Today is President’s Day, which means Aspen is bursting with wealthy vacationers; its airport packed with private jets. But if you find yourself feeling frustrated as you slalom past a seemingly endless string of Bogner jackets on Spar Gulch, I’d urge you to go easy on our well-to-do visitors. They’ve recently received a bit of bad news in the form of a tax increase, and if President Obama has his way, it appears their tough times are far from over.
A mere six weeks after the fiscal cliff deal levied substantial tax increases on the nation’s richest 1 percent, the president would like another bite of the apple, this time to defray the cost of deferring mandatory spending cuts that are slated to take effect on March 1 .
On that date, approximately $120 billion in mandatory reductions to governmental spending — often referred to as sequestration — will kick in for the remainder of 2013. This sequester is the result of the government’s inability to devise an appropriate deficit reduction plan as part of the debt ceiling crisis of 2011; stated in another manner, because Congress couldn’t agree on how to curb its spending habit, it protected itself from itself by building mandatory cuts into the law beginning Jan. 1, 2013. The year-end fiscal cliff deal pushed these spending reductions back two months, but with March 1 fast approaching, the government once again faces significant looming cuts, particularly to its defense budget.
Neither political party wants the sequester to take effect as scheduled, as the indiscriminate cuts would weaken the military and deal a harsh blow to the still-recovering economy. Republicans want to retain the gross amount of spending cuts, but reallocate them away from defense and to agriculture and Medicare, because who needs food and health care when $120 billion can build you a super-army of lethal flying monkeys.
Democratic leaders, however, are willing to reallocate only half of the spending cuts. To cover the remaining cost, President Obama wants to generate additional revenue through tax reform, so “the wealthiest individuals and corporations can’t take advantage of loopholes and deductions that aren’t available to most Americans.”
But what does that really mean?
Late last week, we got our first glance at which loopholes are on the president’s chopping block, as Rhode Island Democratic Sen. Sheldon Whitehouse set forth two alternative bills that would defer the scheduled sequestration and raise additional tax revenue. Each bill proposes to close three primary loopholes, the prospect of which should have the nation’s richest 1 percent shaking in their carbon-fiber ski boots.
Because certain investment income is taxed at preferential rates ranging from 15 percent to 20 percent, in certain situations, including a particularly famous one involving the eponymous Warren Buffet, wealthy investors pay a lower effective tax rate than their secretaries.
To curb this perceived inequity, the proposed legislation would institute the long-discussed and hotly-debated “Buffett Rule” — in this case rebranded as the “Fair Share Tax.” If enacted, this provision would require all taxpayers with adjusted gross income in excess of $1 million to pay a minimum effective tax rate of 30 percent.
In short, the rule works like this: All taxpayers with adjusted gross income in excess of the million-dollar threshold would be required to compute a second minimum tax calculation in addition to the Alternative Minimum Tax that’s currently in place. This would entail a three step process:
Step 1: Add together the taxpayer’s regular tax liability, Alternative Minimum Tax liability, and payroll tax liability, less any applicable tax credits.
Step 2: Multiply adjusted gross income (reduced by a percentage of charitable contributions) by 30 percent.
Step 3: Pay the higher of the two.
The Fair Share Tax has the ability to substantially increase the tax burden of wealthy taxpayers who derive the bulk of their income from tax-favored investments. It is not uncommon for a hedge fund or private equity fund manager to pay an effective rate of less than 15 percent; applying basic math, if the Fair Share Tax increases the taxpayer’s effective rate to one nearing 30 percent, the taxpayer’s federal tax bill has doubled.
S corporations do not pay tax; rather, the tax is borne by the individual shareholders. This S corporation flow-through income has long enjoyed an employment tax advantage over that of sole proprietorships and partnerships. This is due to the fact that a shareholder’s share of S corporation income is not treated as self-employment income, while earnings attributed to a sole proprietor, general partner or many LLC members are subject to self-employment taxes.
As employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are also not subject to payroll or self-employment tax.
This loophole has been utilized by many wealthy taxpayers, including Newt Gingrich. Gingrich established his businesses as S corporations and paid himself “only” $450,000 in salary while allowing the remaining $2.4 million of taxable income to flow through free from payroll taxes, resulting in a savings of approximately $70,000.
The proposed legislation would put an end to this opportunity, requiring high-income shareholders (adjusted gross income in excess of $250,000 if married, $200,000 if single) to pay self-employment tax on any income allocated to them from a closely-held S corporation in the businesses of providing personal services (think: legal, accounting, health, consulting).
Under the proposed legislation, those aforementioned private jets lined up alongside Highway 82 would suddenly grow a bit more expensive, as they would be required to be depreciated over seven years rather than the current five.
Obviously, this proposed legislation has a long way to go before it becomes law, and has little chance of passing a Republican-controlled House. But if nothing else, it shows that the president is serious about continuing his goal to increase taxes on the wealthy.
Tony J. Nitti, CPA, MST, can be reached at firstname.lastname@example.org .