Impact of the New Federal Tax Law on Maintenance
Changes to the Federal Tax Code have repealed the tax deduction for maintenance.
Matrimonial law in New York State typically is legislated in Albany. However, this year the biggest change in matrimonial law comes from Washington, D.C. The 2017 “Tax Cuts and Jobs Act” includes among its 186 pages a section entitled “Repeal of Deduction for Alimony Payments.” Beginning in 2019, this section eliminates the IRS Code provisions that allow the payor of spousal maintenance to deduct from his or her taxable income any maintenance he or she has paid to his or her spouse or former spouse. This is a radical change from what has been the law since 1942.
There was much written about the change in the tax deductibility of maintenance and a prediction of a year-end rush for people to complete their divorces. However, very little has been written about the new tax law in relation to New York’s Maintenance Guidelines and possible strategies to try to deal with this impact.
COLLECTING MORE INCOME TAX
While the stated purpose for the “Tax Cuts and Jobs Act” is to cut income taxes, streamline the tax code and help promote domestic economic growth, the repeal of the tax deduction for maintenance payments serves no such purpose. It simply helps the government maximize the amount of income taxes it will collect under the revised tax code. It will do this by taxing the entirety of the maintenance payor’s income, including the maintenance he or she will pay, at a tax rate that will be higher than if the maintenance was taxed at the rate of the payor’s spouse or former spouse. This is because of our system of progressive tax rates. This means more money for the government and less money for the divorced or divorcing taxpayers.
A quick and very simplified hypothetical illustration should put the gravity of the situation into perspective. Let us assume a childless marriage with a husband, who has a taxable income of $150,000 per year, and a wife, who has a taxable income of $25,000. Under New York’s Maintenance Guidelines the husband’s presumptive maintenance obligation would be $40,000 per year. Under the “old” tax law, the husband would deduct the $40,000 and pay income taxes on his net taxable income of $110,000 while the wife would include the $40,000 pay income taxes on her gross taxable income of $65,000.
With this amount of maintenance, the wife would remain in the 12 percent tax bracket, which covers the income range of $19,051 to $77,400. On her $65,000 of taxable income she would pay about $7800 of Federal income tax. Of this, $4800 is a result of the maintenance she would receive.
With this amount of maintenance, the husband would remain in the 24 percent tax bracket, which covers the income range of $82,501 to $157,500. Therefore, deducting the $40,000 of maintenance would reduce his income tax liability by $9600. That $40,000 really only cost him $30,400 after taxes.
This shifting of taxable also costs the Federal Government about $4800 of income tax. Instead of collecting $9600 of tax on this $40,000, the Federal Government would only collect $4800. The new tax law will recapture this money for the Federal Government.
Using these same numbers for 2019, the results are radically different. The presumptive maintenance obligation remains $40,000 per year but the husband would pay income taxes on his gross taxable income of $150,000 while the wife would pay income taxes only on her taxable income of $25,000.
The wife would be in the 12 percent tax bracket, which covers the income range of $9526 to $38,700. She would pay about $2810 of federal income tax. That is about $5000 less in tax than she would have paid for 2018.
Applying the new tax code to these figures, the husband would be in the 24 percent tax bracket, which covers the income range of $82,501 to $157,500. He would pay about $35,700 of Federal income tax. That’s about $10,000 more than he would have paid for 2018. And the third party in this equation, the Federal government, gets about $4800 more in taxes collected.
APPLICATION OF THE NEW TAX LAW
The new tax law applies only to new matrimonial agreements, orders and judgments made after December 31, 2018. Agreements, judgments and orders made before the end of 2018 will be treated under the old tax code. Those people who are already divorced or have a signed matrimonial agreement need not worry about the new law. Any future modifications of maintenance paid under a pre-2019 divorce agreement, order or judgment will remain tax deductible to the payor unless the modification expressly states that the new tax code will apply.
All agreements, orders and judgments made after December 31, 2018, will be treated under the new tax code. This will turn New York’s maintenance law on its ear. Practically speaking this could have much more of an impact on matrimonial practice than the implementation of the Maintenance Guidelines in 2016. Where the guidelines created a certain uniformity and consistency in matrimonial practice, the new tax law only creates uncertainty.
