Currently, in alimony arrangements, the payor spouse can deduct alimony payments from their income, which can add up to huge tax savings. Think about it — deducting the total cost of alimony for the year can be quite substantial in many cases.
Alimony payments are includible in the dependent/recipient ’s spouse’s income, for tax filing purposes. The fact that the payor gets to deduct the alimony paid and the recipient spouse has to pay taxes on the alimony received often works to the advantage of both parties. This results in what has been called a “tax subsidy” or “tax arbitrage.” Because the supporting spouse payor is almost always in a higher tax bracket than the recipient spouse, the recipient spouse ends up paying less tax on the income received than would the payor spouse.
How Alimony is Changing with The Tax Cuts and Job Act
On December 22, 2017, the President signed Congress’s Tax Cuts and Job Act (TCJA). There are many dramatic changes to the tax code presented by the TCJA, but one in particular that will drastically affect individuals contemplating separation and divorce — the repeal of deduction for alimony payments and corresponding inclusion in gross income to the recipient spouse. Unlike some of the other changes included in the TCJA, this alteration to the tax code is permanent. Congress predicts that the elimination of the tax deductibility of alimony will increase federal revenue by approximately $6.9 billion over the next 10 years.
However, according to the Tax Cuts and Job Act, for any alimony orders or contracts entered on or after January 1, 2019, the spouse paying alimony can no longer deduct the amount paid from his or her taxable income, and the spouse receiving alimony will no longer have to pay taxes. Therefore, if you are planning to separate and get divorced soon, and you will likely be obligated to pay alimony to your spouse, you need to get your deal done, signed, sealed and delivered, prior to midnight on December 31, 2018. By doing so, you’ll benefit from significant savings on your taxes for the rest of your alimony arrangement.
While at first glance this tax change may appear to benefit the recipient spouse, there may be fewer dollars to “go around” now. Because the supporting spouse will no longer be able to deduct his alimony, he will have less after-tax dollars from which to pay for alimony and his or her own living expenses. The loss of this additional money will likely make it more difficult to negotiate an alimony resolution, although the actual impact of the TCJA changes on the negotiation of alimony remains to be seen.
How Does This Affect Existing Alimony Orders
The change to the tax deductibility of alimony applies only to new alimony judgments or contracts entered or executed after midnight December 31, 2018. Existing alimony orders and contracts will continue to receive the same tax treatment as when they were entered.
What if there is a future change in the amount of alimony to be paid under a prior order or contract?
In North Carolina, the amount of court-ordered alimony can be modified upon a showing to the court of a substantial and material change in circumstances. Some alimony contracts also have provisions that provide that the amount of alimony can be modified upon the occurrence of certain conditions.
The TCJA specifically provides that alimony orders and contracts modified after December 31, 2018, can provide that the alimony paid will no longer be taxable or deductible if the modification specifically states that the TCJA treatment of alimony payments (not deductible by the payor and not taxable income for the recipient) will apply to the modification order or contract. Therefore, it would appear that modifications of pre-December 31, 2018 alimony arrangements can continue to operate under the current deductibility/taxability rules unless the modification opts into the new TCJA treatment. It remains unclear whether other modifications to the tax regulations might alter this “grandfathered” tax treatment going forward.
Until the Internal Revenue Service provides written guidelines on the tax treatment of modified orders and agreements, it might be necessary for a couple modifying their alimony agreement to seek a private letter ruling from the Service.
Dependent Spouse Attorney Fees
In North Carolina, when an individual is entitled to alimony, a court may award reasonable attorney fees to that dependent spouse. Before the enactment of TCJA, the dependent spouse was allowed, as an itemized deduction, to deduct the fees paid to his or her attorney in connection with the production and collection of taxable income, such as alimony. This available deduction, as well as a multitude of other previously available deductions, was eliminated by TCJA effective in 2018. Therefore, even though a dependent spouse may be paying their attorney in 2018 to obtain taxable alimony prior to December 31, 2018, they will not be allowed to deduct those attorney fees paid on their 2018 income tax return.
The Clock is Ticking
It remains to be seen what the ultimate long-term ramifications will be for couples going through separation and divorce in years to come. The only conclusion that we can make is that it is likely that the available funds from which a payor/supporting spouse can pay alimony will be reduced, so a couple facing separation or divorce and the payment of alimony in 2018 have a strong incentive to negotiate and finalize their alimony order or contract before the stroke of midnight on December 31, 2018.