Currently, tax considerations can play an important role in alimony negotiations, but that’s all about to change.
What is Alimony
In North Carolina, alimony, sometimes called “separate maintenance” or “spousal support” in other states, is payment for the support and maintenance of a spouse or former spouse.
In North Carolina, in order for a recipient spouse to qualify for alimony, he or she must establish that he or she is actually substantially dependent upon the other spouse for financial maintenance. The dependent spouse must also establish that the other spouse has the means and ability to pay the alimony sought. The length and duration of the alimony awarded is based upon a number of factors, including but not limited to:
Whether one of the parties committed marital misconduct during the marriage
Standard of living enjoyed by the parties during the marriage
Duration of the marriage
Earning capacities of the parties
Depending on the arrangement, alimony payments can be made, periodically or in a lump sum, for a specified or for an unspecified term and, ordered in an action for divorce or an action for alimony without divorce. Alimony can also be determined between separating and/or divorcing spouses in a private contract.
How is Alimony Determined
In determining the amount and duration of alimony at the present time, the trial judge is required to consider the federal, state and local tax ramifications of the alimony awarded. At least until the end of this calendar year, that means a judge must consider the net income a payor spouse will have after he or she pays the alimony amount ordered. Given that the payor spouse gets to deduct the alimony paid dollar-for-dollar from his or her taxable income.
Correspondingly, the judge must consider what the recipient spouse will “net” from an alimony award after he or she pays taxes on the amount of alimony he or she receives. In essence, the trial judge is required to consider what has been called as the “mirroring effect” of alimony — while one party will take a deduction for the payment, the other party is required to pay taxes on the alimony received on his/her tax return.
How Taxes Can Impact Alimony: A Scenario
Suppose that, as of January 1, 2017, payor/supporting spouse John Doe, who earns $500,000 per year, was ordered to pay $100,000 annually (or approximately $8,333 per month) in taxable alimony to his wife, which he was able to deduct from his 2017 income in computing his annual income tax debt. In our assumption, the recipient/dependent spouse Jane Doe earns $35,000 per year and she is paid $100,000 annually (or approximately $8,333 per month) in taxable alimony beginning January 1, 2017, which she had to report on her income tax return and pay taxes.
In this simple scenario (assuming no itemized deductions or other income to either party), after considering the tax impact of the alimony paid in 2017, John’s combined federal and state marginal income tax rate is 39 percent compared to Jane’s combined federal and state marginal income tax rate of 32.1 percent. Had he not been able to deduct the alimony paid to Jane, John’s combined federal and state marginal income tax rate would have been 45.6 percent.
With the alimony tax deduction in 2017, John’s monthly alimony payment of $8,333 actually only cost him approximately $3,489 per month as a result of the tax savings he realized by being able to deduct the alimony paid from his overall taxable income before computing the amount of taxes owed. By contrast, Jane had to pay approximately $2,510 per month in taxes on her $8,333 per monthly in alimony. Because John’s overall taxable income is reduced by the alimony, in reality John had more disposable dollars from which he can pay alimony to Jane. Jane still had to pay tax on the alimony she received, but at a lower tax rate than would have been paid by John.
At the end of the day, the $8,333 per month in alimony is taxed at Jane’s lower tax rate as compared to John’s higher tax rate — therefore, there were more net dollars to go around in negotiating the amount of alimony John can afford to pay. Attorneys representing John and Jane were able to use these income tax consequences in negotiating an amount of alimony that lowered John’s taxable income while giving Jane more dollars to provide for her living expenses.
How Taxes Will Impact Alimony Moving Forward
The recently enacted Tax Cuts and Job Act (TCJA) has drastic implications for alimony orders or contracts finalized in 2019. The TCJA eliminates the tax write-off of alimony for payor spouses. The act also eliminates recipients for having to pay taxes on alimony. However, this could negatively affect the amount that recipients will receive because there will be less after-tax income from which the supporting spouse can pay alimony.
For divorcing or separating couples, the new tax changes could substantially affect the supporting spouses after-tax income and how much the recipient will receive. For couples in this situation, it’s not too late to try to finalize alimony contracts before this deduction repeal comes into effect on January 1, 2019. The financial wellbeing of both parties could be dramatically impacted by this change.