How the 2017 Tax Act Modified the Tax Penalties of Marriage and Divorce

Thomas A. Tietz, an affiliate within the Legislation Agency of Martin M. Shenkman, P.C., sat in on Carlyn Mcaffrey's presentation on the 2019 Heckerling convention, "Selections and Revisions Which a Minute Will Reverse- How the 2017 Tax Act Modified the Tax Penalties of Marriage and Divorce"  and graciously agreed to share his (copious) notes with our viewers.

1. Marriage and Divorce.

a. Marriage is a relationship with tax consequences- each constructive and destructive. When terminating a wedding, the property switch brought on by that termination has its personal penalties. The Tax Cuts and Jobs Act of 2017 (the "Act") has modified quite a few tax provisions, with far reaching results, on this subject.

2. Existence of a Marriage and Recognition of Divorce.

a. When does a wedding exist? The Federal authorities doesn't have their very own recognition of marriage, it would look to state legislation, or the legislation of a territory/possession of america, to find out if a pair is taken into account married for federal tax functions. Treas. Reg. §301.7701-18(b)(1).

b. If the couple married exterior of america, it will likely be acknowledged for Federal tax functions if any State or Territory acknowledges that marriage (even when that state isn't the one through which they're domiciled). Treas. Reg. §301.7701-18(b)(2). Rev. Rul. 2013-17.

c. When is a divorce efficient? That is additionally a state or territory degree consideration, Federal legislation seems to be to a state recognizing a dissolution of marriage.

d. If a pair will get married on December 31st of a yr, they are going to be supplied with the advantages of marriage for that whole calendar yr. Equally, being divorced on December 31st will relieve you of the burdens of marriage for that whole yr. Code Sec. 6013 (d) (1).

e. Based mostly on the truth that marriage and divorce is set at a state degree, could try to "toggle" out and in of marriage, equally to Grantor belief standing, in an try to realize tax advantages. The Inside Income Service (IRS) has disregarded these toggling makes an attempt up to now. In Rev. Rul. 76-255, 1976-2 C.B. 40, a pair ended a ten-year marriage when within the Dominican Republic, which was subsequently acknowledged underneath Maryland legislation. The IRS didn't argue that the divorce was invalid, however raised the difficulty that the divorce was designed particularly to permit the couple to file individually slightly than as married submitting collectively, bolstered by the truth that they remarried underneath Maryland legislation within the following tax yr, a couple of month after the divorce. The IRS relied on logic from a 1935 case, Gregory v. Helvering, 293 U.S. 465 (1935), which established the foundations for the validity of a "reorganization" underneath federal legislation. In Gregory, the court docket denied the tax advantages of reorganization, indicating that the motives prevented a reorganization for tax functions particularly, even when that reorganization was valued underneath state (Delaware) legislation. The IRS used this logic because of the truth that the Inside Income Code ("Code") has an inner definition of reorganization, in contrast to their lack of a definition of marriage or divorce.

f. Remark: Whereas the IRS could have carried out psychological gymnastics to succeed in the dedication in Rev. Rul. 76-255, contemplating the information of the case the result's unsurprising. With the myriad of adjustments to the tax penalties of marriage and divorce created by the Act, notably the push to finish Property Settlement Agreements (PSAs) by December 31, 2018 for the earlier alimony deduction regime, mentioned additional under, it will likely be fascinating to see if this subject is revisited in higher element sooner or later because of any divorces carried out rapidly, or probably in unconventional methods resembling being divorced in another country, to get the benefit of these disappearing tax boons. Will the IRS probably make the argument a divorce was not legitimate for federal tax functions in 2018; due to this fact, the earlier alimony deduction isn't relevant? 

three. Benefits and Burdens of Marriage.

Professionals

i. Earnings Tax.

1. Joint revenue tax returns are designed to supply a decrease tax burden for 2 married people versus a single particular person who has the identical taxable revenue because the couple. In 2017, a married couple making $500,000 mixed earlier than the Act would have obtained a tax financial savings of roughly 7 % versus a person making the identical quantity on his or her personal. After the Act, that benefit was elevated, with a married couple making $500,000 in 2018 receiving a tax financial savings of 16 % versus a person incomes $500,000.

