The Tax Cuts and Jobs Act (TCJA) changed how the IRS treats alimony and made other substantial changes that affect family law practitioners and their clients. This also impacts CPAs and other accounting professionals, which may now be retained earlier in the divorce process, as compared to after the finalized divorce, which was typically the case.
Under the TCJA, effective Jan. 1, 2019, alimony paid by the payor is no longer deductible, and is not taxable to the recipient for federal tax purposes.
It is important for the parties to know how the alimony paid and received impacts their separate tax filings. Alimony is based upon each party’s income from all sources which can require CPA analysis. Attorneys may call upon CPAs to help calculate the appropriate amount of alimony and to determine the cash flow and the resulting tax impact to the parties. An accountant may also be required to conduct a lifestyle analysis or an investigation as to income if there is, for example, a cash business.
Blended Tax Rates
After the enactment of TCJA the calculation of a blended tax rate is required. The use of a blended tax rate considers both parties’ tax brackets, with the goal of leaving the parties in approximately the same tax position as before the law change. In essence, the alimony amount is now a tax-effected sum on the federal return. The New Jersey state return still treats the alimony as deductible by the payor and taxable to the recipient.
In New Jersey, the unofficial method of calculating the amount of alimony, in most cases, was one-third the difference of the gross income from all sources of each of the parties.
Upon divorce for the federal return, since there are only two possible filing statuses, single or head of household, a preliminary blended tax rate only considers these two filing statuses. Using those two filing statuses with the seven tax brackets in each, 49 possible combinations result. The overall average of the 49 possible combinations is 24.6 percent. Therefore, for settlement purposes, the blended tax rate of 24.6 percent, rounded to 25 percent, would be applied to the difference of the gross income from all sources of each of the parties; thus, providing a tax-effected alimony amount. The tax-effected alimony amount is the starting point at which negations would begin.
Once an approximate amount of alimony is agreed upon, using the blended rate of 25 percent, formalized tax projections can be prepared to fine tune the final amount of alimony. The pro-forma tax returns should be prepared inclusive of the alimony amount in discussion, as per each party’s deductions and other income.