Many people still may not be aware of a significant change with respect to divorce enacted in the new tax law – a change that could create significant problems in reaching divorce settlements.
Prior to the new law, spousal support (what we call maintenance in Missouri and some states call alimony) was treated as deductible for the paying spouse and income for the recipient spouse.
Generally, this had the advantage of maximizing total family income because the tax savings to the paying spouse exceeded the tax burden to the recipient spouse, leaving more net income to spread between the two spouses.
For example, if a high earning spouse has a $30,000 annual maintenance obligation, and that spouse paid at the highest taxable rate of 40%, that spouse receives a tax benefit of .4(30,000) = $12,000. The recipient spouse will pay at the lower tax rate of 15%, a tax burden of .15(30,000) = $4,500.
The difference between the benefit and burden of $7,500 is the extra net household income for both spouses – meaning even more could be shifted if necessary or that frees up for other types of support. Thus, under the old system, the tax code encouraged maximizing maintenance and helped see that spouses in need of support could receive as much as possible based on income.
The new law changes this structure in two critical ways.
First, the paying spouse can no longer deduct maintenance, giving that spouse zero tax advantage. Second, the recipient spouse no longer pays income tax on maintenance, giving that spouse a significant tax advantage. While it may look like shifting the tax burden favors the recipient spouse, it really hurts that spouse by limiting the ability of the paying spouse to pay.
Using our same numbers from the above example, the paying spouse loses the $12,000 tax benefit and the recipient spouse gains a new tax benefit of $4,500; instead of net family income expanding by $7,500, it now decreases by $7,500.
That’s right – the new tax law costs the spouses $15,000, which means that $30,000 maintenance obligation becomes $45,000 in real dollars. It actually is even worse in a way – relieving recipients of paying tax on maintenance for many spouses is redundant as their income with maintenance would leave them paying almost no tax at all under the new rate structure.
What does this change mean in practical purposes for divorcing spouses?
In the short term, it may play havoc with cases currently pending. The new law does not take effect until January 1, 2019, and all judgments entered before that date will operate under the old law. So, for spouses seeking maintenance and wanting to maximize the family income, it would appear to encourage a quicker settlement. However, the paying spouse may see an advantage to delay so that spouse can argue maintenance should be much lower because of the tax hit caused by the new law.
The wrinkle in that strategy, however, is that the trial judge may find maintenance appropriate and award an amount higher than the paying spouse can afford when factoring in the tax implications. Indeed, some judges may not have full awareness of the tax issue and continue awarding maintenance based upon current assumptions. Moving forward into 2019, some judges may choose not to compensate for the change in the law, putting more of a burden on the paying spouse.
In the long term, by reducing net taxable family income, the new tax law makes maintenance more costly and burdens the paying spouse only. In Missouri, this may spark calls for reform.
Legislators last year introduced caps to the duration of maintenance; while they never became law, that momentum could increase with the new tax law and encourage creating a formula for maintenance like we have for child support – a formula that may ultimately hurt recipient spouses by making maintenance presumptively lower and for less duration.
Congress likely adopted this law as a compromise to find a way to maximize tax revenue but to still look sympathetic toward spouses receiving maintenance. However, it unwittingly created a situation that lowers income available to pay maintenance, and that hurts all recipient spouses. Worse, it created unneeded chaos in the legal system that will find much more resistance on the part of paying spouses to pay maintenance and more asking of maintenance by recipient spouses – putting the parties further apart from agreement and taking away the middle ground.
The major takeaway? Make sure you know the tax consequences of any maintenance arrangement before agreeing to a settlement.
If you have any questions about the new tax law and divorce, contact us – we can help.