On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act, Public Law 115-97 (“the Act”). Among the changes to the tax code made by the Act were significant changes to the deductions available to taxpayers. For divorcing taxpayers and those divorcing in the future, a significant change was the repeal of the deduction for payment of spousal support for orders and agreements after December 31, 2018. As discussed below, this is a major sea change for divorcing couples and will result in less money for the now-divided family.
Tax Treatment of Spousal Support Under Current Law
Currently, unless divorcing spouses agree otherwise, alimony or spousal support paid from one spouse to another pursuant to a marital agreement or court order is deductible from the income of the paying spouse and taxable as ordinary income to the receiving spouse. In almost all cases, the payor spouse is in a higher tax bracket than the receiving spouse, so the result of shifting income from one to the other is a reduction in the amount of taxes paid on the amount of the alimony.
An example illustrates the point. Assume that ex-husband pays $10,000 per month in spousal support and is in the 35% tax bracket. Ex-wife makes little earned income and even with the spousal support is in the 24% bracket. If the alimony were taxed as income to ex-husband, the tax on $10,000 would be $3,500 each month. When taxed at ex-wife’s rate, the tax on $10,000 per month is $2,400 per month. The difference is $1,100 per month or $13,200 (this example assumes that the alimony deduction does not reduce the payor’s tax rate. If that happens, then tax effect includes not only the deduction of the spousal support but also the difference in rates for the remainder of the payor spouse’s income).
Where does that money go? It goes to the family in some fashion. Very rarely is it possible for a family that is primarily dependent on one high wage earner to go from one household to two and not have a reduction in the lifestyle for one or both of the post-divorce households. When alimony is deductible, it softens this blow somewhat because, as shown above, by shifting $120,000 of income from the payor spouse to the receiving spouse, an additional $13,200 per year becomes available to the family.
After 2018, The IRS Gets More Money
If the couple in our example above do not divorce until after December 31, 2018, the $13,200 goes to the IRS, effectively reducing the financial pie that can be divided between the parties, whether by agreement or by court order. The payor spouse has to pay the taxes, meaning that less money is available to pay to the receiving spouse in the form of alimony. Who will ultimately suffer the financial burden depends on the parties’ agreement or on the court’s decision. For many divorcing spouses, a couple hundred dollars a month makes a huge difference.
How to Deal with the Change in Negotiation or Trial
Just as the Act results in a sea change on the deductibility of alimony, it will also result in a sea change in how spousal support is negotiated and presented to the trial court in a divorce case. On a frequent basis under the current scheme where spousal support is deductible, counsel for the receiving spouse will present evidence of their client’s need for financial support to maintain the lifestyle established during the marriage, and will then demonstrate (to the other side or to the court) that to actually receive that amount, the needed amount has to be “grossed up” to account for taxes.
Usually, the receiving spouse’s representative will go further and also demonstrate the “savings” to the payor spouse to convince the payor spouse or the court that the impact of paying, to use the example above, $10,000 a month in spousal support is actually less for the payor spouse. In the case of the example above, the actual cost to the payor spouse is $7,500 since they would have to pay $3,500 in taxes on the $10,000 if they did not pay the alimony. Under this example, the payor spouse pays $7,500 net and the receiving spouse receives $8,600 net.
After December 31, 2018, the representative for the payor spouse will want to convince the other spouse or the court that their client simply cannot afford to pay the requested amount of spousal support because the alimony is not deductible and to pay the requested amount in after tax dollars is simply not possible if the payor is to maintain their other financial obligations.
Going back again to our example, when alimony is deductible, paying $10,000 per month “costs” the payor $7,500 while the receiving spouse receives $8,600. When alimony is no longer deductible, for a payor spouse in the 35% tax bracket to pay $8,600 per month will “cost” the payor $13,231 [$13,231 X .35 = $4,630.85. $13,231 – 4,630.85 = $8,600.14]. So, for the receiving spouse to obtain the same benefit will cost the paying spouse $3,231 more income each month or $38,772 per year.
These examples ignore state income taxes. If, as many states do, the state income tax begins with federal adjusted gross income, the effect of repealing deductibility of spousal support is even greater.
If possible, couples proceeding through divorce should try to resolve spousal support prior to the end of this year. For agreements and decrees entered prior to December 31, 2018, the deductibility of spousal support will be grandfathered in and remain deductible for the foreseeable future.