Judgments and Orders that contain provisions requiring the payment of alimony (called spousal maintenance in Minnesota) come with a caveat. The person receiving the money must declare the payment on their Federal tax return and the person paying the money gets to deduct the payments on their Federal tax return.
After reviewing tax year 2010 the IRS found that over one-half million taxpayers claimed alimony deductions totaling more than $10 billion. A lot of money.
There was however a problem. Apparently around 266,000 of the tax returns filed by the payors/recipients showed either no income being reported or the amount reported did not match the amount on the recipient’s tax return.
The IRS calculated that there was a spousal maintenance gap in excess of $2.3 billion on the 2010 returns.
The IRS does not have the resources to review tax returns involving the payment and receipt of spousal maintenance to determine who reported alimony income and payments accurately or inaccurately. So, Congress decided it was time to fix the problem.
They fixed the problem by ending the deduction for spousal maintenance on Federal tax returns.
Effective with all judgments and orders entered after December 31, 2018 the Federal deduction for making a payment of spousal maintenance ends. So too does the need to declare the payment as income. Excepted from this are modifications of pre-existing decrees or orders entered on or before December 31, 2018.
This law does not impact judgments and orders entered on or before December 31, 2018.
For those with a 2018 court proceeding involving an initial request for alimony the changes to the tax laws will provide little comfort if the parties are unable to get a decree, or order, entered prior to December 31, 2018.
More than ever, it will be important to work with lawyers and forensic accountants who understand the divorce process and can help calculate the impact of the new laws on the calculation and allocation of income between the parties using spousal maintenance as the payment vehicle.
The new tax laws have a “sunset” provision that phases out many of the tax changes after December 31, 2025. This “sunset” provision will not apply to the deductibility of spousal maintenance.
Changes that will have an impact on divorce decrees.
The new tax laws include changes to the standard deduction, intended to reduce the number of taxpayers who would need to itemize their deductions. That may or may not be financially beneficial for some divorcing spouses, where returns are being submitted as Married Filing Separately. Questions arise regarding which parent will be able to claim the children, who is able to claim Head of Household status, and who is entitled to claim the increased child tax credit.
New Minnesota child support laws go into effect August 1, 2018. All divorce decrees entered on or after that date will be required to provide a statement of how much parenting time is assigned to each parent. This is intended to allow for the calculation of child support, which will be based on actual overnights with the children, but which could also be used to address the issue of which parent is able to claim Head of Household and claim the child tax credit. This may complicate settlement negotiations as the trade-offs that once occurred, allowing parents to consider having one parent claim the children as dependents with the other parent claiming Head of Household status, are now likely in jeopardy.
In trial, attorneys will need to inform the Court regarding the cost of paying and receiving maintenance so the judicial officer can make an informed decision. The calculation of income for presentation in trial or in a hearing on spousal maintenance is made more challenging by the new tax laws.
For small business owners the first issue is how the new tax laws will impact the calculation of their Taxable Income. The new laws provide a deduction for Qualified Business Income (QBI) that is available for S corporations, partnerships and sole proprietorships. It provides a deduction of up to 20% of reported trade or business income. If one or both of the parties have QBI the impact of the new laws will need to be calculated to determine if the new laws will have an impact on the income of one or both spouses.
The cash flow or net income will need to be calculated with consideration of limits set on state and local taxes that are deductible; the tax limitations on itemized deductions for high-income taxpayers; the impact of the limits on mortgage interest and home equity debt interest; and the issue of which parent can claim Head of Household and the Child Tax Credit all of which make the calculation of income available to pay spousal maintenance more complex.
The foregoing will impact the calculation of net cash flow for both parties. There is currently no case law offering guidance on how the new tax laws will, or should, impact the payment of spousal maintenance.
Until the new tax law, a deduction for a payment of spousal maintenance typically lowered the tax rate of the payor. This was the spoonful of honey that made the medicine, i.e. payment of maintenance, go down easier. An attorney could always tell the client that they weren’t really paying $5,000 per month because the after-tax effect really resulted in an out-of-pocket payment of $3,500, or whatever the reduced amount was. This occurred because the deduction of maintenance lowered the tax rate at which the payor was taxed and provided a savings that made the pain of the payment less palpable. The tax burden for declaring the payment was on the recipient who was obligated to declare the payment as income and pay tax (excluding FICA and Medicare) on the income. The theory was that the recipient was likely in a lower tax bracket than the payor and that shifting the obligation to pay taxes to the recipient would result in a tax benefit that would result in a lower tax payment overall, allowing the parties to negotiate an increased maintenance payment. That benefit per the NSYNC song has now gone, BYE, BYE, BYE. Payors will no longer reap the benefit of lowering their tax rate when making a spousal maintenance payment and that will make spousal maintenance negotiations more challenging.
Antenuptial Agreements and the Payment of Maintenance
Many spouses may come to a divorce with an Antenuptial Agreement (a/k/a Pre-Nuptial Agreement). Those agreements may contain provisions related to the payment of alimony (spousal maintenance). Those agreements were likely drafted based on an assumption that maintenance was deductible to the Payor and included in the income of the Recipient.
The impact of the new tax laws on these agreements is unknown and there is no case law addressing how the changes to the tax laws should be interpreted and applied to contracts that were created when the laws were substantially different. No doubt the appellate courts will address any issues that arise on a case by case basis.
Can a Post-Nuptial Agreements be drafted to account for the tax law changes? Would both spouses be interested in signing such an agreement?
The impact of this new tax law on how maintenance is negotiated and paid will not be known for a while. Whether there are creative alternatives that will allow the Payor and Recipient to retain any of the benefits afforded under the prior law is unknown but unlikely.
One could keep fingers crossed that the Democrats will regain their footing in Congress and will make alimony deductible again but in my opinion the deduction is gone and will not return.
If you have clients who are involved in or contemplating a divorce it would be wise to advise them to make every effort to address and resolve the spousal maintenance issues with entry of a decree or an order on or before December 31, 2018. This is especially true for high income individuals.