- Treatment of Pass-Through Income From a Business
The 2017 Tax Cuts and Jobs Act (TCJA) has created some substantial revisions to the tax code in regards to pass-through businesses. A pass-through business is designed to avoid paying double taxation by not paying income taxes at the corporate level. Instead, corporate income is allocated among the owners of a pass-through business, while income taxes are only levied at the individual owner’s level. Some common examples of pass-through business entities are sole proprietorships, partnerships, and S-corporations.
The TCJA offers specific provisions in regards to pass-through businesses, which are scheduled to expire in 2025. These changes are complex in nature and can be difficult to comprehend. One of these major changes was a revision in the deduction for income for these types of businesses. Under the TCJA, a new tax deduction of up to 20 percent of income from pass-through businesses was created. However, the size of the deduction varies based on factors such as the income of the owner, the salary of the employees, the nature of the business, and the total property owned. As discussed further in this summary, there are a number of limitations that high-income owners face to avoid any creative accounting abuses of the tax code. The TCJA’s 20 percent pass-through deduction is generally viewed as making the tax code much more complex than it had been previously.
Prior to the implementation of the TCJA, the previous law allowed income from pass-through businesses to be taxed at ordinary income rates. These income tax rates were set at a maximum rate of 39.6 percent. Under the TCJA, there is a 20 percent deduction for “qualified business income”, or QBI. Here, the maximum rate is set at 29.6 percent. This deduction is limited for taxable income above $157,500 (single) and $315,000 (joint).
The income deduction offered in the TCJA is subject to a number of limits. These limits were designed to target high-income owners of pass-through businesses in order to prevent abuse of the provisions. The high-income households face a number of limitations that preclude their ability to qualify for this new income deduction. One example of a limitation is one that targets specialized service businesses, such as law firms or medical offices. A second example of a limitation is one that restricts the deduction based upon the salary of the businesses’ employees and the value of the property owned by the business. Additionally, it should be noted that there are exemptions from these two limitations. Specifically, any income from real estate investment trusts, certain publicly traded partnerships, and some agricultural cooperatives may be exempt from any limitations depending on their criteria and qualifications.
- New Standard Deductions & Elimination of Personal and Dependent
When talking about the 2017 Tax Cuts and Jobs Act(TCJA) the standard deductions were nearly doubled. Before this people could only deduct $6500 to $12000 for “individual fliers”, and $13,000 to $24,000 for “joint filers.” By making standard deductions bigger the value amount of itemized deductions is drastically devalued. Under the TCJA, it is in the filers best interest to take standard deductions rather than to itemize their deductions. An example to consider is a married couple who, under previous law, would have taken $14,000 in itemized deductions. However, under the TCJA, it is in the filers best interest to take the standard deduction of $24,000 and then deduct an extra $10,000. Not only does this act to deduct more this way but it also skips the process of trying to complete Schedule A of a the Form 1040.
In the 2018 tax year, the total amount of standard deductions depended on the filing status and the age a party was at the end of the year. If a party was single/married and filed separately and is under 65, theirs standard deduction would be $12,000. If a party is single/married and filed separately and are 65 or older, they could take out $13,600. If they were married filing jointly and both spouses were under 65 the standard deduction, they could take was $24,000. If they were married filing jointly and one of the spouses was 65 or older the standard deduction, they could take was $25,300. If both spouses were 65 or older the standard deduction, they could take was $26,600. A head of household under 65 could take an $18,000 while 65 or older was $19,600. A qualifying widower under 65 could take $24,000 and one 65 or older could take $25,300. If they file a tax return for a period of less than 12 months because they are changing their yearly accounting period, they have been a non-resident alien during the tax year, or they are married filing separately and their spouse is itemizing their deductions, they will have no choice but to itemize their deductions.
Another key provision of the TCJA was the elimination of the personal exemption. TCJA has suspended all personal and dependent exemptions from 2018 to 2025. This had a major effect on the federal and state government(s) alike. The way congress eliminated the personal exemption was confusing for some states to figure out their own tax laws. The personal exemption in every state links to the federal code in some way. This “conformity issue” seems problematic for a lot of states. The TCJA did not eliminate the personal exemption per se, rather the exemption was kept and the value was just set at $0. This change was not problematic to the nine states that used the personal exemption amount in their calculations prior to the TCJA as these amounts also fell to $0. However to another 18 states which includes Kansas, Nebraska, Illinois, Missouri, Oklahoma, Ohio, and Virginia this was a more complicated issue. These states used the number of personal exemptions reported on federal returns in the state tax calculations. These states, however, set “their own independent amounts for their exemption credits.” A good example is an Illinois 2017 tax return when it asked filers to multiply the number of personal exemptions on their federal return “by the states $2,175 exemption.” Many other states follow a similar pattern including Missouri and Nebraska.
Had the TCJA just eliminated the federal personal exemption it would have, by default, eliminated all the state exemptions. Under 26 U.S. Code § 151 the federal exemption still remains. Additionally the IRS did not include a line for the number of personal exemptions in the updated 1040, but rather asked filers to list dependents. However there is a good solution that all states could take up. A state could change the statute to “define its personal exemptions as the sum of the federal filer, the filer’s spouse, and dependents.” That would be the equivalent as adding up old federal personal exemptions. States like Maryland, Michigan, and Wisconsin have already started this type of process.
Missouri has eliminated its personal exemption as part of a “larger tax overhaul.” Nebraska has sought to use the federal child tax credit count plus the filer and spouse to compute a personal exemption count. States like Illinois, Kansas, and Virginia have not made any changes yet.
Additionally dependent exemptions have been suspended, but doesn’t mean a party cannot get tax credits or breaks indirectly. There are many ways to do this which will be discussed in further depth later on.
