Tip of the Month:
Tax Law Changes – May, 2003
Impact on Divorce

The Jobs and Growth Tax Relief Reconciliation Act of 2003 became law on May, 28, 2003. Major provisions which impact divorce are:

1. Tax Rates Reduced for all of 2003

Old Rate	New Rate
27%	25%
30%	28%
35%	33%
38.6%	35%

2. Under Age 17 Child Tax Credit Increased to $1,000 from $600 for 2003 & 2004
   A. Refundable Credit not changed. Senate passed bill to increase refundable credit from 10% of income over $10,500 to 15% of such income. House also passed bill with this provision but House bill made increase in child tax credit permanent and increased income level for Married, Joint from $110,000 to $150,000. This must be reconciled by a joint committee and action is expected in July.

3. Marriage Tax Penalty Eliminated (Income under $65,000)
   A. Standard Deduction for Married, Joint increased to twice that of Single (from $7,950 to $9,500)
   B. Standard Deduction for Married, Separate increased from $3,975 to $4,750 (same as Single)
   C. Married, Joint 15% tax bracket expanded to twice that of Single (from $47,450 to $56,800)
   D. Married, Separate 15% tax bracket is now same as Single (increased from $23,725 to $28,400)

10% Tax Bracket Expanded
A. Single & Married, Separate from $6,000 to $7,000
B. Married, Joint from $12,000 to $14,000
5. Alternative Minimum Tax (AMT) Exclusion Amount Increased
   A. Single & Head of Household from $37,350 to $40,250
   B. Married, Joint from $49,000 to $58,000
   C. Married, Separate from $24,500 to $29,000

6. Tax Rate on Long Term Capital Gains
   A. Tax rate on long term capital gains reduced from 20% to 15% with individuals in 10% or 15% tax brackets having a rate of 5%. Not subject to AMT.

7. Tax Rates on Corporate Dividends
   A. Reduced from regular tax rates to a maximum of 15% with individuals in 10% and 15% tax brackets having a rate of 5%. Not subject to AMT

What this Means in Divorce
The net result of all these changes on divorce is VERY SIGNIFICANT. I’m sure you have already heard about these changes. Let’s look at a few aspects you may not have heard about.

Under Age 17 Child Tax Credit & New Tax Rates
Allocation of the child dependency exemption and the under age 17 child tax credit will be even more important. A $1,000 credit is a lot more than a $600 credit and the child tax credit is now worth more than the tax savings from the child dependency exemption.

Many more individuals will be receiving the “refundable portion” of the child tax credit. The rate reductions mean many divorced individuals with children will pay no tax and may get money returned through the Earned Income Credit and the Refundable Child Tax Credit. Do not assume the refundable child tax credit is only for very low income individuals as the press has been stating. With the child tax credit now at $1,000, the refundable portion is going to be available to many individuals and if the Congress increases the refundable portion to 15% of income over $10,500, this will be very valuable for many divorcing individuals. Shown below is the impact on total taxes for a mother with 2 child dependency exemptions and $3,000 per year in child care costs. Her federal taxes under the new law would be:

The refundable child tax credit is important at incomes levels slightly above $35,000. Note that for this typical divorced mother, no federal income tax is paid until income approaches $40,000. At income levels of $35,000 and under, the divorced mother with 2 children would not only pay zero federal income tax but would also be receiving refundable cash from the tax system to supplement income. Refundable credits are real cash just like salary or investment income and need to be included in divorce financial calculations.

Elimination of Marriage Tax Penalty and Timing of Divorce
Most working individuals (at income under $65,000 and without children) will no longer have lower taxes if they get divorced in 2003 instead of filing a Married, Joint return in 2003. This will make taxes a more neutral event in determining the timing of divorce.

