How Tax Reform Changes Alimony and Lawsuit Tax Obligations

The Tax Cuts and Jobs Act made significant changes to the deductibility of alimony and personal lawsuit recoveries, which could have a big impact on tax liability for people looking to divorce or those who are involved in personal lawsuits. Here’s what you need to know.

Divorce and other legal proceedings are rarely enjoyable. Now, under the new Tax Cuts and Jobs Act (TCJA) laws, they are even less so due to the fact that you can no longer deduct payments made for alimony (for divorces post-2018) or certain legal bills. In addition, if you are a recipient of alimony payments, keep in mind that they will no longer be considered part of your taxable income.

Whether your alimony payments are voluntary payments or court-mandated ones, they can be significant. So it’s important for you to understand how the TCJA can impact your tax situation going. Here’s a quick synopsis.

Understanding the Tax Cuts and Jobs Act (TCJA)

The Tax Cuts and Jobs Act (TCJA) is a landmark piece of legislation signed into law by President Donald Trump in 2017. This near-comprehensive overhaul of the US tax code aims to stimulate economic growth through a series of tax cuts and reforms. One of the key features of the TCJA is the reduction in tax rates for both individuals and businesses, which is intended to increase disposable income and encourage investment.

The TCJA also impacted business taxes. For one, it reduced the corporate tax rate permanently, primarily benefiting shareholders and high-income earners. In contrast, the TCJA’s individual tax cuts are temporary and set to expire in 2025. There were also changes that allowed businesses to deduct the full cost of certain business property purchases like heavy equipment during the same year (sometimes called immediate expensing).

There were lots of other changes, too. The TCJA removed the individual penalty for individuals that didn’t get health insurance. The child tax credit raised, and so did the estate tax exemption.

In addition to lowering tax rates, the TCJA significantly increased the standard deduction, making it more attractive for many taxpayers to forgo itemizing deductions. However, it also eliminated personal exemptions, which could offset some of the benefits for larger families.

For those navigating a divorce, the TCJA brings notable changes to the taxation of alimony payments. Understanding these changes is crucial for effective tax planning and to ensure you are taking full advantage of available tax benefits under the new law.

How Tax Reform Impacts Taxable Income from Alimony Payments

Before the TCJA’s reform of the tax code, alimony payments meeting tax law requirements could be deducted by the payer on their federal income tax return. Meanwhile, the recipient would report alimony payments as taxable income. Both payer and payee could find that these payments had a substantial impact on their adjusted gross income for the year under the previous law.

Starting in 2019, alimony payments (sometimes called spousal support or spousal maintenance payments) were no longer tax deductible and recipients of them no longer had to include them in their taxable income. This applies to divorces executed after Dec. 31, 2018 (or divorces that are modified after this date, provided the modified written separation agreement or divorce agreement specifically states that the new tax rules shall be applied to these alimony payments).

In addition, child support payments or payments to divide the marital property are also treated as nondeductible personal expenses for the payer and tax-free payments for the recipient.

A Note on the Requirements for Deductible Alimony

If you have an alimony agreement that pre-dates 2019 it may still qualify as deductible alimony if it meets the following requirements.

1. The payment must be made based on a written divorce or separation agreement.
2. Payment must be to or on behalf of your spouse or former spouse, not a third-party.
3. Ex-spouses cannot live together or file taxes jointly.
4. Payments must be made in cash or a cash equivalent.
5. The payment cannot be child support.
6. For the payer to claim a tax deduction they must note the payee’s Social Security number on their return.
7. No obligations for payments to continue after the recipient’s death can be included in the alimony agreement.

How Tax Reform Impacts Taxable Income from Lawsuit Settlements

Tax reform ushers in higher taxes on lawsuit settlements with no deduction for attorney fees in some cases. For example, if you win a lawsuit in a $100,000 case, you will pay taxes on the full $100,000, regardless of how much you pay in legal fees. However, there are two important exceptions:

• This new law does not generally apply to qualified personal physical injury cases. In these scenarios, the entire recovery from the case is usually tax-free.
• It should also not impact recoveries from cases where plaintiffs bring claims against their employers, but you should check with your tax professional in regard to your specific circumstances to be sure.

In most other personal lawsuits, there is no longer a write-off for legal fees or costs, so you would be taxed on all of your recovery. At first, this may not seem like a big deal, but when you consider it includes lawsuits related to issues such as privacy, defamation of character, divorce, child custody, wrongful imprisonment, malpractice, punitive damages and other common legal troubles the impact is likely to be much more widespread among taxpayers.

The impact of tax reform on legal fees may increase your tax bill considerably. The TCJA makes significant changes to the deductibility of alimony and personal lawsuit recoveries, which can really add up to a significant tax liability on your tax return. Again, it is key to make sure you discuss your personal legal situation as it relates to taxes with a qualified professional. They’ll help you understand your responsibilities and the role of the Internal Revenue Service in enforcing these tax laws.

Tax Planning Strategies

Effective tax planning is essential to minimize tax liability and maximize tax benefits under the TCJA. Here are some strategies to consider:

• Take Advantage of the Increased Standard Deduction: The TCJA nearly doubled the standard deduction to $12,000 for single filers and $24,000 for joint filers. This increase can significantly reduce your taxable income and lower your overall tax liability compared to itemized deductions.
• Itemize Deductions Strategically: While the TCJA limits state and local tax (SALT) deductions to $10,000, itemizing can still be beneficial if you have high medical expenses, mortgage interest, or charitable donations. Carefully evaluate your expenses to determine if itemizing will provide greater tax benefits.
• Utilize Tax Credits: The TCJA retained several valuable tax credits, including the child tax credit, which can provide substantial tax savings for families. Make sure to explore all available credits to reduce your tax bill.
• Consider a Roth IRA Conversion: With the TCJA lowering tax rates, now might be an opportune time to convert a traditional IRA to a Roth IRA. This move can offer tax-free growth and withdrawals in retirement, providing long-term tax benefits.

Conclusion

The Tax Cuts and Jobs Act (TCJA) has brought significant changes to the tax landscape, impacting taxable income, separate maintenance payments, and overall tax obligations. Understanding these changes is crucial for effective tax planning. By leveraging available tax benefits and employing strategic tax planning, individuals and businesses can minimize their tax liability and maximize their savings. Consulting with a tax professional is essential to ensure compliance with the TCJA and to optimize your tax planning strategies.

Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.