Family Law and Divorce Tax – Revisited
By: Kris Hallengren, CPA/ABV, CFF, ASA, MSF
The Tax Cuts & Jobs Act of 2017 (“TCJA”) was enacted on December 22, 2017 as part of the Fiscal Year 2018 Budget Reconciliation Resolution. Several provisions of the TCJA will impact individuals, including those who divorce, because it reduces or repeals individual income tax deductions and exemptions. Significantly, the TCJA repeals the deduction for alimony payments. Congress was not concerned with the effect of its legislation upon the national debt beyond 10 years, so many (but not all) of the provisions affecting individual income tax brackets and deductions will expire in 2025. Currently, House Bill 6760, which would make the tax cuts permanent, is being reviewed by the Senate’s Finance Committee.
Attorneys who practice in the area of family law should be aware of the following:
1) The TCJA contains a permanent repeal of the alimony tax deduction. It does not expire after 2025 like many other provisions of the TCJA. The repeal affects alimony that is paid under a divorce or separation instrument that is signed on or after January 1, 2019. We will refer to this as a “new law” alimony award.
2) If alimony is paid under an “instrument” (including Court Order or written agreement) signed on or before December 31, 2018, it will continue to be deductible by the payor if all requirements of IRC §71 are met. We will refer to this as an “old law” alimony award.
3) If an old law alimony award is modified, by agreement or Order, after December 31, 2018, it will continue to be governed by the “old law” (i.e., deductible by the payor and taxable to the recipient) unless both parties expressly elect to be governed by the “new law” (i.e., not deductible by payor, not taxable to the recipient).
4) After 2018, practitioners who draft alimony provisions in a Marital Settlement Agreement might consider including the following language in order to have the parties expressly acknowledge their intent that the “new law” apply to their agreement:
This Agreement has been executed subsequent to the effective date of the Tax Cuts & Jobs Act of 2017 (“TCJA”) with the mutual intent of the parties that the payments required by this Paragraph shall neither be taxable to Recipient as alimony, nor deductible as alimony by Payor. If, prior to the termination of Payor’s obligation, the alimony tax deduction is restored to its pre-TCJA status by change in law, regulation or judicial interpretation, the parties expressly agree that Payor’s payments shall continue to be non-deductible to Payor and non-taxable to Recipient as they would have been entitled to so agree under IRC §71(b)(1)(B).
(Non-) Deductibility of Attorney’s Fees
Prior to the enactment of the TCJA, a party could claim a deduction for attorney’s fees related to “tax advice.” IRC §212(3). In addition, a party could deduct fees incurred by him/her attributable to services rendered in securing an award of alimony (i.e., taxable income) pursuant to IRC §212(1). Legal fees incurred by the party who was ordered to pay (or agreed to pay) alimony were not deductible, unless they were part of “tax advice.” However, under the TCJA, Miscellaneous Itemized Deductions (IRC §67), for tax years 2018 through 2025, have been eliminated. This means there is no ability to deduct legal fees, tax preparation fees, employee business expenses, or investment advisory fees. Legal fees incurred in securing an award of alimony or collecting alimony are no longer deductible.
Although the TCJA eliminated and/or reduced the ability to claim many itemized deductions, it increased the Standard Deduction on individual tax returns for taxable years 2018 through 2025, as follows:
Standard Deduction on individual income tax returns for taxable years 2018 through 2025 (IRC §63)
- $24,000 for Joint filers (up from $12,700)
- $18,000 for Head of Household
- $12,000 for all others (up from $6,350)
Due to the increase in the amount of the standard deduction, as well as changes to the rules concerning itemized deductions, it is expected that many taxpayers who previously itemized deductions will now claim the standard deduction.
Personal Exemptions (IRC §151) and Child Tax Credit
The exemption amount was $4,050 for each dependent for 2017 tax returns. Beginning in 2018, it will be zero ($0). The personal exemption you claimed for yourself, your spouse, and each qualifying child or qualifying relative have been eliminated for tax years 2018 through 2025. On the surface, it appears that there is no longer a need to allocate the dependency exemption for a minor child in your Marital Settlement Agreement, unless the child will still be a minor in 2026 and thereafter. Yet, it is an issue that should still be addressed in settlement agreements and may impact a party’s filing status and his/her ability to claim the Child Tax Credit.
The Child Tax Credit has increased from $1,000 to $2,000 per qualifying child. And the phase-out for claiming the credit has significantly increased to $400,000 for Married Filing Jointly and $200,000 for others. The ability to claim the credit is conditioned upon the tax payer’s ability to “claim” the child as a dependent. The parent who has the child for the most overnights will be able to claim the Child Tax Credit. If the parents have an equal number of overnights (pretend it’s leap year), then the test becomes “which parent has the higher income?” So, do you need to negotiate the Dependency Exemption/Child Tax Credit?
State and Local Taxes (SALT)
Beginning with the 2018 tax year, only $10,000 ($5,000 for married filing separately) of non-business state and local taxes (SALT) may be deducted, including state and local real property taxes, personal property taxes, and state and local income taxes.