C. Limits to SALT and Mortgage Interest Deduction
The Tax Cuts and Jobs Act may have some significant impact to housing. This includes for a couple of people who own homes their “net after-tax housing costs” will increase under this act. Renting will be desirable for people considering to purchase a house. Even if people are determined to buy a house they may come to find that the market will be dried up. The effect this tax overhaul has is dependent on where a party lives, how much was spent on the home, and how much this bill changes their “overall tax burden.”
If a party actually does buy a home between now and 2026, they can “deduct the interest on up to $750,000 in mortgage debt used to purchase or improve it as an itemized deduction.” This cap is only in effect for purchases of homes after December 14, 2017. If there was a mortgage taken out earlier than that date people can deduct up to $1,000,000 in debt even those manage to get a lower rate. It is important to note that under this new law interest on up to $100,000 of equity debt to improve the home was deductible. This meant that the IRS saw interest on a mortgage of no more than $1.1 million could be claimed at a time. This new legislation wiped this deduction for home equity debt which included existing loans beginning in 2018. If there is no new legislation in 2026, the law will go back to interest up to $1.1 million in mortgage and home equity debt as a deductible.
Luckily, since the majority of homes in the United States are worth less than $750,000, this legislation will not increase costs for a lot of home buyers. If a buyer lives in an area with expensive housing markets, specifically along the coast, they will likely be hurt by this legislation. The purpose of this is that by treating current homeowners better than potential future homeowners the law dissuades people from moving who have a house that is valued over $750,000. The purpose of dissuading this move is to free up the “already tight supply” of cheaper homes for others.
State and local tax deductions have changed dramatically under the TCJA. Under old tax laws property, taxes paid to the state and local governments could be claimed as an itemized deduction. This assertion is under the assumption that one did not have to pay the alternative minimum tax. Under the old law, it was also permissible to deduct state and local income as well as sales taxes. The new law bundles these “SALT” taxes together while also limiting the amount of deductions a filer can take. The total amount of deductions under the SALT concept is $10,000 for individuals and married couples alike. Some homeowners live in “high-tax” areas including: New York, New Jersey, Connecticut, Maryland, and California. $10,000 under this specific provision does not come close to covering tax bills including: property and income tax. Not surprisingly, there was a massive flush of homeowners to pay property taxes before 2018 so they could be deducted on 2017 taxes. However, on December 27, the IRS stated that “2018 taxes that had already been assessed were eligible for payment.”
Some state governments, however, are looking for creative ways to remedy this for 2018 and the future. A good example is that since this new law does not limit charitable deductions California allows residents to make significant charitable contributions to the state instead of allowing tax payments. It has yet to be seen if this will legally be allowed. New York has also been playing with ideas like replacing state income taxes with payroll taxes.
Even if SALT and mortgage-interest changes do not impact a party directly do not assume their “net after-tax housing” costs will always remain the same. As previously state before the new law doubles a standard deduction to $12,000 for single filers and $24,000 for married couples filing jointly. In this sense the increase in standard deduction will cancel out benefits of itemizing. This is because the mortgage interest and a $10,000 SALT deduction combined, will not exceed $24,0000. Eliminating a tax incentive to buy a home is without a doubt a big impact on the real estate industry. Many people have pointed out that ownership of a home might not be as economically productive as people believe it to be. If reduced tax benefits do actually lower home prices, then first-time buyers could come out ahead of everyone.
Many real estate professionals do agree on one thing: the TCJA could have been significantly worse. Many early versions of the TCJA “eliminated property tax deductions entirely and cut the mortgage-interest cap even further.” The biggest victory for this industry is that the TCJA “maintains the exclusion for capital gains from the sale of a primary residence.” An example is if a taxpayer who sells a home can exclude no more than $250,000 of gain that is not taxed. If it a person is married and filing jointly, then the maximum is $500,000. This is only applicable though if the person has owned and used the home as a primary place of residence “two of the past five years.” Early versions of the TCJA would have significantly increased this ownership to five of the past eight years. Additionally it would keep higher-income taxpayers form claiming this exemption in general.
II. Calculating Spousal and Child Support
- Child Tax Credit Increase
After the implementation of the new tax reform legislation, the child tax credit is increased by$1000, going from $1000 to now $2000 per child. Criterion for the eligibility of the tax credit, however, remains the same:
(1) the child is your son, daughter, stepchild, eligible foster child, brother, sister, stepbrother, stepsister, half brother, half sister or a descendant of any of them,
(2) the child is younger than seventeen at the end of the tax year,
(3) the child did not provide over half of his or her own support for the tax year,
(4) the child lives with the taxpayer for more than half of the tax year,
(5) the taxpayer claims the child as dependent,
(6) the child does not file a joint return for the year, and
This child tax credit is refundable, up to $1400. In the event the taxpayer does not owe any tax before claiming the child tax credit, the taxpayer will receive a $1400 refund per qualifying child. Prior to the tax reform, the child tax credit was not refundable. While the child tax credit is refundable if a party owes zero taxes, the new law restricts the amount of the refundable portion that the taxpayer may receive. The refundable portion of the child tax credit is capped at “15% of the earned income that exceeds $2,500.” Therefore, in order to receive the full refund amount of $1400 for one child, “you need to have at least $11,830 of earned income to qualify.”
- The earned income is $10,000 and at this income level, a party owes no taxes. The refundable portion of the credit would be $1,125. The take the earned income of $10,000 minus $2,500 which equals $7,500. 15% of $7,500 equals the refundable portion of the child tax credit.
- The earned income is $50,000 and the tax owed is $5,000. Because they owe taxes, the full $2,000 credit is applied to the taxes owed. So instead of paying $5,000 they only pay $3,000.
