It removes the federal alimony tax deduction on spousal support agreements and orders finalized next year. What does this mean for those contemplating divorce or in the middle of the process? It could be an added incentive to finish the process before the end of the year.
The ex-spouse who pays alimony (spousal support in California) has traditionally been able to benefit from a tax deduction for the amount paid. On the other side, any alimony received has been taxable income to the support recipient. This scheme continues for pre-2019 divorce or separation instruments (the IRS definition includes a “divorce decree, separate maintenance decree or written separation agreement”), meaning that agreements or orders obtained in 2018 will continue to enjoy the benefit of the current tax treatment. How does the Tax Cuts and Jobs Act elimination of the deduction change the spousal support analysis?
Impact on Spousal Support Awards
The change aligns spousal support more closely with child support payments, which have always been tax neutral (neither the payor or payee reports child support on their tax return). Unlike child support, separating and divorcing couples have been able to take advantage of tax-deductible support payments, especially couples who have a significant disparity in income and, therefore, pay income tax at different rates. If the amount of tax saved by the Payor (because of the tax-deduction) is greater than the amount of tax paid by the Recipient (because the payment is taxable), this difference results in lower tax overall on the same amount of income, creating additional after-tax money to support the family. Temporary spousal support guidelines, in use in many California counties, intentionally apportion this extra money between the parties.
Commentators have argued about whether the change benefits the higher or lower income spouse. A benefit for the lower income spouse is that he or she no longer pays income tax on spousal support. The higher income spouse, on the other hand, who will no longer benefit from a tax-deduction, will likely pay less support overall because his or his income taxes will be greater.
Each situation is unique. For couples who will be in the same tax bracket (after adjusting for spousal support paid and received), there is likely to be little change in the amount of net spendable (after-tax) income from spousal support compared to a taxable/deductible support payment. However, for high-net worth families with complex financial portfolios, the financial impact of the lost tax deduction could be significant. To see whether it makes a difference in your case, it may be necessary to run two analyses under each framework to determine the best possible outcome.
The proximity of the effective date of the new law presents other problems. In order to claim the spousal support deduction in 2018, the parties cannot file a joint tax return, but must file separate tax returns. The amount of tax due depends on your tax filing status (Single, Married, Married filing Separately, Head of Household). If your marriage has not been dissolved by December 31, 2018, and if you have no dependent minors, your only option would be to file as Married Filing Separately, which is the least favorable tax rate. Filing as a single person requires that your marriage be legally dissolved on or before December 31, 2018.
Here is where it gets tricky: the courts in California are not permitted to grant a legal divorce until six months after jurisdiction has been established over both parties (i.e. a Petition for Dissolution has been filed and the other person has received formal notice of the filing). Unless the legal divorce process has been commenced before June 30, 2018, it will not be possible to obtain a termination of marital status by December 31 of this year. If one or both parties will be required to file his or her 2018 taxes as Married Filing Separately, the financial benefit of paying deductible/taxable spousal support may be significantly reduced.
If you are contemplating separation or divorce, or if you have already commenced this process, consultation with your tax professional and family law attorney can help you to better understand how this change in the law might affect you.