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The Alimony Deduction Lives on in New York … With a Few New Loopholes

The matrimonial bar is grappling with the effect of a tax bill passed by Congress and signed by President Trump at the end of 2017, which removes the option for divorcing spouses to pay alimony that is taxable to the payee and deductible by the payor. Matrimonial practitioners have long used the alimony deduction to help our clients and thus encourage settlements. But the 2017 statute abolishes the deduction with respect to matrimonial agreements signed after Dec. 31, 2018.

The New York legislature mitigated the federal change and threw in a few new twists. The state budget makes alimony deductible from state and New York City taxable income, even if the agreement came too late for the federal deduction. Furthermore, loopholes in the state law will sometimes allow one party to enjoy a deduction without the other party reporting income, to achieve tax savings that pre-2017 federal law did not allow, and even to deduct the same payment twice.

The Pre-2017 Law. Since at least 1942, federal tax law has allowed parties who pay what is defined as “alimony or separate maintenance” to deduct those payments from their income. If the payor deducts alimony, the payee must report it as income. Taxable/deductible alimony will create a net savings if, as often happens, the payor faces a higher marginal tax rate than the payee.

By adjusting the exact amount of alimony to be paid, the parties can decide whether the tax savings benefit the payor, benefit the payee, or are divided between them. For example, if the payor spouse is in a 30 percent tax bracket and the payee spouse is in a 20 percent tax bracket, then instead of transferring $1,000 tax-free, they can pay $1,263 in taxable/deductible alimony. That costs the payor only $884 after tax, but after tax the payee nets $1,010.

The New Federal and State Statutes. Until the federal change goes into effect, alimony can be deducted from the payor’s “gross income” and included in the payee’s “gross income” under sections 71 and 215 of the Internal Revenue Code of 1986, as amended (the IRC). Section 11051 of the 2017 federal law (informally known as the Tax Cuts and Jobs Act or TCJA), however, repeals those sections as to separation agreements (and judgments of divorce) signed after Dec. 31, 2018. In response, Part JJ of the Fiscal Year 2019 state budget provides that “alimony or separate maintenance payments” made under agreements signed after Dec. 31, 2018 will be added to the payee’s federal adjusted gross income and deducted from the payor’s federal adjusted gross income. Governor Cuomo proposed that change to “decouple” state income tax law from changes made under the TCJA. Presumably, a New York subtraction from income for payments that would have been federally deductible alimony if not for the TJCA and a New York addition for payments that would have been federally taxable alimony if not for the TCJA will be reported on Form IT-225, New York State Modifications, with other modifications to federal adjusted gross income.

Loophole #1: Payments Across the State Border. The easiest situation in which to exploit the new state law is one in which the alimony payor is a New York state resident for tax purposes, but the payee is not. The payor will still be able to deduct the full amount paid from his or her New York state taxable income. The payee will owe no tax on that income, because the payment is not treated as New York source income subject to tax in the hands of a non-resident. A non-New York resident who has New York source income will pay New York state income tax and so may also benefit from the New York state alimony deduction. A resident of a low-tax state such as Florida is especially likely to have his or her aggregate tax burden reduced.

Loophole #2: Payments Across the New York City Border. Similarly, the parties will receive a net savings if the payor is a New York City resident for tax purposes but the payee is not. The payor will be able to deduct alimony from his or her New York City taxable income. The payee will owe no New York City tax on the payments, even if he or she is a New York state resident for tax purposes.

Loophole #3: Replacing Equitable Distribution With Short-Term Alimony. Because taxable/deductible alimony can generate net savings for the parties at the expense of the government, Congress and the IRS have limited its use. The new state law, however, appears to omit those limits.

In particular, the “recapture” or “excess front-loading” provision, current IRC §71(f), prevents parties from creating tax savings by labeling as taxable/deductible alimony payments that are really equitable distribution, i.e., transfers of property shortly after a settlement agreement.

Determining when recapture applies is quite complicated. (For an accessible treatment, see the 2017 version of IRS Publication 504.) In general, recapture is triggered by a steep decrease in payments of taxable/deductible alimony during the first three calendar years in which alimony is paid under a separation agreement.

Recapture roughly undoes the tax treatment of alimony. The payor, who had deducted alimony, must add the recaptured amount to federally taxable income in the third calendar year in which payments are made. The payee, who had paid tax on the alimony, can then deduct it. Because New York state (and City) taxable income is currently derived from federally taxable income, recapture now also increases state and City taxes.

