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Biden’s payroll tax doughnut hole isn’t so sweet

Jim HamillJoe Biden has released a few more details about his tax plan.

One should never take a candidate’s tax plan to mean an actual plan. It’s a bit more than a party platform but definitely less certain to be pursued than a dinner reservation. But’s let’s consider it anyway.

Biden says taxes will go up for high-income people. This will happen. If you doubt that, look at the budget deficit. Let’s now pause for howling.

There is a recession! There is a pandemic! Sure. But the “plan” does not have to be implemented in January 2021. It’s a plan in principle. It will wait until the economy recovers. I’ll actually bet you on that point.

If we want to be critical, there is a bigger target than the recovery thing. Biden says the trigger point for higher taxes will be $400,000. We can assume this is taxable income, which might equate to something more like $450,000 to $500,000 of gross income sources.

The top tax rate is now 37% for regular sources of income. An increase will not end up being significant. Let’s say that the new rate becomes 42%. Still way below the 91% Eisenhower rate, the 70% Kennedy/Johnson/Nixon/Ford/Carter rate, and the 50% post-Reagan I rate.

The world will not end. It didn’t before. But there are other aspects of the Biden plan that are more interesting to debate. First, one would have to assume the 3.8% surtax on investment income would remain. If so, 42% is now 45.8% for investment income.

Second, Biden proposes to reinstate the “Pease” limitation. This reduces itemized deductions as income exceeds a threshold. So as income rises deductions are lost and the effective rate goes above the statutory rate.

Third, Biden proposes a doughnut hole for payroll taxes. This is a doughnut hole designed to fatten up the federal coffers.

Payroll taxes have two components – OASDI and Medicare. The OADSI share is 6.2% for both the employee and the employer and, in 2020, is capped at $137,700 of wages.

Democratic presidential candidate Joe Biden speaks at a union training center Sept. 18 in Hermantown, Minnesota. (Carolyn Kaster/Associated Press)

Self-employed people pay 12.4% of their earnings for OASDI, but again capped at $137,700. The doughnut would mean that no tax is paid from the current cap (which is inflation adjusted) up to $400,000. But at $400,000, it’s back!

So forget about nibbling around the edges with an income tax rate increase, perhaps from 37% to 42% (my made-up number). Tack 6.2% or 12.4% on top of that and a bit of wailing might be in order.

You “tax people” know I am leaving out a few details because there are other deductions that phase out as income rises and there is a surtax on payroll tax similar to the one I mentioned for investment income (just a lower rate).

But to keep things simple, let’s say you are self-employed and make $500,000. Now you pay 37% plus 2.9% Medicare tax. Biden raises your rate to 42%. You still pay the same Medicare tax.

But, whoops, the doughnut hole disappears. The doughnut whips around and hits you with 12.4% more tax. More as in compared to now. So your rate actually goes up 17.4% (using my made-up 5% income tax rate increase). It could be 42% + 2.9% + 12.4%, or 57.3%.

This, of course, is only at the margin. It is only for each additional dollar of income. But it kicks in at your taxable income above the $400,000.

You have three choices to deal with the doughnut. First, pay the added tax. Second, if you are a member of an LLC, or can become a member of an LLC, argue that not all of your earnings are subject to the 12.4%. Third, create an S corporation to pay yourself less than all of your earnings and therefore lower your payroll tax.

Don’t follow? Fantastic! More work for tax advisers. This is a tax planner’s dream. A client who knows they have a problem but does not know what to do about it, and a planner who knows that something can be done. For a price.

Don’t like that dagger sticking out of your thigh? I just might be able to extract that for you. Will that be cash, credit card or check?

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

 

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