As many of you may know from watching the news, the House of Representatives, working with the President, have unveiled a new tax reform proposal called the Tax Cuts and Jobs Act. Most of the attention has focused on the rates and the home mortgage deduction. Almost no one seems to focus on changes that could have devastating consequences for divorced individuals.
Some very brief background: in order to pass the tax proposal in the Senate without a filibuster of 60 votes, Congress must make its proposal revenue neutral, meaning that whatever revenue is lost by lower tax rates must be offset by an increase in revenue somewhere else. As one might expect, that requires Congress to look at eliminating deductions that otherwise reduce taxable income.
One such deduction is for spousal support, or maintenance. Currently, the Internal Revenue Code allows a party paying maintenance to reduce taxable income dollar-for-dollar, so if a party pays $10,000 per year in maintenance and earns $100,000, that party has a taxable income of $90,000. The greater the income of the party, the more important the tax consequence because of the likelihood it puts that party at a lower marginal tax rate. At a minimum, the maintenance paid results in a tax rebate equal to the party’s income tax bracket – anywhere from 25 to 40 percent savings. Returning to our example, that $10,000 maintenance payment would result in a tax savings of at least $3,500.
The proposal unveiled this week would eliminate the maintenance deduction, but it will grandfather in all current court orders, but for those entered after the law, including any modifications, the obligor spouse could not write off maintenance.
What kind of impact could this have on divorce settlements or judgments?
For a spouse requiring maintenance, the tax change could hurt that spouse’s ability to receive a sufficient amount to meet reasonable needs because the spouse paying maintenance knows that he or she has no tax benefit and would be resistant to paying a higher amount or might ask for more property in exchange. On the other hand, if courts do not take the tax consequences into consideration, courts could end up awarding maintenance that the obligor spouse cannot afford to pay.
The bill sponsors claim that the tax deduction amounts to a “divorce subsidy” that yields better tax results for divorced people as compared to when they were married. But this is an incorrect argument. When a couple divorces, they no longer share households and in effect establish two separate households with a great deal of redundancy if they have children. If the sponsors of the bill believe people get divorced because of the generous subsidy for maintenance, that is simply absurd. The deduction exists as a recognition that the party paying maintenance is transferring income to the former spouse for support for which the paying spouse derives no benefit (as opposed to child support, where the parent derives a benefit in making sure that parent’s children have their reasonable needs met). Removing the deduction now becomes a “divorce penalty” for the paying spouse, making it less likely a party would want to pay maintenance. And the party receiving maintenance still has to count those sums as income – in effect doubling the divorce penalty.
If this bill becomes law with the deduction removed, it will have far-reaching negative consequences on spousal support, from fewer maintenance awards to reduced maintenance awards to unequal property distributions to offset maintenance.
Concerned parties are encouraged to let their representatives in Congress know how they feel about this proposed change to the law.
If you have questions about tax reform proposals and maintenance, contact us – we can help.