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Taxation has become a highly polarizing topic in the U.S. over the last three decades. The Tax Cuts and Jobs Act, or TCJA, which was signed into law in 2017, has has brought many changes to the tax code. Most of the changes are temporary and will sunset after 2025. Under TCJA, there currently seven tax brackets ranging from 10% to 37%, with rates indexed to inflation. The law has nearly doubled the standard deduction while the personal exemption was repealed. The Standard and Local Tax, or SALT, deduction, which used to be an unlimited deduction reported on Schedule A, is now limited to $10,000.
Perhaps the most significant change to the tax code made by the TCJA, was the repeal of the alimony deduction. Prior to 2018, alimony payments were deductible to the payor and includable as income to the payee for income tax purposes. Now spousal support is no longer deductible to the payor, and unlike many TCJA provisions, this particular change does not sundown at the end of 2025. The new law applies to all agreements enter into after December 31, 2018. If there's disagreement as to whether TCJA applies to modifications, the general rule is that the Settlement Agreement needs to be clear as to whether the TCJA will apply to the modification. With the loss of the deduction for alimony or inclusion of alimony, there is often the unintended consequence of making divorce settlement negotiations harder. At the very least, lawyers have to be more creative and work harder in negotiating settlements because they can’t use alimony as a way to resolve cases. Besides increased attorney fees in divorce cases, there will also be an increase in fees paid to CPAs and financial advisors.
The repeal of the alimony deduction requires amily law attorneys to be more creative when it comes to using work arounds. For example, an attorney may suggest making the spouse who would have been the recipient of spousal support under the previous deduction laws an employee at an existing family business with a compensation package that calls for a sum certain. There may also be a provision that the employee spouse cannot be fired as a means for reconciling the lost deduction. It may be necessary for the agreement to define the job and include other documents you would expect to see in a traditional employment contract like a non-compete agreement. This is sometimes used to give a job to a child rather than the payor spouse as part of the couple's agreement. It's important to note though that this type of work around can subject the business to risk including the disclosure of trade secrets and other confidential business information as well as the possibility that deferred compensation provisions may be violated.
Family law attorneys may recommend that you employ other work around options including splitting existing retirement accounts using a properly drafted QDRO or funding a deferred compensation account for one spouse. Parties with an existing business might agree to employee a child with a provision that the child cannot be fired. Whatever work around is used, it's important to draft with flexibility because although the non-deductibility of alimony is not a temporary provision that will sundown at the end of 2025, it is always possible that the tax code could be amended and the alimony deduction would come back. Parties may want to address whether the agreement will change if that occurs. Family law and tax attorneys will likely see an increase in their decree modification caseloads specific to modification work and also more clients needing attorneys to interpret decrees to address things that weren’t originally addressed. A CPA familiar with divorce taxation is a must for a work around and a financial advisor knowledgeable in family law issues may also be needed.
While TCJA doesn’t directly impact the calculation of child support, it’s provisions do affect the calculation of gross annual income and net monthly resources (i.e., wages, self-employment income, net rental income), which could have a direct and significant impact on the calculation of child support depending on your circumstances.
When you are going through a divorce, several credits could be addressed in your agreement including the child tax, the earned income credit, and adoption credits. Because credit are always better than deductions spouses tend to do a lot of fighting about who gets them. Under the old law, the child tax credit was $1000. Under the new law is $2000. Under the old law, $1000 was refundable while $1400 is refundable under the new law. Under the new law there was no non-child credit, under the new law there is a $500 non-child credit. Under the old law the phase out was about $110,000, but $400,000 under the new law. What this means is that attorneys will be seeing more use of dependent credits in settlements under the TCJA.
With the Earned Income Credit, or EIC, the child used to have to be below 18 or under 24 if enrolled in college. The EIC also required the child to reside for at least half the year with the parent claiming the credit. Attorneys used to look at who was the custodial parent, the amount of support being paid, and exceptions to the rule like support agreement or custodial parent relinquished rights, but now tax credits are in place to if you over lay this a lot the same apply to both dependency exemption and credit.
A lot of divorce decrees are silent on what happens with 529 college savings plans in the divorce. Now that Section 529 has been expanded to include payment of elementary and high school up to $10,000 a year as well as for paying off student loan debt, it’s even more important that decrees specify what happens with those plans. This is especially important since decrees drafted prior to this expansion may have obligated a spouse to pay private elementary and/or high school expenses and now there is a fight over whether the 529 plan can be used to pay those instead. A decree should also state who can request documentation on plan balances as well as what happens if a spouse should misappropriate money from that plan.
