Divorce Tax Revisited

Divorce Tax Revisited

DIVORCE TAX REVISITED Baltimore County Bar Association Family Law Committee October 17, 2018 Thomas C. Ries, Esquire Kris Hallengren, CPA/ABV, CFF, ASA, MSF To protect the confidential and proprietary information included in this

material, it may not be disclosed or provided to any third parties without the approval of Weyrich, Cronin & Sorra Certified Public Accountants & Business Consultants www.wcscpa.com Weyrich, Cronin & Sorra

Repeal of the Alimony Deduction Alimony (IRC 71 and 215) The TCJA contains a permanent repeal of the alimony tax deduction. It does not expire after 2025 like many other provisions of the TCJA. The repeal affects alimony that is paid under a divorce or separation instrument that is signed on or after January 1, 2019. If alimony is

paid under an instrument (including Court Order or written agreement) signed on or before December 31, 2018, it will continue to be deductible by the payor if all requirements of IRC 71 are met. Alimony Changes Will apply to any separation or divorce instrument defined in Section 71(b)(2) executed: After December 31, 2018, or

On or before December 31, 2018, and modified after that date, if the modification expressly provides that these amendments made by the Act apply to such modification Before December 31, 2018 but substantially modified after December 31, 2018. Example: $0 alimony as of separation agreement, modified agreement which would include alimony which would likely constitute a substantial modification. Post-nuptial or pre-nuptial agreements will not likely allow the parties to grandfather in under the old laws.

Alimony Changes Many tax experts and practitioners believe that, so long as you have the written separation agreement before 1/1/19, you will be governed by the existing old law. Even if the divorce occurs in 2019 or later, if that decree incorporates but does not merge the 2018 Agreement, you would take the position that the required written instrument is the written separation agreement (the 2nd of the 3 possibilities in Section 71(b)(2)).

Alimony Changes If you have an old tax law agreement or order and it is modified after 12-31-18, the tax ramifications will still be governed by the old tax law unless there is an express statement in the new written instrument (including a court order) that the amendments made by the new tax law will apply. Tip: This means that, if the modification does not expressly elect that

the payments will be non-deductible under the TCJA, then they will continue to qualify for the alimony tax deduction. Alimony Changes IRC 71(b)(1)(A) requires a payment to be under a divorce or separation instrument in order to qualify as alimony. IRC 71(b)(2) defines divorce or separation instrument as a decree or written instrument incident to a decree OR a written separation

agreement OR a decree requiring spousal support payments. Alimony Changes There has been much discussion and some debate regarding the TCJAs repeal of the alimony deduction, effective 1/1/19. One issue is whether a signed Agreement for alimony executed on or before 12/31/18 - where the parties never get divorced or, at least, dont get divorced until 2019 or later - will be governed

by the existing old law. This goes to the heart of the unknown debate if you have a signed Agreement in 2018, but the divorce occurs in 2019 or later, are you still governed by the old existing alimony law? Most tax experts and practitioners say the old law would carry the day in the example above. Drafting Tips

If you negotiate a written Agreement before the end of 2018, and you represent the payor of modifiable alimony who wants to retain the income tax deduction of his/her payments, consider including a provision along the following: This Agreement has been executed prior to the effective date of the Tax Cuts & Jobs Act of 2017 (TCJA), with the mutual intent of the parties that the alimony payments pursuant to this Paragraph will be deductible by Payor under IRC 71 and taxable to Recipient under IRC

215. Precautionary Measures Also consider including: If there is any modification of Payors alimony payments to Recipient by agreement or Court Order subsequent to the effective date of the TCJA, the parties agree that they shall NOT elect to apply the TCJA to the alimony payments made after such modification. The parties

intend and agree that all of Payors monthly alimony payments made pursuant to this Agreement, and any modification thereof, shall remain as tax deductible alimony to Payor under IRC 71 and taxable to Recipient under IRC 215. Precautionary Measures Absolutely continue to have non-merger language in any decree that approves a pre-2019 Agreement for alimony

