Divorce can be complicated, particularly where there are children involved. However, even cases involving significant amounts of spousal support are highly contentious. Prior to the 2019 change, The IRS provided a useful negotiation tool, making spousal support tax-deductible to the paying spouse; this will all end on January 1, 2019. This article will briefly discuss how support payments and taxes interacted before the January 1, 2019 laws go into effect, and how support payments and taxes will interact after the January 1, 2019 laws go into effect.
If you received a divorce in California, there are four general areas that the tax laws will impact that divorce: (1) dependency exemptions; (2) division of property; (3) tax filing status; and (4) support – this article will specifically discuss the tax implications for support orders, which are issued in conjunction with a dissolution proceeding.
There are 3 basic forms of support in California: (1) family support; (2) child support; and (3) spousal support (commonly referred to as “alimony”). Each form of support receives different treatment under the tax code, which makes it essential that people seeking a divorce contact a competent family law attorney, so they can assist you in determining whether support payments are tax-deductible, or whether that support is considered income for tax purposes.
- Family Support Agreements and Their Tax Implications Prior to the Implementation of the January 1, 2019 Tax Laws
In California, provided both parties agree in writing, parties to a dissolution can opt to have a support order for both family and spousal support entered, this is referred to as “family support.” This combination allows the parties to treat the entire “family order” to be treated as though it were spousal support or child support. The practical implication of this is that a “family support” order can be deemed entirely tax-deductible (for the party paying) and entirely taxable (for the party receiving the support). Alternatively, the entire “family order” can be non-taxable like child support. Since a written agreement is a pre-requisite to a “family order”, that written agreement needs to expressly set out the nature of the “family support” if you want to effectuate your desired goals as it relates to taxes.
It is important to note that since “family support” requires an agreement, that agreement can be negated unilaterally by either party. If this happens, then the Court will enter a child support order in conjunction with a spousal support order. The pre-2019 tax implications for these orders is discussed below.
- Child Support and Its Tax Implications Prior to the Implementation of the January 1, 2019 Tax Laws
Pursuant to IRS Code §71, subsection (c)(1), states: “Subsection (a) [the subsection establishing that support payments are taxable] shall not apply to that part of any payment which the terms of the divorce or separation instrument fix (in terms of an amount of money or a part of the payment) as a sum which is payable for the support of children of the payor spouse.”
As a general rule, child support payments are not imputed to the recipient (commonly referred to as the “Payee”) of that support’s income, which means that child support payments do not constitute taxable income to the payee; similarly, child support payments are not tax-deductible to the person making the payment (commonly referred to as the “Payor”).
A pre-requisite to obtaining the non-taxable status on these payments is that the Court specifically designate the amount of the payments as “child support.” In the event that the Court is silent on the nature of the payment, it is possible that those payments will not be considered “child support” for tax purposes; a prime example is the federally claimable “Child and Dependent Care Credit. Spousal support is where most battles regarding taxable amounts take place, though this will all change January 1, 2019.
- Spousal Support (“Alimony) and Its Tax Implications Prior to the Implementation of the January 1, 2019 Tax Laws
IRS Tax Code §71, subsection (b)(1), states: “The term ‘alimony or separate maintenance payment’ [which are taxable/deductible] means any payment in cash if:
- (A) “such payment is received by (or on behalf of) a spouse under a divorce or separation instrument”
- IRS Tax Code §71, subsection (b)(2), clarifies: “The term “divorce or separation instrument” means:
- (A) “a decree of divorce or separate maintenance or a written instrument incident to such a decree”
- (B) “a written separation agreement” or
- (C) “a decree (not described in subparagraph (A) requiring a spouse to make payments for the support or maintenance of the other spouse.”
- (B) “the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under this section and not allowable as a deduction under section 215”
- (C) “in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made” and
- (D) “there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.”
