Since December of 2017 we have heard news reports, read articles, and heard speeches about the changes that were added to the tax code through the Tax Cuts and Jobs Act and how it would affect the average taxpayer. For divorcing couples, two of the changes with the most wide-reaching impact have been the removal of the alimony deduction and the change to the dependency exemption and child tax credit.
Elimination of Alimony Tax Deduction
Without a doubt, the biggest change to the tax code for divorcing couples is the fact that for all agreements finalized after Dec. 31, 2018, alimony is neither taxable to the recipient spouse, nor deductible by the paying spouse. This change had an immediate effect on parties considering a divorce at the end of 2018, and trying to finalize agreements both before and after the deadline. We have already seen this change impact negotiations as the amount, term, and payment schedule for alimony are now being negotiated under a new framework. Note, that for all taxpayers continuing to either pay or receive alimony under agreements entered prior to Dec. 31, 2018, the old reporting rules continue to apply, i.e., the alimony remains taxable to the recipient and deductible by the payor.
The Internal Revenue Service has explained that one of the reasons for the change has been the extreme difficulty in confirming under audit that the correct amounts of income and deductions were being reported. The paying spouse was required to include the social security number of the recipient on their tax return; however, the same requirement was not made of the recipient spouse. The IRS simply did not have the staff or resources to match the offsetting returns and ensure that the correct amounts were being reported.
Now, alimony calculations must be considered on an after-tax basis, just like child support. The paying spouse still pays taxes on all amounts paid as alimony, and the recipient spouse retains the full amount, with no tax liability. In practice, this has created more flexibility in negotiating agreements. With the elimination of the alimony deduction, the rules surrounding alimony recapture have been eliminated. The prior code regulated the amount of alimony that could be paid in the first three years following the divorce. This provision was enacted to ensure that parties were not re-characterizing property settlements as alimony in order to take advantage of large tax deductions. With that constraint no longer an issue, negotiations now can focus on creative strategies of lump sum alimony payments in order to reach an agreement.
For parties with higher annual incomes, while the monthly alimony amounts might be lower, such support awards should not disappear entirely because of the change in the tax law. While the tax burden has certainly increased to the paying spouse, the ability to pay and needs of the recipient spouse continue to be important factors. For example, for a party with an income of $600,000 per year, the approximate net after-tax monthly income is $30,000 (depending on deductions and state taxes). At this level, alimony should be part of any financial settlement.
At more modest income levels, the tax burden could have a much greater impact, particularly where child support is also being considered. For example, for a party with an income of $100,000 per year, the approximate net after-tax monthly income is $6,800. If child support is to be deducted from this monthly amount, the ability to pay alimony becomes problematic.
It remains to be seen how this change will be considered by judges in various jurisdictions. Tax considerations of financial issues have always been a complicating factor when presenting a divorce case in court. Quite often, competing financial experts with differing points of view and agendas, can make the explanation very difficult. The trial lawyer still has the burden of educating the judge about the impact of the new treatment of alimony in each unique case. It will also remain the burden of the attorney to demonstrate to the trier of fact both the need of the recipient, and the financial wherewithal of the payor. That element remains a constant in all divorce cases.
Elimination of Child Dependency Exemption
For tax purposes, the custodial parent is considered to be the parent with whom the child resides the greater number of nights during the tax year. As we are seeing equal custody arrangements more and more frequently, it is important to know that the second test is the parent with the higher adjusted gross income. The custodial parent is eligible to file as head of household rather than single for the tax year. The results of these tests could be that the “Custodial Parent” for tax purposes could be different from 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 stating which parent will claim the dependency exemption in a settlement agreement is not accurate or effective language. Instead, the real question is which parent will claim the child tax credit. The child tax credit offers up to $2,000 per child under age 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 completely disappears at $240,000. The IRS has provided guidance that the child tax credit can be released to the noncustodial parent through Form 8332 just as the dependency exemption was previously.
Another credit tied to the parent who claims the child as a dependent is the dependent care credit. This credit is available to the parent who claimed the child for the tax year, has earned income and actually paid the expenses for work-related childcare. The credit starts at 35% of the expenses up to $3,000 for one child, and $6,000 for two or more children. It is phased down to 20% of such expenses for taxpayers with an annual income over $43,000.
During the divorce process, which parent will claim the children is an important topic to consider. The best practice is to consult an accountant to determine how each individual will be affected in order to have effective settlement negotiations on this topic. As more time passes since the enactment of the most recent tax changes, it will become much more apparent how both of these changes are affecting negotiations, settlement agreements, and court decisions. We will most likely fully understand and appreciate the changes just in time for the tax law to change again!
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert “Bob” Boyd is a co-founder of Boyd Collar Nolen Tuggle & Roddenbery and a leader in family law who has received recognition from his colleagues across Georgia and the nation. He can be reached at firstname.lastname@example.org.
Beth Garrett is a partner in the Divorce Litigation Support Practice at Frazier & Deeter, primarily assisting high-net-worth individuals and corporate executives with divorce, tax, and accounting issues. She can be reached at email@example.com.