As an additional layer of protection, include language that the alimony will be renegotiated to consider the non-taxable nature of the payments if it is subsequently determined that what everyone thought and intended to be taxable ends up being non-taxable. Proposed Language for Post-2018 Alimony Also consider including: This Agreement has been executed subsequent to the effective date of the

Tax Cuts & Jobs Act of 2017 (TCJA) with the mutual intent of the parties that the payments require by this Paragraph shall neither be taxable to Recipient as alimony, nor deductible as alimony by Payor. If, prior to the termination of Payors obligation, the alimony tax deduction is restored to its pre-TCJA status by change in law, regulation or judicial interpretation, the parties expressly agree that Payors payments shall continue to be nondeductible to Payor and non-taxable to Recipient as they would have been entitled to so agree under IRC 71(b)(1)(B).

Impact of New Alimony Rules Will considerably affect divorce negotiations during 2018 Making alimony a revenue neutral item for the government was a primary reason for the change, but it will cost the divorcing tax payer AND will also impact the recipient Will increase the out-of-pocket expenses of divorcing taxpayers unless alimony is decreased for the value of the lost tax deductions

Payors are likely to pay less, knowing the payment is not deductible resulting in decreased bargaining power of the recipient Post 2018 Alimony Alternatives 1. Additional retirement assets could be transferred at pre-tax values in lieu of alimony - QDRO distributions are not subject to 10% early withdrawal

penalty - IRA distributions can be annuitized under Section 72(t) to avoid the 10% penalty - Tip: The payer could consider aggressive funding of plans to replenish the retirement accounts and could receive current tax deductions on contributions if the payer owns a business Post 2018 Alimony Alternatives

2. Transfer additional funds from investment accounts at precapital gains tax values in lieu of alimony - Recipient will pay taxes only when the investments are sold with potentially lower tax rates 3. Use other marital assets to offset the present value of otherwise tax deductible/includible alimony Attorneys Fees and Miscellaneous Itemized Deductions (IRC 67)

For tax years 2018 through 2025, say goodbye. This means no ability to deduct legal fees, tax preparation fees, employee business expenses, or investment advisory fees. Legal fees incurred in securing an award of alimony or collecting alimony are no longer deductible. Itemized Deduction Limitation for high-income earners was repealed.

Standard Deduction Standard Deduction on individual income tax returns for taxable years 2018 through 2025 (IRC 63) - $24,000 for Joint filers (up from $12,700) - $18,000 for Head of Household - $12,000 for all others (up from $6,350) Due to the increase in the amount of the standard deduction, as well as changes to the rules concerning itemized deductions, it is expected that

many taxpayers who previously itemized deductions will now claim the standard deduction. Personal Exemptions (you and your dependents) IRC 151 Exemption amount was $4,050 for each dependent for 2017 tax returns. Beginning in 2018, it will be Zero ($0). The personal exemption you claimed for yourself, your spouse, and each

qualifying child or qualifying relative have been eliminated for tax years 2018 through 2025. On the surface, it appears that there is no longer a need to allocate the dependency exemption for a minor child in your Marital Settlement Agreement, unless the child will still be a minor in 2026 and thereafter. AMT Exemption increased; Exemption phase out threshold substantially increased.

Personal Exemptions (you and your dependents) Notice 2018-70 The elimination of personal tax exemption will not be taken into account when deciding who is a qualifying relative from 2018 to 2025. In defining a qualifying relative for purposes of various provisions of the code, including those for purposes of the new $500 credit for non-child dependents and head of household

filing status the exemption amount will be treated as $4,150. MD has not issued guidance on how they will handle state tax exemptions. Exemptions & Credit Income phaseouts have been significantly increased to $400,000 for Married Filing Jointly and $200,000 for others.

Tip: Child tax credits could become a material negotiating point in high net worth divorces. Impact of Kiddie Changes Historically, dependent children with $2,100 of unearned income were captured on parents return. Children subject to the Kiddie Tax are no longer included on their parents return and will now file a separate tax return.

