Alimony & Taxes: After 2018, maintenance payments won’t be tax deductible
Published in Chicago Lawyer Magazine, October 2018
By Daniel Stefani
One aspect of President Donald Trump’s changes to the federal tax code affects alimony (also known as maintenance in Illinois). Specifically, payment of maintenance pursuant to a dissolution of marriage judgment entered after Dec. 31 will no longer be tax deductible by the payor and tax includable to the payee. This represents a major change in federal tax law which will affect all state law which governs dissolutions of marriage and more specifically the payment of maintenance. Maintenance is spousal support which is different than child support. Child support was never tax deductible by the payor.
This change in federal law will eliminate the arbitrage that was sometimes created when a high income payor of maintenance made tax deductible payments to their former spouse who had little to no income other than the maintenance received. The payee ex-spouse was taxed at a much lower effective federal income tax rate than the payor ex-spouse would have been if they paid income tax on the maintenance amount.
In many cases, the payor would have paid approximately 40 percent on the highest layer of their gross income but when deductible and taxed to the payee, many stay-at-home ex-spouses end up paying federal income tax at closer to a 25 percent rate. The result is the payee spouse gets more and it costs the payor less. This new change to the tax code closes that loophole by the end of the year. As such, litigants who can create this arbitrage should be motivated to get their divorce finalized by Dec. 31.
Maintenance will continue to be tax deductible by the payor and taxable to the payee for any divorce judgments that were executed before Dec. 31. To the extent those judgments are ever modified after Dec. 31, the maintenance will still be tax deductible to the payor and taxable to the payee unless both parties agree in writing that the payments are not.
This change in the federal tax code created a dilemma in Illinois because the state maintenance laws had percentage guidelines for certain cases but were based on the maintenance being tax deductible by the payor and taxable to the payee.
In response, the Illinois legislature passed a recent bill into law with new maintenance guidelines for situations where the payment of maintenance would be subject to a divorce judgment entered after Dec. 31. For those cases where the alimony is not tax deductible, the new guidelines call for a calculation by taking 33 1/3 percent of the payor’s net annual income minus 25 percent of the payee’s net annual income.
That amount as calculated for maintenance when added to the net income of the payee, if any, shall not result in the payee receiving an amount that is in excess of 40 percent of the combined net income of the parties. If it does, the guideline does not apply.
Both this new guideline and the current guideline apply only if the court first makes a finding that a maintenance award is appropriate and that the combined gross annual income of the parties is less than $500,000.
In cases where the divorce judgment was entered before Dec. 31 or modification proceedings after Dec. 31, where the parties do not agree to change the deductibility, the current guideline remains, namely the maintenance is tax deductible by payor and is calculated by taking 30 percent of the payor’s gross annual income minus 20 percent of the payee’s gross annual income. The amount calculated as maintenance, when added to the gross income of the payee, if any, may not result in the payee receiving an amount that is in excess of 40 percent of the combined gross income of the parties. If it does, the guideline does not apply.
In cases where the guideline does not apply, the maintenance amount is calculated by the court after consideration of 14 factors in the statute including the standard of living established during the marriage, the needs of each party and many other factors.
In the case where maintenance is paid in addition to child support, the new statute clarifies that if the application of guideline maintenance results in a combined maintenance and child support obligation that exceeds 50 percent of the payor ’s net income, the court may determine nonguideline maintenance in accordance with the 14 factors and not in accordance with the guidelines for maintenance and/or child support.
The new guidelines attempt to have each spouse share equally in any detrimental effect of the maintenance no longer being tax deductible to the payor.
As an example, if the payor’s gross income is $500,000 a year and the payee has no gross income, for two minor children, under the current guidelines where the maintenance is tax deductible, the payor would pay approximately $12,500 in tax deductible maintenance and $2,100 a month in child support that is not tax deductible to the payor.
Under the new guideline, the payor would pay $8,760 in maintenance (which is not tax deductible by payor or taxable to the payee) and $2,126 in child support (which is also not tax deductible by payor or taxable to the payee).
Dan Stefani is a principal at Katz & Stefani. The firm’s practice is limited to family law matters. His work on behalf of mainly high net-worth clients, as well as spouses of high net-worth individuals, involves valuations of closely held corporations, partnerships and other entities, detailed analysis of complex financial transactions, child custody and support issues as well as paternity and domestic violence.