Another issue is changes in the so-called Kiddie Tax, which was created in 1986 to address taxation of investment and unearned income tax for individuals under 17 years old. Before the TCJA, unearned income over 2100 of dependent child was subject to tax at parents rate so parents with ex. business employing kid would go to cap and now get taxed, but now it is taxed at trust and estate rate. Under original draft of secure act that was altered. If you end up with a kiddie tax issue in a divorce action because top brackets for estates and trust start at 12,500—this impacts divorce because children could have to file a separate return and you’ll need cooperation of the parents to be unable to get those filed. So that may be an issue. He recently had someone adamant that they didn’t have to file returns for the kid but all three kids tripped the filing requirement so they did.
Changes in mortgage qualified residence interest also affect divorce settlements. Under the old law, In there was a $1,000,000 limit on mortgage interest paid for primary and secondary homes combined and also for home equity loans up to $100,000 for primary and secondary homes combined. Under the new the mortgage interest is limited to $750,000, which includes mortgage and Home Equity Line of Credit, or HELOC, balance. Generally, this applies to new acquisition debt incurred on or before Dec 15, 2017. In divorce, perhaps even more significant than the changes in limits is the documentation requirement. The party who retains the home and the debt must have records showing mortgage and HELOC balances as of December 15, 2017 and breakdown how funds were used (ex. to improve the residence). HELOC was repealed and that can be significantly affect divorce. In the past, a party would take out a home equity loan to pay legal fees and other settlement expenses, but under TCJA, that’s longer deductible. You can still do it, mind you, it just isn’t deductible and thus is no longer affects settlement negotiations. Attorneys must make sure there’s also a requirement for the spouse in possession to turn over those records over to the other party so they can comply if asked. This would likely be most important in the event of an audit. Keep in mind that an audit would be most likely within two years after the divorce action so the decree should require the records to be maintained so deduction can be substantiated if needed.
Before tax year 2018, we knew there were a host of itemized deductions—things you could put at the bottom of Schedule A (ex. unreimbursed employee expenses, uniforms, supplies, tax preparation fees, legal fees, unreimbursed travel, home office). However, TCJA eliminated almost all of these itemized deductions so you have an extremely gutted Schedule A, and with that gutted schedule A you can deduct certain things. This made people made because a tax consultant would plan for divorce and now you cannot get a deduction. Likewise, safe deposit to secure assets and also attorney fees to protect assets are no longer deductible. There has been some discussion as to whether some need of these itemized deductions need to come back, particularly the tax preparation fees deduction, but for the time being, these items cannot be deducted.
The four tax statuses remain the same under the TCJA—single, Head of Household, married filing jointly, and filing separately, and as was the case under the prior law, one’s tax status is still determined by their status on the last day of the year. With HOH, status is based on whether you are unmarried or considered unmarried as of last day of the year and whether you paid more than half of the cost of keeping up the home during tax year. Additionally, the qualifying individual must have lived with the person claiming HOH status for at least half of the year. The HOH tax rate is usually lower and certain credits are available provided you meet the requirements for HOH status.
One thing about married filing jointly it included deductions and credits for both parties to the marriage and has to be signed by both parties and once you sign, you are jointly and severally liable for the items on the return so one spouse could be liable for all the tax. Ex. If you have one client upset because of joint return and the IRS is coming after just one spouse. IRS now has strict rules about providing info for other taxpayers so a lot of time the client is in the blind about what’s going on with their ex, and even if the decree states who is responsible for paying, the agreement isn’t binding on the IRS, whose position is that someone needs to pay it and if it is paid by the wrong party, that’s is a civil state law matter to be dealt with in family court.
When people married filing separately, particularly in community property state, you will still need information from both taxpayers. Including a provision setting forth who is required to provide information when it is needed can be helpful, but in a lot of cases filing a separate return can lead to more tax so you have to weigh the higher tax vs. joint liability. In some cases, particularly where one spouse doesn’t have knowledge of items on the return, you may not worry about the higher tax because down the road you’ll have a business interest (Schedule C or E item) where one party doesn’t have knowledge about it and there ends up being an audit of some kind. Relief is available for innocent party, generally comes in one of three forms: innocent spouse relief, separation of liability (which can apply to divorced joint filers) and equitable relief. Each type of relief has different requirements. The issue is there’s a knowledge requirement with innocent spouse. Cases say even if spouses are both are lawyers, if one didn’t know what was going on (even if they had some notice) you can still get innocent spouse relief.
As always, if you are going to divide IRA s other retirement plans, you must have a Qualified Domestic Relations Order, or QDRO. Under the Setting Every Community up for Retirement Enhancement Act, or SECURE, there are reforms designed to make retirement easier and the funds more accessible. This includes ncreasing required minimum distribution age to 72 up from 70 ½. With senior divorce on the rise, divorce attorneys should expect to see more retirement assets carried into divorce action.