How the Tax Cuts and Jobs Act Affects Divorce Settlements
The new law is a game changer for divorce and separation agreements. Here are some of the key changes you need to watch out for.
The Tax Cuts and Jobs Act of 2017, signed by President Trump on December 22, 2017, made a number of important changes to the Internal Revenue Code, some of which either directly or indirectly relate to divorce. Due to the speed with which the law was enacted, there are many uncertainties in the interpretation and application of the changes. However, family law attorneys and other advisors must be proactive in ensuring they understand how these changes may affect their clients, particularly as they concern alimony, exemptions and deductions that could impact their clients' bottom line.
New Tax Rules for Alimony Agreements
The 2017 tax legislation introduced two significant changes to how alimony is treated for tax purposes, but stipulated that these changes would only apply to divorce or separation instruments that are executed after December 31, 2018.1 For instruments executed after that date, alimony is no longer tax deductible for the paying spouse and does not need to be reported as income by the receiving spouse.2, 3 Unlike some other provisions of the new law, these rules are not set to expire and will remain in place unless changed by Congress in the future.
Agreements Executed on or Before December 31, 2018
Divorce or separation agreements executed on or before December 31, 2018 will be grandfathered in, provided the parties involved have a written separation agreement by that date. This means that as long as an agreement is reached prior to the deadline, paying spouses may still take the alimony deduction and receiving spouses must still report the alimony they receive as income. A decree of divorce need not be acquired by the deadline — a written separation agreement is sufficient under the law.
While existing alimony agreements can be amended to fall under the provisions of the new law should the parties involved desire it, it's unclear whether other modifications made after the December 31, 2018 deadline will cause the agreement to lose its grandfathered status. It's possible that modifying the agreement after the deadline might result in the paying spouse being unable to take the alimony deduction going forward.
Until the IRS provides guidance on this matter, it may be necessary to seek a private letter ruling (PLR) to clarify what the result of such modifications might be. This could be expensive. In addition to needing to hire an attorney to draft the paperwork needed to seek a PLR, a taxpayer will need to pay a "user fee" to the IRS.
The new legislation repeals the section of the Internal Revenue Code that dealt with the taxation of alimony trusts.4 Previously, the income of a trust payable to a divorced spouse would be taxable income for the beneficiary spouse, rather than the grantor spouse. Under the new law, this is no longer the case. The grantor spouse may have to pay the income tax on trust income, even though they do not receive the distributions from the trust.
It does not appear that existing alimony trusts will be grandfathered in and allowed to follow the old tax rules — grantors may have to follow the new law going forward.
Despite this change in the tax treatment of trusts, there may still be benefits to creating trusts in divorce, particularly if you wish to leave assets directly to heirs or need to provide support for an ex-spouse with whom you prefer to have no direct contact.
Changes to Exemptions and Deductions
The 2017 tax legislation also repealed several important exemptions and deductions that could affect divorce agreements.
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