Why the Millionaires' Tax is Unfair

Over the past few months, there has been talk in Congress about increasing federal income taxes on "millionaires."  Many people, including members of Congress, are concerned that such an increase will be counterproductive because tax increases will take away the millionaires' incentive to work.  In fact, I heard a Congressman make that statement in a recent radio interview.  This reason could not be further from the truth.

In 1987, tax laws were changed to encourage businesses operating in the corporate form to elect S corporation status.  At that time, most closely held businesses that were not already S corporations elected S status.  The main difference between a C corp and an S corp is that a C corp pays tax on its income, and an S corp does not.  The S corp passes its income through to its shareholders, who include it on their personal income tax returns and pay personal income tax on the income, whether or not the income is distributed to them.


Why is this important?  It is important because a person that has ownership in an S corporation, partnership, or limited liability company may report income high enough to throw them into the "millionaire" tax bracket, when they receive little or none of the income that they are required to report on their tax returns.  The problem is compounded by other tax rules, which require many businesses to report taxable income on the accrual basis of accounting, that is, recognizing taxable income when the income is earned rather than when it is received.  So now imagine this reality; the S corp shareholder is not only paying tax on income that he has not received, but is paying tax on income not even received by his corporation!  And if any tax rate increase is enacted, it may very well be this phantom income that causes the shareholder to be subject to the millionaires' tax.

So if the S corp shareholders must pay tax on income that they have not received, where do they get the money to pay this tax?  Sometimes it comes from the shareholders' personal funds, but most often it is distributed to the shareholders from the corporation.  The theory is that if the business was a C corp, it would be required to pay its own income taxes, so it distributes an equivalent amount to reimburse the shareholders for the tax liability arising from reporting the S corp income.   And if there is a tax increase, it is likely that this policy will continue, but the additional distribution will reduce the amount of money available to the business to create jobs, purchase equipment, and finance growth.  This is the reason why business owners object to the proposed milionaires' tax.  It is not because it takes away their incentive to work, but because it reduces their ability to reinvest in their business.  The most troubling part of this whole story is that members of the United States Congress do not grasp this concept.

Can this problem be solved without upsetting our entire pass through entity tax structure?  I think it can, and the solution is relatively simple.  If any proposed millionaires' tax is enacted, the only pass through entity income that should be considered in calculating income subject to the tax should be the amount actually distributed by the S corp, partnership, or limited liability company.  Furthermore, distributions used to pay federal or state income taxes on the pass through entity income should be excluded from the calculation and the increased tax rates.  This will prevent business owners who report phantom income from being subject to increased taxes on income not received.