Understanding the Tax Treatment of Alimony

The Tax Cuts and Jobs Act of 2017 represented the most significant overhaul of federal tax law in over thirty years. The tax law changes were sweeping in reach, and divorce situations were not immune from their influence. 

Prior to the enactment of the 2017 tax law, spousal support payments that qualified as alimony were characterized as taxable income to the recipient and deductible by the payer. Today, alimony payments made pursuant to a divorce instrument finalized (or modified) after December 31, 2018 are no longer treated as taxable income to the recipient, and alimony payments cannot be deductible by the payer. The federal income tax treatment of alimony payments made pursuant to a divorce instrument finalized prior to January 1, 2019, are grandfathered under the rules of the prior law. 

Unlike many of the changes in the individual income tax provisions of the federal tax law which are set to sunset at the end of 2025, the change in federal income tax treatment of alimony is permanent, absent future legislative change.

In addition to potentially changing the manner in which property settlement agreements are reached by divorcing spouses and their advisors, the net effect of this change in the tax law is that the de facto shifting of tax brackets (i.e., lower income taxes paid) will no longer occur. Beginning with divorces finalized (or modified) on or after January 1, 2019, the presumed higher tax-bracket spouse loses an often significant deduction, and cannot shift a portion of his or her income tax burden to the presumed lower tax-bracket spouse.

Additional considerations

Other changes in the federal tax law may also have an impact in divorce matters and may be worth considering, either prospectively or if former spouses decide to revisit a divorce agreement already in place:

• Personal exemption has been eliminated: Before 2018, the exemption per child could only be taken by one parent. The current law eliminates personal exemptions for dependents after 2017, until the provision sunsets after 2025. If this tax benefit was part of a settlement agreement negotiated before the benefit was eliminated, impacted taxpayers should consider the effect of its elimination.
• Limitations on/elimination of deductions (such as professional advisor fees): The professional fees paid during the course of a divorce can be substantial. The inability to deduct such fees should be factored in by divorcing parties as they negotiate the property settlement agreement.
• Decreased corporate tax rates: The lowering of federal income tax rates applicable to corporations could result in higher business valuations for closely held businesses, which are often a component of property settlement agreements. The higher the percentage of a divorcing couple’s net worth that is represented by less liquid and harder to split business interests, the greater the strain on the more liquid assets.
• Education expenses: The current tax law allows for distributions from 529 Plans to be used for qualified education expenses, not only for college, but also for tuition expenses for elementary, middle, and high school (up to $10,000 per year). Divorce instruments often address responsibility for maintaining assets for payment of education expenses.  Agreements already in effect may need to be re-examined to be sure that both parents are aligned as to funding and purposes of, and distributions from, these established education accounts.
• Child tax credit: The annual child tax credit, which is typically available to the custodial parent, increased from $1,000 to $2,000. Existing divorce instruments should be reviewed to determine if the current tax law merits consideration of possible modification.

Divorcing spouses and their advisors should be aware how the current tax law may impact divorce settlements moving forward.  Further, taxpayers should review with their advisors any existing pre-nuptial, post-nuptial, and property settlement agreements, or other marital or divorce agreements, to understand the impact of today’s taxes and to also consider whether possible modification is desirable and appropriate.

Please visit our visit our Matrimonial and Divorce Advisory Solutions resource page for more timely divorce planning content.

Source: www.irs.gov.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.