Tax Reform: Who Pays, Who Profits : Would Pay The Same : Fewer Deductions but Lower Bracket Offset Each Other
“When there is an income tax,” Plato said, “the just man will pay more and the unjust less on the same amount of income.”
Twenty-three centuries later, the Treasury Department has concluded much the same. It doesn’t buy the Greek philosopher’s premise that income taxes and justice are mutually exclusive, of course.
But in its mission of tax reform, the Treasury has acknowledged that injustice runs deep in the tax laws and must be routed out. On the other hand, many taxpayers would pay a heavy price for the reforms.
To translate the Treasury’s theories to real-world cases, The Times examined how the taxes of three individuals and two companies would be affected if the agency’s tax-simplification proposal were enacted in full. Tax calculations were performed by the Los Angeles office of the Price Waterhouse accounting firm.
The analysis relies on several assumptions: All provisions have been phased in; inflation is at 4%; and the proposed depreciation method was in effect when assets were acquired. To calculate taxes under current law, 1984 tax rates and law are used, even when the taxpayer’s most recent available numbers are from the 1983 tax year.
Among the case studies, the individual “winner” has relatively low income while the individual “loser” is a wealthy man with substantial tax shelters. The family for whom the proposed changes would result in a wash, falls somewhere in the middle.
The business “winner” is in retailing, an industry that isn’t favored under the current tax system. The corporate “loser” is a high-technology company. Some analysts had speculated that high-tech companies would fare well, especially in comparison to smokestack industries.
Pierce O’Donnell was resigned to a tax hike.
“As I see it, the primary ingredients of any fair and equitable tax system are predictability . . . and an equitable sharing of the tax burden,” said the Los Angeles lawyer, Pasadena newspaper publisher and lifelong Democrat. “Any system that will accomplish both, I’m in favor of . . . even if I end up paying more every year,” which he figured he would.
With an income exceeding $100,000, business interests generating losses (for tax purposes) of nearly $10,000, and itemized deductions of $40,000, O’Donnell, 37, and his wife Connie, 36, a speech pathologist, looked like prime suspects to be among the estimated 22% minority facing higher taxes under the tax-reform plan.
Surprise.
Their income subject to taxation would increase by $10,000 under the tax plan. But because of the lower rates, their tax bill would remain substantially the same--increasing by less than 1%.
Under existing law, the O’Donnells, who were college sweethearts at Georgetown University and have been married for 14 1/2 years, are in the 42% tax bracket and pay federal income taxes of $13,935 on taxable income of $59,709, for an effective tax rate of 23.3%.
The bulk of their taxable income is derived from wages--$14,653 from Connie’s part-time job at a Southland hospital and $100,000 from Pierce’s law firm, O’Donnell & Gordon, a 2-year-old firm specializing in entertainment industry litigation.
To that, they add $477 in interest income, $302 in dividends, $1,291 in refunded state income taxes, a mere $1 in taxable capital gains and $1,487 in outside income from Connie O’Donnell for two part-time jobs.
From that $118,211 total, they are entitled to subtract $9,718 in losses from several business deals.
Chief among Pierce O’Donnell’s business deals is Pasadena Media Inc., a year-old newspaper publishing company that publishes The Weekly, a 30,000-circulation newspaper serving Pasadena, Altadena, San Marino and South Pasadena, and Nine to Nine, a business entertainment biweekly serving downtown Pasadena. O’Donnell is the company’s chairman and largest shareholder.
He also is a partner in a venture to restore two buildings in the Old Town section of Pasadena, in a business that is part owner of a Washington hotel and office building, and in some telecommunications, broadcasting and oil and gas businesses.
From total income of $108,493, the O’Donnells subtract their tax-deferred contributions to an Individual Retirement Account, or IRA, (each contributed the $2,000 maximum) and the $1,265 allowance for two-earner families, bringing their adjusted gross income to $103,228.
Topping their list of itemized deductions are $14,129 in home mortgage interest, $9,345 in other interest expenses and $10,407 in cash contributions to charities. They also deduct $8,343 in state and local taxes, miscellaneous deductions of $695 and a $1,000 personal deduction for each O’Donnell and their two children.
Their calculated tax on the resulting taxable income is $15,057. From that, they subtract an investment tax credit of $542, $100 in political contributions and a $480 child care credit, for a net tax bill of $13,935.
If the Treasury package were enacted just as proposed and its provisions fully implemented, the couple’s total income subject to taxation would grow by $508 to $108,801.
On a positive note, their $1,291 state income tax refund would be excluded from income because state income taxes would no longer be a deductible expense. Moreover, only $286 of their $477 in interest income would be subject to taxation after an adjustment for a 4% inflation rate. (The Treasury proposes a 40% exclusion of income from taxation when inflation is 4%.)
Wages, dividend income and Connie’s outside income would remain unchanged by the tax plan.
On the down side, their full $2 in capital gains would be taxable. And $1,789 of the $9,718 loss from business ventures would be disallowed because it was derived from partnerships comprising more than 35 partners.
Treated as Corporation Under the tax-reform proposals, such partnerships would be treated as a corporation for tax purposes, meaning that the partners could no longer claim deductions for the business on their personal tax returns. Critics of this provision charge that investors would no longer put money at risk in new ventures if there were no immediate tax benefits.
Their $1,265 allowance for two-earner families also would be denied. But they would get the bulk of that back if they each contributed the new IRA maximum--$2,500, up from $2,000.
Child care expenses, for which the O’Donnells currently take the maximum $480 credit, would instead be deductible as an adjustment of $2,400 per-child--a slight break for the O’Donnells.
In all, their adjustments would increase to $7,400 from $5,265, lowering adjusted gross income to $101,401 from the current $103,228.
True to the Treasury’s intent, however, the O’Donnells’ itemized deductions would decline markedly--to $24,296 from $39,519. The $8,343 deduction for state and local taxes would be denied, as would their $695 in miscellaneous deductions. Miscellaneous deductions are allowed only to the extent they exceed 1% of adjusted gross income, or $1,014 in the O’Donnells’ case.
Mortgage interest on principal residences would continue to be deductible in full. But other interest would be limited to $5,000 over the taxpayer’s investment income, meaning $5,588 in the O’Donnells’ case.
Bid to Curb Abuse And since charitable contributions would be allowed only to the extent they exceed 2% of adjusted gross income (an effort by Treasury to curb abuse by taxpayers whose charitable gifts are strictly tax-motivated), the O’Donnells--whose only criticism of the tax package is this provision--could deduct $8,379 of their $10,407 contribution.
After subtracting the $3,800 Zero Bracket Amount (the income floor below which no one is taxed; it is currently $3,400 for married couples) and $8,000 in personal deductions (double the current allowance), the O’Donnells have taxable income of $69,105, up from $59,709.
The credits for child care, political contributions and investment taxes would be abolished, adding $1,122 to their tax bill. But since they would fall to the 35% tax bracket from the 42% bracket, their overall tax bill would increase by only $121, or less than 1%, to $14,056.
