The following is a guest post from Ed Lyman, a trial and appellate attorney at Walzer Melcher LLP who handles complex dissolution of marriage and domestic partnerships for high net worth individuals.
Family law attorneys and accountants are struggling to grasp the impact of the GOP’s tax overhaul on divorces. The biggest changes that affect divorcées is the repeal of various deductions, the creation of new ones, large tax cuts for business entities, and eliminating many exemptions. These changes require special attention when calculating alimony, child support, and division of marital assets.
Here’s an overview of the big changes:
- New standard deduction amount. For 2018, the new standard deduction nearly doubled since 2017. This year, the amounts are $12,000 for singles and married but filing separately, $24,000 for joint filers, and $18,000 for head of household.
- Important changes to deductions, exemptions, and credits. A fair spousal or child support award depends on an accurate calculation of each party’s income. Trump’s tax plan cut important deductions and credits, including personal exemptions, most miscellaneous itemized deductions, and the alimony deduction. Deductions lower an individual’s overall tax liability; thus, when a deduction is eliminated, less income is available for alimony and child support. Historically, individuals who pay alimony receive a tax deduction, while their ex-spouses who receive alimony, must include those payments as taxable income. The GOP tax plan repealed the alimony deduction, but only for those divorced on or after January 1, 2019. Individuals with a divorce judgment before 2019 are grandfathered in and won’t lose their alimony deduction even if the court modifies a previous alimony order after that date, unless the parties expressly opt out of the alimony deduction. Note that the elimination of personal exemptions doesn’t mean that divorcées should ignore them. “I call them ‘Zombie Exemptions’ because they still have an indirect value.” Art Grater said. For example, they are used to determine the child tax credit. And in 2018, the child tax credit doubled to $2,000 per qualifying child. This can be used as leverage in negotiating the terms of a divorce. Also, divorcées represented by counsel will no longer be able to deduct legal expenses on their taxes because most miscellaneous itemized deductions subject to the 2% floor are suspended through 2025.
- New deduction for qualified business income. Determining whether either party to a divorce will receive the new qualified business income deduction is tricky. Internal Revenue Code §199A permits self-employed individuals to deduct up to 20% of their qualified business income from sole proprietorships, S corporations, limited liability companies, and 20% of qualified real estate investment trust dividends. If an individual owns rental property, he or she may receive a 20% deduction on rental income. But the qualified business income deduction has limits. For example, if a client pays herself as an employee of a partnership her W-2 income doesn’t qualify for the deduction. Only the partnership’s income that’s allocable to her ownership interest in the partnership will qualify for the deduction. For example, if the partnership earns $1 million of income in 2018, and she holds a 25 percent partnership interest, then $250,000 will constitute qualified business income. But if she pays herself an additional $100,000 per year as a W-2 employee of the partnership, her wages aren’t included in the total amount of qualified business income. This deduction has several other limitations, such as qualified business income doesn’t include capital gains or losses, dividends, interest income, or foreign income. With this in mind, practitioners should include Schedule K-1s as part of their discovery plans.
- Big tax cuts for businesses. Divorcées who own businesses will be benefitted by the overall decreased tax rates for business income. Accurately valuing businesses owned by the marital estate is critical to fair division. The overall tax rate on C-corporations has dropped more than 10%. And the rate on passthrough entities has dropped more than 3% and 10% when the new qualified business income deduction applies.
On the tax aspects of spousal support, see CEB’s Practice Under the California Family Code: Dissolution, Legal Separation, Nullity §§6.28-6.37. And check out summaries, resources, and a free webinar and videos on the 2018 Tax Cuts and Jobs Act on ceb.com.
Other CEBblog posts you may find interesting:
- The Times They Are A-Changing (for Estate Planners)
- Just Passing Through: New Deduction for Business Income Expires in 2026
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