The JGTRRA of 2003: Financial Implications for 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.

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.