In addition to increasing the child tax credit, the tax reform legislation lowered the income threshold in order to claim the credit. To qualify for the child tax credit, the minimum one family needs to earn is $2,500. Furthermore, the income threshold at which the child tax credit is phased out is increased to $200,000, or $400,000 (if married filing jointly). “Phase out means that the credit is reduced as your income increases.” Once the taxpayer’s income reaches the threshold level, for each $1,000, the child tax credit is then reduced by $50. For example, if the adjusted gross income is $201,000, they can still receive a child tax credit of $1,950. For a single taxpayer, if their income exceeds $240,000, the child tax credit would be reduced to zero. Whereas, if married filing jointly, the adjusted gross income would have to exceed $440,000 for the child tax credit to be reduced to zero. This allows for more families with children under the age of seventeen to qualify for the larger child tax credit. Once the adjusted gross income reaches $200,000 or $400,000, the child tax credit begins to decrease.
Taxpayers with children over seventeen years of age should not be discouraged because a new credit is available for those children who do not qualify for the child tax credit. A child over the age of seventeen can be claimed as a dependent and a credit of up to $500 is available for the qualifying dependent. A child claimed under the child tax credit cannot be claimed under the credit for other dependents. This credit for dependents can be calculated along with the child tax credit. The total of both the dependent credit and the child tax credit is subject to one single phase out when the adjusted gross income exceeds $200,000, or if married filing jointly, $400,000.
- The Tax Treatment of Support Payments
A payment is alimony only if all the following requirements are met:
- The spouses don’t file a joint return with each other;
- The payment is in cash (including checks or money orders);
- The payment is to or for a spouse or a former spouse made under a divorce or separation instrument;
- The divorce or separation instrument doesn’t designate the payment as not alimony;
- The spouses aren’t members of the same household when the payment is made (This requirement applies only if the spouses are legally separated under a decree of divorce or of separate maintenance.);
- There’s no liability to make the payment (in cash or property) after the death of the recipient spouse; and
- The payment isn’t treated as child support or a property settlement.
Support payments made under a divorce agreement or separation agreement. entered into prior to 2019, are deductible by the spouse making the payments and the recipient spouse must include support payments in his or her income. However, with the new tax reform, any support payments made under a divorce or separation agreement (1) executed after 2018, or (2) executed before 2019 but later modified if the modification expressly states the repeal of the deduction for support payments applies to the modification, can no longer be deducted by the payor spouse. And the recipient spouse no longer is required to include support payments in his or her adjusted gross income under an agreement executed after 2018 or prior to 2019 if modified.
Thus, under the new tax law, the spouse who is paying the support payments is responsible for paying the taxes on the payments as well. The new tax law will not affect any separation agreements entered into before 2019 unless modified. In order for the new law to apply to a modification after 2019, the modification must change the terms of the support payments and it specifically says that support payments are not deductible by the payor spouse or included in the income of the recipient spouse. Support payments do not include:
- Child support,
- Noncash property settlements,
- Payments that are the other spouse’s part of community property income,
- Payments to keep up the payor’s property,
- Use of the payor’s property, or
- Voluntary payments (i.e. those that are not required by a divorce or separation agreement).
The impact on how divorce cases are litigated could be astronomical. Under this new tax law, payors of alimony/spousal maintenance will no longer get to deduct their payments on their taxes. On the flip-end, those who receive alimony/spousal maintenance will no longer have to include the amount they receive as income on their tax returns.
This will, in the eyes of same, result in a windfall for those receiving alimony/spousal maintenance. Many also theorize that payor spouses will be less inclined to pay alimony/spousal maintenance by consent. Instead, they will opt to litigate their case given the financial hit that might worry them.
Some think as well that family and divorce courts might be less inclined to enter lucrative alimony/spousal maintenance awards when the payor is no longer able to deduct it on their taxes. To address this issue statutorily, as one example, Illinois actually changed their maintenance formula after the repeal of the alimony tax deduction. Under the prior law, maintenance was calculated by subtracting 20 percent of the recipient’s gross income from 30 percent of the payor’s gross income, with a cap equaling 40 percent of the parties’ combined income. Under the new law, 25 percent of the recipient’s net income is subtracted from 33.33 percent of the payor’s net income to determine the amount of spousal maintenance.
Nonetheless, it will be interesting to see how this change in the tax code impacts divorce cases into the future.
- How the Changes Impact After-Tax Income
After-tax income is the net income after the deduction of all federal, state, and withholding taxes. After-tax income also represents the amount of disposable income that a person or entity has available to spend. To calculate after-tax income, deductions are subtracted from gross income. The difference is the taxable income on which income taxes are due. After-tax income is the difference between gross income and the income tax due. Pre-TCJA after-tax income would look like this:
Archie Klunker earns $30,000 and claims $10,000 in itemized deductions, resulting in a taxable income of $20,000. Archie elected to use itemized deductions because, between his support payments and medical expense deductions, they were greater than the standard deduction of $6,350. Archie’s federal income tax rate is 15%, making the income tax due $3,000. The after-tax income is $27,000, or the difference between gross earnings and income tax ($30,000-$3,000=$27,000).
Given that after-tax income equals gross income deductions taken out of taxable income, changes to the standard deduction in the TCJA have greatly impacted after-tax income. For example:
Herbert Fonzli earns $30,000 and claims $12,200 in deductions (standard trumped itemized), resulting in a taxable income of $17,800. Fonzli’s federal income tax rate is 12%, making the income tax due $2,136. The after-tax income is $27,864, or the difference between gross earnings and income tax ($30,000-$2,136=$27,864).
When individuals account for state and local taxes while calculating after-tax income, sales tax and property taxes are also excluded from gross income. Continuing with the above examples, assume both men live in the state of Missouri. The state tax rate for 2019 is 5.4%. Both Kansas City and St. Louis, MO, have an earnings tax of 1%. Archie pays $1,080 in state income tax and $200 in local earnings tax resulting in an after-tax income of $25,720 ($27,000-$1280=$25,720). Herbert pays $961.20 in state income tax and $178 in local earnings tax resulting in $25,860.80 ($27,864-$1,139.20=$25,860.80).
