Tax Reform and the ‘Law of Unintended Consequences’

Take-Away: The recent changes to the federal income tax code eliminates personal exemptions, expands the use of 529 accounts, and  it repeals the taxation of spousal support receipts. These rule changes may cause chaos in state divorce courts across the country for previously negotiated settlement agreement where the tax deduction and contractual obligations were critical to the economics of that settlement. The change in alimony rules could also lead to more contested divorce trials.

Background: In my prior life as a practicing attorney I periodically had the dubious pleasure of representing clients in their divorces. I was fortunate in that many of those clients were wealthy (and thus I got paid). Often one of the assets that was hotly contested in the divorce was the value of a closely held business for equitable distribution purposes. Sometimes when a closely held business was the lightening rod in the divorce, there were not enough ‘other’ marital assets to compensate the other spouse who did not receive the business as part of the division of the marital assets. In those situations often a large  i.e. generous spousal support award was agreed upon to compensate the spouse who did not receive the business. [Few divorce judges would ever consider just dividing the business between the two divorcing spouses, who neither like, nor trust, each other. If the business were divided between the spouses as part of the divorce settlement, the judge could expect to have the same litigants before him or her in future years, not as spouses fighting a divorce,  but as partners fighting a business divorce.] The reasoning, in part, for the large spousal support award was that the closely held business spun off income to its owner, and the owner could ‘share’ some of that income with his/her former spouse in the form of a spousal support award. Under the prior tax rules, the business owner could deduct the spousal support award that was paid [called an ‘above the line’ tax deduction] and the recipient former spouse would have to report the income on his/her Form 1040 income tax return. [IRC 71] This legal ‘splitting’ of income enabled the payor spouse to reduce his/her taxable income, perhaps to a lower marginal income tax bracket, and it exposed the paid spousal support potentially to a lower income tax bracket for the recipient spouse.

Example: Husband and Wife are in a divorce. Husband operates a business that is valued for the divorce purposes at $3.0 million. Husband’s business income puts the couple in a marginal 44% tax bracket (rounding up for federal, state, and NIIT.) They have agreed to divide Husband’s 401(k) account of $1.0 million, $500,000 to each; Wife will roll her share of the 401(k) into an IRA.  Also assume the spouses have divided their remaining non-business assets 50-50% of $200,000 each receiving $100,000 (cars, furniture, homes, and ‘stuff n’ things.’) What to do they do with the $3.0 million business? Husband agrees to pay Wife spousal support of $1.5 million, paid at the rate of $100,000 a year for the next 15 years, taking her to her retirement age when she can begin to take RMD distributions from her IRA which was permitted to grow in a tax-deferred environment over that 15 year period. Husband thinks that $1.5 million is too big a number, but when he is advised that he is at the 44% marginal combined income tax bracket, and the $100,000 a year paid is an income tax deduction, he can rationalize that the true cost to him over the next 15 years is about $56,000 a year [$840,000 ‘out-of-pocket’ over the next 15 years.] It is probably an even lower number if a ‘time-use-of-money’ discount factor is applied to the installment spousal support award to reflect inflation over the next 15 years. Wife looks at the $100,000 a year payment as a number, after her personal exemption and standard deduction, as providing a comfortable lifestyle to her over the next 15 years, even after the payment of state and federal income taxes. More likely she would be at the 25% federal income tax bracket, but she might have other deductions that could expose the spousal support award perhaps to the former 15% marginal income tax bracket. The key point is that the tax deduction available to Husband was sufficient to induce him to stop fighting over the ‘real’ value of ‘his’ business and  while it gets him to a frame of reference where the ‘ true cost’ to him was not nearly as bad as the raw spousal support amount implied, if the federal government was paying 44% of the ‘bill.’ I settled numerous divorces over the years primarily in reliance upon the income-shifting nature of a spousal support award. But that was ‘then.’

