The new GOP Tax Plan presents implications for divorce planning. Divorce practitioners who understand the nuances of the bill and the full scope of how it may impact clients will have a strategic advantage, as there are benefits to agreements made before year end. The purpose of this article is to identify the provisions that affect divorcing couples, to dispel myths, and to highlight opportunities.
The tax plan released on Thursday, November 2, 2017, known as the Tax Cuts and Jobs Act, includes various provisions that impact individuals who are divorced or who are currently in the divorce process:
1. Repeal of the tax deduction for alimony payments (Note: there is a timing opportunity to consider)
2. Higher business valuations affecting property division
3. Expected higher stock portfolio values also affecting property division
4. A lower rate on income from pass-through entities (this is part-myth and part-reality)
5. Repeal of the Estate Tax resulting in potentially much higher inheritances
6. Repeal of deductions for state and local taxes affecting disposable income
7. Repeal of mortgage interest deductions for home equity indebtedness over $500,000
…but the devil is in the details.
Section 1309 of the bill appears to be the most talked about provision: the repeal of the alimony tax deduction. As the characterization of alimony versus child support is often times a significant negotiating item in determining support calculations, this item in the bill seems to be getting a great deal of attention.
It is true that the bill repeals this tax deduction and appears to be supported by a policy decision that allows divorced families to shift income from higher tax brackets to lower tax brackets, resulting in a married couple being at a disadvantage when it comes to minimizing their taxes. Regardless of the agenda behind Section 1309, the result would be tax-free support for the alimony recipient and higher taxes for the payer.
A few additional items to be aware of:
First, this provision would be for divorces finalized AFTER December 31, 2017, presenting a timing advantage to settlements made in 2017. According to the bill, divorce agreements made in 2017 have the tax deductibility of alimony “grandfathered in”.
Second, and very worthy of noting, the bill addresses modifications of existing agreements made after 2017 stating that a modification would need to include a clear agreement to adopt the new tax law for a recipient to get tax free treatment. Because modified support orders are not automatically grandfathered in for the tax deductibility of alimony, this may result in a battleground issue for future modifications making them risky to the person paying alimony in many circumstances.
2. HIGHER BUSINESS VALUATIONS
A less obvious result of the bill stems from the provisions relating to lower individual and corporate tax rates. As closely held companies are often one of the biggest assets in a marital estate, this provision should not be overlooked. The income approach to business valuation is based on a multiple of after-tax cash flows. With lower taxes, the after-tax cash flow of a business would naturally be higher, resulting in a higher business value under existing valuation models.
3. HIGHER PORTFOLIO VALUES
While this is speculative, since many factors impact investment portfolios, lower taxes may result in higher stock valuations.
For a high net worth couple with a large investment portfolio, the timing of property division may be highly relevant if the securities are not going to be divided in kind.
4. LOWER TAX RATES FOR PASS-THROUGH ENTITIES
Section 3001 of the bill titled “Reduction in Corporate Tax Rate” has widespread implications but it is not as simple as the headlines would make it seem. The details of the bill do reduce the tax rate and even go so far as to limit the rate on pass-through income, which is certainly appealing to business owners.
However, there’s a catch! The reduced tax rate may not apply to companies that provide personal services.
In essence, the bill’s provisions separate out the portion of pass-through income that has the elements of compensation versus the portion that is pure non-service-related profit. The following quotes from the summary of the bill published on the GOP website illustrate the above mentioned “catch”:
“Active business owners can choose between a simple formula and a more complex business capital formula to separate compensation income from non-compensation income.”
“Professional service businesses, such as accounting and law firms, are subject to a stricter facts-and-circumstances test that presumes that most of their income is wages.”
The lower tax on pass-through entity income is not quite what it seems, and many closely-held businesses will not benefit from this provision.
5. ESTATE TAX REPEAL
This provision appears to be exactly what its title describes. For families with expected inheritances, those dollar amounts may increase significantly if this bill becomes law. While this is not a factor in every divorce, those with inheritance as a relevant piece of the puzzle could find this provision to be a game changer.
6. STATE AND LOCAL TAX DEDUCTION
Section 1303 of the bill repeals the deduction for state income taxes. However, it leaves in real estate taxes on a primary residence as a deduction. For a divorcing individual counting on a state income tax deduction, the result may be a reduction in disposable income post-divorce.
7. MORTGAGE INTEREST DEDUCTION
Section 1302 of the bill limits mortgage interest deductions. Currently, interest on up to $1,000,000 of home mortgage equity debt is tax deductible. Under the new provisions, this amount would be reduced to interest on up to $500,000 of debt. For a divorcing individual counting on this deduction, the result may be a reduction in disposable income post-divorce.
When viewed in its entirety, the bill has implications for alimony treatment, disposable income calculations for post-divorce planning, property division connected to business valuation, inheritances, and divisions of income tax deductions in the year of a divorce. The lower business tax rates may be more hype than reality to many businesses, such as medical practices, accounting firms, and others that provide professional services.
Financial strategies for divorce will need to evolve to keep up with these changes should they become law. Even the possibility that they may become law presents interesting timing opportunities for settlements, such as locking in the alimony deduction while possible.