When you think about tools for negotiating a difficult divorce, the Internal Revenue Code probably doesn’t spring to mind. But for decades, federal tax law has made one aspect of divorce negotiations a little bit easier. That changes at the end of 2018, thanks to the Tax Cuts and Jobs Act of 2017.
Spousal Support (Alimony) Under Current Law
Currently, when one spouse in a divorcing couple agrees to or is ordered to pay spousal support (also known as spousal maintenance, or alimony) to the other spouse, the payor spouse receives a tax deduction and the recipient spouse pays income tax on the maintenance payments. This makes sense because the party who actually receives the use and benefit of the money is the one who pays income tax on those dollars. But, that’s not the only advantage.
While spousal maintenance is often a hotly contested issue in divorce cases, the current tax structure makes it a bit easier to negotiate. One of the key difficulties in most divorce cases is the fact that the parties are required to establish two separate lives and households using the same resources that previously supported one. That often means a decline in standard of living for both parties. The current tax structure actually helps those dollars go further.
The Current Tax Structure Can Help Alleviate the Strain of Splitting Resources
Spousal maintenance is intended to supplement a spouse whose earning capacity is significantly lower or who, for other reasons, may have difficulty maintaining a fair standard of living for himself or herself. Therefore, it follows that the party paying maintenance typically has significantly higher income than the recipient spouse. When the tax liability for the support payment shifts from the higher-earning spouse to the lower-earning spouse, the tax rate applied to those funds generally drops significantly. That means the spousal support dollars are literally worth more to the recipient spouse than they cost the payor spouse.
That’s a bit complicated in the abstract, so let’s look at how it might play out for a hypothetical divorcing couple.
John has taxable income of $95,000/year and has been the primary breadwinner in the household. Mary works part-time from home while caring for two pre-school children, and has $10,000/year in taxable income.
Under the Illinois spousal maintenance guidelines, John might agree or be ordered to pay Mary $26,500 annually in spousal maintenance. (Exact numbers will vary dependent on other factors.)
John’s taxable income places him in the 28% income tax bracket, while Mary’s places her in the 15% bracket. That means that the $26,500 John pays out would have been worth $19,080 to him post-tax. But, the additional $26,500 isn’t enough to push Mary out of the 15% bracket. So, she gets to keep $22,525 of those dollars.
Purely through the shifting of the tax obligation, the amount of net income that has to stretch to support these two households increased by $3,445.
The difference in tax liability (and, thus, net income) may be even more significant when the breadwinner is a higher earner and/or the lower-earning spouse has little or no independent income.
Changes Under the Trump Tax Plan
The Tax Cuts and Jobs Act of 2017 flips the tax burden for spousal support, shifting tax liability back to the paying spouse. Under the new law, John’s tax rate would drop slightly (to 24%), but he’d be paying taxes on an additional $26,500, and that $26,500 would be taxed at his rate rather than Mary’s significantly lower rate.
<h3>Who is Affected by the Spousal Maintenance Tax Change?</h3>
The new law won’t affect the tax treatment of existing orders, or those entered in 2018. In other words, there will be no impact for those already divorced, and no alternative for those whose divorce decrees are entered on or after January 1, 2019.
Those with pending divorce cases or who are on the verge of filing for divorce, however, fall into a short window in which the upcoming change in tax treatment of alimony payments may factor into strategy and negotiations. Ensuring that the divorce case is wrapped up and the order entered before the end of 2018 will shift the tax burden for any spousal maintenance payments to the recipient. Delaying until the start of the new year will mean the payor spouse bears the tax liability.
Who Benefits from Delay?
At first glance, it might seem that every paying spouse would want to get the divorce case wrapped up quickly, to avoid tax liability, and every recipient spouse would want to delay until 2019 to ensure that he or she received maintenance payments tax free. However, the analysis is actually much more complex.
First, there’s the issue illustrated in the example above: when the lower-earning spouse is responsible for the taxes, the tax burden is lower, leaving more money to go around.
Second, negotiating spousal maintenance may become more difficult and contentious when the paying spouse knows that he or she will be paying taxes on earned income that’s routed directly to the other spouse. The impact of this change may also spill over into other areas of negotiation, such as which parent claims minor children as dependents on their tax returns.
Finally, and perhaps most significantly, the new tax law leaves the future of spousal maintenance calculations unclear. While Illinois and most other states have formulas or guidelines for determining the appropriate amount and duration of any spousal support order, those calculations are predicated in part on the present tax-shifting system. It remains to be seen whether and to what degree the guidelines will be adjusted in light of the changes to the Internal Revenue Code, or how judges may factor the new tax law into their spousal support orders.
Talk to an Experienced Divorce Lawyer about Spousal Maintenance
If you are considering divorce and there is a significant income disparity between you and your spouse, or one spouse has special needs or limited earning capacity that may affect the need for spousal maintenance, it is in your best interests to talk to a seasoned divorce lawyer as soon as possible. Ignoring or trying to predict the impact the new tax law could have on your case could be costly.