Emerging Issues Regarding the Tax Treatment of Alimony

Emerging Issues Regarding the Tax Treatment of Alimony

As we discussed in a previous blog, the reforms of the Tax Cuts and Jobs Act of 2017 (“TCJA”) resulted in significant changes concerning federal tax treatment of alimony or spousal support in California. Under the new rules, the tax treatment of alimony payments was effectively reversed, allowing the receiving spouse to exclude alimony or spousal support payments from their income for federal income tax purposes. However, the change also means that the spouse paying alimony can no longer deduct spousal support payments under Federal Tax Law.

In July, the IRS issued guidance regarding the treatment of alimony payments under a modified divorce agreement.

The IRS explained that the reforms of the Tax Cuts and Jobs Act (TCJA) regarding the tax treatment of alimony only applied to modifications that:

  • Changed the terms of an alimony or spousal support order
  • Expressly stated that alimony or spousal support payments were not deductible by the payor or reportable by the receiving spouse

The clarification provided by the IRS makes sense. Otherwise, a person could risk losing favorable tax treatment for their alimony payments by modifying an unrelated provision in their divorce orders.

The Alimony Tax Gap & Reversing the Alimony Tax Deduction

Officials and proponents of reforming the alimony tax deduction pointed to the “alimony tax gap” as a reason for reversing the tax treatment of alimony payments for federal income tax purposes. The alimony tax gap is a growing discrepancy between the total amount that taxpayers deducted for paying alimony and the total amount that recipients reported as income.

For instance, when a former spouse receives alimony payments those payment should be claimed as income on the receiving spouse’s tax return. In addition, the alimony payment amount should be equal to the amount that their former spouse reports as alimony paid on their tax return. In 2010, there was a $2.3 billion discrepancy between amounts reported as alimony paid and received. The IRS noticed that many taxpayers were not reporting alimony receipts. Furthermore, those who did report alimony receipts reported amounts that differed from deductions claimed on the other spouse’s corresponding tax return.

By reversing the tax treatment of alimony payments, proponents of the TCJA’s reforms hope to get a more accurate picture of the overall taxable revenue between divorced spouses by making payor spouses liable paying taxes on those payments, rather than the receiving spouse.

In August, the Treasury Inspector General for Tax Administration (TIGTA) reported that the alimony tax gap grew to 38% for the 2016 tax year. This means that there are $3.2 billion unaccounted for regarding alimony payments in the United States.

The effect these reforms will have on the alimony tax gap is not yet clear. However, TIGTA doubts the new tax treatment of alimony payments will yield measurable results any time soon. The TIGTA noted that the number of taxpayers reporting alimony under the pre-TCJA rules might continue to be large for years. As a result, any systemic sources of the alimony tax gap will also remain.

Responses to the Alimony Tax Reform

As mentioned before, the TCJA’s reforms do not apply to divorce orders and agreements issued before January 1, 2019. Only spousal support orders issued or modified on or after January 1, 2019, are subject to the new tax treatment.

Opponents of the TCJA’s reforms cautioned the issue of spousal support would be a more contentious aspect of divorce litigation. Furthermore, the reforms introduce a new disincentive for post-2019 modifications of pre-2019 spousal support orders.

However, there is now a market for finding creative solutions to minimizing the tax consequences of the new alimony tax rules under the TCJA’s reforms. It’s no surprise that people would have strong feelings about paying spousal support and being taxed for doing so.

Among the ways one can minimize the tax consequences of alimony for concerned spouses, are:

  • Negotiating for lower alimony with pre-tax retirement accounts
  • Creating a charitable trust, naming your former spouse as beneficiary
  • Replacing alimony for tax-favorable investment products that are divisible as marital assets

It’s also important to keep in mind the TCJA’s reforms only apply to the tax treatment of alimony for federal income tax purposes. As we also mentioned before, California still lets taxpayers deduct paid alimony from their state income tax returns, so long as those payments qualify as tax-deductible alimony under the state’s tax regulations.

Ask Castellanos & Associates, APLC for Legal Advice

It’s reasonable to assume that the tax treatment of spousal support will continue to be an important topic for the foreseeable future. As a result, our firm will continue to monitor these changes as well as any further federal or state changes impacting the tax treatment of alimony or spousal support in California.

If you are looking for an experienced divorce attorney, please contact Castellanos & Associates, APLC. Our attorneys are dedicated to protecting your legal rights during a divorce, including any concerns you may have obtaining spousal support to help you move forward.

For a free initial consultation, call us at (323) 212-5599 or contact us online today.