Divorce, Broken Hearts and US Tax

The Price of Divorce has just Increased
By Michael Rowlands

Divorce might have just become more expensive for US taxpayers. In the US, alimony payments (otherwise known as maintenance or periodical payments in the United Kingdom), but not child maintenance, are deductible by the paying spouse and are taxable to the recipient spouse as income. In the small print of the widely heralded tax reforms approved by the Trump administration in January 2018, the tax break will end for all divorce financial settlements finalised after December 31, 2018.

This has led some to predict a divorce rush before the new rules take effect.

I asked Ed Rieu of US tax advisory firm Sopher & Co to explain the history and the impact of this change:

"The US originally allowed a deduction for alimony by the paying spouse equal to the amount included in taxable income by the recipient spouse. The rules evolved to the current rules that allow a deduction even where the recipient did not include any amount in income.

To be deductible, the alimony needs to be paid in cash, under a court order between legally separated persons and must end on the death of the payee spouse (or on a fixed date). Further, the order must not designate the payment as not being deductible by the payor or includible in income by the recipient. A lump sum prepayment can also qualify as deductible alimony. Fixed payments for child support, however, do not qualify as deductible alimony nor do lump sum payments in splitting marital assets.

As an aside, this non-taxation rule on lump sum pre-payments does not apply to transfer of assets to a non-US citizen spouse. Thus, where a US citizen or permanent resident transfers assets to such spouses, gain will be realised on the value of assets transferred in excess of base cost and income will be realised to the value of any pension or other deferred income rights transferred. This requires up-front strategic planning to identify what assets may be transferred with a minimum US tax exposure.

Because the spouse paying alimony is typically in a higher tax bracket than the recipient, the alimony payment usually results in an overall tax saving which is often split by the parties in the financial settlement. The US Congress recognised this and recently legislated that effective for court orders issued after 31 December 2018, no deduction will be allowed for alimony payments and the receipt of income will not be taxable. Alimony paid on court orders issued prior to 1 January 2018 will still be deductible (and receipt of alimony will still be taxable). While the overall savings gained by the couple may be lower given the reduction in US tax rates (from 39.6% to 37%), the net savings to be realised has nevertheless led to a current rush by couples to expedite resolution of financial issues by year end."

Inevitably there will be pressure for US taxpayers to finalise divorce settlements over the next eleven months and for some, the loss of the tax break may even be a tipping point spurring them to divorce. Before taking any radical decisions, however, it might be valuable for US citizens seeking their divorce in England (perhaps because they are resident here) to consider how the changes will impact. Maintenance settlements here are awarded based on “need”. There is no principle of a “fair sharing” of income. The less well-off spouse (usually the wife) will present a schedule of her own and any children’s annual income needs. The schedule will be a comprehensive list, everything from bath salts to butlers, aiming to reflect the actual standard of living of the marriage. The needs, of course, must be affordable and reasonable, but the court will normally carry out a balancing exercise with the edge being given to the parent who has the primary care of children going forward.

Yet since the English court also looks at the net income available in prescribing maintenance payments, it is inevitable that some separated households will be impacted by the new tax hit and will find the future a good deal harder. One would like to think the new rules may create a short term financial disincentive to divorce but I suspect for wealthy US clients it simply means divorce has become more expensive.

The author is Michael Rowlands, at law firm Kingsley Napley LLP.
T: +44 (0)20 7814 1210
E: mrowlands@kingsleynapley.co.uk


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