Tip: May need to consider requesting childrens returns to determine if assets have been shifted. Impact to Family Law Prior Divorce Agreements may need to be revisited however, the benefit has to outweigh the cost. Tax benefit was likely negotiated as a trade-off for another concession. With higher credit amounts and higher income phaseouts dependent

children may play a bigger part in negotiations. Although the personal exemption deduction is gone, the new credit amounts may be a bigger benefit or reasonable offset. May need to consider if the provision being negotiated sunsets at the end of 2025. Theres currently a bill in the House to make the tax cuts permanent. Mortgage Interest Changes

New Law: Effective Date Applies to new acquisition debt incurred on or before December 12, 2017 Exception: For a taxpayer who entered into a written binding contract before Dec. 15, 2017 to close on the purchase of a principal residence before Jan. 1, 2018, and who purchased that residence before Apr. 1, 2018, the old law applies Types of Personal Residence Debt 1. Qualified Acquisition Indebtedness (QAI) debt secured by the home and incurred to buy, build, or

remodel that home (no change in QAI definition) 2. Home Equity Indebtedness (HEI) not deductible except QAI qualifying portion Qualified Residence Interest (QRI) deduction limitations Interest on QAI up to $750,000 for primary and secondary homes (combined) Interest mortgage and HELOC balances used to build, buy, or remodel the home secured by the debt Mortgage Interest Changes Transition Rules

The interest on up to $1,000,000 QAI for principal and second residence mortgages (combined) continues to be deductible for existing mortgages at December 15, 2017. Existing mortgages can be refinanced and the interest can continue to be deductible In the case of any indebtedness which is incurred to refinance indebtedness, such refinanced indebtedness will be treated as incurred on the date that the original indebtedness was incurred to the extent the amount of the indebtedness resulting from such financing does not surpass the amount of the refinanced indebtedness Refinanced balance and equity taken/additional funds used to remodel that home

After 2017, HELOC interest related to non-QAI purposes will no longer be deductible Impact of Mortgage Interest Changes Refinancing of mortgages and HELOCs are very likely in divorce For future tracking purposes, the party retaining the home and related debt(s) should get the

following records: -Identify all mortgage and HELOC balances as of 12/15/2017 and breakdown by: QAI Mortgage balances QAI HELOC balances funds used to build, buy, or remodel the home securing that HELOC HEI HELOC balances funds NOT used to build, buy, or remodel the home securing that HELOC

-If existing mortgages are refinanced and mortgage debt is increased, breakdown the newly refinanced debt balance by Portion related to QAI mortgages in place at 12/15/2017 Portion related to QAI mortgages on new acquisitions after 12/15/2017 Portion of new debt related to QAI (remodeling / home improvements) Portion of new debt related to Non-QAI purposes (other personal uses)

SALT Beginning with the 2018 tax year, only $10,000 ($5,000 for married filing separately) of non-business state and local deductions (SALT) may be deducted, including state and local real property taxes, personal property taxes, and state and local income taxes. 529 Plans [529(c) and 529(e)(3)(A)] Qualified higher education expense now includes expenses for tuition

in connection with enrollment or attendance at an elementary or secondary public, private, or religious school; provided, however, the amount of cash distributions for elementary or secondary school cannot be more than $10,000 during any taxable year. The $10,000 limit for elementary and secondary school is applied on a per-student limit. 529 Plan Changes Since 529 plans can now be used for reasons other than college

and this was likely not addressed in previous divorce settlements, dissipation of college funds may become an issue. Tip: Perform analysis on statements to determine use of funds and address the proper course of action if dissipation is occurring and it appears college costs will no longer have enough funding. State affirmatively that funds can only be used for post-secondary college expenses.

