Divorce Tax Rule Changes
New rules in Tax Cuts and Jobs Act
With the enactment of the Tax Cuts and Jobs Act (“TCJA”), divorce attorneys and those that are divorced, in the process of divorce or who have a pre or post nuptial agreement should familiarize themselves with the new rules. Failure to do so can have serious tax consequences to the client, and further, may subject a legal representative to malpractice claim or a bar grievance being filed.
Changes affecting Alimony
The most significant change is the deductibility of alimony. Under the TCJA, alimony is no longer deductible by the payor nor is it includable as income for the recipient. The changes apply to any divorce or separation instrument executed after December 31, 2018. The new rules also apply to any divorce or separation instrument executed on or before December 31, 2018, and modified after that date provided the modification expressly provides that the TCJA amendments apply. Accordingly, divorce attorneys as well as their clients need to pay particular attention to these new rules and the effective date. In addition, attorneys who are representing the paying spouse should consult with outside tax counsel for purposes of tax effecting and monetizing the loss of the deduction to the payor and the tax savings to the recipient.
The term “divorce or separation instrument” is defined as “(A) decree of divorce or separate maintenance or a written instrument incident to such a decree; (B) a written separation agreement; or (3) a decree not described in subparagraph A requiring a spouse to make payments for the support or maintenance of the other spouse.” 26 U.S.C. § 71(b)(2).
The rule changes under the TCJA also affect the use of alimony trusts. Prior to December 31, 2018 alimony trusts were permissible and used to minimize the interaction between former spouses as well as secure the interest of the recipient spouse. These trusts were also used where a family business was involved in order to shield assets of the business from third party creditors. With the repeal of 26 U.S.C. § 682, alimony trusts may no longer be used in divorce after 2018. More importantly, an alimony trust created after 2018 will result in the spouse creating the trust to be taxed on any income generated by the trust. 26 U.S.C. § 672(e).
Personal exemptions
In addition to the change in the alimony rules and the prohibition on the use of alimony trusts, the TCJA provides for the suspension of personal exemptions in favor of a new larger standard deduction. The suspension of personal exemptions is not permanent and scheduled to burn off after December 31, 2025. Most matrimonial agreements, including divorce settlement agreements and pre and post nuptial agreements identify which spouse is to take the children as personal exemptions for federal income tax purposes and for which year. Who gets the exemption is the result of negotiation and considered in evaluating the value and fairness of the overall settlement. Loss of personal exemption is of particular importance to a party who divorced prior to the effective date and gave up something of value in exchange for the personal exemptions. Under the new rules, the loss of personal exemptions represents a real loss.
In certain circumstances, the financial impact occasioned by the changes to the divorce rules under the TCJA, may warrant one spouse making an application to the court for the modification of an existing divorce settlement agreement or a pre or post-nuptial agreement. However, attempting to either set aside or reform any such agreement will be an uphill battle for the following reasons: First, a divorce settlement agreement or a pre or post nuptial agreement will typically contain what is commonly referred to as an: “Integration Clause,” which effectively prevents either party from changing the terms of the agreement without a written modification signed by both parties. The likelihood that the spouse losing a tax benefit would ever sign such a modification is slim. Second, seeking to have an agreement set aside by a court is rarely, if ever, successful absent a showing of fraud, duress or unconscionability. Likewise, advancing a quasi-contract theory as a basis for reformation of an agreement will likely fail.
The takeaway here is that both attorneys and their clients should consult a tax attorney prior to entering into a divorce settlement agreement or a pre-nuptial agreement, to determine the tax implications associated with the changes to divorce rules. Furthermore, in cases involving significant marital assets, which have been the subject of estate planning, a review of the parties testamentary and trust documents is essential to avoid any unintended consequences. Consideration of the changes under the TCJA should be included when conducting financial analysis in a divorce case.
