parties in a family law matter are set to expire after 2025. Depending on how a future Congress handles the changes, we may be revisiting many of these issues in eight years. Thus, it is important to draft an agreement with some flexibility around the issues identified in this list.
3. Elimination of Alimony Income and Deduction
The elimination of the taxability and deductibility of alimony only applies to divorce or separation instruments entered into after December 31, 2018, and modifications to existing divorce or separation instruments entered into on or before December 31, 2018, if the modification “expressly provides that the amendments apply to such modification.” This means that subsequent modifications to existing agreements entered into on or before December 31, 2018, will not automatically be subject to the new tax rules, unless specific language is included in the modified agreement opting into the new tax rules. All amended agreements should, therefore, be read with care to ensure language of this type does not get included and fundamentally change the tax benefits anticipated under the agreement. Still confused? The following examples should provide a better understanding:
Entered into before December 31, 2018: Alimony can be taxable to recipient and deductible to the payor.
Entered into before December 31, 2018 and modified after December 31, 2018: Alimony can continue to be taxable to recipient and deductible to the payor provide that 1.) the amended agreement does not state otherwise or 2.) the amended agreement does not include language expressly stating that the tax law amendments under Tax Cuts and Jobs Act of 2017 apply to the amended agreement. (The act of simply modifying the agreement after December 31, 2018, does not automatically trigger the new tax rules.)
Entered into after December 31, 2018: Alimony will not be taxable to the recipient and will not be deductible to the payor.
Entered into after December 31, 2018, and modified after December 31, 2018: Alimony will not be taxable to recipient and will not be deductible to the payor.
A key aspect in applying this change, especially as 2018 comes to a close, is understanding how the tax code defines “divorce or separation instruments.” This definition is found in Internal Revenue Code Section 71, which defines a divorce or separation instruments as
i. A decree of divorce or separate maintenance or written instrument incident to such a decree,
ii. A written separation agreement, or
iii. A decree (not already described above) requiring a spouse to make payments for the support or maintenance of the other spouse.
There is no requirement for an agreement to be put on the record before 12:59 p.m. on December 31, 2018, for alimony to continue to be deductible, only that such agreement is entered into by that time.
Since we don’t know if this new rule may change eight years from now, it is important to consider language in today’s agreements that address future changes to the tax treatment of alimony to ensure neither the payor nor recipient experiences an unexpected burden or benefit.
4. Will Inherently Increase Child Support Obligations
The current child support guidelines base support on the gross income of each party. Beginning in 2019, there will no longer be a need to “gross up” alimony payments for income tax considerations. If alimony is paid and considered taxable to a recipient, a $5,000 per month payment may net the recipient $4,000 in spendable cash. If this payment is no longer taxable, then a payment of $4,000 per month in alimony will provide the recipient with the same amount of spendable cash. Even though the recipient may end up with the same amount of spendable cash, using the lower net alimony figure of $4,000 in the calculation of child support will inherently result in a higher support obligation for the paying party.
For example, assume a shared custody arrangement (183 nights with mother and 182 nights with father) involving one child where the paying spouse earns $15,000 per month and is responsible for the child’s health insurance of $250 per month. The receiving spouse earns $4,000 per month and is to receive $3,500 in taxable alimony per month. The calculated child support obligation is $137 per month.
Now, assume the paying spouse is not going to get a deduction for the $3,500 alimony payment and the receiving spouse will not be taxed on the receipt of those funds. The paying spouse is likely only going to be willing to pay an amount equal to the net cash the receiving spouse would have received after considering the payment of income taxes.
Assuming this amount is $2,500 per month instead of $3,500 per month, then all things being equal, the calculated child support obligation would increase to $266 per month, even though the receiving spouse has the same amount of spendable alimony dollars available to her under both scenarios.
5. Suspension of Deductions for Personal Exemptions
In the past, parties would negotiate for the ability to claim qualifying children as dependents for deduction purposes. This deduction provided the taxpayer with a personal exemption deduction of approximately $4,000 per child (assuming the adjusted gross income did not phase out the deduction). The deduction would serve to reduce the taxpayer’s taxable income, resulting in the calculation of a lower tax liability.
Even though this deduction has been suspended, agreements involving children of an age that may still qualify for the deduction eight years from now should continue to address this deduction. Language that identifies how the deduction will be handled if the suspension of the personal exemption is not subsequently made permanent will help clients navigate this uncertainty down the road.