Alimony Before Tax Reform

Prior to the signing of the Tax Cuts and Jobs Act (the Act) on Dec. 22, 2017, alimony was deductible to the payer making the alimony payments, and was considered taxable income to the payee of the alimony payments. The relevant tax code sections were as follows:

Title 26 U.S. Code § 71 – “Gross income includes amounts received as alimony or separate maintenance payments.”

Title 26 U.S. Code § 215 – “In the case of an individual, there shall be allowed as a deduction an amount equal to the alimony or separate maintenance payments paid during such individual’s taxable year.”

The payer making the alimony payments was able to deduct the alimony payments before arriving at their adjusted gross income. The result was a reduction to their taxable income, and therefore a reduction in taxes owed. The payee of the alimony would then report the alimony as taxable income, and pay taxes on income based on the payee’s income tax rate.

Alimony After Tax Reform

Under the new law, alimony payments made by the payer will no longer be deductible and alimony payments received by the payee will no longer be taxable. This is similar to the historical (and continued) treatment of child support payments. According to Section 11051 of the Act, the effective date of the amendments which repeal the deduction of alimony payments is a follows:

  1. Any divorce or separation instrument executed after Dec. 31, 2018.
  2. Any divorce or separation instrument 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 modification.

The Impact of New Rules

The following is an illustrative example of the upcoming changes to alimony, as well as two scenarios determining alimony under the new tax laws.

Assume the payer earns a salary of $200,000 and falls within the 40 percent tax bracket, while the payee earns a salary of $50,000 and is in the 25 percent tax bracket. If alimony is awarded in the amount of $40,000 per year, this award represents 20 percent of the payer’s gross income. Under current law, the payer would be able to deduct the alimony payment of $40,000 from his/her taxable income and the payee would include the alimony payment in his/her taxable income as shown in Table 1 below.

In this example, the payer receives a tax benefit for the deductibility of the alimony payment resulting in an after-tax alimony payment of $24,000. The payee pays tax on the alimony received resulting in an after-tax payment of $30,000. This scenario, where the payer is in a higher tax bracket than the payee, presents a benefit to both parties where “Uncle Sam” essentially pays the difference in the after-tax alimony of $6,000.

Using the same assumptions as above, under the new tax laws effective Dec. 31, 2018, the after-tax alimony would change significantly. The alimony payments would no longer be deductible to the payer or taxable to the payee.

In this example under the new tax law, without changing any assumptions or the amount of annual alimony payments, the payer would pay an additional $16,000 in after-tax dollars and the payee would receive an additional $10,000 in after-tax dollars. The payee would be benefiting at the detriment of the payer based on the above.

However, there are ways to make the impact of the new law more equitable, such as adjusting alimony payments as demonstrated in the following two scenarios.

Scenario  #1 – No change in after-tax alimony to payee

Alimony payments can be adjusted so the after-tax alimony payment to the payee remain unchanged under the current and the new tax laws. In the current law as shown in Table 1 above, the payee receives alimony payments of $40,000 per year which results in $30,000 after-tax. Under the new tax laws effective Dec. 31, 2018, alimony payments will no longer be taxable to the payee. Therefore, the payee needs to receive alimony payments of $30,000 (15 percent of the payer’s annual gross income) to be unaffected by the new tax laws. Despite the reduction in alimony from $40,000 to $30,000 annually as shown in Table 3 below, this is actually a detriment to the payer due to losing the ability to deduct the alimony payments.

As shown in Table 3 above, by adjusting the alimony payments from $40,000 to $30,000, the payee has been unaffected by the change in the tax laws. However, this has come to the detriment of the payer. The after-tax payments to the payer under the current law were only $24,000 while the after-tax alimony payments under the new law are $30,000, resulting in a $6,000 annual increase to the payer. Therefore, in order to keep the after-tax alimony payments to the payee consistent, it will cost the payer an additional $6,000.

Scenario #2 – Alimony payments adjusted so both parties are impacted equally

Alimony payments can be adjusted so the after-tax alimony payments impact both parties equally. This scenario will likely result in the payer paying slightly more and the payee receiving slightly less. The goal in this scenario is for both parties to be impacted equally by the new tax laws. Under the current law as shown in Table 1 above, the after-tax payment made by the payer is $24,000 and the after-tax payment to the payee is $30,000, with the difference of $6,000 being “paid” by Uncle Sam. To adjust the after-tax payment equally for both parties, they would both split the benefit previously “paid” by the government.  Therefore, both parties would split the difference and pay an additional $3,000.

In this scenario as shown in Table 4 above, the alimony payment would be adjusted to $27,000. Alimony payments of $27,000 represent 13.5 percent of the payer’s annual gross income. This adjustment would result in an increase in the amount paid by the payer (from $24,000 to $27,000) and a decrease in the amount received by the payee (from $30,000 to $27,000).

Practice Tips for Family Law Practitioners

The new alimony laws enacted as a result of tax reform should be carefully reviewed on a case-by-case basis. The following are a few tips and considerations for individuals and family law practitioners related to alimony:

  1. The change in alimony taxation goes into effect after 2018, meaning any divorce or separation instruments finalized during the 2018 year will be grandfathered into pre-tax reform alimony taxation rules. Therefore, any individuals contemplating or currently going through a divorce may be incentivized to arrive upon a settlement agreement on or before Dec. 31, 2018.
  2. Settlement agreements executed before Jan. 1, 2019, but are legally modified in 2019 and thereafter may be subject to new alimony taxation laws if the modification specifically states the new rules are to apply.
  3. Non-modifiable alimony payments may be appealing to the payor spouse now more than ever before, as an agreement entered into prior to Dec. 31, 2018 for a non-modifiable support arrangement will secure the deductibility to the payor spouse for the term of the arrangement. However, non-modifiable alimony may be risky for certain individuals who experience or expect large fluctuations in income.
  4. Many questions need to be addressed and revisited by the Internal Revenue Service. Therefore, software programs used to calculate alimony are still being updated. Consider consulting with a tax professional to ensure alimony calculations reflect the appropriate amount of taxes.
  5. Some prenuptial and postnuptial agreements have alimony provisions that assume the current alimony taxation laws. For married couples who have a prenuptial or postnuptial agreement with alimony provisions, the agreements may need to be revisited to account for the tax law change.
  6. The alimony recapture rule has not been changed by the Act. However, for any divorce or separation instrument entered into or modified after Dec. 31, 2018, where alimony is not deductible to the payor and taxable to the payee, the alimony recapture rule becomes irrelevant.
  7. It may be advantageous for both spouses to work together to execute their divorce agreement prior to Dec. 31, 2018.  Assuming this will result in the best tax treatment, there should be more assets available for property settlement negotiations.

Due to the new tax laws, there will likely be a push to finalize divorce or separations by Dec. 31, 2018, while tax circumstances are known with some certainty. The impact of the alimony changes should be considered in conjunction with the multitude of changes reflected in the Act. You should strongly encourage your clients to consult with a tax advisor at Doeren Mayhew. We stand ready with them to assist your clients in the midst of a divorce or contemplating divorce. Contact us today!

About the Authors

Jason W. LeRoy, ASA, CVA, CFE – Shareholder, Valuation and Litigation Support Group
Theresa R. Greer, CVA, CFE – Consultant, Valuation and Litigation Support Group

Jason and Theresa specialize in preparing business valuations for litigation and non-litigation purposes, and providing expert witness testimony and marital dissolution consulting services, as well as fraud and forensic accounting services. Jason can be contacted directly at leroy@doeren.com or 248.244.3177 and Theresa can be reached at greer@doeren.com or 248.244.3078.