THE PROS AND CONS
The new tax law simplifies certain things for divorcing people. Under the new tax law neither maintenance nor child support payments will have any tax consequences to either party. No longer will a maintenance payee be surprised by a tax bill inflated because of maintenance received when he or she did not properly anticipate the income taxes. This probably is a good thing since no one likes surprises with their divorce or their tax bill. However, from the perspective of the maintenance payor, this new law could be expensive.
The problem is not the new tax law nor is it New York’s Maintenance Guidelines. It is the nexus between guidelines and federal tax law that creates the problem. They were not designed to work together.
This is something that attorneys cannot ignore, wish away or try to have the parties waive. The Federal government will not honor a new agreement that makes maintenance taxable to the payee and tax deductible to the payor. A payor who tries to deduct maintenance under an agreement or order made after 2018 will have the deduction disallowed by the IRS and will be stuck with a tax bill with penalties and interest.
The repeal is permanent. However, as with anything to do with the tax code, it may not last. In any event, the tax shifting strategies that divorce attorneys have used for decades no longer will work. The practical application of the law of maintenance must change.
WHAT ABOUT THE KIDS?
The tax treatment of child support payments will not change under the revised tax code. However, the new tax law will have some impact on divorcing couples with minor children since it eliminates both personal and dependent income tax exemptions. These were $4,050 per exemption in 2017. This means that there no longer will be the annoying argument over who gets to claim the kids on their income tax returns.
The elimination of the dependent tax exemptions is supposed to be offset by the increase in the standard deduction. The new tax law increases the standard deduction for single filers from $6,350 to $12,000. The head of household standard deduction increases from $9,350 to $18,000. For people with one or two kids, this could work out.
The present problem is created by the nexus between state matrimonial laws and the federal tax law. This creates a very specific problem in every state where there are spousal maintenance guidelines or a statutory maintenance formula if the state law is not revised to address the impact of the new federal tax law. In states where there is no statutory maintenance formula, the issue still presents itself. However, in these states the judges typically have significantly more discretion in setting the amount and duration of maintenance, or alimony as many of them call it.
New York’s legislature has not acted to address the new tax code. Based upon how long it took to adopt the Maintenance Guidelines initially, it is fair to expect that changing the guidelines will not be accomplished anytime soon.
This is not to say that this is something that cannot be done. Illinois state law makers appreciated the potential adverse impacts of the new tax law. They changed that state’s formula for spousal maintenance. Starting in 2019 payor spouses will be obliged to pay less to payee spouses with decrease in presumptive spousal maintenance payments to balance out the impact of the change in the tax code.
Currently, the Illinois spousal maintenance formula requires taking 30 percent of the payor’s gross income and subtracting from this 20 percent of the payee’s gross income to determine the amount of maintenance. Under the new Illinois formula, courts will take 33.3 percent of the payor’s net income and subtract 25 percent of the payee’s net income to determine the amount of maintenance. If our Mr. and Mrs. Hypothetical lived in Illinois, and had the same incomes of $150,000 and $25,000 respectively, under the old Illinois law, his maintenance obligation would have been $40,000, just like in New York. Under the new Illinois law, his maintenance obligation would be about $32,200. There is no reason why New York cannot fashion a similar revision to the Maintenance Guidelines.
NEW YORK PRACTICE OPTIONS
What are New York’s divorce attorneys to do in light of the new tax law and New York’s Maintenance Guidelines? One good answer appears to be right in the Maintenance Guidelines. Domestic Relations Law section 236(B)(6)(e)(1) states that the “court shall order the post-divorce maintenance guideline obligation…unless the court finds that the post-divorce maintenance guideline obligation is unjust or inappropriate.” This determination shall be based upon consideration of the 13 statutory factors detailed in the Domestic Relations Law. Based upon such consideration, a court then may adjust the post-divorce maintenance guidelines obligation accordingly.
Among these factors to be considered is “(j) the tax consequences to each party.” This factor has not been a major consideration up to now since the tax consequences were as expected; the payor gets the deduction and the payee claims the income in a lower tax bracket. But now, this factor will be thrust to the forefront.
The Maintenance Guidelines were adopted with the old tax code in mind. Their strict application, with the dramatically different treatment of maintenance under the new tax code and its radically different tax impact to the parties, appears to be, as a matter of law, unjust or inappropriate.
