At the beginning of this year, major changes to the federal tax code took effect, including one that greatly impacts the tax implications for alimony. Prior to 2019, the law allowed alimony payers to take a tax deduction on their payments while alimony receivers were required to claim the payments as taxable income. Now, neither side is allowed to deduct or required to claim.
According to a recent New York Times article, the reason for this change was an imbalance that has long existed. Since the provisions were first enacted in 1942, alimony payers have been very likely to claim the deduction while alimony receivers have been much less likely to report the income. Getting rid of both requirements means less of a revenue shortfall for the IRS.
Unfortunately, while the new provisions simplify the tax code, they may also be making it harder for divorcing spouses to reach an agreement on alimony. In response, some wealthier divorcees are turning to a creative solution: paying alimony through what’s called a grantor trust.
In short, these trusts are established after the divorce has been finalized and are funded with assets that generate income. Although it functions like regular alimony payments, the trust is essentially another form of property settlement.
The paying spouse funding the trust is no longer responsible for taxes, but the receiving spouse does need to pay taxes on the distribution. While this might be a sticking point in negotiations, lawyers for the paying spouse make the terms more palatable by ensuring that payments continue even after the paying spouse passes away.
Like most creative tax-mitigation strategies, this one has its critics. And this approach will certainly not be appropriate for every divorce involving alimony. The important takeaway, however, is that you always need to keep tax considerations in mind when working through the terms of your divorce. Otherwise, the settlement you end up with may not be nearly as fair or as sustainable as it first seems.
The best way to ensure that no important financial details are missed in your own divorce is to work with an experienced family law attorney.