Paul L. Caron

Friday, March 31, 2023

Weekly SSRN Tax Article Review And Roundup: Layser Reviews Revisiting The Tax Treatment Of Alimony By Davis, Soled & Soled

This week, Michelle Layser (San Diego) reviews Tessa R. Davis (South Carolina; Google Scholar), Amy H. Soled (Rutgers) & Jay A. Soled (Rutgers; Google Scholar), Revisiting the Tax Treatment of Alimony, 72 Kansas L. Rev. __ (2023):

Michelle-layserLike many tax professors, I teach my students that the tax laws that exist today reflect choices about what, when, and who to tax. In many cases, lawmakers have options, and the best approach is not always obvious. The tax treatment of alimony is a case in point. When it comes to support payments made by a divorced person to a former spouse, Congress has three options: tax the recipient, tax the payer, or tax them both. For many years, the law allowed alimony payers to deduct the payments, and it required recipients to include alimony in their income. The Tax Cuts and Jobs Act changed the tax treatment of alimony by disallowing the deduction for alimony payers and allowing recipients to exclude the payments from income. But did the change reflect good policy?

According to a new article by Professors Tessa Davis, Amy Soled and Jay Soled, the new law—which actually isn’t as new as it seems—actually does reflect good tax policy. The authors begin by reminding us that from 1913 to 1942, courts had concluded that alimony should be taxed only once, and it should be taxed to the alimony payer, who was presumed to be the husband. The authors argue that the early rules were grounded in a “paternalistic attitude toward women and wives,” and the assumption that “[w]omen require protection, which is the responsibility of men.” Nevertheless, it is notable that in the early years of the income tax, the taxation of alimony looked a lot like it does today.

However, in the 1940s, Congress began to worry that husbands—not wives—might need protection. At the time, marginal tax rates were very high (peaking at 94 percent in 1944-45). The overwhelmingly male Congress was receptive to the argument that taxing alimony overburdened men. To illustrate, the authors provide the following example. Assume a divorced husband earns $400,000 income but pays $200,000 alimony to his former wife. If we assume a 45% effective tax rate, the husband will owe $180,000 taxes, leaving him with only $20,000 after-tax income (after paying alimony). Yikes.

So, Congress changed the law in 1942 to allow alimony payers to deduct the payments, while requiring recipients to include them in income. And until the law was changed at the end of 2017, that was the law—at least on the books. In practice, divorced spouses often exploited a loophole: the taxation of alimony was inconsistent with the taxation of child support or property settlements. Unlike alimony recipients, taxpayers who received child support or property settlements were permitted to exclude the payments from income. This inconsistency encouraged divorced spouses to characterize the same payments differently for tax reporting. Payers claimed the payments were deductible as alimony, while recipients called the same payments “child support” and excluded them from income.

Congress was aware of this tax avoidance strategy and took several steps to curb the behavior. Rules were enacted to define “alimony” more specifically for tax purposes, and divorced spouses were even required to provide each other’s social security numbers on their tax returns. These changes probably helped, but they did not end abusive tax planning around alimony. By the time Congress began negotiating the Tax Cuts and Jobs Act, the tax treatment of alimony was a known, and long-standing, problem. For procedural reasons, Congress needed to find revenue-raising tax changes, and the alimony deduction seemed like a good candidate. Accordingly, Congress changed the tax treatment of alimony—again—bringing it back full-circle to its original form: tax the payer, not the recipient.

The authors note that the primary motivation, and the most obvious benefits, of the new law relate to revenue raising, administrative ease, and increased compliance. Taxpayers now have fewer options to avoid paying tax on alimony, and that means the government will undoubtedly raise more revenue. But these aren’t the only relevant policy considerations. Equity is also an important objective, and the authors provide a thorough analysis of whether the new rules tax the right party. They argue that it does. First, they argue that the new rule correctly taxes divorced spouses as a single unit, which makes sense because “(1) divorced couples continue to share a common tax minimization agenda, (2) the so-called ‘alimony subsidy’ election is inequitable insofar as it largely inures to financially well-to-do taxpayers, and (3) absence such treatment, divorced taxpayers have proven to be noncompliant in their tax-reporting practices.”

Next, they argue that within that single unit, the new law “properly places the tax responsibility with the alimony payer.” The authors base this conclusion on three theories. First, the theory of human capital suggests that post-marital payments like alimony are “a means of compensating the recipient partner for investments in human capital.” Second, the assignment of income doctrine suggests that the alimony payer should be denied a deduction because income should be taxed to “the taxpayer responsible for its generation.” The authors argue that the old rule improperly permitted taxpayers to shift income earned by the payer to the recipient through alimony payments. Third, the new rule is consistent with the concept of ability to pay since the payer’s income is typically higher than the recipient’s.

For these reasons, the authors conclude that “[i]n its current iteration, alimony taxation should enhance taxpayer compliance, yield additional revenue, and facilitate administrative ease” and it “better aligns the taxation of alimony with three key concepts in tax: human capital theory, the assignment of income doctrine, and the concept of ability to pay.” They end with a question: if the current rule is so clearly correct, then why did it take Congress so long to reinstate it? I would love to see this question explored in a follow-up article, as well as further discussion of the third option: tax both parties. Though I suspect most tax experts would be wary of taxing both parties, the authors acknowledge that it is an option—and it is the only option that has yet to be adopted by Congress.

This Article provides an accessible primer to the taxation of alimony, and it offers a fun case study about how changing attitudes about gender roles and family dynamics have influenced tax law over time. I recommend this article to anyone interested in individual income taxation, families and tax law, gender and tax law, tax compliance, or tax reform.

Here’s the rest of this week’s roundup:

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