The U.S. House of Representatives passed the “Tax Cuts and Jobs Act”, its version of tax reform, on Nov. 16. The bill, if signed, would eliminate the deduction for alimony obligations entered into after Dec. 31, 2017. The Senate’s tax reform plan, which appears to be on its way to debate and a vote on the Senate floor, currently retains the alimony deduction. The House and Senate will have to work out these differences to enact tax reform.
Current Alimony Tax Law and Proposed Changes
Under current Federal tax law, alimony can be structured so that it is deductible by the payer spouse and taxable to the recipient spouse. This can achieve significant overall tax savings because the payer spouse is typically in a significantly higher marginal income tax bracket than the recipient spouse. The deduction allows a divorced couple to “shift” taxable income to a lower tax bracket.
For example, if an ex-husband is in a 40 percent marginal tax bracket and pays his ex-wife $6,000 per month in alimony, the obligation actually costs him only $3,600 per month because of the deduction for alimony paid. On the other hand, the ex-wife (who we will assume pays a 15 percent effective tax rate) will pay taxes on the alimony and receive a net after-tax benefit of $5,100. Because of the alimony deduction (and associated rate-shifting opportunity), the ex-husband pays $3,600 out-of-pocket and the ex-wife receives $5,100 net of taxes. The $1,500 difference between the “cost” to the payer and the benefit to the recipient is effectively a government subsidy. Using this example, the loss of the alimony deduction and the subsidy which arises from it would result in either the payer paying more, the recipient receiving less, or, perhaps most likely, some combination of the two.
Additionally, the alimony deduction is an “above-the-line deduction” – meaning that the payer spouse does not have to itemize his or her deductions to take advantage of the tax benefit. Above-the-line deductions are particularly valuable for those in the middle class, who might not be able to take itemized deductions because of their reliance on the standard deduction.
If the proposed House change becomes law, affected Mississippians will also lose the deduction for their state income tax, too. Mississippi state tax law follows the federal law.
Importantly, the proposed law would preserve the deduction for those with alimony obligations in place on or before Dec. 31, 2017, assuming such obligations otherwise qualify as deductible alimony. An in-depth discussion of the current requirements for deductible alimony is beyond the scope of this article, but very generally, alimony payments must meet the following criteria to be deductible: (i) the payment must be in cash; (ii) the payment must be pursuant to a divorce or separation instrument; (iii) the instrument must not elect for the alimony to not be deductible; (iv) legally separated spouses cannot live together; and (v) the payer’s obligation must end no later than the death of the payee spouse.
Summary of Possible Changes & Ramifications.
Alimony is awarded in two distinct ways. The parties can agree to an amount of alimony (and to the other financial terms of the divorce), or, if no agreement can be reached, the court will decide the financial terms of the divorce, including whether alimony will be awarded.
The proposed elimination of the alimony deduction, if it becomes law, will have a profound effect on future divorce settlements and judgments. Deductible alimony has been a long-standing tool when the parties’ incomes are disparate. If the tax advantage of paying alimony is eliminated, the payer spouse may be less likely to voluntarily agree to pay alimony. Even if a spouse agrees to pay alimony, the payer will have less after-tax dollars to do so.
Parties also often negotiate alimony in lieu of increased property settlements (which are generally tax-free). For example, divorcing spouses may agree that high-earning spouse will pay more alimony in exchange for a reduced share of the marital estate. The loss of the tax benefits of this arrangement may make these types of settlements less likely.
If the parties cannot agree on a financial settlement, a court would also consider the tax effect of alimony when deciding whether to award alimony, and in what form and amount. If the deduction is eliminated, it is likely that awards will be reduced because of the loss of the tax benefits of income shifting.
This change isn’t final yet. Although the House bill would repeal the alimony deduction, the Senate tax reform proposal would retain it. However, for those currently in the process of obtaining a divorce, now may be the time to conclude a divorce agreement in the event this valuable tax benefit is eliminated.
CLARKE C. LUKE is a tax attorney at Watkins & Eager PLLC. SUSAN L. STEFFEY is a member of Watkins & Eager’s Domestic Relations & Family Law practice group. WE Law is a continuing legal series written exclusively for the Mississippi Business Journal by lawyers of Watkins & Eager PLLC. Additional information is available at www.watkinseager.com.
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