Now that alimony is no longer tax deductible, family law professionals have to find new tax planning techniques to settle cases.
By Michelle Gallagher, Financial and Valuation Expert
One of the most impactful changes of the Tax Cuts & Jobs Act (TCJA) was the change to the tax treatment of alimony. Under prior law, alimony and separate maintenance payments were deductible by the payer and includable in income by the recipient. Taking advantage of the tax rate differences between the divorcing parties was a common technique in settling cases because the higher-earning spouse was receiving a tax benefit proportional to the amount paid to the lower-earning spouse. Plus, knowing alimony payments were going to be tax deductible was often considered a psychological “win” by the paying party, making it more palatable to accept. With the new law now in place, family law professionals are having to find new ways to settle cases using other tax planning techniques.
Here are six key takeaways on the TCJA and alimony.
1. The Changes Apply to Federal Law – Not State Law
The alimony changes under the TCJA were made to IRC Section 71, which are federal tax provisions; not state. Many states, however, begin their determination of taxable income with federal taxable income. It will be interesting to see whether the states will adjust for alimony. New York, for example, has already announced that it will operate as before, where alimony is taxable and deductible. Some states that have decoupled and exclude alimony from taxable income are New Hampshire, Pennsylvania, and Tennessee. Keep an eye on your state rules as they may be changing too!
2. The TCJA Only Impacts Agreements Entered After December 31, 2018
Some people think that all alimony from here on out is not deductible and not includable, but that is incorrect. It only applies to divorce or separation agreements executed after December 31, 2018.
3. Modifications Matter
If a divorce or separation agreement was executed prior to 12/31/2018 and modifications are made later, TCJA will not apply unless the agreement specifically states that it will apply. Attorneys need to be especially careful when drafting any modification agreement. Many are recommending that modification agreements specifically state whether TCJA will or will not apply and whether alimony will be taxable or nontaxable. Make sure modification agreements are clear!
4. Transfer Retirement Accounts at Pretax Values Instead of Paying Alimony
One technique being used in 2019 in place of tax deductible/includable alimony is the creative splitting of retirement accounts. The recipient will pay taxes on distributions when received, and other post-tax assets can be allocated to the other spouse to offset. If the recipient is under 59 1⁄2, there are still ways to receive the distributions without being subject to the 10% early withdrawal penalties. A QDRO can be used with qualified retirement accounts and IRA accounts can be annuitized under IRC 72(t).
For business owners, there are opportunities to replenish retirement plan assets that were unequally distributed to the recipient and when doing that, the business would presumably get a tax deduction for those contributions. Aggressive contribution plans like cash balance plans are a popular choice to replenish retirement funds that were transferred with the divorce on a more accelerated basis.
5. Business Owners: Assign Nonvoting Ownership or Interest Only in an Entity in Lieu of Alimony
This one can be tricky and may require changes to company agreements, but if done properly, can be a very viable solution. It’s also important to be careful that the business’s operations don’t suffer if certain payments are required to be made. The parties will need advice from their tax professionals to determine how best to structure payments for the best tax advantages. Depending on the entity type, the form of payment may need to be distributions or dividends, and if services could be provided by the ex-spouse, wages could even be paid, making the payments tax deductible.
6. Anticipate Future Tax Changes in the Agreement
Although the TCJA change to the alimony rules is permanent, you never know what changes may lie ahead when it comes to taxes. It would be prudent to add provisions for tax law changes in an alimony agreement so if the tax law changes, the agreement can be revisited. Be specific about what can be modified. If there is a change in tax law that only alimony or support can be adjusted, you can’t just modify anything in the agreement.
Michelle Gallagher (CPA/ABV/CFF) is a nationally-recognized business valuation expert. In addition to serving clients with valuation for tax and other matters, she leads Adamy Valuation’s family law practice. Her extensive experience includes serving as a trusted consultant, expert witness, mediator, and court-appointed expert. www.adamyvaluation.com
Learn more about this topic at the AAML/BVR National Divorce Conference, May 8-10, 2019 www.bvresources.com/events/national-divorce-conference-2019
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