Sweeping tax reform was signed into law by President Trump on December 22, 2017. If you’re in the middle of a divorce or separation agreement, and you will be the spouse receiving alimony, it may be worth your while to delay matters and ink the deal after January 1, 2019 when the new tax law regarding alimony takes effect. On the other hand, if you will be the paying spouse, you’ll likely want to wrap things up before that date. Here’s why –
A payment of cash from one spouse to the other under the terms of a divorce or separation agreement, regardless of how it may be labeled in that agreement, will be characterized for US income tax purposes as “alimony” if the payment meets certain criteria. Current law looks to the criteria listed in Internal Revenue Code Section 71(a), the new law looks to the criteria listed in the new law itself that will become part of Internal Revenue Code Section 152(d)(5), as amended. Under current law, if treated as “alimony,” the payment will be tax deductible for the payor, and will be taxable income to the payee. The anticipated tax law changes these results as of January 1, 2019 making the alimony both non-deductible and non-taxable.
Parties wishing to utilize the new rules can modify their old divorce agreements. The parties’ situation should be reviewed to see if it is tax advantageous to use the new rules. Yes! This can certainly be the case. Here’s an example – assume a US resident payor (non-US citizen) departs the US losing US residency. Payment of alimony to a US recipient will be taxable income to the recipient, but the non-US payor may no longer care about any US tax deductions. Such a couple may benefit from the new rules and might look into modifying their current divorce agreement.
Taxation and Withholding Duties
When paid to a nonresident alien individual (NRA), alimony income from US sources is taxable to the recipient as “fixed, determinable, annual or periodical” (so-called “FDAP”) income. Under the current US tax rules, payments of alimony income to an NRA are taxable and will be subject to gross withholding at source if the alimony is derived from “US sources” (more later on this concept). This is significant because the US payor will have withholding duties. If he fails to meet them he can become personally liable for the tax. Payments of US-source income (such as alimony payments that are considered to have a US source) are also subject to reporting requirements. The payor of the alimony should obtain a Form W8-BEN from the NRA recipient. Part I of the Form contains a certification that the recipient is a NRA and Part II will cover the right to claim treaty benefits, that can reduce or eliminate withholding, if any such treaty benefits exist. The Form W8-BEN is retained by the payor; it is not sent to the IRS. If the alimony is from US sources, withholding will be required by the payor at the 30% (or lower treaty rate).
“Source” of Alimony Income
The source of alimony income is the residence of the payor and not the location of the court that issued the divorce decree (e.g., a US or foreign court). This was made clear in the case of Elinor Manning versus the Commissioner. Thus, if the paying spouse is a US resident (regardless of his or her citizenship), the alimony will be treated as having a “US source” and, under current law, reporting and withholding obligations must be met when paying the NRA recipient. On the other hand, if the paying spouse is resident overseas (even if a US citizen), then the alimony will not have a “US source” and it should not be taxable in the hands of the NRA recipient. Reporting and withholding should not be required on the part of the paying spouse, regardless of whether the new law is in effect.
The New Rules – Ring Out the Old Divorce Agreements, Ring in the New
Under the new tax law, the existing rules regarding alimony (deductible by the paying spouse and taxable to the recipient spouse) remain in effect through the end of 2018. Alimony will not be deductible, nor taxable, under new agreements signed beginning on January 1, 2019. With respect to agreements signed prior to January 1, 2019, these remain “as is”. Alimony paid pursuant these “old” agreements is taxable under the current rules, unless the parties modify them on or after January 1, 2019, by specifically referencing the new law and stating the agreement is modified by the new law.
Simply put, if a new divorce decree is inked in the calendar year 2018, the new tax laws will not apply to alimony paid and received. The new alimony tax laws would apply only to decrees signed in the year 2019 and beyond, unless an older decree is properly modified by the parties. So, even though new rules change the alimony picture substantially, if you have a decree governed by the old tax rules, don’t forget to report the alimony income on your tax return. If you are the paying party, ensure that you undertake the required withholding duties if necessary.
We can help you make sure you do things correctly. As mentioned, the parties should seek qualified tax advice to see if modifying an old agreement makes sense and if the new rules can be more advantageous .
All the US tax information you need, every week — Just follow me on Twitter @VLJeker