Before state and local taxes, the TCJA has netted a total increase of $860.80 in after-tax income between Archie’s 2017 tax rate and Fonzli’s 2019 tax rate ($27,860-$27000=$860).
The TCJA has produced a 2.2 % increase in average after-tax income for people of all income groups and a $243 billion decrease in federal revenue. This is because the amount of after-tax income is directly proportional to the amount of revenue the government receives; the more after-tax income that tax payers receive, the less money the government takes. Despite the increase in after-tax income, however, the places that money flows from have undergone some changes. That alimony and other support payments can no longer be deducted by the payor might make the increased standard deduction a more reasonable choice than itemized deductions. This is unfortunate if the support payments are more than $12,200. However, the recipient of support payments also no longer has to claim support payments as income. This lowers their gross income and potentially lowers their tax rate.
The CTC plays a big role in after-tax income, especially in the lower brackets. The effects of changing elements of the CTC are even more distinct for married taxpayers with kids. As discussed earlier, the CTC is expanded under the TCJA, and increases from $1,000 to $2,000 per qualifying child. The CTC has two components. First, the credit reduces any income taxes a party owes. If a party makes less than about $35,000 (like our two examples), and the credit is more than the taxes owed, they get the extra money back in their tax refund. The CTC is partially refundable up to $1,400, where it used to be a nonrefundable credit. By reducing the taxable income, it increases the after-tax income. The TCJA further reduced the refundability threshold to $2,500 starting in 2018, but that lower threshold will expire after 2025 when the $3,000 refundability threshold returns. Increasing the refundable portion and lowering the earnings threshold expands the CTC to more households and leaves people with more after-tax income. Lower thresholds allow people to start accessing the credit at lower incomes, thereby increasing their after-tax income.
III. Negotiating Settlement and Support Agreements
- Practical Settlement Considerations
Negotiating for settlement and support agreements can give a client a sense of
control where tensions and emotions are running high. Being able to participate in settlement is important because (1) a party can control the outcome of their case, (2) they can save thousands of dollars by avoiding trial, (3) divorces may take a very long time, (4) the divorcing parties may not be happy with the decision a judge makes, and (5) there may be less hostility between the parties after the case.
When calculating a divorce settlement, the first thing task is figuring out what assets need to be divided and documenting these assets. Aside from making a list of assets to divide, these assets also need a value. Determining a value for liquid assets is simple-look at the balance on a specified date to determine the value, whereas a home valuation may require an expert or a car can be priced through Kelley Blue Book. In addition to valuing the assets, ownership of the asset needs to be ascertained as well. Ask whether the asset is marital property, or separate property, or is it a joint asset or liability? The final step in settlement is to divide the assets. Equitable division of the assets does not necessarily mean a 50/50 split, or an equal split. Each party needs to be willing to come to a compromise, i.e. give up something in order to gain something, otherwise if settlement falls through, the next step is trial. In trial, the parties may have less control over what they receive and trial is expensive. “Both sides need to keep in mind that their negotiations are neither the beginning nor the end of their relationship and that if negotiations break down, a strike occurs-and everyone loses.” Whereas the end of trial is “akin to the final round of a 15-round boxing contest, with both parties exhausted and hanging on for dear life.” Thus, it is beneficial to try to work through settlement. Markedly, property transfers between spouses, or former spouses incident to divorce are tax free under 26 U.S. Code § 1041.
- Be cordial.
- Do not give ultimatums as this does not facilitate discussions of settlement and compromise.
- Do not give deadlines, which are similar to ultimatums.
- Make full disclosures voluntarily and freely thereby
encouraging settlement conversations.
- Do not be afraid to take the first step in working towards settlement.
- Never negotiate backwards: This rule states that when an offer is made, any subsequent proposals should be close to the other side’s position, not farther away thereby discouraging further settlement discussions.
- Never refuse to negotiate; there is no harm in attempting to settle even if settlement is unlikely.
- Attorneys should never get personal.
- Never get angry at a settlement proposal.
- Be prepared.
Mediation and collaborative law are other ways in which some divorcing parties my attempt to settle their divorce outside of court. In collaborative law, a financial neutral is often used who can help the parties navigate the financial issues, including tax matters. If you want information on collaborative practice, the International Academy of Collaborative Practice is a great resource.
Even if the case is not being resolved through collaborative practice or mediation, a financial expert can often help resolve the tax issues in a case through settlement or trial. Thus, think about enlisting a forensic accountant or other financial expert for the appropriate assistance. This could include certified public accountants, divorce finance analysts, business valuators and even vocational or lifestyle experts.
B. Transfers Between Spouses and Third Parties
A property transfer incident to divorce occurs if the transfer occurs within one year after the date the marriage ends, or the transfer is related to the end of the marriage. A transfer of property is related to the end of the marriage when the transfer is made under the original or modified divorce or separation agreement and the transfer occurs within six years after the date the marriage ends.
However, when a party transfers property to a third party on behalf of their spouse or former spouse if incident to a divorce, the transfer of property is treated as two transfers. The two transfers are:
- A transfer of the property from to a spouse or former spouse.
- An immediate transfer of the property from a spouse or former spouse to the third party.
There is no gain or loss to be recognized on the first transfer. However, the other spouse or former spouse may have to recognize gain or loss on the second transfer to the third party. For this recognition of gain or loss on the second transfer to be applicable, the transfer from a party to the third party must be one of the following:
- Required by a divorce or separation agreement;
- Requested in writing by the other spouse or former spouse; or
- Consented to in writing by the other spouse or former spouse. This consent must state that both a party and their spouse (or former spouse) intend this transfer to be treated as a transfer from you to your spouse (or former spouse) pursuant to the rules of IRS Code Section 1041.