2. The losses of 1 partner can offset the good points of the opposite partner, permitting for extra sturdy harvesting of good points and losses. Code Sec. 6013(a).

three. The adjusted gross revenue (AGI) of a charitably inclined partner might be augmented by the AGI of the opposite partner, permitting for bigger deductions for important charitable presents, which can have exceeded the varied AGI caps in any other case. Code Sec. 170.

four. Remark: With the usual deduction for married individuals submitting collectively elevated to $24,000 in 2018, many practitioners have mentioned the idea of "bundling" charitable deductions to permit for these charitable presents to succeed in the brink required to itemize deductions. If taxpayers start to make extra important charitable presents in particular years underneath this bundling idea, the potential for the varied AGI caps on charitable deductions to be reached will increase. As well as, Vanguard has predicted that the annual nominal fee of return for inventory and bond investments over the subsequent 10 years to be three to five %, in comparison with the historic common of 9 to 11 %.  When a consumer has important wealth, however low revenue for the yr through which charitable presents are made, the AGI caps for charitable present deductions could turn out to be an surprising issue for that consumer.

5. One partner can promote property to the opposite partner with out paying tax on achieve, as it will likely be thought-about a present that's topic to the limitless marital present deduction. This may not apply to any particular person whose partner is a non-resident alien. Code Sec. 1041.

6. Married people who every earn revenue could find yourself paying a better tax fee mixed than they'd have paid in the event that they have been people submitting individually. Based mostly upon the speed schedule adjustments applied from the Act, the brink for this penalty to start affecting taxpayers is revenue earned above $600,000. After the present fee schedules sunsets for years after 2025, the brink quantity will scale back to $233,350.

7. The state and native tax (SALT) deduction was restricted to $10,000 within the Act. Nevertheless, married solely obtain a single $10,000 deduction, whereas two people would obtain a $10,000 deduction every. Code Sec. 164 (b) (6).

eight. Remark: Married people can think about using Non-Grantor trusts to probably achieve extra SALT deduction. Every particular person can set up a Non-Grantor belief and contribute a portion of a trip house (or pursuits in an LLC or different entity that owns the holiday house) with SALT prices (i.e. property taxes), in addition to belongings which generate revenue equal to or higher than the SALT prices. Because the Non-Grantor belief is taxed individually from the Grantor, it receives its personal $10,000 SALT deduction and might offset as much as $10,000 in revenue generated contained in the belief. Train warning when establishing multiple Non-Grantor belief to keep away from points underneath both the reciprocal belief doctrine or Sec. 643(f) a number of belief guidelines, to keep away from collapse of the trusts by means of the IRS efficiently arguing the trusts have been established just for tax avoidance. Embrace important variations in every belief if establishing a number of trusts (i.e. totally different beneficiaries, totally different powers offered underneath every instrument, and so forth.).

9. Certified Residence Curiosity: Married people who've a mortgage on a certified private residence, which might embody the mortgages secured by the taxpayer's private residence plus one extra house additionally used as a private residence, can deduct the certified curiosity funds primarily based on mortgage principal as much as $750,000 (this quantity was decreased by the Act from $1 million. Any mortgages established earlier than 2017 retain the $1 million cap. This discount sunsets and will increase again to $1 million in 2026. Tax Act § 11043). Two single people would every be capable of obtain curiosity deductions on principal as much as $750,000, successfully growing their certified mortgage curiosity deduction to a cap of $1,500,000 in mortgage principal. Code Sec. 163(h).

Cons

ii. Property Tax.

1. Spouses could make tax free presents to one another throughout life, and the limitless marital deduction permits for tax free bequests upon loss of life. Code Secs. 2523 and 2056.