If there are children and the non-custodial parent has been out of the marital home for the last six months of 2003, there will be some savings for both parties over a Married Joint return if they use Married, Separate and Head of Household to file for the current year. The taxes for the Married, Separate individual will be the same as if that individual were Single if income is under $65,000 per year. From a tax perspective, filing separate returns before divorce may save pre-divorce taxes but this will be contingent on the income level of the parties. Because the tax differences are not material, the timing of divorce is more neutral from a tax perspective. The other advantages of separate pre-divorce tax returns will no longer have a negative tax number associated with that option.

A lot of the rules we have all used for years on the tax issue of divorcing this year vs next year have been materially changed and you will need to get used to a whole new set of rules. The general rule of “If both parties work, get the divorce now” is no longer correct. Now getting divorced in the current year just to save taxes is no longer needed – the tax for a Married, Separate return will be the same as for a Single return when income is under $65,000.

Alternative Minimum Tax (AMT) – New Problem in Divorce
AMT is going to be a consideration in high income divorces because the AMT is being triggered in many more cases. This may show up in alimony cases and the impact of the AMT is to reduce the alimony tax savings from the different tax brackets of the parties. The AMT means that individuals will have to pay more tax than the tax from the regular tax formula. We will cover this in a future Tax Tip column. For now, be aware that the AMT is a 2nd tax calculation where no personal exemptions or standard deduction amounts are allowed. Itemized deductions for state and local taxes are also not allowed. Instead, Adjusted Gross Income (starting point in tax calculation) is reduced by an AMT exclusion amount which is $40,250 for Single and Head of Household. Remaining income is taxed at 26% of the first $175,000 and 28% on amounts over $175,000. The AMT is the amount by which this calculation is greater than taxes computed from the regular tax formula. Tax credits and the lower tax rate for dividends and long term capital gains do not impact the AMT calculation (they just make it more complicated).

You have read in the press that many more families are being hit by the AMT and this number is going to increase significantly in the next few years. Nobody tells you why. Here’s why. The initial rate for the AMT was designed to be 2% under the 2nd tier tax rate prior to all the tax rate reductions in the last 2 years. We then had a 15% and a 28% tax bracket. The AMT rate was set up to be 26% on the initial $175,000 and then 28% on income over that. It was never more than the 2nd tax rate of 28% in the then existing tax schedule.

Tax Rate Reductions & AMT
In the past 2 years the regular tax rates have been reduced but the tax rates to be used in the AMT formula have not been changed. So now there are tax rates of 10%, 15%, 25%, 28%, 33% and 35%. Note what was 28% in the old tax rate system designed for the AMT is now 25%. So the AMT formula is kicking in on a lot of households that have:
1. Taxable Income over $60,000
2. Several children
3. High state and local taxes

This has nothing to do with tax preference items like Incentive Tax Options – it is the way the AMT formula works. 26% is greater than the 10%, 15% and 25% tax rates applicable to the initial levels of income in the regular tax formula ($68,800 for Single and $98,250 for Head of Household). The $40,250 AMT exclusion amount is not sufficient to offset the loss of personal exemptions, standard deduction, taxes in itemized deductions and these initial lower regular tax rates.

What is happening in higher income alimony cases is that the alimony is lowering the income of the paying party and increasing the income of the receiving party. If alimony is significant, it may also trigger the AMT for both parties which can lower or even eliminate the tax savings of alimony. While FinPlan’s Divorce Planner® software program accurately and automatically calculates the AMT, I would still suggest using a financial professional in your high end alimony cases. Explaining to clients and Courts how alimony does not lower the combined taxes of the parties is simply beyond the scope of most family lawyers and that is going to happen in many more cases. Software will assist you in determining that this is present but explaining this counter intuitive situation is another matter. You are going to be faced with high income cases in which paying all support as child support is going to result in higher after-tax cash for the parties than a mix of alimony and child support. This is not how family law has been practiced in the past. Get used to the new world of “lower tax rates”.

Until the AMT tax rates are lowered (they will be changed but no one knows when), family lawyers are going to be working on alimony impact numbers which have never been seen before and are totally counter intuitive. An intuitive hypothesis would have been that more alimony and less child support would increase the combined after-tax cash of the parties. In some alimony cases this will not longer be true and it is because of the AMT.