My readers know that broad US tax reform was enacted in December under the commonly called Tax Cuts and Jobs Act (“TCJA”). Today’s post is a reminder of how the new tax rules will impact any US spouse who will be either paying or receiving alimony. The clock is ticking and action must be taken before year-end. If you’re in the middle of a divorce or separation agreement, and you will be the spouse receiving alimony, it may be worth your while to delay the inevitable and close the deal after January 1, 2019 when the new tax law regarding alimony takes effect. On the other hand, if you will be the paying spouse, you’ll likely want to wrap things up before that date. Here’s why –
A payment of cash from one spouse to the other under the terms of a divorce or separation agreement, regardless of how it may be labeled in that agreement, will be characterized for US income tax purposes as “alimony” if the payment meets certain criteria. Under current law, if treated as “alimony,” the payment will be tax deductible for the payor, and will be taxable income to the payee. TCJA changes these results as of January 1, 2019 making the alimony both non-deductible and non-taxable.
So, if you are in divorce proceedings and want an “alimony” deduction for some or all of the payments that will be made to your ex-spouse, the TCJA gives you a huge incentive to get your agreement fully inked no later than December 31, 2018. Conversely, if you will be the recipient of alimony payments, you will have an incentive to postpone signing the agreement until next year, because the alimony payments can then be received tax-free.
Alimony- Qualification Rules
Whether a payment made under a pre-2019 divorce agreement will qualify as tax-deductible alimony is determined by strict rules contained in Internal Revenue Code Section 71 and implementing Treasury Regulations. Briefly, all the following requirements must be satisfied:
- The payment must be made pursuant to a written divorce or separation instrument, which includes a divorce decree, separate maintenance decree and separation instrument.
- The payment must be to, or on behalf of, a spouse or ex-spouse. Payments made to third parties are permissible if done properly; as an example, a payment made on behalf of the ex-spouse directly to the bank on a mortgage loan. The payment must be made on behalf of a spouse or ex-spouse and pursuant to a divorce or separation agreement or at the written request of the spouse or ex-spouse.
- The divorce or separation agreement cannot provide that the payment is not “alimony” or state that it is not deductible as alimony by the payor or not includable in the payee’s gross income.
- Once the divorce or legal separation has occurred, the parties cannot live in the same household or file a joint tax return. Either of these events will disqualify the payments as deductible alimony.
- The payment must be made in cash or cash equivalent.
- The payment cannot be classified as fixed or deemed child support under somewhat complicated US tax rules. A tax professional should be consulted if your agreement will include payments that you wish to be treated as alimony as well as payments that are for child support.
- The tax return of the individual who is paying the alimony must include the payee’s Social Security number.
- There must be no obligations for payments to continue after the recipient’s death. In other words, the obligation to make payments (other than delinquent payments) must terminate if the ex-spouse who is receiving the payments passes away. If the agreement does not address this point, then applicable local law will control. If under that law, the payor must continue to make payments after the recipient’s death (e.g., to the recipient’s estate or beneficiaries), the payments will not qualify as alimony.
Should I Modify My Old Divorce Agreement?
Parties wishing to utilize the new rules wrought by TCJA can modify their old divorce agreements. The parties’ situation should be reviewed to see if it is tax advantageous to use the new rules. Yes! This can certainly be the case. Here’s an example – assume a US resident payor (non-US citizen) departs the US losing US residency. Payment of alimony to a US citizen (or US resident) recipient will be taxable income to the recipient, but the non-US payor may no longer care about any US tax deductions. Such a couple may benefit from the new rules and might look into modifying their current divorce agreement.
Alimony Payments to a Nonresident Alien – Don’t Forget Withholding Duties
Payments of alimony to a nonresident alien individual (NRA) are taxable and will be subject to gross withholding at source if the alimony is derived from “US sources” (I will explain this concept later). This is significant because the US payor of the alimony must meet withholding duties and if neglected, the payor can become personally liable for the tax. Payments of US-source income (such as alimony payments that are considered to have a US source) are also subject to reporting requirements. The payor of the alimony should obtain a Form W8-BEN from the NRA recipient. Part I of the Form contains a certification that the recipient is a NRA and Part II will cover the right to claim treaty benefits, that can reduce or eliminate withholding, if any such treaty benefits exist. The Form W8-BEN is retained by the payor; it is not sent to the IRS. If the alimony is from US sources, withholding will be required by the payor at the 30% (or lower treaty rate).
“Source” of Alimony Income
The source of alimony income is the residence of the payor and not the location of the court that issued the divorce decree (e.g., a US or foreign court). This was made clear in the case of Elinor Manning versus the Commissioner. Thus, if the paying spouse is a US resident (regardless of his or her citizenship), the alimony will be treated as having a “US source” and, under current law, reporting and withholding obligations must be met when paying the NRA recipient. On the other hand, if the paying spouse is resident overseas (even if a US citizen), then the alimony will not have a “US source” and it should not be taxable in the hands of the NRA recipient. Reporting and withholding should not be required on the part of the paying spouse, regardless of whether the new TCJA law is in effect.
The New Rules –Timing is Everything
Under the new tax law, the existing rules regarding alimony (deductible by the paying spouse and taxable to the recipient spouse) remain in effect through the end of 2018. Alimony will not be deductible, nor taxable, under new agreements signed beginning on January 1, 2019. With respect to agreements signed prior to January 1, 2019, these remain “as is”. Alimony paid pursuant these “old” agreements is taxable under the current rules, unless the parties modify them on or after January 1, 2019, by specifically referencing the new law and stating the agreement is modified by the new law.
Simply put, if a new divorce decree is inked in the calendar year 2018, the new tax laws will not apply to alimony paid and received. The new alimony tax laws would apply only to decrees signed in the year 2019 and beyond, unless an older decree is properly modified by the parties. So, even though new rules change the alimony picture substantially, if you have a decree governed by the old tax rules, don’t forget to report the alimony income on your tax return. If you are the paying party, ensure that you undertake the required withholding duties if necessary.
We can help you make sure you do things correctly. As mentioned, the parties should seek qualified tax advice to see if modifying an old agreement makes sense and if the new rules can be more advantageous .
Posted September 26, 2018
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