Businesses Highlights of the Tax Cut and Jobs Act (TCJA) Lowered the corporate tax rate to a flat 21% permanently The maximum Section 179 deduction and phase out threshold were increased to $1 million and $2.5 million from $250,000 and $500,000. For subsequent tax years, these amounts will be indexed for inflation Corporate alternative minimum was eliminated for tax years beginning

after December 31, 2017 Repeals the domestic activities deduction (IRC Section 199) formerly known as the manufacturing or R&D deduction Interest Expense Every business will be subject to a net interest expense disallowance on corporate debt Net interest expense in excess of 30% of the company adjusted taxable

income will be disallowed Adjusted taxable income in this instance is generally defined as taxable income plus depreciation and amortization Taxpayers with average annual gross receipts for the prior three years of $25 million or less are exempt from this limitation The non-deductible portion of interest expense may be carried forward and utilized in future years with no expiration date

Net Operating Losses (NOLs) Net operating losses (NOLs) can no longer be carried back NOLs can be carried forward indefinitely with the exception of property and casualty insurance companies. The NOL deduction is limited to 80% of taxable income Excess Business Losses For noncorporate taxpayers business losses that exceed a certain amount

will be expressed as Excess Business Losses Threshold amount for a tax year is $500,000 for married individuals filing jointly, and $250,000 for other individuals, with both amounts indexed for inflation Threshold is applied at the shareholder or partner level Excess business losses are carried forward and treated as part of the taxpayers net operating loss (NOL) carryforward in subsequent tax years. The losses cannot be used in the current tax year

Business Meals & Entertainment Business Meals For food and beverage expenses associated with operating a business or trade, the deduction remains at 50% For tax years 2018 through 2025, the 50% deduction will include expenses obtained for meals provided to employees for the convenience of the employer. It was previously 100% deductible.

Business travel employee meals will remain deductible at 50% Business Entertainment: No longer deductible For instance, golf outings, sports tickets, and related venues Qualified Business Income Deduction (QBID) An individual generally may deduct 20% of qualified income from a partnership, S corporation, or sole partnership for tax years 2018 through 2025

The 20% deduction is allowed as a deduction reducing taxable income but is not allowed in computing Adjusted Gross Income (AGI) Certain industries including health, financial services, and law are excluded from the preferential rate unless their taxable income for single filers is below $157,500 Qualified Business Income Deduction (QBID) The 20% deduction is limited to deter high income earners from

recharacterizing income as pass through The deduction is phased out for taxable income between $315,000 and $415,000 for certain types of businesses Is also limited to 50% of wages paid or 25% of wages plus 2.5% of the basis in depreciable property Walker vs. Grow (2004) To what extent, are distributions made to fund shareholder level taxes

Tip: Given all the changes in the tax law, it may be beneficial to run the analysis to determine the effect of the tax law on 2018 income Walker v. Grow, 170 Md. App. 255 Court of Special Appeals of Maryland September 12, 2006, Filed No. 2613, SEPTEMBER TERM, 2004 Adjusting for Abnormal Capex/Depreciation Ratios

The new tax law will result in depreciation following an irregular pattern for a much longer period than the length of a majority of management projections The main issue present is the impact timing differences has on present value Income will appear depressed for businesses with heavy capital expenditures Tip: Normalizing accelerated depreciation could become material to assess true income GAAP Financials are Insufficient for DCF Calculations

GAAP income statements will not fully illustrate the impact of some tax changes For instance, depreciation will be based on GAAP rules and not on the accelerated schedule permitted for tax purposes Hence, the cash savings will not be directly illustrated Tip: More forward looking DCFs will need to be considered while most judges have a preference for CCFs

Example Sole Proprietorship making taxable income of $447,000 Taxes increased 7%, Opposing Expert did not consider tax change $41,000 (10%) decline in valuation of business interest Conclusion Based on early studies by Dan VanVleet C-Corp values increased substantially (24.1%)

Pass-through entities (non-service based) values increased (14%) SEAM intact at 9.2% Pass-through entities (service based) values increased (4.3%) but SEAM no longer exists Thank You! QUESTIONS?

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