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US Tax Reform: Spotlight on divorce and separation

Private Clients - 13 Feb 2018

In a major policy shift, the US federal tax rules affecting spousal maintenance payments agreed in a financial settlement on divorce or formal separation will change from January 1 2019.

Under current tax law, any payment in cash resulting from a divorce decree or formal separation agreement is considered alimony unless it falls outside the definition of alimony.  Child support is not considered as alimony and is a non-tax item.

Alimony paid is deductible by the payor on his/her tax return and alimony received is picked up as income on the tax return of the recipient. This default treatment can be overridden by agreement and potentially by a provision in a tax treaty. 

At present the UK/US tax treaty appears to offer protection from tax to the recipient of spousal maintenance payments provided at least one of the parties is tax resident in the UK. While it requires a certain level of disclosure on the annual US federal tax return of the recipient, it equally does not appear to prevent the spouse making the payments from claiming a deduction for those payments on their federal tax return. It presents an alternative to the complete exclusion from alimony treatment that special wording in the consent order or financial settlement would achieve. However, relying on the relief provided by the tax treaty comes with its own risks. Where the recipient ceases to be tax resident in the US or the UK, such protection may no longer apply. This would be true if they relocate to the US while the other party is also resident in the US or if they move to a country that does not have a tax treaty containing the same language as that of the UK/US treaty.

As noted above, the rules will change as of 2019 when these alimony provisions will be removed from the Internal Revenue Code. All payments will then be treated as arising from after tax income and there will therefore be no inclusion in income for payments received, nor will there be a deduction allowed for the person making the payments. All agreements ratified before the end of 2018 will still fall under the prior rules even for payments made after the end of 2018.     

The knock-on effects of this law change are potentially far-reaching. Traditionally, alimony settlements were set at a certain level because there was a tax benefit available to both parties when one spouse had little or no income of their own. It effectively provided a mechanism for assigning income to a taxpayer in a lower tax bracket and generating an effective tax refund through a deduction for the person paying the alimony. Agreements reached after December 31, 2018 (and subject to the new rules) could lead to significantly different conclusions about the level of alimony required. There could be a rush to the Courts in order to ensure that any divorce already in process is finalized before the end of the 2018 calendar year (and therefore stays within the current rules).

One of the tax reform changes linked to this is the removal of the deduction of a so-called personal exemption amount for dependent children. It is common for US-based agreements to include provisions about which spouse can continue to claim the tax benefit available from this deduction. The general rule would put the deduction in the hands of the custodian spouse, but the parties can agree to vary that and allow the other spouse to have the benefit. The new tax law has removed any deduction for dependent children and therefore this benefit has also been removed. If this tax benefit was a factor in arriving at a financial settlement, it may be that certain agreements need to be revisited and adjusted.

There are several other side effects of these changes which may not be particularly apparent to a spouse resident in the UK, but certainly will be to a US resident spouse. Under current law, alimony is considered to be ‘compensation’ for purposes of determining eligibility to make contributions to a qualified retirement plan. Once the inclusion in income is removed, then and unless the rules regarding pension contributions are also changed, the recipient spouse will no longer be able to fund a pension of their own if this is their only source of ‘compensation’.     

In a separate change, access to the special US college savings plans known as 529 plans has been extended to cover high school education (up to $10,000). This could potentially affect divorce agreements that were reached on the basis of whether / how such funds would be used, as the party who created the account can now access a significant portion of the funds at an earlier stage. This will affect their ability to meet the terms of an earlier agreement.  Will that require a modification to the original financial settlement?

Finally, could the impact of any of these tax reform changes lead to a large enough change in the financial circumstances of one or both parties to warrant a revision to their original agreement? Equally, could any pre- or post-nuptial agreements drawn up prior to these changes be materially affected?   

The tax reforms are widely seen as benefitting most people and providing tax cuts. However, there are clearly some (as yet unquantified) side effects which could significantly alter the financial circumstances of the parties to a divorce. This in turn could lead to one or other party seeking to renegotiate the terms that were agreed prior to these changes taking effect. 

One simple example affects individuals who have a significant interest in a non-US corporation and who have previously deferred undistributed earnings in that company. These individuals will now be required to recognize the deferred earnings in 2018, regardless of actual distributions, but equally they must either estimate and pay over the associated tax by April 15th 2018, or make an election to pay the tax in steadily increasing instalments over eight years. This has ramifications on their tax position on both sides of the Atlantic as there may be unplanned distributions required that will be taxed at the higher dividend tax rates in the UK in order to fund the new US tax charge.

It is clear that the new US tax legislation is still being digested and the implications are becoming clearer by the day. Many of the changes seem to be having unintended consequences compared to the original intent.  It remains to be seen whether any technical corrections will be made to the rules in the future.

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David Foster

David Foster

Private Client Associate Director

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