Divorce planning after tax reform
Over 600,000 taxpayers claimed a deduction for alimony on their 2015 returns, but for divorces entered into after 2018, alimony will no longer be deductible by the payor and the income will not be taxed to the recipient, thanks to the Tax Cuts and Jobs Act.
“The law has gone back almost 80 years,” said Marilyn Chinitz, a partner at law firm Blank Rome who specializes in matrimonial litigation involving high-net-worth individuals.
“The Revenue Act of 1942 made alimony payments deductible to the paying spouse and taxable to the recipient,” observed Chinitz, who counts Tom Cruise and Michael Douglas among the clients she has represented in divorce litigation. “But that’s all changed. Now, everyone is racing to get their divorce done before 2019. It can be problematic if the divorce is settled after 2018 because one spouse will lose a benefit and the other spouse will gain. If a case is close to settling, you would hope to close it out before the end of the year.”
“Where we see a need for guidance from the IRS is where a prenuptial agreement prior to 2019 mandates payments to a spouse if there is a ‘triggering event’ and it calls for alimony to be taxed to the recipient and deductible by the payor,” she continued. “How will the provision be honored by the courts, and by the IRS even though under the law alimony is no longer deductible? There might be the need for a post nuptial agreement to address the changes in the tax law.”
Another area that tax reform has changed in divorce negotiations is in the valuation of businesses, according to Chinitz. “The cash flow will increase for flow-through entities,” she said. “The consequence of that will be that the business can be valued at a higher amount. A lot of forensic accountants will be looking at the value of these businesses. When your client gives a statement of net worth for purposes of divorce negotiations, you want to value the assets to benefit your client.”
If you represent the non-moneyed spouse, make sure that the assets they receive are unencumbered, Chinitz advised: “There should be no liens, or hidden capital gains taxes to be paid.”
“For example, if you had a choice between a brokerage account with a value of $1 million and a house valued at $500,000, you might think that $1 million sounds better than $500,000,” she said. “But you have to look at the asset and see what liabilities are involved. If the brokerage account has capital gain embedded, then a house without a mortgage may be the better asset. When advising clients it’s important to know that there may be hidden capital gain embedded in the asset.”
Pension plans present their own problems, according to Chinitz. “Defined-benefit plans are generally not portable or accessible prior to retirement,” she said. “They can be valued and paid as a lump sum, or there can be an agreement that the nonparticipating spouse will receive a share in the benefits later. A QDRO [qualified domestic relations order] accomplishes this by allowing the spouses to roll over the payments from the plan tax-free.”
The QDRO recognizes joint marital ownership of the pension plan, and specifies the terms under which the non-plan participant (the alternate payee) receives their share of the proceeds of the plan. Under a QDRO, a person receiving the payment may roll it over just as if they were the employee receiving a plan distribution and choosing to roll it over. The spouse or former spouse reports the payments received under the QDRO as if they were a plan participant.
“It’s extremely important that CPAs and other financial advisors understand what pension funds are available so that they can be properly distributed in a divorce,” said Chinitz. “A spouse going through a divorce needs to choose assets wisely because they need to secure their future. You want to advise your client to select assets that provide an income stream to fund a lifestyle similar to what they enjoyed when they were married.”