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Warner Angle Hallam Jackson & Formanek PLC

     

Divorce and Family Law

Divorce and the 2017 Tax Law: Spousal Maintenance, Business Valuations, and Child Support

The federal Tax Cuts and Jobs Act, which was passed in December 2017, impacts divorce cases in three major areas: spousal maintenance, business valuations, and the allocation of the child dependent exemption in child support matters.

Perhaps the Act’s most impactful change with respect to family law is the reversal of the taxability of spousal maintenance payments. Much has already been written on this topic, and I will leave the comparison calculations to the CPAs.

  • For settlements and court decisions entered before December 31, 2018, spousal maintenance payments are deductible from the payor’s income and taxable income to the recipient.

  • For settlements and court decisions entered on or after January 1, 2019, the reverse is true: Spousal maintenance payments will no longer be deductible to the payor and will not constitute taxable income to the recipient.

How this will affect settlement negotiations and trials remains to be seen. One significant benefit of the change will be eliminating the need to tax-effect, or “gross up,” the spousal maintenance payments.

Under current law, if the parties agree or the court determines that the recipient’s reasonable needs are $5,000 per month, the recipient must net $5,000 per month. Since the payments are taxable income to the recipient, the payments must be “grossed up” to cover the taxes, probably to $6,000 to $7,500. This requires the parties to make an educated guess about the recipient’s effective tax rate, which may not always be accurate. Alternatively, the parties may need to engage a tax expert to calculate the recipient’s effective tax rate, which requires an examination of all of the recipient’s sources of income. This may not always be possible, such as in cases where the recipient spouse is rejoining the work force and does not yet have certain employment.

Under the new law, the need to tax-effect the payment is eliminated. If the recipient’s reasonable needs are $5,000 per month, then this is the amount that should be ordered by the court (assuming the payor’s ability to pay this amount). Thus, the new tax law simplifies matters by eliminating the guesswork and necessity of a tax expert to tax-effect the spousal maintenance payments.

Business Valuations in Divorce

The consensus among many business valuation experts is that, in the absence of other changes in the business, the new tax law will increase the value of businesses in divorce cases. This means that the spouse who keeps the business will have to pay more to buy out the other spouse.

For valuations of operating businesses relying primarily on the income approach (e.g., professional practices, retail operations, and some manufacturers and wholesalers), the Act’s flat corporate tax rate of 21%, the lower individual income tax brackets, and the availability of the Qualified Business Income deduction mean potentially more cash flow available to the business owner. More cash flow to capitalize means a higher present value calculation.

Under the market approach, the new lower tax rate could render comparable previous sales as no longer truly comparable. Sales completed under the old tax law would likely be undervalued compared with future sales under the new lower tax rate.

For valuations utilizing the asset approach, the new tax law appears to be the least impactful. For instance, the value of a company that simply owns real estate or a non-occupied commercial structure is based on the appraised value of the hard assets, rather than capitalized income, and is thus largely unaffected by the new tax law.

Special thanks to Melissa E. Loughlin-Sines of Henry & Horne for her critique and insight for the above section.

Child Support and the Dependent Exemption

Under Arizona law, when the court enters a child support order, the court is also required to assign the right to claim the dependent exemption for each child on the parent’s income tax returns. This is valuable to the parents: For tax year 2017, each exemption was worth a $4,050 deduction from the parent’s gross income.

Starting with tax year 2018, the new tax law eliminates all personal exemptions. There remains the issue of which parent can claim each child as a dependent, but the associated exemption (deduction from gross income) is eliminated. The Arizona Child Support Guidelines specifically refer to the “dependent exemption” and require the exemptions to be allocated proportionately between the parents, based on their respective share of the combined gross income. Presumably, the same rules apply to the allocation of the right to claim each child as a dependent, not just the associated exemption, but it appears the Guidelines will need revised language.

The importance of allocating the right to claim each child as a dependent, for divorce purposes, now relates solely to the right to claim the child tax credit (CTC). The CTC is also valuable to the parents, as it is a straight $2,000 deduction from the tax owed. This amount begins to phase out at an income of $200,000 for a single filer ($400,000 for married filers). Additionally, while a child may be claimed as a dependent past age 18 if certain conditions are met, the CTC applies only to a child who will be 16 years old or younger on December 31st of the tax year in which the credit is claimed.

For settlements and court orders, the dependent exemption should be allocated between the parties for tax year 2017, and the right to claim the child as a dependent (and the associated CTC) should be allocated between the parents for tax year 2018 through each child’s 17th birthday. In addition to specifying this allocation in the divorce decree, the parties should simultaneously execute IRS Form 8332 to formally transfer the right to claim each child as a dependent for all future years.

 
          

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