There are many problems with the Act, but one raises particular concern. The 2013 tax adversely impacts the most successful of the closely held businesses operating as limited liability companies, S corporations, or other pass-through tax entities. Additionally, though not discussed herein, because deficit spending was not addressed, no solution to the country’s fiscal problems has been reached. We are still peering over the edge of a fiscal cliff, with spending cut issues, debt ceiling issues and undoubtedly more tax issues to be dealt with before March 1, 2013.
Individuals with pass-through tax entity income
According to the Congressional Research Service, pass-through tax entities (principally S corporations and LLCs) represent over half of the business income in the United States. These are now the predominate form of closely held business and a source of much of the current job growth. Such business income, even when retained in the business, is included in the owners’ individual taxable income.
The active owners of pass-through entities are classified as self-employed, and the passive owners who provide capital for the business are investors with investment income. The Act increases the income tax rate to 39.6 percent on individual taxpayers (including owners of pass-through entities on the income remaining in the business) with adjusted gross income (“AGI”) above specified thresholds (generally $400,000 or $450,000).
This 39.6% increase also interfaces with other increases effective in 2013 to raise the tax burden further. For example:
a) the phasing out personal exemptions and phasing down itemized deductions for taxpayers with income above $250,000 (individuals), $300,000 (married filing jointly and surviving spouses), $275,000 (head of households) or $150,000 (married filing separately) which is simply a back door rate increase;
b) a new .9 percent increase in the self-employment tax for self-employment income in excess of $250,000 (married filing separately) and $200,000 (individuals);
c) an increase in the capital gains tax rate to 20 percent for taxpayers in the 39.6 percent bracket; and
d) the new 3.8 percent tax on investment income for taxpayers in the 33 percent bracket.
Compare this to the rates for publicly traded C-corporations. The maximum C corporation tax rate of 35% is currently the highest in the developed world and a recognized impediment to U.S. global competitiveness. The Act raises the non-corporate business tax rate for successful pass-throughs from the 35 percent maximum (the same as corporations) to:
i. a new maximum of 39.6 percent (not including the 2013 additional .9 percent self-employment tax increase and the additional taxes resulting from phased down itemized deductions and loss of personal exemptions) for all active individual owners, and
ii. 39.6 percent plus the new 3.8 percent tax on investment income (total 43.4 percent) for investor owners reaching the specified income thresholds.
For the successful active pass-through owners with sufficient AGI, the new 2013 increase of 4.6 percentage points is a 13 percent increase in the marginal rate (4.6 percent divided by 35 percent) and for investors the combined 4.6 percent income tax and 3.8 percent investment tax is a 25 percent increase in the marginal tax rate (8.4 percent divided by 35 percent). It is impossible for this to have a positive effect on the financial health of the affected businesses, and likely results in less expansion, slower growth, and diminished hiring capacity.
In addition, the rewards for investing (in C corporations or pass-throughs) are diminished for many successful individual investors and active business owners. When the 3.8 percent tax on investment income for taxpayers with AGI in excess of $250,000 is combined with the new capital gains tax, a married taxpayer filing a joint return will have a long term capital gain tax of 15 percent, 18.8 percent or 23.8 percent depending on whether her AGI is below $250,000, between $250,000 and $450,000 or over $450,000.
Dividends are taxed in the same manner as long term capital gains. For taxpayers in the 39.6 percent bracket, the marginal tax increase on capital gains and dividends is 58.7 percent (8.8 percent divided by 15 percent)! Short term capital gains are taxed as investment income and for taxpayers in the 39.6 percent the effective rate is 43.4 percent. (a 24 percent increase from 2012 - 8.4 percent divided by 35 percent). These massive increases are hardly a recipe to encourage investment in U.S. business (corporate or pass-through) or for the operators and investors in pass-through entities to take additional risk (hiring people and otherwise trying to expand the business) for reduced after tax reward.
Griffith practices law as a partner at Waller, where he leads the firm’s tax practice.