2. Spouses can break up taxable presents between one another, successfully doubling the annual present exclusion quantity of $15,000 per particular person to $30,000 for the couple (as long as every partner is a US citizen or domiciliary). Code Sec. 2013

three. Portability. the surviving partner can use the deceased partner's unused exemption ("DSUE") of the primary partner. This helps forestall the lack of the primary partner's unused property tax exemption of $10 million inflation adjusted (at the moment $11.four million in 2019, scheduled to lower to $5 million inflation adjusted in 2026). Code Sec. 2010(c). 

four. Alimony.

a. Earlier than the Act, alimony created a state of affairs that allowed for a person to "break up" their revenue with one other taxpayer whom a person was not married to, one of many solely methods this was attainable.

b. Previous to 1942, the Supreme Courtroom resolution of Gould v. Gould 245 U.S. 151 (1917) had decided that alimony funds weren't taxable to the recipient, the person paying the alimony needed to additionally pay the revenue tax on that cost. The Tax Act of 1942 statutorily overrode this resolution, requiring the recipient particular person to report gross revenue for the alimony obtained, and permitting the paying particular person to deduct from gross revenue for quantities paid. This modified adjusted gross revenue instantly, and was not an itemized deduction, permitting it for use at the side of the usual deduction.

c. This method was reversed by the Act for any funds made underneath a divorce or separation settlement finalized after December 31, 2018. At the moment, any particular person paying alimony underneath divorce decrees or PSAs signed in 2019 or past can't scale back their AGI by the quantities paid, and people receiving alimony underneath these agreements don't must report that quantity as revenue.

d. The adjustments to alimony created by the Act are "everlasting", as in they aren't scheduled to sundown in 2026.

e. It was estimated by the Joint Committee on Taxation that the repeal of the alimony deduction would generate $6.9B of extra income between 2019 and 2027, or lower than zero.5 % of the entire projected deficit created by the Act of $1.45 trillion.

f. IRS statistics for 2015 tax year- 586,253 taxpayers reported alimony funds to cut back AGI, however solely 415,515 reported alimony revenue. Did it make sense to repeal the alimony deduction because of this, or was higher enforcement the suitable transfer?

g. The Home Methods and Means Committee commented that the selection to repeal the alimony deduction was to take away a "subsidy" for divorce that created a tax benefit for divorced people compared to married people.

h. Nevertheless, for center class taxpayers the alimony was much less of a "subsidy", and extra of a safety from the growing tax burden brought on by a divorce. Instance: A household with $189ok in revenue and $165ok in taxable revenue, if that revenue is generated by two married people, the household unit pays about $26,500 in revenue taxes. If after a divorce just one particular person earned everything of the $189ok in revenue, that particular person would have their revenue tax burden elevated to roughly $38ok, a rise of 36 %. Previous to the Act, if the person incomes the revenue had paid alimony of $94,500 (50 % of complete revenue), the alimony deduction would have created a tax burden roughly equal to what the people had when married. Because of the Act, the identical quantity of revenue the household generated previous to the divorce must help the household with higher tax price, placing extra pressure on these households.

i. As revenue earned by particular person will increase, the impact of the change on alimony deductions by the Act decreases. For a person incomes $1,000,000 a yr, the elevated tax burden brought on by the change (if complete alimony paid per yr is $500,000) is roughly eight.5 %.

j. Remark: The change within the alimony deduction exemplifies extra stress positioned upon American households that many people won't actually comprehend till it impacts their backside line. The results of divorce already positioned important stress on the revenue a household unit generated- the associated fee to keep up separate households,  transportation prices, probably extra youngster care prices, amongst many different unexpected bills. Practitioners might want to help their shoppers in getting ready for these extra prices, which might embody working with the shoppers wealth advisers to organize a price range primarily based upon the adjustments created by the divorce. Beforehand, the negotiations of PSAs included the expectation of the person paying alimony to obtain a deduction, with this incentive eliminated how PSAs are negotiated might want to change to account equitable distribution of belongings within the new paradigm.

