January 20, 2018
Editor’s Note: President Trump signed the Tax Reform bill into law on Dec. 22, 2017, which was after this column went to press.
A new piece of legislation has been introduced in Congress that, if passed, will have major implications on divorce settlements throughout the country as well as Tennessee. Tennessee family law practitioners should be aware of the proposals in this bill and this article attempts to give the lay of the land if the legislation should pass through both houses of Congress in the near future.
The United States Internal Revenue Code currently provides that a party who pays alimony may treat the alimony amount as a deduction from their federal tax return. Corresponding with that deduction, parties receiving alimony, or maintenance, from a former spouse currently must declare the money received as income on their individual return. This format seems to be in keeping with the standard methodology throughout the tax code that money received by a party is deemed to be income and payment by a party of an expense shall be eligible to be deducted from that party’s return as a legitimate expense.
In December, the House of Representatives introduced the “Tax Cuts and Jobs Act” as Bill number H.R. 1. Within the bill, amendments to the Internal Revenue Code (IRC) of 1986 were attached and, under Section 1309 of the bill, there is a subsection titled “Repeal of Deduction for Alimony Payments.” While it appears that this change could lead to more revenue, it is not clear at this time how much, if any, impact that this change will make from a revenue collection standpoint. The Joint Committee on Taxation’s published a description of the changes adopted in the bill, in reference to these amendments, offers the explanation that: “Under the proposal, alimony and separate maintenance payments are not deductible by the payor spouse. The proposal repeals sections 61(a)(8) and 71 of the Code. These sections specify that alimony and separate maintenance payments are included in income. Thus, the intent of the proposal is to follow the rule of the Supreme Court’s holding in Gould v. Gould 245 U.S. 151 (1917), in which the Court held that such payments are not income to the recipient.” A more credible reason for the changes might be that they are projected to generate more than $8 billion in additional tax revenue over the next 10 years.
More critically from a family law attorney’s perspective, this alteration of the existing law will have several major repercussions. Clearly, future divorce settlements must consider the effect of the elimination of the alimony deduction more carefully during the negotiating process. Considering that under the current tax code, payors in the highest bracket pay 39.6 percent, an elimination of the deduction for alimony effective means that an alimony award will “cost” the payor almost 40 percent more by requiring that he or she use post-tax dollars to make these payments rather than pre-tax dollars. Secondly, on the receiving end of support payments, a person getting alimony will now have additional money that is effectively tax-free since it will no longer be considered income for federal taxation purposes. Lastly, the most recent previous overhaul of the tax code took place in 1986 and, based on the cited treatment of alimony payments, family law attorneys have structured their settlements going back decades with the current taxation environment in mind.
Negotiations in a divorce settlement have many dimensions and, frequently, individual items in a marital dissolution agreement are not negotiated in a vacuum without considering any other issues. It is easy to see how negotiations regarding settlement in alimony cases can be greatly complicated by the issues presented if these changes to the tax code become law. To take the first two issues in conjunction with one another, an example, albeit a simplistic one, will be beneficial. If a case is considered to be appropriate for alimony and the award would be $3,000 per month to the receiving spouse and the payor spouse has income of $500,000 per year placing him or her in the highest federal income tax bracket, the requirement that the payor pay tax on the $36,000 of alimony per year prior to paying it to the receiving spouse would result in an additional tax liability of more than $14,000 per year.
On the other end of the equation, if the receiving spouse pays in the 33 percent tax bracket, prior to this amendment to the law they would end up paying $12,000 in federal income taxes for the alimony they received. Changing the definition of income under the code to exclude alimony payments would save the receiving spouse $12,000 per year. Combining these two results would create a net income difference of more than $26,000 between the parties as compared to the result prior to the amendment to the code, an amount that would not be insignificant even for the relatively wealthy clients in the example.
Settlements that contemplate alimony may well begin to reflect this change to the detriment of the receiving spouse as attorneys negotiating for the payor spouse argue that the payor spouse’s liability has changed significantly under the new code and this should be somehow offset in another area of the overall divorce settlement.
Another, perhaps more important question is, how will this change affect pre-existing alimony awards and commitments that may date back decades. This question, however, is one that was thoroughly contemplated by the drafters of the amendment and one that is easily answered by the language in the proposed. The legislation provides that the effective date of the amendment “shall apply to — (1) any divorce or separation instrument (as defined in section 71(b)(2) of the Internal Revenue Code of 1986 as in effect before the date of the enforcement of this Act) executed after Dec. 31, 2018, and (2) any divorce or separation instrument (as so defined) executed on or before such date and modified after such date if the modification expressly provides that the amendments made by this section apply to such modifications.”
Pre-existing settlements, and any settlements that are finalized prior to the end of the 2018 calendar year, are exempted from the modifications, protecting alimony awards and their current tax status. The slightly longer than 12-month delay in implementation of the new modifications will give practitioners time to plan accordingly with the new code in mind.
As every reader will know, the climate for passing legislation in Washington is very uncertain. On Nov. 16, 2017, the House of Representatives passed the larger bill containing the amendments to Sections 71 and 215 of the Internal Revenue Code discussed above. The Senate has also passed its own version of the tax reform bill passed by the House and, after conference was held, and as this article went to press, a compromise bill was set to be voted on before the end of 2017. However, all of the versions of the tax reform plan, from both House and Senate, retained the revision to the treatment of alimony and family law practitioners should be clear on the sea change that has been enacted.
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