TCJA: Changes to Alimony Reporting Requirements
Divorce is never an easy situation to endure and the IRS has complicated matters by changing how alimony is treated on your taxes. Historically, the spouse ordered to pay alimony was able to claim a deduction on their taxes while the recipient was required to include alimony on their tax return subject to income taxes. That is no longer the case with a few caveats.
Divorce decrees and separation agreements that include alimony payments and were finalized prior to January 1, 2019 are still deducted from gross income for the payer and reported as taxable income for the recipient. To claim the deduction, the payer will need to report the Tax Identification Number (TIN) of the recipient. To be in compliance, the recipient also needs to report the TIN of the payer as this is how the IRS verifies alimony paid matches alimony claimed as income.
Alimony is deducted as an “above the line” deduction meaning the amount is deducted regardless of whether the payer is itemizing. It is an advantageous situation for the payer because they are generally the one with a higher tax bracket compared to the recipient and are now able to reduce the amount of income subject to that higher tax rate. It does mean the recipient is subject to income tax on that amount but based on the assumption they are in a lower tax bracket, it works out better overall.
However, when the Tax Cuts & Jobs Act (TCJA) was enacted, the alimony deduction and income reporting requirement was changed. For divorce decrees and separation agreements finalized on or after January 1, 2019, alimony is not reported as income for recipient and not claimed as deduction for payer. The harm in this occurs to the payer who is paying taxes in a higher tax bracket on money they have paid to another person who won’t be paying any taxes on the funds. By doing this, the IRS is hoping to see a projected increase in income tax revenue of $6.9 billion over the next 10 years.
A pre-2019 decree or separation agreement can be amended so that it will then be subject to the new law. To accomplish this, the amendment must very clearly state that the new TCJA treatment will now apply. This would need to be evaluated on a case-by-case basis as it would not provide a benefit to the payer but would be favorable for the recipient. Moreover, if either party seeks a modification to the terms of the agreement such as a reduction in the amount of alimony ordered due to a change in circumstances, this would nullify the favorable existing tax treatment. According to the IRS, this is because technically a new order exists that was established after January 1, 2019.
In a divorce, balancing between the property settlement and alimony payments is a very delicate matter for the parties and their lawyers to negotiate. A strategy to lessen the burden of the alimony tax law change is by funding a tax-free property settlement with a transfer of funds from the payer’s IRA to the recipient spouse IRA. The recipient will not pay tax on such a property tax settlement until distributions from the IRA begin, and the payer avoids income tax altogether. However, if the recipient is in a significantly lower tax bracket than the payer, then it is an advantageous situation for the couple in the long run, as the US Treasury is effectively funding part of the divorce. We can assist in these calculations.
If you find yourself in the situation of paying or receiving alimony and are unsure of the tax implications, don’t hesitate to contact your KTLLP advisor for guidance.