5. Prenuptial and Postnuptial agreements.

a. The adjustments to the alimony deduction mentioned above could have ripple results for prenuptial and postnuptial agreements signed earlier than the Act. As these agreements usually established sure help ranges primarily based upon expectation of the paying partner profiting from the alimony deduction, the help ranges negotiated in these agreements could now not be sustainable or equitable.

b. It's unlikely that prenuptial and postnuptial agreements could be thought-about as a divorce or separation instrument, so even when the settlement was signed earlier than December 31, 2018 the funds negotiated underneath these agreements doubtless won't fall underneath the aegis of the earlier alimony deduction regime.

c. These agreements usually embody a severance clause, which can comprise language that gives if any provision of the settlement is taken into account unenforceable or unlawful underneath current legislation, these provisions will probably be renegotiated by the events in good religion to keep up the spirit of the settlement. If the settlement in query consists of this type of clause, it might permit the payor partner to have a chance to renegotiate the help degree underneath the settlement.

d. Remark: It could be prudent for practitioners to debate prenuptial and postnuptial agreements with their shoppers to particularly elevate this concern. Proactively addressing any surprising outcomes prompted underneath postnuptial and prenuptial agreements because of the adjustments by the Act. Property plans put in place by the people may must be reviewed to find out if the planning in place violates any phrases of the prenuptial or postnuptial agreements because of the modified financial outcomes underneath the settlement.

6. Coping with current, and using, Trusts throughout and after Divorce.

a. One tax benefit of married people is the power to carry out present and property tax free transfers between each other. Sec. 2516 creates a particular exception for marital settlements indicating that if a partner transfers belongings to a partner or ex-spouse pursuant to a PSA there will probably be no present tax as long as that switch occurs inside both one yr earlier than or one yr after a finalized divorce settlement. This rule extends to transfers made to trusts through which the partner is a beneficiary.

i. Warning have to be exercised when making transfers to a belief pursuant to Sec. 2516 to keep away from a present tax entice underneath Sec. 2702, which gives that if the Grantor ex-spouse retains the rest curiosity of the belief, the total worth of the present made to the belief will probably be assessed as a present made by the Grantor ex-spouse, inflicting present tax prices or use of present tax exemption.

ii. Treasury Regulation § 25.2702-1(c)(7) creates an exception to this present tax entice if the rest curiosity of the belief is retained by the beneficiary ex-spouse.

iii. If the rest curiosity is offered to the kids of the transferor, the transferor is more likely to keep away from any points underneath Sec. 2702, because the transferor didn't retain any the rest curiosity underneath the belief. Nevertheless, underneath the joint buy rule of Code Sec.2702, making a belief on this method could trigger destructive present tax outcomes for the transferee beneficiary ex-spouse. Code Sec.2702(c)(2) gives a consequence that the beneficiary ex-spouse, from receiving a time period curiosity within the belief, with the rest curiosity to go to the transferor (and transferee's) youngsters, will probably be thought-about as having obtained everything of the worth of the belief, and thereafter transferring to the opposite member of the family (i.e. the beneficiary ex-spouses youngsters on this instance), with the beneficiary ex-spouse incurring a present tax price in consequence.

iv. Remark: The whole thing of the present tax entice considerations posed by Sec. 2702 are past the scope of those expeditiously created notes. Practitioners ought to train warning to know the potential repercussions of any transactions made to a belief underneath the aegis of Sec. 2516, and to tell shoppers of any potential present tax points associated to the proposed planning. Take into account the present excessive present tax exemption quantity of $11.four million in 2019 and distinction it with potential revenue tax financial savings this system would offer. If the divorcing spouses are properly underneath the present and property tax exemption quantity (considering that it's slated to cut back by half in 2026) this planning can probably be a boon even with the present tax considerations.

b. Underneath Sec. 1041, no achieve needs to be acknowledged for such transfers, and the idea of the asset inside the belief will carry over from the Grantor.

c. Non-Grantor Trusts.