In any of these three situations, the transfer to a spouse or former spouse does not recognize any gain or loss.
C. Reporting Income From Property
Property that is received from a party’s spouse, or former spouse, if the transfer is incident to divorce, is treated as property attained by gift for income tax purposes. Therefore, the value of the property is not taxable to the recipient spouse. However, any income received from property after a transfer from spouse or former spouse should be reported. If income-producing property, i.e. an interest in business, rental property or stocks, is transferred then a party should include on their tax return any profit or loss, rental income or loss, dividends, or interest that is generated or derived from the property during the year until the property is transferred. After the income-producing property is transferred, the spouse or former spouse, incident to divorce, reports any income or loss that is results. If interest in a passive activity (rental property or any business in which the spouse does not materially participate) with unused passive activity losses is transferred, the transferor cannot deduct accumulated unused passive activity losses allocable to the interest. The transferor’s spouse or former spouse, incident to divorce, then increases the adjusted basis of the transferred interest by the amount of the unused losses. If the transfer is of an investment credit property with recapture potential, the transferor does not have to recapture any part of the credit; however, the spouse or former spouse may have to recapture part of the credit if the property is disposed of or the spouse, or former spouse, changes its use before the end of the recapture period. If interests in non-statutory stock options and non-qualified deferred compensation are transferred, the transferor spouse does not include any amount in gross income upon the transfer. However, the spouse or former spouse includes an amount in gross income if he or she exercises the stock options, or when the deferred compensation is paid or made available.
The new tax legislation has also changed who is taxable on alimony trusts or grantor trusts. Under 26 USC § 672(e)(1)(a), a grantor must be treated as holding any power or interest held by any individual who was the spouse of the grantor at the time of the creation of such power or interest. Since the donor spouse is treated as having retained rights to income and principal in the trust, this will typically result in grantor trust status. This means that the donor spouse will be taxed on all or some of the trust income. Even after divorce, the donor spouse will continue to be taxed on the trust income because under § 672(e)(1)(a), “the spousal relationship that gives rise to the grantor trust status looks to the time of the creation of the trust, not the status in any later tax year.”
Section 682 of the Code provided a remedy to the donor spouse for the unwanted circumstance of having to pay taxes on the trust income. Under § 682, it was the donee spouse who was taxed on the income, however, the donor spouse could still be taxed on some of the income, i.e. capital gains. Now, with the advent of the new tax law, § 682 of the code was repealed. This repeal will have no affect on older trusts created prior to the repeal and to those spouses divorced or legally separated under a divorce or separation agreement executed on or before December 31, 2018, unless it is modified after this date. For those divorces or legal separations that occur after December 31, 2018, the donor spouse will be taxable on the income of the grantor trusts.
The non-recognition rule states: when a transfer of property is made from a party t to their spouse, or former spouse incident to divorce, there is generally no gain or loss recognized on the transfer. This rule does not apply (1) if the other spouse or former spouse is a nonresident alien; or to (2) certain transfers in trust; or to (3) certain stock redemptions under a divorce or separation instrument or valid written agreement that are taxable under applicable law.
If a party makes a transfer of property in trust for the benefit of their spouse or former spouse, if incident to divorce, they generally recognize no gain or loss. But a party may have to recognize gain or loss if, incident to divorce, “you transfer an installment obligation in trust for the benefit of your former spouse.” An installment obligation, or installment sale, is “a sale of property where you receive at least one payment after tax year of the sale.” In addition, a party must recognize as gain on the transfer of property in trust the amount by which the liabilities assumed by the trust, plus the liabilities to which the property is subject, exceed the total of their adjusted basis in the transferred property.
Furthermore, most transfers of property between spouses, or former spouses incident to divorce, do not need to be reported on a gift tax return. These transfers typically fall under the following exceptions:
- It is made in settlement of marital support rights. Under this written agreement, a transfer of property is not subject to gift tax if they are divorced within the three-year period beginning one year before and two years after the date of the agreement, irrespective of whether this agreement is part of a divorce decree.
- It qualifies for the marital deduction.
- It is made under a divorce decree.
- It is made under a written agreement, and they are divorced within a specified period.
- It qualifies for the annual exclusion.
E. Tax Pitfalls When Assets are Sold or Transferred
There is no gain or loss when property is transferred to a spouse or former spouse incident to a divorce, but the property tax basis shifts to the recipient. So, if the ex-spouse gets property in divorce and then later sells it, the ex-spouse “will pay capital gains tax on all the appreciation” before and after the transfer as well. The “capital gains tax” is a tax placed on the “positive difference between the sale price of the asset and its original purchase price.” So, once real property is sold, it is subject to a capital gains tax.
Selling the marital home as part of the divorce decree may also have tax implications. If the parties owned the home and lived there for at least two years out of the last five years, then the law allows each party to avoid tax on the first $250,000 (if filing single) or $500,000 (if filing jointly) of gain on the sale of the marital home. If, however, this two-out-of-five year test is not met, “[t]he limit on tax-free profit in this case depends on the portion of the two-year period for which the home was owned and used.” For instance, if the marital home was used for one year rather than two, each party can exclude $125,000 of gain. Furthermore, this exclusion applies only to the principal residence, but if the parties have more than one home, a “facts and circumstances” test should be applied to determine which property is the principal residence. If a party was separated or divorced prior to the sale of the home, they can treat the home as their residence if:
- They are a sole or joint owner, and
- Their spouse or former spouse is allowed to live in the home under a divorce or separation agreement and uses the home as his or her main home.
