What Would Happen If Ross and Rachel Got Divorced Under the House Tax Bill

It doesn’t take a legal expert to understand that a divorce typically results in the separation of two parties who previously acted as a financial, spiritual, and social unit. Because parties tend to be highly dependent on one another prior to a divorce, New York law has recognized that the lesser-earning spouse is typically entitled to maintenance payments (commonly referred to as alimony) for a certain duration of time. As the law currently stands, because money was transferred out of one spouse’s income and into the other’s income, the tax law is currently structured to recognize this transfer and has allowed for a tax deduction by the spouse paying maintenance.

WHAT WILL CHANGE?

As the law currently stands, there is an adjustment to gross income for the spouse paying maintenance to his or her ex-spouse. The effect of this adjustment is that the amount paid in maintenance is not counted when taxing the individual’s income. The current law also counts maintenance as income for the ex-spouse receiving maintenance payments. So the overall effect is the amount paid in spousal support is counted as income to the recipient spouse and not the payor spouse.  Under the proposed House Tax Bill, the adjustment in gross income is eliminated for the spouse paying alimony. What does this mean? Instead of the tax obligation being transferred to the spouse receiving alimony, the spouse paying alimony pays tax on the funds which are then transferred to the recipient spouse. The recipient spouse receives the alimony free and clear of any tax obligation.

ROSS AND RACHEL

The following example is included to further clarify how the House Bill will affect the parties’ distribution of income for tax purposes:

CURRENT TAX LAW:

Rachel makes $70,000 per year as a fashion designer. Ross makes 30,000 per year as a museum tour guide. Rachel and Ross divorced and Rachel pays $10,000 per year for 5 years to Ross for spousal maintenance. At the end of the first year, when each files their taxes, Ross reports $10,000 worth of income related to the alimony payments and his total income which he pays taxes on is $40,000. Rachel claims a deduction for the $10,000 paid in alimony and pays taxes on $60,000 worth of income. 

REPUBLICAN HOUSE BILL:

Rachel and Ross continue to earn $70,000 and $30,000 respectively based on their individual salaries. Rachel pays to Ross $10,000 over the course of the year in spousal maintenance. However, at the end of the year, there is no tax deduction for Rachel. So in reality, Rachel technically only has $60,000 worth of income, but she will pay taxes as if she actually retained the full $70,000. Ross will receive an extra $10,000, but will only pay taxes on his $30,000 worth of income from his job at the museum.

The current tax law allows for a gap where the parties’ combined tax obligation can be lessened by bringing the higher-earning spouse into a lower tax bracket.  This has presented divorce attorneys with opportunities to negotiate favorable terms for both parties by getting the lesser earning spouse more maintenance while lessening the higher earner’s tax obligations. Under the Republican House Bill, the parties will not have wiggle room in their negotiations to allow the higher-earning spouse to pay more to gain favorable tax consequences. Under the current tax law, the parties also had the option to opt-out of the adjustment in income which is no longer available under the new Bill if passed.  

SO ULTIMATELY HOW WILL THE TAX BILL AFFECT YOUR DIVORCE IF PASSED?

Well, if there is no finalized settlement agreement if and when the Bill is passed, then the negotiations are about to get heated. This law will have a profound effect on the distribution of the marital estate.  Furthermore, the Bill will leave attorneys with less bargaining chips to bring to a negotiation.  It’s unclear how courts will account for this change in the tax structure, if at all.  Under New York law, the Court may consider tax consequences, among other things, when making a determination as to whether to deviate from the guideline amount of spousal support.  However, only time will tell whether courts will find it necessary to change the support amount based on the tax law.