GET AN ACCOUNTANT
A deviation from the presumptive post-divorce maintenance guideline obligation probably would entail a reduction in the amount of the maintenance obligation. However, to do this math intelligently, it appears to be prudent practice to enlist the services of a certified public accountant to calculate the tax impact of the new tax law on the parties.
Calculating income taxes is far beyond the skill set of a matrimonial attorney. What needs to be done in this situation would require calculating the tax impact under the old law and the new law if the Maintenance Guidelines were followed. Trying to do this math under two versions of the tax code to determine the tax impact of the new law clearly is something that requires the expertise of a certified public accountant. Keep in mind that there are other changes in the tax law that may impact the tax calculations for the parties. Given the amount of money in controversy, the fees spent on an accountant makes sense.
This could get more expensive if the accountant has to testify at trial. Even then this seems like a prudent and cost-effective investment for a maintenance payor. This expert testimony would be necessary to competently prove the tax impact at trial and give the judge the information they need to determine what is a fair and just deviation from the guidelines.
HOW MUCH TO DEVIATE
With the tax impact of the new law determined for a particular case, then there is the question of how much of a deviation from the guidelines is appropriate. It appears that this question will be the one that will create the most controversy and be subject to the most litigation.
The first thing that may come to mind is that the fairest way to address this is to calculate the tax impact of maintenance to the payor and reduce the maintenance award in that amount. Going back to our hypothetical husband and wife we can illustrate this method. Under the old law the husband by deducting the $40,000 of maintenance would have reduced his income tax liability by $9600. Under the new law, maybe his maintenance should only be $30,400.
However, this method of deviation creates a problem for the hypothetical wife. Before she had to pay taxes on the $40,000 of maintenance at 12 percent, her tax rate. Using this method, she essentially would be taxed at the husband’s rate of 24 percent. Under old law she would have had netted $35,200. Now she would have only $30,400 of maintenance.
Another option to determine a fair and just about the maintenance would be to adjust the presumptive maintenance award by the average of the parties’ respective tax brackets. For example, where the wife is in the 12 percent tax bracket and the husband is in the 24 percent tax bracket, the court could reduce a maintenance award by 18 percent to split the tax impact between the parties.
This could be illustrated as follows with Mr. and Mrs. Hypothetical. If the husband’s guidelines maintenance obligation of $40,000 was adjusted by 18 percent it would be reduced by $7200 to $32,800. This would save him $7200 and cost the wife only $2400.
In this vein, the maintenance guidelines are wealth redistribution that allocate the total marital income 60/40 between the payor spouse and payee spouse. With this in mind, instead of averaging the tax rates, a court could weigh the two rates along the 60/40 ratio of the maintenance guidelines. This would shift 40 percent of the tax burden to the payee by a corresponding reduction of the maintenance award.
This could be illustrated as follows with Mr. and Mrs. Hypothetical. If the husband’s $40,000 guidelines maintenance obligation was being taxed to him at 24 percent for a total of $9600 of tax. Dividing this tax 60/40 would yield $5760 to him and $3840 to the wife. Maintenance would be reduced from $40,000 to $36,160.
This too could provide a reasonable compromise. It distributes the tax burden between the parties in an equitable manner that approximates the ratio of wealth distribution in the maintenance guidelines.
The new Illinois maintenance formula also provides a third way to allocate the tax impact in an equitable manner between the parties. It roughly allocates the tax liability 2/3 to the payor and 1/3 to the payee. There also are options that could be explored with regard to equitable distribution and even child support to address the tax impact of the new tax law. These could get complicated and are beyond the scope of this discussion.
The new tax law will make divorce practice more difficult because it maximizes the amount of income tax that a divorcing couple will have to pay. It thereby will drain the finite financial resources of the parties, which rarely are sufficient to allow one household to split into two without some significant financial strain. Practically speaking, the relative certainty or consistency that the maintenance guidelines brought to matrimonial practice probably will be undone by the new tax law.
There is no clear answer as to what is the right or wrong way to address the impact of the elimination of the spousal maintenance tax deduction. Clearly something must be done and it appears that a variety of tactics and strategies offer some viable solutions.