While the House tax reform bill changes the current tax treatment of alimony, the Senate version maintains the status quo. However, the discussion of the tax treatment of alimony often neglects the family law context and fails to consider the unintended consequence of potential reductions of alimony transfers.
Currently, alimony is an above-the-line deduction to the payor per §215. However, alimony was intended to be more revenue-neutral, so the flip side is that alimony is includable as gross income to the recipient per §71. There is still a tax benefit to the divorcing couple because the higher-income alimony payor taking the deduction is usually in a higher tax bracket than the lower-income recipient spouse paying the tax. Furthermore, the divorcing spouses may change the tax treatment of their alimony by agreement. In contrast, there are no tax consequences to the other two main financials transfers in divorce—property division and child support.
These tax rules on alimony have made federal income tax planning an important aspect of matrimonial practice for decades. In particular, they incentivize the higher-income spouse to agree to pay alimony in a time when state legislators and courts are chipping away at the alimony obligation. Furthermore, to the extent that judges take into account tax consequences in divorce cases, eliminating the alimony deduction may result in a decrease in alimony awards.
Despite its high impact in family law, the current tax treatment of alimony has only a small fiscal effect. Indeed, denying the current tax treatment to alimony payments would increase tax revenues by under $1 billion per year. However, some of this money can be recovered by simply better enforcing §71.
While alimony payors often take a deduction, payees do not always include alimony in their gross income. The Treasury Inspector General for Tax Administration (TIGTA) found that 47% of 567,887 tax returns filed in 2010 with an alimony deduction had either no corresponding alimony income reported by recipient spouse, or the amount of alimony income reported did not match the deduction taken. This meant potentially $1.7 billion in unreported taxes over 5 years. TIGTA had recommended that the IRS send out warning letters to taxpayers alerting them to potential alimony errors.
Thus, changing the current tax treatment of alimony while ignoring the family law context may result in the unintended consequence of reducing alimony transfers, especially in voluntary divorce settlements. If the goal is to guard the public fisc and preserve alimony transfers, enforcement of §71 may be a better approach than denying tax treatment to alimony.