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Biden’s Payroll Tax Hike Plan: Beyond the Donut Hole

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What You Need to Know

  • Biden's plan to impose payroll taxes on high earners would create a
  • High-earning clients might be able to offset, defer or reclassify income to avoid the extra tax.
  • While there has been little talk about this plan lately, lawmakers are well aware that the Social Security and Medicare trust funds have shortfalls that need to be addressed.

If you stroll through the streets of Chicago, you have likely heard from the locals and longtime transplants about the famous Stan’s Donuts & Coffee on North Damen Avenue. Though skeptical and deviant from my preferred desserts, I must profess — the donuts live up to their hype.

Yet there is another, far less savory donut — or at least a donut hole — that has everyone talking: President Joe Biden’s plan to impose payroll taxes on earnings above $400,000, creating a “hole” between that figure and the current ceiling of $142,800 in taxed wages.

Payroll Tax Rates

For wage earners, Social Security and Medicare taxes — collectively known as payroll taxes — equal 6.2% and 1.45%, respectively, and are automatically withheld from paychecks by employers under the “pay as you go” tax system. Note that for 2021, Social Security taxes are only applied up to $142,800 in earnings, but Medicare taxes have no income limitation.

In addition, there is an “additional Medicare tax” of 0.9% that applies to earnings exceeding $200,000 (single) and $250,000 (married filing jointly) of adjusted gross income (AGI). Except for the Additional Medicare Tax, employers pay an equivalent share of these taxes on the wage earners’ income but can deduct these taxes on their tax returns.

Meanwhile, self-employed individuals, who act as both an employer and employee, are responsible for paying both shares of these taxes through quarterly payments. Referred to as self-employment taxes, the Social Security tax equals 12.4% of up to $142,800 in 2021 earnings, while the Medicare portion equals 2.9% without limit.

Self-employed individuals also face the Additional Medicare Tax, but the rate stays at 0.9% since it only applies to the employee portion of earnings. Lastly, and not including the Additional Medicare Tax, self-employed persons can deduct the employer portion of self-employment taxes as an adjustment for AGI.

The Donut Hole

Payroll taxes are an important piece of government revenue collection and are used to fund federal insurance programs such as Social Security and Medicare. In fact, in 2019, payroll taxes accounted for 38% of Internal Revenue collections; second only to income taxes at 57%.

In recent years there has been much concern regarding the solvency of these programs, especially Social Security. The 2020 Annual Social Security and Medicare Trust Fund Report estimates that full benefit payments can be paid until 2034, when payments would decrease to 79% of benefits

Social Security has faced solvency issues before, only to be later resolved through tax reforms. Perhaps most noticeable were the 1983 amendments to the Social Security Act. However, reform takes many faces, and who it ultimately impacts depends on current lawmakers and public perception. 

Biden’s proposal for reform is reimposing the Social Security tax on employees and self-employed persons earning over $400,000, thus creating a donut-hole effect from $142,800 to $400,000 in earnings.

Medicare taxes, however, would remain unchanged. Figures 1 and 2 demonstrate the severity of these proposed changes. In both scenarios, the taxpayers roughly face a whopping 33% tax increase!

Chart: Payroll tax for a single individual with $500,000 of W-2 wages
Chart: Payroll tax for a single individual with $500,000 of self-employment income

Implications

It should be noted that few taxpayers would be affected by the payroll tax increase because only 1.8% of households exceed $400,000 of total income. In addition, even if a household exceeds that number, there is likely a strong chance that some (or much) of that income is from other sources like passive or portfolio income, which are not subject to payroll taxes.

Lastly, Social Security is a social insurance program that is designed to favor neither the rich nor poor. This is roughly accomplished in two ways. 

First, the Social Security Administration uses actuarial calculations to help ensure that cumulative retirement benefits are approximately equal to lifetime contributions regardless of whether a recipient starts benefits early or late at reduced or enhanced levels, respectively.

More specifically, benefits are based on an individual’s highest 35 years of inflation-adjusted earnings. Upon the full retirement age (FRA), which is either age 66 or 67 depending on birth year, retirees can claim their full unreduced benefits.

Conversely, retirees can claim benefits as early as age 62, but with a 25% reduction, or claim as late as age 70 with a 24-32% increase. This is important because wealthier retirees typically can afford to delay Social Security, thus enjoying enhanced benefits, whereas less wealthy retirees may need to claim early to supplement retirement income needs and consequently face permanently reduced benefits.

Second, despite Social Security taxes being regressive because of their fixed percentage and taxable earnings ceiling, subsequent benefits are progressive because lower earners receive higher replacement ratios on lifetime contributions.

In addition, in 2021 the maximum individual benefit at full retirement age is $3,113 per month, thus higher earners cannot receive outwardly disproportional benefits. Altogether, Social Security is more impactful on a lower earning individual in retirement.

