As you read this article, please note a critically important point that I would not want you to miss. The point is that certain clauses you design in your divorce decree may be deemed invalid over time. They could be deemed invalid even though you and your ex-spouse didn’t do anything to change your original agreement. Read on to place this in further context and see why this could happen to you or one of your clients.
Prior to the change in the tax laws in 2018, it was common for parties who were going through a divorce and who have children to use their tax dependency exemptions as ‘currency’ at the negotiating table.
What is a dependency exemption?
A dependency exemption is where you receive a tax deduction for your children who qualify as ‘your dependent’. It should be noted, there are also special rules for dependent relatives which is beyond the scope of this article.
To be considered your dependent, your child could not be over a certain age, you had to provide for more than half of your child’s support, your child had to live with you for a certain number of months during the year, among other factors. If these conditions were met you were then considered eligible to claim your child as a dependent on your tax return. This assumed you were not limited (a.k.a. phased out) from taking these deductions as a result of making too much money.
The monetary and psychological value of a dependency exemption
In 2017, each dependency exemption was worth $4,050 as a tax deduction. If your divorce agreement was designed for you to claim your child as your dependent and your tax bracket was, say, 30% you would save $1,215 each year. Claiming 3 children on your tax return would translate into $3,645 in your pocket. Over a course of 10 years this could amount to $36,450 in money you would save in taxes.
Dependency exemptions were deemed to have some value at the negotiating table. It was not only the monetary value but also the psychological value that came into play during negotiations. If everything else was equal and you gained a dependency exemption from your divorce negotiations, psychologically you felt you gained something as a parent. Although there were usually many other elements to tackle, having the right to claim your child as your dependent on your tax return felt good.
By having ‘dependents’ you might also be eligible for a different tax filing status, commonly referred to as “head of household”. A head of household status provided you a more preferred tax bracket which could lower your overall tax liability. Again, more tax savings for you.
When an uneven number of children are in the picture
When a divorce included an uneven number of children, say 3 children, the parties might agree to swap who would take the dependency exemptions on their tax return each year. In 2017, claiming 3 children translated into $12,150 ($4,050 x 3 children) worth of tax deductions. Since you cannot split an exemption in half this meant 2 of your 3 children might be claimed on one person’s return. The other child might be claimed on the other person’s return. The person who received the 2 dependencies gained $8,100 in tax deductions. While the other person gained $4,050 in tax deductions.
If one person was in a higher tax bracket than the other person, it might have been beneficial to bunch the dependency exemptions on one party’s tax return and pay the agreed upon cash savings out to the other party each year.
This change in the tax law impacts both ‘open’ and ‘closed’ divorces
You may have noticed I have consistently phrased the use of claiming a dependency exemption with past tense. Why? With the recent change in the tax laws, people are no longer allowed to claim a dependency exemption on their tax returns. This impacts how divorce decrees are designed. Dependency exemptions are no longer considered ‘currency’ at the negotiating table. After December 31, 2017, your personal exemptions and dependency exemptions will no longer be allowed as tax deductions on your personal tax return.
If you have already gone through a divorce and you used the dependency exemption to gain some leverage you will discover on your 2018 tax return that this benefit has been removed. In other words, if you used this as one of the bargaining chips in your divorce proceeding and your settlement is finalized you will no longer receive this benefit. Why? In an effort to simplify the tax code, the Administration has removed the dependency exemptions as a valid tax deduction.
It is important to note certain states automatically follow the Federal rules. If you live in a certain state you would automatically receive similar tax benefits for certain tax deductions offered by the federal government.
With that said, if the federal government removes certain tax deductions, such as the dependency exemption, certain states may also restrict you from claiming the deduction on your state tax return too. This translates into you losing even more money as a result of the change in the tax laws.
Key Perspective – Clauses in your divorce decree may be deemed invalid over time
The terms you incorporate in your divorce decree can change over time even if you or your spouse do not initiate the change. Other people, in this example the government, made certain decisions that will now impact how you live your life. You may have less money in your pocket simply as a result of a change in the tax rules around the dependency exemptions.
If you are going through a divorce process — or considering re-opening your divorce proceeding — it is critical to properly architect your divorce to minimize the implications that certain clauses could have over time as they could be deemed invalid. To manage your risks, you need to try to anticipate these changes. You need to build appropriate conditions in your divorce decree to manage your exposure. It is important to balance the variables you know about today and the ones you can reasonably predict in the future. Often times the components in the future are not taken into account which cause people to unexpectedly re-open their divorce proceedings later in life.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
If You Have a Question
If you have a question, feel free to contact me at [email protected] or 617-680-5222. The call is free. I will spend 30–60 minutes with you. I will provide you an honest assessment as to where I think you are positioned in your divorce process or answer any questions you have. I may provide you some guidance, insight or advice that you can take with you as you wish. There is no obligation to move forward. The phone call is designed to ease your fears, provide you some options to pursue and a potential road to run on that can lead you down a path to achieve a successful outcome.
About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
- preserve the value of their business or marital estate
- continuously strive to provide a return on our services
- build balanced financial solutions grounded in evidence
- find ways to make our client, and at times both parties, money through the process
- design their divorce to work for them and their family’s life
- provide mental clarity to make decisions
- reduce the total process time from start to close
- minimize the stress and unpleasant memories that can last a lifetime
As we reach an agreed upon settlement structure, we help our clients identify a fitting attorney who can leverage the financial solution to draft and record the requisite legal documents. Where outcomes are at risk from a traditional process, we function as expert financial negotiators or financial mediators to turn around the situation and achieve our client’s desired outcomes.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.