Furthermore, if the home was transferred to a party by a spouse or former spouse, regardless of whether the transfer was incident to divorce, they may count any time when their spouse, or former spouse, owned the home as time when they owned it. But the residence requirement must be accomplished on its own. The residence requirement entails owning the home and using it as a residence for at least twenty-four months of the previous five years. Moreover, this capital gains tax exemption can be claimed only once every two years.
It is also important to keep in mind that the non-recognition rule applies to transfers incident to divorce, transfers that occur within one year after the date the marriage ends. So, if a party plans to transfer property or assets to their former spouse more than one year after the divorce, the separation agreement should clearly state the transaction and that such transaction is part of the property settlement. Failure to do so may be considered a taxable sale or gift to the former spouse, forcing the transferor spouse to pay taxes.
IV. Amending Existing Agreements/Orders
A. Filing Status of Divorcing Parties
When a marriage ends, the tax situation of the parties involved changes. But while divorce ends the legal marriage, it doesn’t terminate either party’s obligation to pay their fair share of federal income tax. If the divorce is final by Dec. 31 of the tax-filing year, the IRS will consider the couple unmarried for the entire year and it won’t be possible to file a joint return. This is because once a couple is no longer married, they can’t file their federal income taxes with a status of “married filing jointly” or even “married filing separately.” The remaining options to choose between are “single” or “head of household.” The right choice depends on how each party qualifies.
Filing as head of household has some big benefits compared to filing as single, including a higher standard deduction of $18,350 , eligibility for valuable tax credits (CTC, etc.), and often a lower tax rate. But a party can only file as head of household if:
- They’re not considered married as of Dec. 31 of the year for which they’re filing the tax return.
- They paid at least half the cost of keeping up a home during the year in which they’re filing.
- They have a “qualifying person” who either lived with them for at least half the year or who meets other specific requirements, including being temporarily absent for specific reasons. Some examples are children attending school, married children they claim as dependents, or qualifying parents they support and claim as dependents even if they don’t live with them.
After divorce, the parties cannot both file as head of household based on shared support and care for the same child or children. Children can count as qualifying persons only for the custodial parent, the parent that the child lives with for most of the year. If both parents share the child for an equal amount of time, the parent whose adjusted gross income is higher can claim the child for the purposes of filing as head of household. Divorce decrees usually establish the custodial parent. The noncustodial parent is unable to use any children from the marriage to claim head-of-household status. If the custodial parent releases the right to claim the child by signing IRS Form 8332, it will allow the noncustodial parent to claim the child as a dependent and claim the CTC. However, there’s no exception equivalent for head-of-household filing status.
The rules and regulations of the Internal Revenue Service (IRS) set forth that a parent is entitled to claim head of household for the child or children based upon the number of nights he or she has possession of the child. The IRS’s rules and regulations also set out which parent or parents are entitled to claim child-related deductions and exemptions. It is important to understand the rules and regulations for the child-related deductions and exemptions to which you believe your clients are entitled or would be entitled prior to negotiating their divorce settlement. The divorcing parties may contractually agree that one parent has the right to claim the child-related deductions and exemptions. This ability may be a useful negotiating tool, especially if one parent does not benefit much from those deductions or exemptions or is unable to claim them because his or her income is too great. Therefore, it is imperative to understand how any child-related deductions and exemptions will affect the parties after the divorce and to monetize that benefit for your client’s interests. Quantifying the monetized benefit can be a useful negotiation tool in negotiating the final divorce settlement.
The typical agreement in a final decree for divorce provides that for each year of marriage both parties are equally responsible for any federal income tax liability and both parties are entitled to one-half of any federal income tax refund for any year of marriage. However, the “typical” arrangement may not work for your client’s situation. It is important that you find out if the parties have filed a federal income tax return for each year of marriage, whether they were audited any of those years, and whether any tax liability is owed for any year of marriage. Copies of all of your federal income tax returns for each year of marriage for at least 7 years should be obtained. If one spouse owns his or her own business or has many complicated investments such as real estate investments, then their potential for being audited may be higher than the average person W-2 employee. Thus, the IRS may determine in the future that a party and their spouse owe money for a prior year of marriage. The parties, or at minimum your client, should discuss with their risks of being audited for a prior year of marriage and of owing a liability for any prior year of marriage with a tax professional before a “typical” arrangement is drafted.
For the official divorce year, a party will file a separate return since their marital status for that year is determined by the marital status on the last day of the year. One option is that for the months of the year a party was married, they claim one-half of their spouse’s income, withholding, and deductions and their spouse claims one-half of their income, withholding, and deductions. How a party files their federal income tax return for the year of divorce MUST be set out in their divorce settlement. If there is no language in the divorce decree that specifically states that the parties are partitioning income for the year of divorce, then the default per the IRS is the option above. Additionally, parties may have mortgage interest and property tax deductions, charitable deductions, or other deductions from the period of time that they were married during the year of divorce. One party may not be able to itemize deductions based upon their income so finding out whether they would benefit from taking all or part of these deductions for that period of time will be important for parties to know prior to starting divorce settlement negotiations. Parties should divide or address these itemized deductions from the year of divorce in their divorce settlement.
In a family law case, it is usually wise for a client to employ a tax expert (forensic accountant or a personal accountant at a minimum) to help advise a client as to the tax consequences as to the effects of a divorce and the decisions a client will have to make as to possible resolutions to a case. Tax experts can often give client’s tax advice that is valuable to the resolution of a case that a family law attorney simply cannot give.
