Child Support

November 2018 : Beware: Spousal Support Tax Treatment Changes January 1, 2019

Posted by Joseph W. Cunningham, JD, CPA

View / Download November 2018 Article – PDF File

As previously reported in this column, the 2017 Tax Cuts and Jobs Act (Act), signed into law in December 2017, radically changes the tax treatment of alimony/spousal support beginning in 2019. The other changes made by the Act affecting divorce took effect January 1, 2018.

Thus, there is a small window within which to decide whether to have existing law – or the new law – apply to divorces that can be finalized this year or next.

The New Law

In a total reversal, alimony/spousal support will not be deductible by the payer or taxable to the payee for divorce and separation judgments and decrees entered on or after December 31, 2018.

This also applies to modified judgments of divorce or separation effective after 2018.

Additionally, it applies to divorce and separation decrees entered before December 31, 2018 if the parties elect to have
the new law apply.

The Act is Not Applicable to Divorce and Separation Decrees Entered Before December 31, 2018

For all existing divorce settlements and those entered by year-end, alimony will continue to be taxable/deductible.

Hence, a window of opportunity before year-end for the many situations in which the alimony payer is in a meaningfully higher tax bracket than the payee. This has set the stage for creative uses of “Section 71 payments” under which the disparity in tax brackets can be used to provide a tax subsidy. Examples include using Section 71 payments to:

  • Divide non-qualified deferred compensation on a taxable/ deductible basis.
  • Structure installment payments of a business buy-out of the non-owner spouse’s marital interest on a taxable/deductible basis.
  • Pay attorney fees on a taxable/deductible basis.

However, after 2018, these opportunities and similar others will no longer be available. In situations where there is significant disparity in brackets, using Section 71 payments in such circumstances may no longer be beneficial.

Effect of Judgment Amendments Post 2018

If a pre-2019 divorce or separation judgment or decree is amended on or after December 31, 2018, the new nontaxable/nondeductible law applies.

Query: Would this be the result even if the amendment does not pertain to spousal support? If the answer has not become clear by year-end, the distinct possibility of losing taxable/deductible status of spousal support payments must be considered before advising the post-2018 amendment of a pre-2019 judgment providing for taxable/deductible alimony.

Fundamental Change in the Dynamic of Alimony/Spousal Support

When the alimony deduction was enacted in 1948, the theory was that, if a former family’s income is split between the parties in some manner post-divorce, the tax treatment should correspond.

The result in many cases has been less combined tax paid on the payer’s income. Because of budgetary concerns—including the enormous cost of the Act—eliminating the alimony deduction became a revenue raising option to help alleviate the Act’s deficit-increasing effect.

This creates a new paradigm for divorce practitioners and alimony guideline providers. That is, we will need to think in terms of after-tax dollars for spousal support, similar to child support.

How to Avoid Paying Alimony with After-Tax Dollars Under the New Law?

One approach is to negate the adverse tax consequences of the new law by using 401(k) funds. As we know, more and more employees have 401(k) accounts than in years past.

Example

  • H, 40 years old, is a middle-management employee at a small company. He earns $60,000 a year. He has a combined 26% federal-state income tax bracket.
  • W is a stay-at-home mom who works part time and earns $10,000 annually. Hence, as head-of-household, her standard deduction offsets her income for federal taxable tax. Her income is subject to minimal Michigan tax.
  • The parties agree on alimony of $1,250 a month, i.e., $15,000 annually, for 5 years when their youngest child will be either working or in community college.
  • H has a 401(k) balance of $150,000, which is split evenly with W receiving $75,000 and H receiving $75,000.
  • In addition to W receiving her $75,000 share, the parties agree that H will transfer his $75,000 share of the 401(k) to W in lieu of spousal support. She can withdraw $15,000 annually, paying approximately $2,000 in tax. H will pay W $2,000 per year to reimburse her for the taxes she will pay on her withdrawals. Thus, W will have $15,000 per year, which is $1,250 a month after-tax spousal support.
  • While W ends up with $15,000 a year after tax either way, using the 401(k) account saves H tax as follows:
Not Use 401(k) Use 401(k)
Payments Over 5 Years:
Payments $75,000 $10,000
Tax at 26% to Provide Funds $26,000 $3,500
401(k) Funds 0 $75,000
Total Cost to H $101,000 $88,500

Observations

  1. The example shows that, in relatively modest circumstances, use of a 401(k) account can result in considerable tax savings.
  2. It provides a means of using pre-tax dollars to fund aftertax obligations – an advantage where there is disparity in brackets.
  3. In the example, the tax on H’s $75,000 share of the 401(k) was shifted to W – at her lower bracket – incident to satisfying his after-tax spousal support obligation.
  4. At 40, H has ample time for his 401(k) account to be replenished.
  5. Using 401(k) funds for a spousal support obligation as shown in the example requires that the plan allow for annual withdrawals, Many plans do not do so. But, a small business plan, as in the example, often does.
  6. A 401(k) account can be used for other purposes, such as buying out the other spouse’s marital interest in (1) a business or (2) a cottage up north.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Beware: Spousal Support Tax Treatment Changes January 1, 2019”
View / Download November 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “November 2018 : Beware: Spousal Support Tax Treatment Changes January 1, 2019”

