With changes brought about by the Tax Cuts and Jobs Act, many people are left wondering how they will be affected come tax time. One change in particular will change negotiations for divorce agreements that will be finalized after Dec. 31, 2018 and could possibly give rise to old divorce agreements being revisited. That change concerns the deductibility/taxability of alimony and unlike other changes, this one is permanent.
Pre-Tax Cuts and Jobs Act
Before the Tax Cuts and Jobs Act (TCJA), alimony payments made to an ex-spouse were deductible on your tax return. For those receiving alimony payments, the amount being received was taxable income and needed to be reported on the recipient’s tax return.
- For any divorce agreement finalized before Jan. 1, 2019, alimony payments will remain deductible and alimony being received will still be considered taxable income.
The tax implications that come along with deducting alimony are two fold, given that there are two people involved.
The payor may be willing to agree to a higher alimony payment to receive the deduction on their tax return, which will likely reduce their tax liability at the end of the year. The payee, however, is only concerned with how much he or she will receive. However, he or she needs to make sure all required tax payments are made throughout the year. Otherwise, the tax price will go up (due to penalties and interest).
So, Why The Change?
From an administrative stand point, tracking how much alimony being paid or received by a taxpayer was difficult. Cases involving alimony hinge on records kept by each taxpayer. When those records are non-existent, partially kept, or don’t match the records of the ex-spouse, it creates difficulties for the IRS to determine which taxpayer’s return is correct.
Keeping records of alimony paid or received is important and can be done by:
- Keeping copies of the checks paid or received
- Keeping receipts of alimony paid or received by cash
- A spreadsheet containing the check number, the amount of the check, and the date of the check that was paid or received
- Make sure that the check or receipt has a memo stating the payment is for alimony and not child support
- If the payment contains a lump sum for both, there should be a memo indicating how much is allocated to child support and how much is allocated to alimony.
- For additional information on what records to keep see Alimony Guidelines: What Records to Keep Regarding Your Alimony
The two major issues that were arising from alimony being deductible by the payor and taxable to the payee were:
- The payor unknowingly taking a deduction for alimony that was actually child support
- Alimony not being reported by the payee due to being unaware that the alimony received was taxable
Remember, any payments made or received that are for both child support and alimony get allocated to child support first.
Example:
Taxpayer A is required to pay $1,000 a month in child support ($12,000 per year) and $1,000 a month in alimony ($12,000 per year) to Taxpayer B. Despite the requirement to pay $2,000 each month Taxpayer A instead pays Taxpayer B $1,000. When Taxpayer A files their tax return they claim an alimony deduction of $6,000 because they believe each month the $1,000 that they pay is being split, $500 for child support and $500 for alimony. Taxpayer B does not claim any alimony as income on their tax return.
In this example, the issue is that the $1,000 a month being paid by Taxpayer A is only covering the child support payment, which is what any money paid is allocated to first. However, because they took a deduction on their tax return for alimony being paid, the IRS may exam Taxpayer B’s tax return because according to Taxpayer A’s return, Taxpayer B should have claimed $6,000 in taxable income.
This of course creates a problem for Taxpayer B because they are now forced to supply the IRS with information proving that the money received was not alimony and therefore is not taxable. If Taxpayer B did not keep proper records, they may end up paying tax on money that should not have been taxable.
Now let’s take a look at the situation in reverse.
Example:
Taxpayer A is required to pay $1,000 a month in child support ($12,000 a year) and $1,000 in alimony ($12,000 a year) to Taxpayer B. Each month Taxpayer A makes his required payment of $2,000 a month (1/2 for child support and 1/2 for alimony). When Taxpayer A files their tax return they take the alimony deduction of $12,000 because that is what they paid Taxpayer B during the year. Taxpayer B however does not claim the $12,000 as alimony received on their tax return.
In this example, Taxpayer A is properly reporting the alimony deduction. Taxpayer B though does not claim the alimony received on the tax return even though it is taxable. The IRS may examine Taxpayer A’s return and request proof the deduction taken was actually alimony paid since Taxpayer B’s tax return doesn’t show the money was ever received.
This can create a problem for Taxpayer A if proper records were not kept. Specifically, the deduction will be denied and additional tax assessed.
No Longer Deductible and No Longer Taxable
Alimony payments made or received, pursuant to a divorce agreement that was finalized or renegotiated on or after Jan. 1, 2019, will no longer be deductible by the payor and no longer taxable to the payee. The change to the deductibility/taxability of alimony can be found in Section 11051 of the Tax Cuts and Jobs Act.
Again, from an administrative stand point, this should help in reducing the amount of cases that arise from taxes not being paid on alimony received and alimony deductions that were improperly being claimed. It also may seem like it should lessen the pressure put on the taxpayers to keep records of alimony paid or received. However, keeping records will always be important due to proving whether the payments paid/received were for child support or alimony when you are being audited by the IRS.
For instance, during an audit the IRS may examine the bank statements of a taxpayer and see money that was deposited but not claimed on the tax return (this being alimony or child support that was received). The taxpayer would still need some way to prove the money deposited was alimony or child support. Otherwise, the taxpayer may end up being assessed tax on payments that were nontaxable.
The Negotiation Of A Divorce Agreement After 12/31/2018
The changes to alimony taxation will certainly impact how divorce agreements are negotiated in the future. With alimony no longer being deductible, the payor spouse needs to ensure the tax implications are factored into any agreement. If this major change to the tax code is overlooked the payor will certainly end up in a worse financial position.
On the other hand, spouses who receive alimony no longer have to worry about paying taxes on the money they receive. But, during the negotiations for the divorce agreement the amount they are able to agree upon receiving may end up being less due to the spouse paying the alimony not being able to deduct the payment.
If you are going through a divorce or are renegotiating an alimony order/agreement after 12/31/2018 please make sure you bring this change to the attention of your divorce attorney. If the alimony is not calculated properly (including the tax implications) it will likely lead to additional court proceedings (i.e. one party requesting to have the tax implications accounted for).
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