|
|
|
|
The JGTRRA of 2003: Financial Implications
for Divorce
July 2003
By Jerry L. Style and Carl M. Palatnik
On May 23, 2003, the U.S. Congress approved the Jobs and Growth Tax Relief Reconciliation
Act of 2003 (JGTRRA) and, within a week, President Bush signed the act into law.
JGTRRA reduces tax rates across the board, increases the Child Tax Credit from
$600 to $1000, and eases the marriage tax penalty. It also reduces the tax on
dividends and capital gains and increases write-offs on capital assets for businesses.
Marriage-penalty relief directly affects married taxpayers, but what effect will
the new law have on people going through divorce?
Tax Planning Issues Related to JGTRRA
Tax planning, although complex, is a virtual necessity in divorce because there
are a variety of tax issues that relate to both income and assets. Proper planning
can typically reduce the overall tax burden on one or both parties and enhance
their respective post-divorce financial positions. In contrast, poor planning
can have profoundly negative long-term effects on the parties. Although JGTRRA
does not specifically address divorce taxation issues, changes incorporated into
the law will have a significant impact on people going through divorce.
One of the major consequences of an overall lowering of taxes is an enhancement
of post-divorce cash flow. This makes new or alternative post-divorce settlement
options more attractive and potentially workable. Tax relief under the new act,
however, extends beyond a simple lowering of tax rates and the expansion of tax
brackets. Because of both the across-the-board cuts and targeted provisions such
as the expansion of the Child Tax Credit, alternative property division and payment
obligation scenarios involving the division of assets, the structuring of child-
and spousal-support payments and the claiming of dependency exemptions must be
carefully analyzed in its context.
Phaseout Provisions: A Word of Caution
In performing these calculations, it should be noted that, as in its predecessor
— the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)
— Congress used a “smoke-and-mirrors” approach in putting together
the law in order to stay within its self-imposed limit of $350 billion. Because
of this, many of the provisions of the act are scheduled to “sunset”
over the next 2 to 7 years. Without these provisions, the estimated cost of the
changes would have ballooned to approximately $800 billion. Since it is impossible
to predict what changes will occur when these provisions are scheduled to disappear,
or whether interim modifications might be made, their potentially transient nature
must be taken into account in the tax-planning process.
The Child Tax Credit is an excellent example of the complexity of these phaseout
provisions. This credit is only available to taxpayers with a qualifying child,
who, among other things, is the taxpayer’s dependent. Because of this, changes
to the Child Tax Credit can have a major impact on the respective value of the
dependency exemptions to each of the parties. To illustrate the complexity of
these changes, and the need for incorporating flexibility into the tax planning
process, under JGTRRA the maximum Child Tax Credit per child under age 17 increases
to $1000 for the years 2003 and 2004, but is reduced to $700 for the years 2005
to 2008. The credit then increases to $800 for the year 2009 and $1000 for the
year 2010. In 2011, it drops again, this time to $500.
The complexity of these phaseouts is also illustrated by the dance of the expanded
10% tax bracket. This tax bracket remains at $7000 for single individuals for
the years 2003 and 2004, but is reduced to $6000 for the years 2005 to 2007. In
2008, it returns to $7000, but is adjusted for inflation through 2010. It then
completely disappears in the year 2011.
A third example of the variability of these changes relates to marriage penalty
relief, which remains in full force for years 2003 and 2004, reappears to a lesser
degree for years 2005 to 2007, disappears in full for years 2008 to 2010 and returns
in full force for the year 2011. Got it!
The Child Tax Credit and the Value of Dependency Exemptions
Claiming dependency exemptions has always been a fertile area for tax planning
in divorce. Let us assume, for example, a situation in which the husband is in
the 28% marginal tax bracket and the wife in the 15% bracket. Based on differences
in marginal tax brackets, a $3050 exemption for a child would theoretically be
worth $854 to the husband or $458 to the wife, a difference of $396. Under prior
law, the Child Tax Credit would potentially add $600 for a qualifying child. Under
JGTRRA, this amount increases to $1000. The husband can therefore potentially
reduce his taxes by $1854, or the wife $1458. In either case, the value of the
dependency exemption is potentially much larger than ever before.
