By Jerry Style and Carl 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