New Rules: I confess I am not sure where these new tax rules came from, or what the perceived abuses of the ‘old’ tax rules were that prompted Congress to make the changes that it did last week. All I know is that the tax deduction [IRC 215] and the taxation [IRC 71(b)] of spousal support awards was perhaps the most effective way to help induce divorcing spouses to reach a settlement. But why Congress chose to eliminate dependency personal exemptions and expand the use of 529 accounts is not readily apparent.

• Alimony No Longer Tax Deductible: Alimony payments [called spousal support in Michigan, but they are one and the same] will not be deductible by the payor ex-spouse, and they will not be included in income of the payee ex-spouse.
• Effective Date for Alimony Change: The new rule will apply to any divorce or legal separation instrument [defined in IRC 71(b)(2)] for any divorce or legal separation instrument executed after December 31, 2018, or for any divorce or separation instrument executed on or before that date, and modified after that date, if the modification expressly provides that the amendments made by this new section applies to such modification.
• Elimination of Personal Exemptions: Yet another provision often found in divorce settlements was the parents’ ability to ‘contract’ which of the two parents would be able to claim the minor children as dependents for purposes of claiming the $4,050 personal exemption for each dependent. That was a valuable tax benefit to the parent who negotiated the ability to claim the dependency exemption for the minor children. Now the dependency exemption is eliminated beginning in 2018.
• Expanded 529 Accounts: In the past, amounts held in IRC 529 accounts were to be used solely for higher education expenses, e.g. college and trade school expenses. With the tax reform instituted last week, assets held in a 529 account can now be used, up to $10,000 per year, for elementary and high school education, including religious and home-based education expenses.
• Sunset: These changes to the individual income tax rules sunset in 8 years.

Unintended Consequences:

• Post-Divorce Breach of Contract Actions?: What about the parent who negotiated for the right to claim the minor children as income tax dependents in exchange for the other parent receiving more marital assets as a quid pro quo? Will former spouses go back to the divorce court and claim breach of contract? Will  motions be filed to modify the property settlement agreement due to the loss of the dependency exemption? Will the spouse who thought he/she was entitled to claim the dependency exemptions, which are no longer available, now ask the Family Court to impose a constructive trust on the assets of their ex-spouse received in the divorce, claiming that ex-spouse was unjustly enriched?
• More Divorce Trials?: Will more divorce cases be tried to Family Court judges [most recent statistics indicate that over 92% of divorces are settled and never go to trial] if the business owner no longer has as the option an ‘above-the-line’ tax deduction for a spousal support award and must now have to come up with an after-tax amount to pay their former spouse for his/her share of the business? Rather than using a long-term tax deductible spousal support to resolved a dispute over the present fair market value of the business,  the business and its value will even be more hotly contested in divorce trials.
• More Rancorous Negotiations?: Even when support awards were tax deductible by the payor, they were volatile topics that often resulted in the most protracted and emotional negotiations of the divorce settlement process. If spousal support is no longer tax deductible by the payor-spouse, will those imbedded emotional reactions to paying their ex-spouse part of their after-tax earnings produce even more intractability in the settlement negotiations?
• Resurgence of Alimony Trusts?: Will there be a renewed interest in alimony trusts under IRC 682? With an alimony trust rather than pay directly to one ex-spouse alimony [no longer tax deductible to the payor and taxable to the payee] instead income producing assets are transferred to an irrevocable trust as part of the divorce settlement, of which the ex-spouse is named as the sole beneficiary. All the income is paid to the ex-spouse beneficiary from the alimony trust for a specific period of years, or until a specified event, e.g. the youngest child of the marriage graduates from college. At the end of the alimony trust term the assets revert to the trust settlor, the ex-spouse who created the alimony trust. The income distributed from the alimony trust to the ex-spouse beneficiary is taxable to that beneficiary. Admittedly there is no income tax deduction to the spouse who set up the alimony trust, but none of the income from the trust will be taxable to the trust settlor while the alimony trust Upon the occurrence of the specified event or the alimony trust ends by its terms, the trust assets are returned to the settlor. As reported in the past, an alimony trust is a statutory exception to the normal grantor trust rules, where the income generated by the trust is attributed to the trust settlor. Instead, with the alimony trust, the trust income is subject to normal trust taxation rules, meaning that any distributions from the alimony trust to the ex-spouse initially carry out distributable net income from the trust to the trust beneficiary and it is taxed at the trust beneficiary’s marginal income tax bracket. Example: In the past,  50% of the value of the closely held business was paid to the ex-spouse as installment tax-deductible alimony, paid in installments over a long period of time. Using an alimony trust instead, half the business can be transferred to the alimony trust and the income generated by the trust’s share of the business will be distributed to the ex-spouse beneficiary for a specific period of time, coming close to achieving the same after-tax consequences as the prior tax regime where spousal support was deductible by the payor. When the alimony trust ends by its terms, the closely held business interest is returned to the ex-spouse who created the trust. While the parties may not like the additional complexity of injecting a trust into the payment situation, an alimony trust may be one solution to the loss of the deduction for spousal support payments.
• 529 Account Depletion: Lots of parents have created and funded 529 accounts to pay for their children’s college education. Most divorce settlement agreements give one parent control over the 529 accounts that were established during the marriage. The obvious intent at the time of the divorce is that the 529 accounts will be maintained and permitted to grow and used to pay for the child’s college education.  What happens if the one parent who was placed in charge of the 529 accounts as part of the divorce settlement now decides to use part of those funds, not for college, but to pay for private high school tuition [the school minor children attend, post-divorce, also is one of those hot emotional topics that parents tend to fight about long after the divorce is ended.] Will the use of the 529 account funds to pay for a private high school education precipitate yet more litigation in the Family Court, post-divorce, with claims of ‘breach of contract’, ‘breach of trust’, or some other volatile label used for ‘bad behavior’ that will rekindle the flames of the divorce that ended long-ago?