i. By means of using trusts, the importance of the repeal of the alimony deduction might be mitigated for rich taxpayers. If a Non-Grantor belief is established after the divorce, pursuant to the phrases of a divorce or settlement settlement, and the belief ends the help obligation of the Grantor of the belief to the beneficiary ex-spouse underneath state legislation, the Grantor ex-spouse won't must pay any taxes for the revenue generated within the belief, and the beneficiary ex-spouse who receives funds pursuant to the belief pays the revenue tax to the extent the quantity obtained is revenue for the belief that yr. The belief itself would pay revenue taxes on any revenue remaining inside the belief, avoiding the cost of extra revenue taxes by the Grantor ex-spouse.

ii. Remark: Carlyn S. McCaffrey has demonstrated a novel potential use for the Non-Grantor belief created by the Act. Practitioners ought to think about, and focus on with their shoppers, if the potential tax financial savings created by means of using a belief on this state of affairs is well worth the administrative time and prices of creating the Non-Grantor belief, in addition to the present tax considerations mentioned above, this system has the potential to turn out to be one other arrow within the quiver of each the matrimonial legal professional and the property planning legal professional on the workforce. One other benefit for the Grantor ex-spouse that can not be quantified, or underestimated, is the power to "reduce ties" by means of using this system and finish the alimony help obligations to his or her ex-spouse.

d. Grantor Belief considerations.

i. A belief created for the aim of offsetting the lack of the alimony deduction shouldn't be a Grantor belief, as it might then trigger the Grantor ex-spouse to shoulder the tax burden for the belief.

ii.  Remark: As proven under, practitioners must be cautious in establishing a belief for the aim of decreasing the tax burden of the lack of the alimony deduction after the Act. Trying to "thread the needle" of Non-Grantor belief standing on this state of affairs is fraught with potential pitfalls. Further considerations concerning avoiding grantor belief standing that aren't mentioned in these notes will must be addressed, and practitioners ought to completely overview the Grantor belief guidelines contained inside Secs. 671 by means of 679.

iii. If the belief revenue or principal is used to discharge an obligation the Grantor ex-spouse to the beneficiary ex-spouse, it might trigger the belief to be tainted and deemed a Grantor belief, with revenue tax being attributed to the Grantor. Sec. 677(b). As mentioned above, it is very important make sure that the contribution by the Grantor to the belief utterly ends the duty the Grantor has to the beneficiary ex-spouse.

iv. Sec. 677 states that if the Grantor's partner is a beneficiary, that exact belief is taken into account a Grantor Belief.

· This impression is proscribed in divorced spouses whose divorce or settlement agreements have been finalized earlier than December 31, 2018, because of receiving the alimony deduction even when it was a Grantor Belief (see Sec. 682).

· As Sec. 682 was repealed by the Act, divorcing spouses can now not depend on this safety.

· Observe that divorce doesn't resolve this downside, if the belief is established earlier than the divorce is finalized, because of Sec. 672(e). This part states that any powers or pursuits the Grantor's partner holds will probably be thought-about powers held by the grantor. This is called the spousal unity rule, and it's possible it doesn't stop to function after divorce. Subsequently, if Sec. 672(e) applies because of the belief being established earlier than divorce, it might trigger aggregation of useful pursuits and powers underneath Sec. 677 and taint the belief as a Grantor belief.

· The IRS requested feedback for utility of 672(e) after divorce. ACTEC requested to IRS that 672(e) utility is terminated after divorce is finalized. The feedback by ACTEC indicated the thought course of included that the spousal unit has financial unity, and when that financial unity is sundered by means of divorce, it's a logical that 672(e) ought to now not apply. As of the time of the presentation, the IRS has not responded.

· Trusts for use to fulfill help obligations shouldn't be established earlier than the settlement settlement, however the institution of the belief might be agreed upon within the PSA.

