Now that it’s 2019, the effects of the Tax Cuts and Jobs Act are official. One change is that alimony is no longer tax-deductible for the payor, although it is still considered income for the recipient. Another involves the valuation of a business in divorce — many businesses will be valued more highly than before. What do you need to be aware of?
Alimony payors may need to negotiate more
In the past, alimony payments could be deducted by the paying spouse, while they were taxable income for the receiving spouse. That had been true since the Revenue Act of 1942. In general, the arrangement resulted in a higher overall income for the divorced couple as a unit, so adjustments may have to be made in other areas to have the same overall effect. For example, the paying spouse might receive a greater share during property division in order to offset the new tax.
An open issue in this area is how old prenuptial agreements will be handled. Some pre-2019 prenuptial agreements specify a particular amount in alimony and were negotiated with the understanding that the alimony paid would be deductible by the payor spouse. Will courts allow changes in the terms of these agreements to reflect the change, or will they be more inclined to invalidate the agreement under such circumstances?
Some flow-through entities will be valued more highly
The new tax law will also have the effect of increasing the cash flow for many flow-through or pass-through entities. These are legal entities where the entity’s income is treated as the income of the owners or investors. Examples include sole proprietorships and S corporations.
As a result, flow-through entities may be valued more highly by forensic accountants and others who value businesses for divorce purposes. The business valuation is often used in negotiations over property division, as well as when one spouse will be buying out of a shared business.
A QDRO is typically required to divide retirement assets
Most divorces are resolved out of court, with the parties presenting a negotiated or mediated settlement to the court for approval. This settlement then becomes the divorce decree.
When negotiating the settlement, you should be aware that a qualified domestic relations order (QDRO) is generally required for a tax-free transfer of retirement funds from one spouse to the other for the purposes of property division.
As you may know, withdrawing retirement funds early from an IRA or 401(k), for example, can result in both taxation and early withdrawal penalties. You generally need to be at least age 59-1/2 to make the withdrawal without taxes and penalties. Therefore, it is typically disadvantageous to have one spouse withdraw funds and transfer them to the other.
To divide these assets without incurring the taxes and penalties — or at all, in some cases — any transfer of retirement assets generally needs to be made under court order, meaning a QDRO. The plan administrator may not have the authority to make a transfer without a QDRO.
The reason this is important during negotiations is that any QDRO must comply with the plan’s rules. Ideally, you should verify that it does before you finalize your agreement and ask a judge to approve it. That way, you won’t need to go back to court a second time because the QDRO did not comply.
Tax issues can profoundly affect the value of your divorce settlement. It’s important to work with an attorney who understands how taxes affect spousal support, child support and property division issues.