The tax reform law known as the Tax Cuts and Jobs Act (TCJA) ushered radical changes to businesses and individuals alike, with the latter experiencing a drop in tax rates and the loss of many popular tax deductions. The deduction for alimony and separate maintenance payments (collectively “alimony”) was eliminated generally for payments made pursuant to divorce or separation agreements executed or finalized after Dec. 31, 2018, so it is important to scrutinize the timing of such agreements.
Pre-TCJA Tax Considerations for Alimony
According to the pre-TCJA law under the Code Section 215(a), alimony payments were deductible by the payor. Conversely, the recipient was taxed on the payments received under Code Sections 71(a) and 61(a)(8).
Payors frequently strategize to maximize alimony payments and reduce property distributions or child support payments to their ex-spouses in order to bolster the benefit of this deduction. And because recipients often are subject to lower tax rates on their receipt of alimony payments, the tax differential between the payor and recipient effectively resulted in federal (and if applicable, state) government financing for a portion of the divorce settlement.
Alimony under the TCJA
Payments made under divorce decrees and separate maintenance orders (collectively “Orders”) entered into after Dec. 31, 2018, will be neither deductible by the payor nor taxable to the recipient. Importantly, Orders in effect prior to Jan. 1, 2019, are not affected by the law change, unless the agreement is modified after that date, and the modification expressly provides that the amendments made by the TCJA are to apply to such modification. The deduction and income dynamic under the prior law still applies prospectively to pre-2019 Orders.
Although the TJCA changes to alimony will not take effect until Jan. 1, 2019, divorcing individuals who want the pre-TJCA rules to remain in effect will need to have their “divorce or separation instrument executed” by Dec. 31, 2018. As mentioned previously, payors with high income stand to benefit from significant tax savings by maintaining the deduction under pre-TJCA law. These individuals will be most interested in preserving the pre-TCJA treatment for alimony.
Even though the highest tax rate under TCJA has decreased from 39.6 to 37 percent, the tax rate differential on alimony between the ex-spouses may not change because income tax rates for the recipients also decreased. For example, in 2017 an individual filing Head of Household with $67,500 in taxable income was subject to a blended tax rate of 15 percent. The 2018 tax rate for this individual is 12 percent. The differential between the payor’s tax rate and the recipient’s tax rate in this example actually increases (from 24.6 percent to 25 percent) under the new law.
Takeaway
TCJA grandfathered the old law for alimony, so there is no need to worry about losing the treatment for pre-TCJA agreements unless they are modified and specifically adopt the new law. But, some individuals may want to have the TJCA rules apply to their previous agreements. This could happen if the income levels of the former spouses change to a point where the rate differential is diminished. In this case, ex-spouses can modify the existing Order to expressly provide that the TJCA rules apply.
In any case, divorce agreements take time to get through the court system, so now is the time to discuss the effects of TCJA if divorcing individuals want the former law to apply. Timely executing a separation agreement is sufficient to lock in the pre-TCJA tax treatment of alimony. To learn more about the taxation of alimony and to plan for its effects under the new law, please contact your local CBIZ tax professional.
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