New tax law could doom divorcing clients
Prenuptial agreements come with a certain social stigma and usually get filed away deep in a drawer never to be talked about again. In light of Congress passing the new tax law, however, those contracts need to be dusted off and reviewed. Certain provisions may no longer reflect what was intended, and in fact, the terms may now disadvantage the very party who had sought protection in the first place.
Financial advisors should immediately contact clients who have prenuptial agreements to determine how they may be impacted by the recent tax bill. If a client’s prenuptial agreement is affected, schedule a meeting with an attorney to quantify the impact.
The most controversial change pertains to the deductibility of alimony payments. Historically, the spouse who paid alimony received a tax deduction equal to the payment amount. The spouse who received the alimony reported the payments as taxable income. By permitting this shift of income from the payer spouse’s higher tax bracket to the recipient spouse’s lower tax bracket, more income was available to divide between divorced spouses. A win for both parties.
However, the new tax law eliminated the payer spouse’s ability to deduct alimony payments. Preexisting alimony orders will not be impacted for any “divorce or separation instrument” effective on or before December 31, 2018.
In a jurisdiction such as Massachusetts, alimony generally should not exceed the recipient spouse's need or 30% to 35% of the difference in income between the spouses. For example, Alex earns $200,000 and Blake has no income. The parties divorce and agree upon an alimony order of 32.5% of the difference between the spouses’ income, or $65,000 per year. By using the $65,000 in payments as a tax deduction, Alex’s obligation actually costs $46,800 per year (assuming a simple tax rate of 28%).
If the above fact pattern occurs after 2018, now without the benefit of the alimony deduction, an alimony payment of $65,000 per year would actually cost Alex $65,000, or $18,200 more. To achieve equity, Alex’s attorney would argue that the alimony payment needs to be adjusted to reflect the loss of the deduction, resulting in less money to Blake.
Most prenuptial agreements were prepared based upon the assumption that alimony would always be tax deductible. Many prenuptial agreements contain specific alimony provisions such as “payer spouse shall pay recipient spouse 30% of the difference in the parties’ incomes,” or “payer spouse shall pay recipient spouse $X per month in alimony.” Given the loss of the deductibility of alimony, the payer spouse (often the spouse who had sought the prenuptial agreement for protection) may now be bound to unfavorable terms. This presents a sizeable problem as prenuptial agreements are enforceable contracts between the parties and binding and conclusive as to the rights of the parties upon divorce.
In other words, barring compelling reasons to invalidate the agreement, the payer spouse may be stuck with an unfriendly alimony obligation.
Ultimately, it must be determined whether modifying the existing agreement is necessary, or whether pursuing the potential benefits of a postnuptial agreement, an agreement made entered into after marriage, may be worthwhile. Either option will require the potentially reluctant participation of the recipient spouse. By failing to act prior to December 31, 2018, the client could be doomed by the very instrument that was put in place for financial protection.