Tax Law Changes Impact High Net Worth Divorces
Statistically speaking, individuals in the United States who have more money do not divorce as often as those with less. However, when they do divorce, they typically are looking to use the tax code advantageously. One of the primary ways this was done prior to the passage of the Tax Cuts and Jobs Act (TCJA) was through the above-the-line deduction of spousal maintenance payments.
“Above-the-line” tax deductions reduce the income of an individual that is subject to taxation and therefore are prized in the tax world. For IRS purposes, it is as if the person never made the money in the first place. Other examples of above-the-line deductions are student loan interest and IRA contributions.
For many decades, spousal maintenance payments being used as an above-the-line deduction were beneficial to both spouses. Under this system, the spouse paying support was able to get comfortable making larger payments because some of the money paid out would be recouped at the end of each tax year and the spouse receiving payments could argue in favor of larger payments for the same reason. The spouse receiving the payments had to report them as taxable income, but since they would naturally have lower earnings, the tax burden was not nearly as great for them as it would be for the paying spouse.
The TCJA eliminates the deductibility of spousal maintenance payments for any alimony agreement entered into after December 31, 2018. It also eliminates maintenance payments from being considered taxable income for the spouse receiving the funds. Clearly, the idea behind these changes is to increase tax revenues while taking the sting out of what were likely to be reduced payments.
What has happened in practice has been a rush for finalization of divorces to come in under the December deadline, as well as a push for alternative methods of spousal maintenance satisfaction, be it the use of qualified domestic relations orders on retirement accounts, outright transfers of retirement accounts, or attempts at lump sum payments of spousal maintenance in the form of transfers of valuable property.
What has also happened is a shifting of negotiating power. Where the lower-earning spouse previously had a bargaining chip in the form of tax benefits they could use to negotiate monthly support payments, now there is only the opportunity to argue over a smaller amount of assets.
Individuals seeking divorces with this time limit in mind may also be up against another time limit, the separation period their state of residence imposes on couples seeking divorce. In some states, the required separation period is only one month while in others it can be a year or more. The length of this requirement can also affect whether a couple can take advantage of the old tax code.
High net worth individuals serious about divorce will likely always be able to identify methods to pay spousal maintenance using tax advantages. However, it is possible that these changes could not only lead to an initial rush for divorce to beat the deadline, but also a corresponding drop in divorce rates as couples try to stay together to avoid financial repercussions. All laws have unintended consequences. This change to the tax code may have many more than anticipated.