B. Itemized and Miscellaneous Deductions
Under the prior law, taxpayers who itemized their deductions were eligible to claim certain deductions under IRC § 67, if their itemized deductions exceeded 2% of adjusted gross income. The TCJA eliminated the miscellaneous itemized deductions for the tax years 2018 through 2025. State and local tax deductions, including property tax, have been limited to $10,000 per year. Many taxpayers lost the benefit of their itemized deductions in 2018 due to these limitations and caps. Prior to the TCJA, taxpayers who itemized their deductions were eligible to deduct legal fees incurred for the production or collection of taxable income under IRC § 212. The portion of the divorce legal fees related to obtaining alimony and spousal support for a recipient was generally tax-deductible under § 212. The IRC § 212 deduction was preserved by the new law, but alimony is no longer taxable income unless it is paid under a pre-2019 divorce instrument or modification. This is because the TCJA does not apply. If the alimony does not qualify as taxable income, then the divorce legal fees will not be deductible. Legal fees incurred for the purpose of enforcing or modifying a pre-2019 alimony or spousal support award and divorce legal fees to obtain a QDRO distribution (see section E) are not tax-deductible for the years 2018 through 2025 because IRC § 67 have been suspended, including legal fees. Divorce legal fees may, under certain circumstances, be added to basis of the property to which they relate.
For individuals, the new law repeals all miscellaneous itemized deductions (MIDS), including those from pass-through entities, that are subject to the 2% floor. Typical deductions included appraisals, tax advice and preparation fees, income production expenses, deposit losses from insolvent financial institutions, and investment management and financial consulting fees. The deductions for unreimbursed employee deductions for travel, meals and entertainment, union dues, home office, job legal fees, malpractice and liability insurance premiums, professional dues and journal subscriptions, work uniforms, licenses, tools and supplies are also repealed. Generally, under prior law, the total amount of itemized deductions was reduced by 3% of AGI over a certain threshold amount. This “pease” limitation on itemized deductions has been repealed. Since trusts and estates compute taxable income in the same manner as individuals, expenses for the MIDS mentioned above will be disallowed. However, it is less clear if expenses paid in connection with the administration of the estate or trust, which would not have been incurred if the property were not held in such trust or estate, are deductible. New code §67(g) provides MIDS are not allowed “notwithstanding [c]ode [§]67(a),” without reference to code §67(e). Personal representative and trustee fees are not considered MIDS.
To be deductible, it may be necessary to determine the expense’s underlying purpose as being either related to income and investment producing activities, therefore non-deductible, or a fiduciary fee that is potentially deductible. When terminating an estate or trust by distributing all assets, the beneficiaries are allowed to use the deductions in excess of gross income for the year of termination on their individual income tax returns. However, any excess deductions considered MIDS for an individual’s tax return are no longer deductible. The act temporarily expands the deduction for medical expenses. For 2018, taxpayers are allowed to deduct medical expenses in excess of 7.5% of their AGI; for 2019, the floor for the deduction will revert back to 10% of AGI. For divorce and separation agreements executed after December 31, 2018, alimony payments will no longer be deductible by the payor or includible in the income of the recipient. This is likely to affect post-2018 settlement negotiations when they are eventually inevitably modified.
C. Tax Withholding and Estimated Tax
Pre-TCJA, a personal exemption deduction was generally available for a taxpayer, his or her spouse, and each dependent child. The amount was set by statute and adjusted annually for inflation. For 2017, the personal exemption was $4,050 for each qualifying person. In general, an individual could calculate his or her taxable income by subtracting from adjusted gross income the applicable personal exemptions (as well as either the standard deduction or applicable itemized deductions). Individuals could use the number of applicable personal exemptions to determine the amount to be withheld from employee wages based on tables published by the IRS.
The TCJA eliminates the personal exemption under IRC § 151 for tax years starting after December 31, 2017 and continuing through December 31, 2025. In other words, the personal exemption amount is reduced to zero until 2026, when it returns to life. Despite removing the personal exemption until 2026, Congress preserved other references to IRC § 151 in the Code. For example, the child tax credit (see section II) is available to taxpayers who would be allowed a deduction under IRC § 151. Even though that deduction no longer exists, the qualifications contained in IRC § 151 still apply for purposes of determining whether a taxpayer is entitled to the child tax credit.
The TCJA makes supplementary changes to the withholding requirements to reflect the fact that personal exemptions no longer exist. Instead of withholding based on personal exemptions, employees now need to withhold based on other criteria, such as eligibility for the child tax credit, whether the taxpayer files jointly or individually, and whether the taxpayer itemizes or uses the standard deduction. The IRS has issued some initial guidance, such as a “withholding calculator” intended to help taxpayers determine their new withholding obligations, and a revised Form W‑4 to enable taxpayers to calculate and modify their withholding from wages. Taxpayers should review and adjust their withholding using the Withholding Calculator and the revised Form W‑4. Given the changes brought by the TCJA, this is especially important for taxpayers who itemized deductions in 2017 and prior years because they may no longer be doing so or their itemized deductions may be substantially reduced due to the TCJA’s changes (i.e. SALT cap).
D. Gift and Estate Tax Considerations
Seemingly harmless are the changes in the Tax Act which relate to taxability of some trust income after a divorce, particularly irrevocable trusts benefiting a former spouse during the marriage. These irrevocable trusts commonly known as grantor trusts usually have provisions which cause the income tax and expenses to be reported by the grantor (the person who created the trust). This means that the tax is paid by the grantor and not by the trust. The grantor spouse is the grantors’ spouse at the time of creation of the trust, and even after divorce for the purposes of the grantor trust, that individual is still the grantor spouse. This meant the grantor would be taxed on the income regardless of whether the grantor and the grantor spouse remain married. The grantor would be taxed on the trust income, while the spouse would gain income and not need to report it or pay income tax. This position was cured by the 2017 Tax Act in §682. This section provided that the trust income would be taxed not on the grantor, but on the grantor spouse. However as of January 1st, 2019, §682 was repealed, the effect of which means the grantor would be required to pay tax while the other does not.
