Jeremy Green, MBA, CPA, ABV, CFE, CFCI, and Senior Forensic & Valuation Associate at TDT, discusses the recent federal tax law changes of alimony payments and how that impacts involved parties. Jeremy specializes in business valuations, forensic accounting and litigation support engagements, succession planning, and management consultation services.
Due to recent changes in federal tax law (The Tax Cuts and Jobs Act of 2017), alimony payments will no longer be tax deductible by the payor for income tax purposes through the year of 2025 for divorce decrees entered after December 31, 2018. Although alimony is not popular among those making the payments, there has previously been an income tax “silver lining”. Due to the progressive structure of the income tax rate schedule, where the higher your income the higher the tax rate, the payor saved more in income taxes through deductibility than the income tax cost of the alimony income to the recipient. Thus, the treasury of the government has subsidized the alimony recipient with the difference in the payor’s tax savings and the recipient’s tax cost.
What Does this Mean?
There may still be a financial benefit to the higher earning payor agreeing to make alimony payments to settle a divorce, but only before 2019. Divorce decrees in existence before 2019 will continue to enjoy the tax benefit of being “grandfathered” with continued deductibility of the alimony amount from their taxable income in future years. In other words, if the divorce does not settle until 2019 and alimony is granted, it will no longer be deductible for tax purposes.
The spouse receiving alimony may also wish to have the divorce settled before 2019. For divorce decrees beginning in 2019, alimony is no longer taxable, and the income tax “silver lining” will no longer exist. Thus, the payor, due to lack of tax deductibility, will likely not be able to afford to make as high of alimony payments as the amount that could have been paid had it still been tax deductible. The recipient will likely receive less alimony than if the divorce had concluded before 2019.
Example of the Impact
Let’s say our higher earner has taxable income of $100,000 a year and pays their ex-spouse $10,000 in alimony. Under the old law for 2018, our higher earner, a “single” filing status taxpayer, will pay taxes on $90,000 of net taxable income since the $10,000 of alimony is fully deductible for federal income tax purposes. The lower earner carries the tax burden for the alimony received by reporting it as taxable income and paying federal income tax on the amount, assuming the ex-spouse, a “head of household” filing status taxpayer, has a small amount of income from a part time job. Therefore, the total tax paid on the $10,000 alimony payment is $1,000. See the calculation below:
Higher Earner – Payor
Lower Earner – Ex-spouse Recipient
The “after tax” cost of the deductible alimony to the higher earner is $7,600 ($10,000 less $2,400) and the net alimony received by the lower earner is $9,000 ($10,000 less $1,000) with a treasury subsidy of $1,400 – a 18.4% beneficial difference to the recipient ex-spouse.
Contrasting the above with a divorce that is dated after 2018, our higher earner has $100,000 of taxable income per year but claims that, due to income taxes owed, will only agree to make alimony payments to the ex-spouse per year that equate to an out-of-pocket cost of $7,600 (the same amount as the Payor’s out-of-pocket cost of Example One above). Therefore, under the new law in effect at the time of their divorce decree, the higher earner’s taxable income would be the full $100,000 because the alimony payments are no longer deductible. Per the following analysis, the out-of-pocket cost to the payor would be $7,600. This leaves only $7,600 to pay as non-taxable alimony to the ex-spouse. See calculation below:
Higher Earner – Payor
Lower Earner – Ex-spouse Recipient
As shown, this example compares current tax law through 2018 to new tax law in 2019, the ex-spouse recipient’s disposable alimony is reduced by $1,400 ($9,000 less $7,600), a nearly 16% reduction of disposable alimony. However, since the new maximum federal income tax rate can be as high as 37% on high income individuals, the reduction of alimony percentage can be as high as 30% to the ex-spouse recipient. Essentially, the new Tax Law for 2019 shifts the tax burden from the low earner paying a lower tax rate (recipient), to the higher earner (payor) and eliminates the treasury subsidy.
Why is this Important?
The more taxes paid on the alimony payments may mean less funds available to pay other things such as increased alimony or child support. Since many recipient ex-spouses also provide a home for the children of the former marriage, the 2019 tax law change removes a tax subsidy to them often in situations where every dollar is important.
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