May 2018 : Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)

Posted by Joseph W. Cunningham, JD, CPA

View / Download May 2018 Article – PDF File

— Facts

  • During the parties’ 11 year marriage, H operated a successful business of which he was the sole corporate shareholder.
  • W was a stay-at-home mom tending to the parties’ two young children.
  • At the time of the divorce, W was earning $11,000 annually for part-time work at a charter school. She testified she was seeking a full-time job.
  • H drew $43,216 from the business in the most recent year.
  • During the pendency of proceedings, H paid W $500/month spousal support and paid all household/family bills pursuant to a status quo order.
  • H incurred substantial debt (1) to make the required support and status quo payments, (2) to pay his and W’s attorney fees, and (3) to pay business expenses. At the time of divorce, the business owed $108,000 including rent in arrears and tax deficiencies.
  • The trial court imputed $20,000 earnings to W and $40,000 to H.
  • The trial court awarded no spousal support to W because:
    • She had a Bachelor’s Degree in Fine Arts while H had just a high school education.
    • H had paid all family expenses during the pendency by incurring substantial business debt.
    • Since W benefitted from this, she was “partially responsible” for such debt.
    • Because H was assuming full responsibility to repay the debt, the trial court viewed this as a “favorable outcome” for W.

Court of Appeals (Court) Decision

  • The Court stated that the trial court failed to make a determination (1) “as to the origin of the debts” of H’s business and (2) “who was responsible for their creation.”
  • Further, the Court noted that W had little, if anything, to do with H’s business and, hence, likely had little, if anything, to do with incurring the debts.
  • The Court remanded the case for reconsideration of (1) W’s responsibility, if any, for the debts after thoroughly reviewing the origin of the debts and (2) the lack of a spousal support award to W.

Comments on the Case and on Treatment of Debts in Determining Money Available for Support

  • The Michigan Child Support Formula Manual (Manual) provides in Section 2.01(B):

    “The objective of determining income is to establish, as accurately as possible, how much money a parent should have available for support. All relevant aspects of a parent’s financial status are open to consideration when determining support.”
    (Emphasis added.)

  • Thus, if H in Bockart had to incur debts to pay family expenses, money used to make payments on the debts is simply not “available for support.”
  • If a business is required to pay on business loans incurred in the ordinary course of business, such as working capital loans or equipment purchase installment payment loans, then the money used to make payments is not available for support.
  • Such payments are not deductible in determining business net income and so must be separately identified when determining money available for support.
  • This is the flip side of adding back deductible depreciation (1) above straight line on personal property or (2) on real property – that is, converting net income to money available.
  • The Court’s focus on the “origin” of the debt seems misplaced. Whether W had any “responsibility” for creation of the debts should not be a deciding factor. Neither should whether the debts were incurred by H or by his company.
  • Rather, of significance is whether the funds from the debts were used for marital purposes. If so, they are debts of the marriage, however incurred.
  • This may not apply to debts to provide for payment of divorce attorney fees. Responsibility for such fees is generally separately considered in divorce settlements.

Concluding Comments

  • Like so many matters in divorce, determining money available for support is a case specific exercise.
  • This is particularly so if one party owns a business or professional practice – both (1) to ensure all items of “indirect” income (excessive perks, etc.) are identified and (2) that legitimate debt payments are excluded from money available for support.
  • Often balance sheets need to be reviewed in addition to income statements.

About the Author

Joe Cunningham has over 25 years of experience specializing in financial and tax aspects of divorce, including business valuation, valuing and dividing retirement benefits, and developing settlement proposals. He has lectured extensively for ICLE, the Family Law Section, and the MACPA. Joe is also the author of numerous journal articles and chapters in family law treatises. His office is in Troy, though his practice is statewide.

Download the PDF file below… “Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)”
View / Download May 2018 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “May 2018 : Court of Appeals Rules on Effect of Corporate Business Debt on Spousal Support. BOCKART V BOCKART, Mich App No 335833 (3/20/18) (Unpublished)”

February 2017: Dependency Exemptions for Divorced or Separated Parents

Posted by Joseph W. Cunningham, JD, CPA
Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Excerpt:

At this time of year, questions often arise as to which of two parents—recently divorced or presently separated—is entitled to the dependency exemption for a child of the marriage.

General Rule under IRC Section 152(e)

IRC Section 152(e) provides a special rule for the right to claim an exemption of a child of divorced or separated parents who, for the year in question:

  • Are divorced or separated under a decree of divorce or separate maintenance at year end; or,
  • Are separated under a written separation agreement at year end; or,
  • Have lived apart at all times during the last six months of the year.
  • And, on a combined basis, had custody of the child for more than half the year; and,
  • On a combined basis, provided more than half the child’s support for the year (support received from a new spouse of a remarried parent is considered provided by that parent).

