Since December 2017, we have heard news reports, read articles, and listened to speeches about the changes introduced to the tax code by the Tax Cuts and Jobs Act and how they would affect the average taxpayer. For divorcing couples, two of the changes with the most far-reaching impact were the elimination of the alimony deduction and changes to the dependent care tax credit and the child tax credit.
Abolition of the maintenance tax deduction
The biggest change in tax law for divorcing couples is undoubtedly the fact that for all contracts concluded after December 31, 2018, maintenance is neither taxable to the receiving spouse nor deductible to the paying spouse. This change had an immediate impact on parties contemplating divorce at the end of 2018 and attempting to finalize agreements both before and after the deadline. We have already seen that this change has had an impact on negotiations, as the amount, duration and payment schedule of maintenance will now be negotiated in a new framework. Note that for all taxpayers who continue to pay alimony under agreements entered into before December 31, 2018, the old reporting rules continue to apply, i.e. the alimony remains taxable for the recipient and deductible for the payer.
The Internal Revenue Service has stated that one of the reasons for the change was that it was extremely difficult to confirm during an audit that the correct amounts of income and deductions were being reported. The paying spouse was required to provide the recipient's Social Security number on their tax return; However, this requirement was not imposed on the recipient's spouse. The IRS simply did not have the staff or resources to reconcile the offsets and ensure that the correct amounts were reported.
Now, alimony calculations, like child support, must be considered on an after-tax basis. The paying spouse continues to pay taxes on any amounts paid as alimony, and the receiving spouse keeps the full amount with no tax liability. In practice, this has led to greater flexibility in negotiating agreements. With the abolition of the alimony deduction, the rules for the recovery of alimony were also abolished. The previous law regulated the amount of maintenance that could be paid in the first three years after the divorce. This provision was enacted to ensure that parties do not recharacterize property settlements as alimony in order to benefit from large tax deductions. With this limitation no longer an issue, negotiations can now focus on creative lump sum alimony strategies to reach an agreement.
For parties with higher annual incomes, the monthly maintenance amounts are likely to be lower, but the change in tax law will not completely eliminate such support payments. While the tax burden on the paying spouse has certainly increased, the receiving spouse's ability to pay and needs continue to be important factors. For example, for a party with an annual income of $600,000, the approximate net monthly income after taxes is $30,000 (subject to deductions and state taxes). At this level, maintenance should be part of any financial arrangement.
At more modest income levels, the tax burden could have a much larger impact, especially when child support is also taken into account. For example, the net monthly after-tax income for a party with an annual income of $100,000 is approximately $6,800. If child support is to be deducted from this monthly amount, the ability to pay maintenance becomes problematic.
It remains to be seen how this change will be taken into account by judges in different jurisdictions. Tax and financial issues have always been a complicating factor when presenting a divorce case in court. Oftentimes, competing financial experts with different viewpoints and goals can be very difficult to explain. The litigator still has the job of educating the judge in each individual case about the implications of the new alimony rules. It remains the duty of the lawyer to prove to the expert both the need of the recipient and the financial resources of the payer. This element remains a constant in all divorce cases.
Abolition of the exemption from child dependency
For tax purposes, the custodial parent is the parent with whom the child spends most nights during the tax year. As we see equal custody arrangements more and more often, it is important to note that the second test is the parent with the higher adjusted gross income. The custodial parent is entitled to file the tax return for the tax year as the head of the household and not as a single person. The results of these tests could be that the “custodial parent” for tax purposes could be different than the custodial parent for child support purposes as determined by state law.
The child dependency exemption is currently suspended from 2018 to 2025. This means that specifying which parent will claim the child dependency exemption in a settlement agreement is neither accurate nor effective. The real question is which parent will claim the tax credit for children. The child tax credit is up to $2,000 per child under 17 at the end of the tax year. The credit begins to phase out when a taxpayer has an adjusted gross income of $200,000 and disappears completely at $240,000. The IRS has provided guidance that the child tax credit can be released to the noncustodial parent via Form 8332, just as the dependency exemption was previously.
Another loan that is tied to the parent who considers the child to be a dependent is the care loan. This credit is available to the parent who claimed the child for the tax year, earned income and actually paid work-related child care expenses. The credit starts at 35% of expenses up to $3,000 for one child and $6,000 for two or more children. For taxpayers with annual income over $43,000, the rate will be gradually reduced to 20% of these expenses.
During the divorce process, the question of which parent claims ownership of the children is an important issue. In order to conduct effective settlement negotiations on this issue, it is advisable to consult an accountant to determine how each individual will be affected. As more time passes since the recent tax changes take effect, it will become clearer how these two changes will impact negotiations, settlement agreements and court decisions. We will most likely fully understand and appreciate the changes in time for another change to the tax law!
This column does not necessarily reflect the opinions of the Bureau of National Affairs, Inc. or its owners.
Co-founder of Boyd Collar Nolen Tuggle & Roddenbery, Robert “Bob” Boyd is a leader in family law who has received recognition from his colleagues throughout Georgia and across the country. He can be reached at bboyd@bcntrlaw.com.
Beth Garrett is a partner in the Divorce Litigation Support Practice at Frazier & Deeter, primarily assisting high net worth individuals and business leaders with divorce, tax and accounting issues. She can be reached at beth.garrett@frazierdeeter.com.
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