What remains unclear, however, is if Biden’s proposal would include a secondary earnings limit and subsequently larger Social Security benefits to help offset the additional upfront taxes. If not, higher earners falling on the wrong side of the donut hole may now be faced with what is essentially an outright tax, without limitation, that acts as a subsidization tool for other Social Security recipients.

Yet even if there is a secondary earnings limitation and larger applicable benefits, higher earners may still prefer to avoid the taxes and instead use the tax savings to fund other retirement or business investments because of higher perceived return potential.

Can You Avoid the Payroll Tax Hike?

Taxpayers wishing to avoid the expanded Social Security tax may have a small silver lining of hope. Despite being widely publicized during election campaigns, Biden’s proposal has gone relatively undiscussed in recent months. Notably, the proposal was absent from the Treasury’s “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals,” published May 28.

Thus, it appears that for the time being the Biden administration has set its eyes on other tax measures such as ordinary income and capital gains taxation, plus expanded tax credits. Regardless, planners and clients should still be prepared, as lawmakers are well aware of the need for another round of Social Security reforms and will likely revisit the topic soon.

For higher wage earners, strategies to limit the donut-hole effect might include the increased utilization of nonqualified deferred compensation and stock option plans. With deferred compensation, the primary goal would be to 1) defer enough salary to avoid the $400,000 limit in the current year, and 2) recognize that same income in future tax years at lower rates.

As per stock options, the two most commonly utilized are nonqualified stock options (NQSOs) and incentive stock options (ISOs). With NQSOs, the exercise of stock will trigger taxable wages equal to the fair market value of the stock at exercise over the original grant price.

However, option holders have generous discretion as to when they exercise, thus they can strategically recognize the income at ideal times. In addition, NQSOs can be gifted to others who may fall under the donut-hole limit.

It should be noted, though, that when recipients exercise the options, the spread between the exercise and market price will be taxable income to the donor, not the recipient. Thus, donors should coordinate closely with donees to ensure their taxable income stays below the donut hole.

Meanwhile, and assuming certain holding periods are met, ISOs enjoy preferential long-term capital gains tax and are not subject to payroll taxes; though a $100,000 annual grant limit exists and they cannot be gifted during life. Altogether, higher wage earners may want to renegotiate their compensation packages with their employer. 

As per self-employed individuals, a keynote strategy is reclassifying earnings as profits and capital gains income because the latter is not subject to payroll taxes. One way is by first incorporating and then electing S corporation status under Section 1362 of the Internal Revenue Code using Form 25533.

Doing so will allow shareholder-owners to split revenues between wages and profits, both of which are taxed at the individual level. The wage portion, which will be paid out to shareholder-owners like a standard salary, will be subject to income, state and payroll taxes. However, profit distributions, which are paid out after business expense deductions like salary and payroll taxes, will only be subject to federal and state taxes.

That said, it is tempting to reclassify all revenues as profits to avoid payroll taxes, but the IRS requires shareholder-owners to pay themselves a reasonable compensation for services they render to the business; otherwise stiff penalties and income reclassification may apply.

In addition, limiting wages can impact the ability to fund qualified retirement accounts, both as an employer and employee, and essentially negate any benefits gained from payroll tax savings.

Lastly, not all businesses may qualify or benefit from S corporation election, and current proposals are seeking a 3.8% Medicare Surtax on S corporation profit distributions. Therefore, careful research and analysis are warranted before making such an election.

Another approach self-employed individuals may take is reclassifying themselves as a limited partner. In this scenario, distributions received by the limited partner would be considered passive income and only subject to federal, state, and/or capital gains taxation — not payroll taxes. Only guaranteed payments for services rendered to the business (which is rare for limited partners) would face payroll taxes since this is a form of earned wages.

However, it should be noted that limited partners are not allowed to materially participate in business management, otherwise, they too face stiff penalties and income reclassification by the IRS. In addition, limited partner losses are restricted to passive income and equity investment, thus excess losses may go unutilized until future tax years.

Overall, this strategy does not work in scenarios where self-employed individuals materially participate in the business and/or have large losses exceeding income that need to be utilized promptly.

Finally, self-employed individuals who do not benefit from S corporation election nor limited partnerships will especially want to pay attention to the $400,000 marker. If these individuals suspect their income will exceed the donut threshold, they may consider accelerating deductible business expenses into the current year to help offset income and avoid taxes.

Again, every taxpayer and tax year will differ, so annual tax analysis is warranted. 

Conclusion

Though Biden’s Social Security proposals seem to have lost momentum for 2021, reform seems inevitable due to looming shortages on the horizon. Hopefully, that reform will be equitable and just for all parties, but planners and clients should be prepared for any situation, good or bad.

As such, it never hurts to have early conversations and run proactive projections showing the impact of these changes. And who knows, advisors might even consider holding these client conversations over coffee and donuts — just watch out for those donut holes.


Dan Johnson, MS, CFP, EA, is an assistant professor for the College for Financial Planning and a part-time instructor for Kaplan Professional, Boston University, and University of California, Los Angeles. He resides in Chicago.