Michael B. Lehner, CPA/ABV, CFE, ASA
732-412-3825
MLehner@zbtcpa.com
zbtcpa
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How the new tax law affects divorce settlements & Business Valuation

new tax law divorce settlements Business Valuation Alimony

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Business valuation experts often help formulate settlement offers in divorce cases. In addition to valuing business interests held by a marital estate, these experts can suggest equitable asset allocations and determine reasonable alimony and child support amounts. Now there’s a new twist to consider: The Tax Cuts and Jobs Act (TCJA).

How does the new law affect alimony?

Before the TCJA was enacted, maintenance payments that met the tax-law definition of alimony could be deducted by the payer for federal income tax purposes. The recipient had to report the money as taxable income. (See “Defining alimony for pre-2019 settlements” at x.)

The tax deduction for alimony payments is eliminated for divorce agreements reached after 2018. For monied spouses, this change could be expensive, because the tax savings from deducting alimony payments can be significant. Most states have statutory guidelines for structuring alimony awards, which could become burdensome under the TCJA unless states revise their guidelines.

This new treatment of alimony will apply to payments under divorce or separation instruments that are modified after December 31, 2018. But the modification must specifically state that the new TCJA treatment applies.

Treating alimony as deductible support generally leaves more money in the marital estate — and less in the hands of the IRS. So, most alimony payers and recipients would prefer to finalize their divorces in 2018.

What other TCJA provisions might affect divorce settlements?

The TCJA contains dozens of major changes that will affect individual and business taxpayers. Those that may affect divorce settlements include:

Reduction of state and local tax (SALT) deductions. For 2018 through 2025, itemized deductions for personal SALT amounts are limited to a combined total of only $10,000 ($5,000 if you use married filing separately status). The limitation applies to state and local 1) income (or sales) taxes, and 2) property taxes. This provision might make owning an expensive home less desirable and potentially depress property values in certain high-tax states. The change could upset the fairness of a negotiated settlement for the spouse who received the primary residence and/or a vacation home. (Individuals can still deduct all property taxes on rental properties under the new law, however.)

Expanded use of Section 529 savings. Under the new tax law, individuals can take tax-free distributions of up to $10,000 per year from a Sec. 529 plan to cover tuition at a public, private, or religious elementary or secondary school, starting in 2018. This change could create a financial hardship if a noncustodial parent had planned to use the Sec. 529 plan to pay for college expenses.

Reduction in business tax rates. Starting in 2018, a flat 21% federal income tax rate applies to C corporations. In addition, the new law eliminates the alternative minimum tax (AMT) for C corporations.

Tax rates were also effectively reduced for sole proprietorships and so-called “pass-through” entities (including partnerships, limited liability companies and S corporations). The reduction will be achieved from a new 20% qualified business income (QBI) deduction, which is available for 2018 through 2025. Numerous rules and restrictions apply to the QBI deduction.

These changes in business tax rates could provide an unintended boon for a spouse who was awarded a private business interest in a divorce settlement.

Your expert understands the new tax law

Experts who combine business valuation skills with an understanding of the new tax law can be a valuable resource when drafting or revising divorce agreements. There may be situations — such as a change in the income levels of the alimony payer or the alimony recipient — where applying these new rules voluntarily could be beneficial for the parties to an existing settlement.

 

Sidebar: Defining alimony for pre-2019 settlements

For pre-2019 alimony payments to be tax deductible, payers must satisfy the following eight requirements:

  1. The payment must be made under a written decree of divorce, separate maintenance or separation.
  2. The payment must be to, or on behalf of a spouse of, a spouse or ex-spouse. Payments to third parties, such as attorneys and mortgage lenders, are permitted if made under a divorce or separation agreement or at the written request of the spouse or ex-spouse.
  3. The divorce or separation instrument can’t state or effectively stipulate that the payment isn’t alimony because it isn’t deductible by the payer or won’t be included in the payee’s gross income.
  4. After the divorce or legal separation, the ex-spouses can’t live in the same household or file a joint tax return.
  5. Payments must be made in cash or cash equivalent.
  6. Payments can’t be classified as fixed or deemed child support. (The rules regarding what constitutes child support are complicated.)
  7. The payer’s tax return must include the payee’s Social Security number.
  8. The obligation to make payments (other than payment of delinquent amounts) must cease if the recipient dies. State law controls if the divorce papers are unclear about whether payments must continue (to the estate and eventually to beneficiaries of the estate). If under state law, the payer must continue to make payments after the recipient’s death, the payments can’t be alimony.

Payments that fail to meet the tax-law definition of alimony are generally treated as child support payments or payments to divide the marital property. Such payments represent nondeductible personal expenses for the payer and tax-free income for the recipient.

Michael Lehner


This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.