· The PSA can present for both the institution of a belief to fulfill the help obligations of the partner, OR have the partner that's supposed to ascertain the belief pay alimony. This provides the Grantor ex-spouse a alternative in methods to fulfill his or her help obligations, and it doubtless avoids the 672(e) points mentioned above.

e. Irrevocable Trusts established in the course of the marriage.

i. Take into account that in lots of conditions irrevocable trusts are exempt from legal guidelines put into place after the belief was established. For instance, trusts established earlier than September 25, 1985 are exempt from era skipping tax as they have been established earlier than it was codified.

ii. All trusts created throughout marriage, which suggests 672(e) aggregation applies each to useful pursuits and powers the Grantor's partner has, needs to be reviewed to find out the impact divorce has upon these trusts.

iii. A tax reimbursement clause included within the separation settlement regarding any distributions obtained by the beneficiary ex-spouse from Grantor trusts established earlier than the divorce might be an efficient option to keep away from the Grantor ex-spouse persevering with to pay revenue tax on belief regarding these distributions.

iv. Solutions on coping with varied sorts of trusts sometimes established earlier than divorce.

·  Spousal Lifetime Entry Belief ("SLAT"). Normally for this type of belief the beneficiaries are the Grantor's partner and the descendants of the Grantor. A SLAT because of the Grantor's partner (on the time the belief was established) being a beneficiary is a Grantor belief. If nothing is completed to change this belief, then the Grantor will proceed to pay the revenue tax on distributions made to the ex-spouse, which can be an undesirable consequence. If there may be an invasion of principal provision within the belief, the Trustee can use this to distribute out all belongings within the belief as a part of the beneficiary ex-spouses claims underneath the divorce or settlement settlement. Outright distribution will not be the most effective resolution, as it might unravel the property tax planning that was the reasoning for establishing the belief. Take into account decanting as a way to protect the property tax planning targets Grantor initially needed to realize (if the elevated property tax exemption quantity of $11.four million didn't change, or presumably even eradicate, the necessity for the property tax planning initially conceived).

·  Remark: As Carlyn S. McCaffrey indicated, outright distributions out of the SLAT needs to be averted until it's decided to be the only option after cautious overview. A overview of the belief phrases and powers offered to protect the targets of the property planning, and probably adapt the belief to the brand new paradigm of the household, could permit the SLAT to proceed to be a strong software of safety for the household. Take into account that if the state the SLAT is situated in permits for non-judicial modifications, this system also can probably be used to replace the executive provisions of the belief if all events, together with the Grantor, could be prepared to signal the modification.

·  Certified Terminable Curiosity Belief ("QTIP"). This belief prevents distributions to anybody aside from the Grantor's partner. Subsequently, as decanting can't change the useful pursuits within the belief, modifying the useful curiosity to anybody aside from the ex-spouse wouldn't be attainable. If there may be a capability to invade the principal, one strategy might be to distribute all belongings out of the belief and embody this distribution in negotiations for the settlement settlement.

a. Take into account asset safety benefits of the QTIP belief earlier than making a dedication to terminate. Instance: Florida has a statute to guard the rest curiosity in a QTIP for the rest beneficiaries from collectors. That is good asset safety for the rest beneficiaries, and creates a cause to decide on to not collapse the QTIP belief.

· A spendthrift clause could make utilizing the strategies mentioned above for the SLAT and QTIP tough to realize. Take into account together with a provision for a fiduciary of the belief to terminate the spendthrift provision within the belief for these sorts of conditions.

· Certified Private Residence Belief ("QPRT"). The Grantor of the QPRT sometimes retains the suitable to stay within the house for a sure interval. Usually as each spouses personal the home collectively, there could be two QPRTs established, every proudly owning 50 % of the private residence. It's uncommon (however not unparalleled) that the spouses will need to stay collectively after getting divorced. Sometimes, they are going to need to divide the home as a part of the belongings and never stay collectively. If the separation settlement provides the suitable of 1 partner to stay within the marital house, the settlement can require the opposite partner to switch their useful curiosity of their specific QPRT in order that the partner dwelling within the marital home has all pursuits within the house. Observe this switch shouldn't occur till after the separation settlement is signed.

These notes aren't produced at the side of or endorsed by the Heckerling Institute on Property Planning. The Heckerling Institute isn't accountable for its content material. For details about the Heckerling Institute go to www.legislation.miami.edu/heckerling.

The creator thanks Carlyn S. McCaffrey for her great presentation.