Background: Temporary and Long-Term Spousal Support
As discussed in our prior blog post, a Court may award temporary spousal support during the pendency of divorce or legal separation proceedings before a final judgment is entered. The Court generally uses the Dissomaster software program to calculate temporary spousal support using the spouses’ respective incomes as the primary inputs.
And the Court must assess each case individually using the factors set forth in Family Code section 4320. As part of the Court’s analysis pursuant to Family Code section 4320, it must consider the immediate and specific tax consequences of spousal support to each party. [Family Code section 4320(j)] For example, the Court must consider which spouse pays taxes, which spouse receives a deduction, and what effect taxes may have on each spouse’s net income.
What Qualifies as “Spousal Support” for Tax Purposes?
Under the current IRS rules, spousal support payments can only reduce taxable income for the higher earning spouse (the “payor spouse”) if these requirements are met:
1. The payor spouse files taxes separately.
2. The payment is made in the form of cash or a cash equivalent (e.g. check, money order).
3. The payment is made pursuant to a legal separation or divorce agreement or order.
4. Under the legal separation or divorce agreement or order, the payor spouse is not required to make payments after the recipient spouse dies.
5. The payment is not for child support.
6. The payor spouse and the recipient spouse don’t share a household when the payor spouse makes the payment.
The Tax Cuts and Jobs Act of 2017 (“TCJA”)
The TCJA will change how spousal support is taxed for future separations and divorces. For the last 75 years, spousal support has been counted as income to the recipient spouse instead of to the payor spouse. The TCJA affects taxpayers that enter marital settlement agreements (“MSAs“) or obtain orders signed by the parties after December 31, 2018. If you are a party to a divorce or legal separation case and want to make spousal support payments deductible to the payor spouse and taxable to the recipient spouse, your MSA, divorce or legal separation order (“Order“) must be signed by both parties before January 1, 2019.
The TCJA does not explicitly state whether the MSA or Order must also be approved by the court before January 1, 2019. Therefore, having a Court approve the MSA or Order before January 1, 2019, is the only way to make sure you can avoid the TCJA’s changes.
In practical terms, if you did not file and serve your divorce petition by the end of June 2018, you will not have a choice as to how spousal support in your case is treated; you will need to follow the rules set forth by the TCJA. Why? Because in California, a divorce cannot be finalized until six months and one day from the time the petition is filed with the court and served on the other party.
An Order for legal separation, however, can be finalized before the six-month “cooling off” period. Therefore, if you are seeking a legal separation, you may continue to have spousal support taxed to the recipient and deductible to the payor even if you do not file and serve the petition by the end of June 2018.
Modifications of Agreements and Orders Signed Before 2019
MSAs and Orders signed before 2019 will be “grandfathered in” under the TCJA. Pursuant to these pre-2019 MSAs and Orders, the payor spouse will be able to take a deduction for spousal support and the recipient spouse will be taxed on receipt of the spousal support.
If a pre-2019 MSA or Order is modified in 2019, it doesn’t lose it’s grandfathered status unless the modification explicitly states that spousal support payments will be treated differently (i.e. payments will not be deductible by the payor spouse and will not be taxed to the recipient spouse).
Pros and Cons of the TCJA
Some proponents of the TCJA’s spousal support provision say that it makes calculations of spousal support cleaner and it makes sense for spousal support to be treated the same as child support, which has always remained taxable income of the payor spouse. Some proponents also believe that divorcing or separating spouses should not be “rewarded” with favorable tax treatment.
However, detractors bemoan the loss of a law that was generally favorable for both spouses and helped to offset the additional expenses of divorce, including increased expenses of running two separate homes rather than one. The pre-TCJA law generally benefited both spouses because the payor spouse would almost always be in a higher tax bracket than the recipient spouse. The pre-TCJA tax law normally led to a lower total tax bill for both parties. The spousal support deduction was especially valuable to the payor spouse because it was an “above-the-line” deduction for state and federal income taxes, meaning the payments reduced the payor spouse’s gross income for purposes of calculating adjusted gross income. Further, the deductions were not subject to the itemized deduction limit, meaning they could be deducted even if the payor spouse did not itemize deductions and took the standard deduction instead.
Adjustments to Spousal Support in light of the TCJA
There are ways to offset some of the TCJA’s tax consequences to divorcing and separating spouses. For example, the spouses can adjust with an equalization payment; a gift of real property (which is not taxed between spouses) may be made or increased; and/or the amount of spousal support itself may be adjusted downward.
As explained in greater detail here, another option is to make some or all spousal support payments via a retirement account. The current IRS tax rules require payor spouses to make spousal support payments in cash or cash equivalents but under the TCJA, that limitation is not necessarily a factor in making arrangements for spousal support. Payor spouses thus have the option to may make payments by transferring funds from their retirement accounts without worrying about the tax consequences. For example, if one spouse makes payments through his or her individual retirement account (IRA) to the other spouse, it is the recipient spouse that would be taxed on withdrawals. Remember, for one spouse to receive funds from an IRA without penalty, he or she would need to be at least 59.5 years old.
How the TCJA may Affect Retirement Savings
Further, as detailed in this article, funds received by the recipient spouse will no longer qualify as “earned income” under the TCJA. Therefore, the recipient will not be able to invest the funds in an IRA but can still put the funds in a 401(k).
Life Insurance to Secure Spousal Support
Under the pre-TCJA rules, the payor spouse could also take a tax deduction for premium payments he or she made on a life insurance policy (term or whole) to secure spousal support payments so long as the recipient spouse is the owner of the policy and the payments are required by the divorce or separation agreement or Order or are made pursuant to a written request by the recipient spouse or a writing he or she signed acknowledging that the payments are for spousal support. To date, it appears that the TCJA does not affect a payor spouse’s ability to take this tax deduction.
Spousal Support Tax Laws in California
The State of California Franchise Tax Board will continue to allow a payor to deduct spousal support payments and will continue to require a payee to report spousal support as income. However, because most taxpayers pay a greater share of taxes to the federal government rather than state government, this deduction is limited in value.
If you have questions about how the TCJA may affect spousal support payments in your case, please consult a family law attorney at Broaden Law LLP.