The final version of the tax reform bill was released Friday, December 15, 2017 and is set for votes this week – and it will pass and become law. Among the many changes, the final bill eliminates the tax deduction for spousal support or alimony payments.
In Michigan, the concept of alimony – the legal obligation imposed on a person to provide financial support to their spouse after marital separation or divorce – is called spousal support. Spousal support, unlike child support, is not based on a formula that dictates whether one spouse will receive and the other will have to pay support at a set amount. Spousal support is decided on a case-by-case basis and is often the product of negotiation embodied in a divorce settlement agreement. If one of the parties asks for spousal support and they cannot agree, spousal support can also be ordered by the judge based on a number of factors.
Right now, spousal support payments are tax deductible by the payer, and they’re taxed like regular income to the recipient. Since the recipient typically makes less money – and is accordingly in a lower tax bracket – this tax treatment tends to keep more money in the former family unit and away from Uncle Sam. According to the IRS, about 600,000 Americans claimed an alimony deduction on their 2015 tax returns, the most recent year for which data is available.
Under the final Bill, for any divorce or separation agreement signed after December 31, 2018, or signed before that date but modified after it (if the modification expressly provides that the new amendments apply), spousal support payments are not deductible by the payor spouse and are not included in the income of the recipient spouse. Rather, income used for spousal support will be taxed at the (generally higher rates) rates applicable to the payer spouse.
The new law generally won’t affect anyone already paying spousal support, but it will mean couples and their attorneys will need to change their thinking for divorce proceedings in the years ahead. This include existing divorces where spousal support was court ordered which, unlike where the parties come to an agreement, spousal support is modifiable. With the loss of the existing tax treatment, post effective December 31, 2018, motions to modify spousal support could become much more contentious and expensive for both parties. This is because the new law has shifted the incentives for the parties, as the tax burden by the payor spouse increases by the amount of their marginal tax rate, whereas the tax drag on the recipient spouse decreases accordingly. For couples currently in divorce negotiations or under an existing arrangement where future spousal support is modifiable, couples and their attorneys should consider adding potential alternate language in their spousal support provisions to address the specific desired tax treatment.
It’s not just future divorces that will be affected by this change in the tax law. Couples and their attorney’s working out prenuptial agreements should take notice. Prenuptial — and postnuptial — agreements typically contain clauses that outline what spousal support would look like should the couple get divorced. Until this point, those clauses have typically been drafted assuming the alimony tax deduction will be in place. Eliminating the spousal support tax deduction may also have spillover implications, complicating how property settlements are reached. This could make some divorce settlements a bit more difficult to achieve.
Wealthy individuals can usually afford higher taxes on spousal support payments although the change in the tax law will affect the negotiating dynamics. However, individuals with more limited means where $500 or $700 dollar per month is going to make a big difference in day-to-day living are going to be more adversely affected by the change.
Fraser Trebilcock attorney Paul V. McCord has more than 20 years of tax litigation experience, including serving as a clerk on the U.S. Tax Court and as a judge of the Michigan Tax Tribunal. Paul has represented clients before the IRS, Michigan Department of Treasury, other state revenue departments and local units of government. He can be contacted at 517.377.0861 or firstname.lastname@example.org.