The actual calculation is more complex and, especially with the increase in the
Child Tax Credit, the respective potential benefits to each spouse could be totally
different. For example, the Child Tax Credit begins to be phased out for single
individuals with adjusted gross incomes in excess of $75,000, the actual length
of the phaseout period dependent upon the number of qualifying children. Because
of this, the Child Tax Credit is not applicable to high-income taxpayers. In the
above example, the dependency exemption might be worth only $854 to the husband
versus $1458 to the wife, a difference of $604, but this time it is in the wife’s
favor! Sometimes less is more.
To complicate matters further, since the availability of the Child Tax Credit
is based on the adjusted gross income of the taxpayer claiming the child as a
dependent, only “above the line” deductions apply toward making a
taxpayer more eligible for the credit. Consequently, deductions for medical expenses,
property and state income taxes, mortgage and investment interest expenses, contributions
and miscellaneous expenses are not applicable.
Certain deductions, however, do reduce adjusted gross income. These include capital
losses, business deductions, 401(k) contributions, deductible IRA contributions,
moving expenses, self-employment health insurance expenses and alimony, among
others. Probably the most important of these in the context of divorce is alimony
or spousal maintenance. It is therefore entirely possible that the simple payment
of alimony by one ex-spouse to the other will reduce adjusted gross income to
a level that increases the value of a dependency exemption to the person paying
alimony and claiming a child as a dependent.
Dependency exemptions are marital assets. Under current law, unless the custodial
parent waives the right, he or she has control over which parent can claim the
dependency exemptions for the children. Needless to say, the value of the exemptions
to each of the parties needs to be calculated prior to making a decision on this
issue. Ideally, exemptions should be applied in the most tax-favorable way, with
tax savings split in an equitable fashion between the parties. As of this writing,
modifications to the law are being debated in Congress, including the timing of
phaseout provisions and whether or when Child Tax Credits should be “refundable,”
ie, paid to taxpayers, such as stay-at-home spouses, whose incomes are low and
who consequently pay little or no tax and theoretically have no payments to refund.
This, of course, would add another wrinkle to the equation.
Will Advance Payments Go to the Right Person?
JGTRRA also provides for an advance payment of $400 per qualifying child of the
increased Child Tax Credit, starting in July 2003. This payment will be sent to
individuals who claimed on their 2002 tax returns dependent children who will
be under age 17 at the end of 2003. If taxpayers were married and filed jointly
in 2002, but divorced in 2003, they would presumably each be entitled to half
the payment. Basically, the IRS will calculate how much Child Tax Credit would
have been paid to a tax filer for the year 2003 if the $1000 Child Tax Credit
had been in effect for the entire year.
This creates an interesting dilemma for certain divorced couples. Some divorcing
couples alternate years in which they claim dependency exemptions and Child Tax
Credits for their children. If the IRS sends an advance payment to the parent
who claimed the credit in 2002, but the parties had agreed that the other parent
would get the credit this year, the payment would go to the wrong parent. This
parent could be out of luck and should watch for any procedure the IRS might implement
to prevent the check from going to the wrong party; or the parent should at least
alert the IRS to the changed situation.
What about taxpayers receiving advanced payments of $400 for dependents they will
not be claiming on their 2003 tax returns? Will they have to give the money back?
As of this writing, taxpayers who receive advance payments, but fail to qualify
for all or part of the credit in 2003 because of limitations in their adjusted
gross incomes, will not be required to return those payments! Stay tuned for further
developments from the IRS.
Capital Gains Taxes
Capital gains taxes on sales subsequent to May 5, 2003 have also been reduced
under the new law, so divorcing parties should be made aware of their effects
on the value of the marital estate. Because of capital gains taxes, a bank account
worth $100,000 would have a higher after-tax value than a stock account worth
$100,000 with a cost basis of $50,000. Under prior law, the tax on the $50,000
profit in the stock account would have been 20% (or $10,000), but this has now
been reduced to 15% (or $7500). The after-tax value of the stock account has therefore
increased from $90,000 to $92,500.
But how many individuals are sitting on capital gains in their stock accounts?
The decline in the stock markets over the past few years has resulted in many
people holding stocks with unrealized losses, not gains. So, lets take the above
example and reverse it. Compare a bank account worth $100,000 with a stock account
worth $100,000, but a cost basis of $150,000. In this case, the stock account
has a hidden tax benefit. This benefit has now been reduced. The benefit is calculated
in two steps. Realized tax losses first offset realized capital gains, resulting
in a maximum tax savings of 15%, down from 20% under the old law. If there are
leftover losses, in this and any subsequent year, the first $3000 of these would
be written off against ordinary income, potentially at a higher tax rate.
