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.

Alimony Trusts

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.

Personal Exemptions and the Child Tax Credit

Personal exemptions have been suspended for the tax years beginning after December 31, 2017 and ending December 31, 2025. This means that during this eight-year period, divorcing parents will not be able to utilize the personal exemption for dependent children and do not need to negotiate which parent will be eligible to take it.

In the meantime, divorcing parents can negotiate which parent should be allowed to claim the Child Tax Credit. However, it's important to remember that when personal exemptions return in 2026, the Child Tax Credit must go to the parent who claims the personal exemption for the child.

Miscellaneous Itemized Deductions

Miscellaneous itemized deductions that could only be claimed if they exceeded 2% of the taxpayer's adjusted gross income have been suspended. Taxpayers will be unable to claim these deductions at all in the tax years beginning after December 31, 2017 and ending December 31, 2025. For divorcing couples, this means that fees incurred for tax advice related to a divorce are no longer deductible. Additionally, fees that a divorced spouse pays to an investment management firm to manage assets are no longer deductible.

Important Considerations Under the New Law

While we'd like the law to be black and white, there are still uncertainties in how the new tax law will affect divorcing couples. These uncertainties will have to be clarified by the IRS or the courts. In more complicated divorce cases, a family law practitioner would be wise to seek the counsel of a tax attorney or CPA experienced in this area. For now, divorcing couples should take a close look at their divorce or separation agreements and consider the following:

Review Withholding and Estimated Tax Payments

Any change in the tax treatment of alimony payments as a result of the 2017 tax legislation should also trigger a review of withholding and estimated tax payment requirements — whether you're entering into a new agreement or modifying an existing one.

Consult State Law

When the federal tax law changes, states may or may not adopt the federal changes for state law purposes. Each state is different. Couples need to look at their state tax law to determine whether the changes made by the 2017 legislation will also change the state income tax consequences of alimony.

Review Trusts

All trusts should be reviewed to determine how and to whom the income of the trust is taxed. To avoid potentially adverse tax consequences related to changes to the tax treatment of alimony trusts, taxpayers should consult with an experienced trust attorney to see if the trust can be modified. It may be possible to obtain a judicial modification or non-judicial settlement, or to decant (i.e. to transfer assets from the existing trust) into a new trust with more favorable provisions.

Review IRA Contribution Eligibility

The 2017 tax legislation repeals a part of the Internal Revenue Code that classified deductible alimony as "compensation" income for the purposes of determining eligibility for deductible IRA contributions.5 This may result in an alimony-receiving spouse being ineligible to make an IRA contribution if the alimony was their only form of income.

Watch Out for Increases in Business Valuations

As a result of the increased cash flow due to the lower C corporation tax rate (reduced from 35 to 21%) and the qualified business income deduction (up to 20%) for pass-through entities such as partnerships, S corporations or sole proprietorships, divorcing couples must be aware of what could be a substantial increase in business valuations when preparing their settlement.

A Game Changing Piece of Legislation

With a one-year delay in the effective date of the divorce-related provisions, divorcing couples and family law practitioners now have some lead time to finalize divorce and separation agreements and utilize the tax advantages available under the existing law. While there are sure to be further clarifications on how exactly the new law will be implemented, it is sure to be a game changer for how divorce and separation agreements are structured in the future. Partnering with trusted legal, tax, trust and estate, and wealth management advisors is critical to ensuring your understanding all of the implications of this new legislation.

  • 1 As defined by Section 71(b)(2) prior to its repeal

    2 Repealing Section 215

    3 Repealing Sections 61(8) and 71

    4 Section 682

    5 The third section of Section 219(f)(1)

  • This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. The Bank of New York Mellon, Hong Kong branch is an authorized institution within the meaning of the Banking Ordinance (Cap.155 of the Laws of Hong Kong) and a registered institution (CE No. AIG365) under the Securities and Futures Ordinance (Cap.571 of the Laws of Hong Kong) carrying on Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management) regulated activities. The Bank of New York Mellon, DIFC Branch (the “Authorised Firm") is communicating these materials on behalf of The Bank of New York Mellon. The Bank of New York Mellon is a wholly owned subsidiary of The Bank of New York Mellon Corporation. This material is intended for Professional Clients only and no other person should act upon it. The Authorised Firm is regulated by the Dubai Financial Services Authority and is located at Dubai International Financial Centre, The Exchange Building 5 North, Level 6, Room 601, P.O. Box 506723, Dubai, UAE. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the Federal Reserve and authorised by the Prudential Regulation Authority. The Bank of New York Mellon London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon is incorporated with limited liability in the State of New York, USA. Head Office: 225 Liberty Street, New York, NY 10286, USA. In the U.K. a number of the services associated with BNY Mellon Wealth Management's Family Office Services– International are provided through The Bank of New York Mellon, London Branch, 160 Queen Victoria Street, London, EC4V 4LA. The London Branch is registered in England and Wales with FC No. 005522 and #BR000818. Investment management services are offered through BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA, which is registered in England No. 1118580 and is authorised and regulated by the Financial Conduct Authority. Offshore trust and administration services are through BNY Mellon Trust Company (Cayman) Ltd. This document is issued in the U.K. by The Bank of New York Mellon. In the United States the information provided within this document is for use by professional investors. This material is a financial promotion in the UK and EMEA. This material, and the statements contained herein, are not an offer or solicitation to buy or sell any products (including financial products) or services or to participate in any particular strategy mentioned and should not be construed as such. BNY Mellon Fund Services (Ireland) Limited is regulated by the Central Bank of Ireland BNY Mellon Investment Servicing (International) Limited is regulated by the Central Bank of Ireland. BNY Mellon Wealth Management, Advisory Services, Inc. is registered as a portfolio manager and exempt market dealer in each province of Canada, and is registered as an investment fund manager in Ontario, Quebec, and Newfoundland & Labrador. Its principal regulator is the Ontario Securities Commission and is subject to Canadian and provincial laws. BNY Mellon, National Association is not licensed to conduct investment business by the Bermuda Monetary Authority (the “BMA") and the BMA does not accept responsibility for the accuracy or correctness of any of the statements made or advice expressed herein. BNY Mellon is not licensed to conduct investment business by the Bermuda Monetary Authority (the “BMA") and the BMA does not accept any responsibility for the accuracy or correctness of any of the statements made or advice expressed herein. Trademarks and logos belong to their respective owners. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. ©2018 The Bank of New York Mellon Corporation. All rights reserved.