In plain English, “spousal support” and “alimony” mean the same thing under IRS Tax Code §71. This means that the spousal support recipient (“Payee”) treats those support payments as taxable income (since the support payments constitute income pursuant to the Tax Code. On the other side of the spectrum, the person making the spousal support payments (“Payor”) treats those payments are 100% tax deductible.
The fact that spousal support payments to the Payee are considered taxable income creates an additional consideration; similar to the tax requirements for independent contractors. Since the Payee will be taxed on the entire support payment at the end of the year (rather than having taxes taken out when the money is transferred), it is wise for the Payee to put about 20% of the total support payment into savings so that the Payee is not required to dig into their wallet during tax season.
On the opposite end of the spectrum, considering the additional expense of support payments, many Payors find themselves unable to maintain their previous quality of life vis-à-vis living expenses. Since spousal support payments are considered 100% tax-deductible, the prudent Payor may opt to reduce the number of withholding allowances with their employer to increase the amount of money they receive each paycheck (you should contact an expert on this matter to determine precisely how much you should modify your withholding allowances so that you net the same amount of money annually).
The preceding portion of this article refers to the state of tax law prior to the enactment of the new law on January 1, 2019. It is entirely possible that these new tax laws will be altered, or returned to their pre-2019 status, when the next administration takes office; it is important to understand the laws of both schemes if that occurs.
Having laid out precisely how the old tax laws interacted with various forms of support payment, the remainder of this article will discuss how the 2019 tax law will impact the various support payments.
- Where Did The 2019 Changes to The Tax Code, In Relation to California Support Payments, Come From?
It is unlikely that this article is the first time you heard about the changes to the tax code that are going into effect on January 1, 2019. As noted above, spousal support is 100% tax-deductible to the Payor, while simultaneously constituting earned income to the Payee. This will all change on January 1, 2019.
President Trump’s hallmark achievement thus far is the Tac Cuts and Jobs Act (commonly referred to as “TCJA”). This law goes into effect January 1, 2019, but will have absolutely no impact on divorces, and support orders) entered into prior to December 31, 2018.
As a practical matter, the TCJA changes will make dissolution negotiations far more difficult; this is particularly true where the parties getting divorced have a high net-worth. The reason for this is probably straightforward, but we will use a few examples to bolster the point.
Pre-2019 Example: Harry and Wendy are seeking a divorce in July of 2018. Harry and Wendy have been bickering about who gets possession of their community property summer beach house, and neither of them are willing to share; it’s an all-or-nothing situation. Harry, who makes $500,000 per year, realizes that he has an additional bargaining chip – he offers to pay Wendy an additional $5,000 per month in spousal support, until she remarries, in exchange for possession of the summer beach house. Wendy, who earns roughly $50,000 per year, would love to have the additional income for quality-of-life purposes. Wendy accepts Harry’s offer. Come tax time, Harry pays property tax on the summer beach house, and only pays income tax on $440,000 of his income because the entire $60,000 is tax-deductible. Wendy does not pay taxes on the summer beach home but pays income taxes on $110,000 because the entire $60,000 in spousal support is considered income.
NOTE: This example only focuses on the additional spousal support Harry offered in exchange for the summer beach house, but the original support would be treated identically.
Post-2019 Example: The same example as above, however, the results are very different. Now, Harry pays taxes on the summer beach home as well as income tax on $500,000 notwithstanding the $60,000 he provided Wendy in spousal support. Meanwhile, Wendy only pays income tax on $50,000 while the remaining $60,000 is tax-free.
As you can see, the 2019 changes removed a very useful bargaining chip in the negotiations.
Time will tell precisely how the 2019 changes will impact negotiations surrounding divorce, and how long these laws stay in effect, but the changes are going into effect nonetheless. If you or a loved one are considering a divorce, it is essential that you contact the attorneys at Maples Family Law today. We pride ourselves on our ability to adapt, as well as our ability to assist parties in reaching mutually agreeable terms as it relates to supporting. While the tax benefits have been removed from spousal support, that is not the only item in our toolbox. From all of us at Maples Family Law, we wish you a safe and happy new year.