Different types of trusts have different benefits to the parties, and this information is very important during the drafting of prenuptial agreement. Examples include irrevocable trusts created for the benefit of the other spouse within their respective estate plans, which qualify for gift tax marital deduction as qualified terminable interest property (QTIP). These are called inter -vivos QTIP trusts. Another example would be the spousal lifetime access trust (SLAT, which acted as a taxable gift by one spouse, and would provide the other with discretionary distributions of trust income. Parties could therefore get the gift tax exemption and still keep the assets within the marriage. SLATs are also affected by the changes. A SLAT would under the new law be considered as a grantor trust and as such the grantor bears the tax liability after 31 December 2018 without exception.
A QDRO is a judgment, decree or order for a retirement plan to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent of a participant. The QDRO must contain certain specific information, such as:
- the participant and each alternate payee’s name and last known mailing address , and
- the amount or percentage of the participant’s benefits to be paid to each alternate payee.
A QDRO may not award an amount or form of benefit that is not available under the plan. A spouse or former spouse who receives QDRO benefits from a retirement plan reports the payments received as if he or she were a plan participant. The spouse or former spouse is given a share of the participant’s cost equal to the cost times a fraction. The numerator of the fraction is the present value of the benefits payable to the spouse or former spouse. The denominator is the present value of all benefits payable to the participant.
An individual may be able to roll over tax-free all or part of a distribution from a qualified retirement plan that he or she received under a QDRO. If a person receiving QDRO payments is either the employee’s spouse or former spouse (not as a non-spousal beneficiary), then he or she can roll it over, just as if he or she were the employee receiving a plan distribution and choosing to roll it over. The divorce settlement may award benefits accrued by the working spouse (the participant) to the other spouse (the alternate payee). As long as this is done via QDRO, the participant is not taxed on benefits transferred to the alternate payee and the early distribution penalty does not apply. The QDRO cannot compel the distribution of benefits to the alternate payee; it merely awards them to this spouse. Benefits are payable on the earliest retirement date, even if the participant has not separated from service [IRC section 414(p)(4)(B)]. Service is defined as:
- the date on which the participant is entitled to a distribution under the plan, or
- the later of
- the date the participant attains age 50, or
- the earliest date on which the participant could begin receiving benefits under the plan if the participant separated from service.
The use of a Qualified Domestic Relations Order (QDRO) can be utilized to transfer more pre-tax assets to the economically disadvantaged former spouse. In place of tax-deductible alimony, one technique being used in 2019 is creative splitting of retirement accounts. The recipient will pay taxes on distributions when received, and other post-tax assets can be allocated to the other spouse to offset. If the recipient is under 59.5 years old, there are still ways to receive the distributions without being subject to the 10% early withdrawal penalties. A QDRO can be used with qualified retirement accounts, and IRA accounts can be annuitized. This technique moves funds that are taxable upon distribution to the person with the lower effective tax rate. If significant retirement assets are transferred, income tax considerations could warrant a little larger percentage of the total marital estate to the economically disadvantaged spouse than would otherwise have been realized.
The structure of the payment is important. Retirement funds can be distributed directly to an ex-spouse under the terms of a QDRO. The distribution will be taxable income to the ex-spouse (payee). However, if the funds are rolled over to an Individual Retirement Account (IRA) from the participant to the ex-spouse, the ex-spouse receiving the funds will later incur a 10% penalty if he/she needs to receive a distribution from the new IRA before age 59.5.The exception to the 10% early distribution penalty under I.R.C. 72(t)(2)(c) applies to distributions from a qualified plan, such as 401(k) plans.
- Practice Pointers
A domestic relations order (DRO) is an order that grants alimony and/or property rights to the pension owner’s spouse, or child support under domestic relations law. For example, a property settlement could trigger the distribution of the retirement benefit plan to anyone who is not the plan participant. For the non-participant spouse to receive payment from the plan, the payment must be made in accordance with the qualified domestic relations order (QDRO). A DRO is qualified if it “(1) creates or recognizes the existence of an ultimate payee’s right to, or assigns to an alternate payee the right to receive benefits with respect to a participant under the plan, and (2) complies with other statutory requirements.” An alternate payee can be a spouse, a child, former spouse, or other dependent that is recognized by the QDRO as having a right to receive either a portion of or all of the benefits payable under the participant’s plan.
For a domestic relations order to become qualified, the plan administrator must join the suit as a party, and then decide if the DRO is qualified, and be permitted to represent the important interests. When determining if the DRO is qualified the plan administrator must determine if it fulfills several requirements. First, there must be a transfer of ownership. Thus, the order must “be one which ‘creates or recognizes the existence of an alternate payee’s right to…receive all or a portion of the benefits’ payable to the owner.” Second, the DRO must specify the names and addresses of each participant in the suit and the alternate payee; the amount that each alternate payee will receive; the number of payments that the order will be effective for; and the exact retirement plan the order governs. Third, DRO must specify the amount and duration of the payments. Fourth, when talking about retirement plans, the DRO must “provide that the court may not order the plan to provide to an alternate payee any type, form, or amount of benefit not normally available to the owning spouse. It also may not order the plan administrator to provide to one alternate payee any benefit already being paid to an alternate payee under another QDRO.”
Drafting a proper QDRO depends largely on the companies your clients have retirement accounts with. It is good practice to contact the companies where these accounts are located and ask if they have a sample QDRO they like their clients to use. Often this can save you and your client time and money. After you have drafted the QDRO but before you have a judge sign off on it, it is a good idea to send the QDRO to the plan administrator and see if it will be acceptable. The plan Administrator can then either approve the QDRO as is or make suggestions as to how to change the document. Following this extra step would prevent having to take multiple QDROs to the judge for their signature and it will often save you and your client time and money in the long run. Once the plan administrator informs you the QDRO will work, you can then proceed with obtaining a judge’s signature.
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