The Marital Residence
You do not have to be an investor to be affected by this change. Many divorcing
couples own homes that will be sold, now or at some time in the future. Unlike
the recent stock market decline, many homeowners have experienced significant
appreciation in the values of their homes. When these homes are sold, they will
be subject to one of the most generous provisions of the tax code. As long as
a taxpayer has owned a home for at least 2 years, and the home has been the primary
residence for 2 of the previous 5 years, a sizable portion of the profits will
be free from tax. That portion is $250,000 for single individuals and $500,000
for married couples. There is also a hardship provision, which prorates this exclusion
amount for shorter ownership periods caused by unforeseen circumstances, such
as divorce.
In today’s housing market, it is not unusual for a couple or an individual
to be sitting on large capital gains. In these situations, the reduction in the
capital gains tax can significantly enhance the after-tax value of the home, thus
increasing the tax value of the marital estate. Since these tax savings can be
large, divorcing couples should determine whether it is in their best interests
to sell the house jointly.
Special Cautions Relating to Business Write-Offs
In an effort to stimulate the economy, JGTRRA also contains provisions to help
businesses, which frequently represent a large and significant component of the
marital estate. The act increases the maximum dollar amount of the Code Sec. 179
first-year depreciation allowance from $25,000 to $100,000 for property placed
in service in the years 2003, 2004 and 2005. It also provides a bonus first-year
depreciation deduction equal to 50% of the adjusted basis of qualified property
acquired and placed in service between May 6, 2003 and Dec. 31, 2004. Third, it
increases the maximum first-year depreciation allowance to $10,710 for new automobiles
placed in service between May 6, 2003 and Dec. 31, 2004.
These benefits reduce the taxable income thrown off by these businesses, leading
to lower taxes and higher cash flows. Interestingly, reductions in business income
could reduce adjusted gross income to the point that a taxpayer would now become
eligible for the Child Tax Credit. Although child support will still be adjusted
for accelerated depreciation, the increased cash flow, even for a few years, could
also positively affect the ability of the business owner to pay spousal support.
In addition, the infusion of capital via tax savings could potentially enhance
the growth and future value of a business. Alternatively, because accelerated
depreciation is subject to recapture, and the amount of accelerated depreciation
on the books could now be significantly higher, might this also have a negative
effect on an arms-length transaction involving a sale of the business? It will
be interesting to see how these issues will be addressed in divorce situations
involving support payments and business valuations.
We have thus come full circle. Is marriage penalty relief an important component
of the act? Yes. Are there specific divorce provisions in the act? No. But will
the act affect people going through divorce? Absolutely.
________________________________________
Jerry L. Style is an enrolled
agent, a certified financial planner, a certified divorce planner, and a partner
in Freedom Financial Services, LLC and Freedom Tax & Business Services, LLC
in Bohemia, NY. Carl M. Palatnik is a certified financial planner,
president of DivorceInteractive.com in Mineola, NY, host of “Divorce Talk”
radio, and a member of the Editorial Board of this publication.
© Copyright 2005, Law Journal Newsletters
|
DivorceInteractive.com tries to provide
quality information, but cannot guarantee the accuracy, completeness or adequacy
of the information, opinions or other content posted on the site. It is not
intended as a substitute for and should not be relied upon as legal, financial,
accounting, tax, medical or other professional advice. It should not be
construed as establishing a professional-client or professional-patient
relationship. The applicability of legal principles is subject to amendment by
the legislature, interpretation by the courts and different application by
different judges and may differ substantially in individual situations or
different states. Before acting on what you have read, it is important to obtain
appropriate professional advice about your particular situation and facts.
Access to and use of DivorceInteractive.com is subject to additional
Terms and Conditions. DivorceInteractive.com
is a secure site and respects your Privacy.
Home |
Advertise With Us |
Professional & Resource Directory
Single File | Divorce News | Glossary | Divorce Discussion Forums
Change Area Code | Terms & Conditions/Legal Disclaimer | Privacy Policy | About Us |
Contact Us
© 2001-2007
DivorceInteractive.com All Rights Reserved.
|
