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A race to divorce? New federal tax law creates complications for some couples

The massive new tax law passed by Congress contains a potentially nasty surprise for divorcing couples that could set off a race to get separation agreements finalized by the end of the year.

Under current law, alimony payments count as a tax deduction for the ex-spouse making the payment. That deduction will go away for payments pursuant to instruments executed after Dec. 31, while those executed before that date will be grandfathered in under the current law and will keep the deduction.

Receipts of alimony payments, meanwhile, will no longer be counted as taxable income for the receiving spouse. The net effect for most divorcing spouses will be negative, however—the ex-spouse making the payments has, almost by definition, a higher income than the receiving spouse, which means that his or her marginal income is taxed at a higher rate than is the receiving spouse’s. The current tax deduction, in effect, provides a subsidy that allows alimony payments to stretch significantly further by transferring dollars to the spouse whose income is taxed at a lower rate.

That subsidy will disappear after this year, which will likely reduce the amount that paying spouses are able to pay in alimony. Even though the receipts will no longer be taxable income, receiving spouses are in most cases likely to end up with less money after taxes, which means that both parties will have an incentive to get an agreement hammered out before the year’s end to take advantage of the current, more favorable, tax treatment.

Richard Livingston, a CPA with Dixon Hughes Goodman in Charleston, South Carolina, said that as he reads the law, separating couples who enter into a voluntary agreement and sign it this year should qualify for the advantageous treatment provided under current law.

“It doesn’t say ‘approved by the court,’ or anything of that nature,” Livingston said. “So my thought is if it’s signed and entered into before Jan. 1, 2019, but it’s not put on the record until after that, it’s still ‘executed’ before that date.”

Livingston said he expects to see a rush of couples trying to settle their cases this year, especially as the deadline gets closer. He said that the same thing happened, to some extent, at the end of 2017. Early drafts of the tax law included the same provisions regarding alimony, but they were initially scheduled to take effect on Jan. 1 of this year, providing a spur for couples concerned about losing the deduction. That rush will likely be even more pronounced this year, now that the tax change is a done deal.

“It’s really going to sink in and people are going to want to get their separation agreement signed before the end of the year in order to take advantage of the deduction,” Livingston said.

Although the federal tax law does not change the way that child support payments are treated for tax purposes, the change regarding alimony payments may nevertheless impact the way child support obligations are calculated in South Carolina. Under the state’s guidelines, obligations are calculated in part by looking at the receiving parent’s gross income, not their after-tax income.

Under current law, a high-earning spouse paying alimony may, in effect, only be paying 72 cents for every dollar of alimony, once the tax deduction is accounted for. Once that deduction disappears, contributing spouses will likely end up negotiating smaller payments in raw dollars, which means that receiving spouses will book a big hit in their gross (before tax) income. As a result, the receiving spouse will be considered to have a higher level of need, and thus child support payments would likely have to rise to compensate, Livingston said.

Because of the ramifications for child support and the more favorable tax treatment for alimony income, some commentators have speculated that the pending change might create conflicting incentives—paying spouses might be motivated to finish the process quickly, while receiving spouses might be inclined to drag out the process. But Dave Holm, an attorney in Raleigh, North Carolina, who is the chair of the North Carolina Bar Association’s family law section, doesn’t see it that way. He thinks both sides have an inducement to get an agreement in under the wire.

“Certainly if I were representing the receiving spouse, I would still want to get it approved this year because there’s less money to go around next year,” Holm said. “So the incentive for everybody is to get it done by the end of the year. There’s more money to go around in 2018 than in 2019 for people who are separated with alimony.”

Livingston and Holm both noted that the massive tax law contains a number of provisions that will impact divorcing couples, particularly those who have dependent children. The law eliminates the personal exemption for claimed dependents (until 2025) but it also significantly expands the Child Tax Credit (until 2025). For higher income couples, the two changes will likely be a wash, but the new rules may have implications for divorcing couples with dependent children.

The end of the tax deduction will also affect trial preparation for the minority of alimony cases that go to trial, Holm said. Currently, it’s typical for a CPA to testify as an expert witness about the tax effects of alimony. That will largely be obviated once the new law takes effect. Trying an alimony case will thus become easier and less expensive, although the value of the tax deduction more than compensated for those expenses, Holm said.

“I think it’s tough on families that are going through tough times already. When you go from living under one roof to living under two roofs, it’s tough to make that work, and the alimony tax situation helped a little bit, but now I think it’s harder,” Holm said. “Usually both lifestyles are going to take a hit. It’s just made it that much harder, I think, to get through a divorce for people with alimony claims.”

Follow David Donovan on Twitter @NCLWDonovan

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