Where Do We Go From Here?

Many of these new tax rules, especially the change in spousal support tax treatment, are a fundamental to divorce law. It is hard to think through all of the implications that will have to be considered, not only of the changes to existing divorce settlements, but also the heightened acrimony in negotiating new divorce settlements, let alone the fact that after 8 years these ‘new’ tax rules suddenly disappear and arguably the ‘old’ rules return. How a divorce settlement gets negotiated with that sunset in mind will be highly challenging to the lawyers, their clients, and even the courts if a judge is required to fashion a divorce settlement with an eye towards the tax consequences that result from the judge’s orders. Similarly, pre-nuptial agreements and post-nuptial agreements will need to address the concepts imposed by the new tax laws, along with the sunset date. I was thinking about a couple of pre-nuptial agreements that I prepared in previous years where the parties entering a new marriage reluctantly contemplated their future divorce, and they mutually agreed that the husband (a successful business owner) would pay to his wife a sizeable spousal support award tied to the number of years of their marriage. Clearly the amount to be paid as spousal support was premised on the belief that the generous spousal support obligation would be tax deductible to the ex-husband, and taxable to the ex-wife. Does the husband, arguably currently happily married, nonetheless now need to raise the topic of the need for he and his wife to hire separate legal counsel to renegotiate their pre-nuptial agreement (currently gathering dust in a desk drawer) in order to reflect the new reality that the spousal support obligation that is buried in their pre-nuptial agreement will no longer be deductible by husband? And why would his wife be eager to change her contractual right to receive a now-tax-free spousal support award should they end up in divorce court in the next 8 years? Sadly these new tax rules seem to ignore the long-standing public policy associated with divorces and their impact on what the parties to a divorce may have contractually agreed to as part of their divorce settlement or in a pre-nuptial agreement. Thousands of divorce settlements and pre-nuptial agreements will be immediately impacted by this change in the tax laws. If the raw emotions of the divorce persist, expect a lot of ex-spouses to go back to their divorce courts seeking relief, either real or imagined. Yep, lots of unintended consequences will arise from a tax law that ‘had’ to be passed by a ‘self-imposed’ Christmas deadline. Our Congress performing at its best.