Starting in 2019, however, it appears that New York state and City income tax laws will not include recapture. New State Tax Law §612(w) and City Administrative Code §11-1712(u) say only that “alimony or separate maintenance payments” are deductible by the payor and taxable to the payee, and they define “alimony or separate maintenance payments” as “payments as defined under” IRC §71, as it existed before the December 2017 change. Nothing in the new state or city law specifically authorizes any “excess alimony payments,” which is how recaptured alimony payments are technically characterized under current IRC §71, to be added to the payor’s income or deducted from the payee’s income. Put another way, although IRC §71(f) requires payors to report additional taxable income in the third year, it does not define the additional income as alimony, and so the new state law does not impose a tax on it.

That difference may encourage many divorcing parties to reclassify some equitable distribution as alimony. Assume the payor spouse is in the top state and city tax brackets, for a total stated marginal tax rate of 12.696 percent. For simplicity, assume the payee has no other income and no exemptions. The payor could offer a distributive award of $200,000, with no ongoing support. That will incur no federal, state, or local taxes and create no deductions. Instead, the payor could offer a $100,000 distributive award and $100,000 alimony in the first year. Before taxes, that is the same offer. The revised offer, however, will secure the payor a $100,000 tax deduction, which is worth $12,696. The payee, if he or she also lives in New York City, will incur $6,151 in state tax and $3,751 in local tax on the alimony income, for a total tax of $9,902. The parties will achieve a net tax savings of $2,794.

Under current law, such an arrangement would trigger recapture, because the amount of taxable/deductible alimony will drop from $100,000 in the first calendar year to zero thereafter. In the third calendar year, recapture would roughly negate the net tax savings. If the parties sign their agreement after Dec. 31, 2018, however, they can save on state and city taxes without facing recapture.

Loophole #4: Modifying Agreements to Deduct Alimony Twice. Both the TCJA and the FY19 state budget have an exception to their effective date provisions. The wording of that exception arguably allows certain payors to deduct payments twice by modifying their agreements.

Section 11051 of the TCJA applies not only to payments under divorce or separation instruments signed after Dec. 31, 2018, but also to payments under instruments signed before that date and modified after that date “if the modification expressly provides that the amendments made by this section apply to such modification.”

The drafters of the state statute copied that provision practically verbatim. Both new State Tax Law §612(w) and new City Administrative Code §11-1712(u) apply to payments made under a divorce or separation instrument executed after Dec. 31, 2018, “and any divorce or separation instrument executed on or before such date and modified after such date if the modification expressly provides that the amendments made by this section apply to such modification.” There, however, the words “this section” literally refer to a section of the State Tax Law or the City Administrative Code, not to a section of a federal law.

So: Assume a separation agreement signed before Dec. 31, 2018 under which the parties agree to payments of taxable/deductible alimony. Assume also that in 2019 the parties agree to modify their agreement, and the modification specifically provides that the payments will be governed by the amendments to state and local law in the FY19 budget, but not by the amendments to federal law in the TCJA. The TCJA will not apply, so the payor’s federal adjusted gross income will reflect a deduction for the alimony paid under current IRC §71.

Changes under the FY19 state budget, however, will apply to the modified agreement. To determine his or her taxable income under New York state and City law, the payor will “subtract from federal adjusted gross income” the amount of alimony paid. But due to the federal deduction, the alimony will already have been subtracted in the process of determining federal adjusted gross income! The payor will thus have deducted each alimony payment twice from taxable income for state and city purposes. (Conversely, if the payee is subject to New York state or City income tax, he or she will report income equal to twice the amount of alimony received. But just as taxable/deductible alimony can result in net savings, doubly taxable/deductible alimony can result in larger net savings.)

In conclusion, the FY19 state budget achieved its major aim: to mitigate the effects of the 2017 federal law on alimony. One can only wonder whether the “loopholes” discussed above will be closed when the Legislature reconvenes, or, if not, whether the New York State Department of Taxation and Finance may attempt to close the loopholes by issuing regulations.

Matthew A. Feigin is a partner in the matrimonial department of Katsky Korins. Elias M. Zuckerman, a partner in the firm’s tax department, and Marcy L. Wachtel, a partner in the matrimonial department, assisted in the preparation of this article.