If these conditions are satisfied, the custodial parent (defined as the parent having physical custody for more than half the year) is automatically entitled to the exemption for a child regardless of:

  • of what the decree or agreement provides
  • which parent furnished more than half of the child’s support.

Waiver Exception to General Rule

For any specified year, or years, or for all future years, the custodial parent may release his or her right to claim the exemption for a child to the noncustodial parent.
……

Continued in PDF file below… “Dependency Exemptions for Divorced or Separated Parents”
View / Download February 2017 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “February 2017: Dependency Exemptions for Divorced or Separated Parents”

October 2015 : Overview of Unallocated Family Support Payments

Posted by Joseph W. Cunningham, JD, CPA
Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Excerpt:

Tax Benefit

  • Combined payments of spousal support and child support – referred to as “family support” – are taxable/deductible under IRC Section 71.
  • Family support is advantageous from a tax standpoint if the support payer (assume H) is in a significantly higher tax bracket than the payee (W).
  • By structuring payments as family support, the child support component – which is generally nontaxable/nondeductible – is converted to taxable/deductible.
  • However, so W is not short-changed, the child support component of the family support payment must be in- creased to cover the tax thereon.
  • To illustrate:
    • H’s average combined federal and state tax bracket is 40% and W’s is 20%.
    • In their divorce settlement, spousal support is $2,500 a month and child support is $1,000.
    • After-tax, the payments are as follows:
      (Table in PDF file)
    • If the child support component is increased to $1,450 and included with spousal support as $3,950 family support, the result is:
      (Table in PDF file)
    • So, by converting child support to family support, Uncle Sam kicks in $3,420 a year, split approximately evenly between H and W.

Requirements to Qualify as Family Support
…

Continued in PDF file below… “Overview of Unallocated Family Support Payments”
View / Download October 2015 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “October 2015 : Overview of Unallocated Family Support Payments”

April 2015 : Four Federal Income Provisions Relating to Divorced or Legally Separated Parents Providing Child Support

Posted by Joseph W. Cunningham, JD, CPA
Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Excerpt:

The following presents basic information on four federal income provisions relating to divorced or legally separated parents providing child support for one (or more) dependent child. These provisions (1) often provide significant tax savings – particularly to parties of modest means – and (2) are often overlooked by divorce counsel who can provide a valuable service by advising clients to check to see if they qualify for any of such tax benefits.

Dependency Exemptions General Rule

IRC Section 152(e) provides that if the parents, on a combined basis, (1) provide more than half a child’s support for the year and (2) have physical custody for more than half the year, then the parent having physical custody for more than half the year (the custodial parent) is entitled to the exemption.

The custodial parent may “release” the exemption to the other parent by executing a written waiver for (1) one year, (2) a specific number of years, or (3) all future years. IRS Form 8332 is the waiver that the custodial parent must execute to release the exemption. e non-custodial parent must attach the executed Form 8332 to his/her tax return for the year(s) for which the exemption has been released.

Other Aspects of the Dependency Exemption

  • The above applies to parents living apart for the last six months of the year as well as to divorced or legally separated parents.
  • “Physical custody” for more than half the year is deter- mined based on overnights. If overnights are equal, the parent with the higher adjusted gross income is deemed the custodial parent.
  • The waiver can be used to, effectively, provide that the parents will claim the exemption in alternating years.
  • Support provided by a parent’s new spouse, or his/her parents, is deemed provided by the parent.
  • The custodial parent may revoke the waiver by executing Part III of Form 8332. Such a revocation applies to the succeeding tax year.
  • The federal income tax exemption amount is $4,000 for 2015.

Phase-Out of the Tax Benefit of Personal and Dependency Exemptions

The tax benefit of personal and dependency exemptions is phased out for high income taxpayers.

The adjusted gross income (AGI) amounts at which the phase-out applies are as follows for 2015:
(Table shown in PDF below)

A taxpayer’s deduction for personal and dependency exemptions is reduced by 2% for each $2,500, or fraction thereof, that his/her AGI exceeds the above threshold amounts.

Example: A single individual has a $300,000 AGI. In addition to his personal exemption, his ex-wife has released the dependency exemption to him for their minor child who lives with her. The phase-out works as follows:

  • Two exemption deductions unreduced – 2 x $4,000 = $8,000
  • Number of $2,500 amounts, or a fraction there- of, by which AGI exceeds threshold – $300,000 – $258,2500/$2,500 = 17
  • Percent reduction in exemption deduction – 2% x 17 = 34%
  • Reduced exemption deductions – 100% – 34% = 66% x $8,000 = $5,280

Practice Pointers
…..

Continued in PDF file below… “Four Federal Income Provisions Relating to Divorced or Legally Separated Parents Providing Child Support”
View / Download April 2015 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section (subscription required)

Read More “April 2015 : Four Federal Income Provisions Relating to Divorced or Legally Separated Parents Providing Child Support”