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 freelancers who divorce or 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 such payments, keep in mind that they will no longer be considered part of your taxable income. Given that these payments can often be significant it is important to know how this change may impact your tax situation going forward. Here’s a quick synopsis.

How tax reform impacts 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 while the recipient of such payments reported them as taxable income.

Starting in 2019, alimony payments are no longer tax deductible and recipients of them no longer have to include them in their taxable income. This applies to divorces executed after Dec. 31, 2018 or modified after this date if the modified 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.

RELATED: Five Key Ways Tax Reform May Affect Your Business Taxes This Year

Keep in mind 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 ex-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 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 tax 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 freelance tax return. Again, it is key to make sure you discuss your personal legal situation as it relates to taxes with a qualified professional.