529 Plans (IRC §§529(c) and 529(e)(3)(A))
“Qualified higher education expense” now includes expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school; provided, however, the amount of cash distributions for elementary or secondary school cannot be more than $10,000 during any taxable year. The $10,000 limit for elementary and secondary school is applied on a per-student limit.
Interest Payments – Qualified Residence (IRC §163(h)(3))
Interest on home equity indebtedness is no longer deductible, even if the home equity line of credit (HELOC) already exists. The only exception to this would occur in instances where the HELOC was used in part to secure the initial home purchase and, even then, the ability to deduct home mortgage interest on “qualified acquisition indebtedness” (QAI) incurred after December 13, 2017 is subject to a cap of $750,000 of acquisition indebtedness.
The mortgage interest changes have an immediate impact on divorce cases since refinancing mortgages and HELOCs often occur in connection with divorce. For future tracking purposes, the party retaining the home and related debt(s) needs to obtain certain mortgage records. The party must identify all mortgage and HELOC balances as of 12/15/2017 and breakdown by QAI mortgage balances, QAI HELOC balances (i.e., funds used to build, buy, or remodel the home securing that HELOC) and HEI HELOC balances (i.e., funds not used to build, buy, or remodel the home securing that HELOC). Additionally, if existing mortgages are refinanced and mortgage debt is increased, the respective party should breakdown the newly refinanced debt balance by the portion related to QAI mortgages in place at 12/15/2017, the portion related to QAI mortgages on new acquisitions after 12/15/2017, the portion of new debt related to QAI, and finally the portion of new debt related to non-QAI purposes.
Highlights of Business Tax Cuts
The TCJA lowered the corporate tax rate to a flat 21%, permanently, and the corporate alternative minimum tax was eliminated for tax years beginning after December 31, 2017.
The maximum IRC §179 deduction and phase-out threshold were increased to $1 million and $2.5 million from $250,000 and $500,000. For subsequent tax years, these amounts will be indexed for inflation.
Expenses incurred for meals provided to employees for the convenience of the employer will no longer be 100% deductible. Instead, for tax years 2018 through 2025, the deduction will be 50%. Additionally, business entertainment such as golf outings, sports tickets and related venues are no longer deductible.
Every business will be subject to a net interest expense disallowance on corporate debt. Net interest expense exceeding 30% of the company’s adjusted taxable income will be disallowed. The non-deductible portion of interest expense may be carried forward and utilized in future years with no expiration date. Taxpayers are exempted from this limitation when their average annual gross receipts for the prior three years are $25 million or less.
The new tax law states that corporate “net operating losses” (NOLs) can no longer be carried back and can only be carried forward indefinitely. The NOL deduction is limited to 80% of taxable income.
The TCJA repealed the domestic activities deduction (IRC §199) formerly known as the manufacturing or R&D deduction.
Qualified Business Income Deduction (QBID) and Excess Business Losses
An individual generally may deduct 20% of qualified income from a partnership, S corporation, or sole partnership for the tax years 2018 through 2025. The 20% deduction is allowed as a deduction reducing taxable income but is not allowed in computing Adjusted Gross Income (AGI). The 20% deduction is limited to deter high income earners from recharacterizing income as pass through. The deduction is phased out for taxable income between $315,000 and $415,000 for certain types of businesses. Certain industries including health, financial services, and law are excluded from the preferential rate unless their taxable income for single filers is below $157,500. The qualified business income deduction is also limited to 50% of wages paid or 25% of wages, plus 2.5% of the basis in depreciable property.
While the TCJA provided the benefit of the QBID, it also instituted restrictions on excess business losses. For noncorporate taxpayers, business losses that exceed a certain amount will be expressed as excess business losses. The threshold amount for a tax year is $500,000 for married individuals filing jointly, and $250,000 for other individuals, with both amounts indexed for inflation. The threshold is applied at the shareholder or partner level. Excess business losses are carried forward and become part of the taxpayer’s net operating losses in the following tax years. Moreover, the losses cannot be used in the current tax year.
Impact on Business Valuation
Due to accelerated depreciation, many companies will begin to experience significant timing differences between their book and tax depreciation. As a result, normalizing accelerated depreciation could become material to assessing true income.
The S-Corporation economic adjustment multiple, which reconciled the fact corporations have a dual layer of taxation when compared to pass-through entities, has nearly been eliminated due to the changes in the corporate and individual tax rates.
Business valuations with an “as of” appraisal date after December 31, 2017 should take all of the aforementioned changes in the tax law into consideration as these items have the potential to impact business cash flows going forward.
The TCJA is the biggest federal tax law overhaul in more than 30 years. The changes described above is a brief overview of the changes that may affect how family law attorneys address alimony, child support and marital property disposition for their clients. These changes, many of which have not been clarified by IRC regulations and subsequent litigation, mean attorneys and their clients should confer with tax advisors to determine the best strategy to pursue in each particular client’s case or matter.
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