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The AIG Bonuses, Part 6:
A question about taxes proves mighty taxing

27 Mar 2009 in ,

On 25 March we posted a note on how AIG employees (and other bonus recipients targeted by H.R. 1586) would have substantial tax liabilities even if they returned the bonuses, as a number of Congressmen and attorneys general have been demanding. The Wall Street Journal's James Taranto saw our post and found a pair of errors, which today we correct.

We pointed out (correctly, we still think) that the receipt of the bonus counts as "above the line" income -- that is, it's part of adjusted gross income (AGI), which is the basis for the special tax in H.R. 1586 on bonus recipients. Our principal insight is that receipt of the bonus is sufficient to trigger tax liability, and this tax liability is not extinguished by returning the bonus to the employer.

So we looked for ways a taxpayer might return the bonus and legally avoid paying taxes if he did as Congress, the President, and state attorney generals are demanding. We showed that taxes might be reduced but that they could not be eliminated. Under the best scenario we could come up with, the bonus recipient who returns his bonus increases his tax liability.

Taranto (correctly, we think) identified two errors in our analysis, which we paraphrase below and explain further:

  1. The Alternative Minimum Tax kicks in when a high-income taxpayer seeks to reduce tax liabilities by using the deductions that are available to taxpayers at large. When it was first enacted in 1969, the AMT may have been "intended to target 155 high-income households that had been eligible for so many tax benefits that they owed little or no income tax under the tax code of the time." Over the years, however, millions of taxpayers now fall under its provisions. In any case, under the AMT legitimate unreimbursed business expenses are not deductible. So many bonus recipients may not be able to reduce their tax liabilities this way. The history of the AMT is particularly interesting because H.R. 1586 represents a similar congressional effort to subject selected individuals to punitive taxes. University of Chicago law professor Richard Epstein says Supreme Court jurisprudence permits such actions even though they appear to clearly violate several provisions of the US Constitution.
  2. H.R. 1586 would tax bonus income "above the line" and not permit taxes to be reduced by "below the line" deductions for such things as charitable contributions. The text states clearly (though we admit we missed this initially) that the 90% tax would be levied on the bonus per se, not the bonus recipient's taxable income after accounting for legal deductions.

Jake DeSantis, who publicly resigned in the New York Times as executive vice president of AIG's Financial Products unit, said that he would donate his bonus to charity. It is not clear that he took account of this aspect of H.R. 1586.

Because DeSantis went public, and revealed enough information to enable us to perform the calculations, we thought it would be useful to diagram how the tax code applies to his situation. This leaves out a host of factors that he did not disclose -- and, we should state clearly, has no legal or ethical obligation to release. Our purpose is to use his case as an illustration to help others understand the implications of the federal tax code to this highly unusual situation. (Caveat: We are not providing tax advice, nor do we think it would be sensible for DeSantis or any other bonus recipient to rely on our analysis in lieu of professional tax advice.)

The diagram below presents a decision tree for the bonus recipient facing facts analogous to those reported by DeSantis. We show our work below the diagram. The dark blue triangle at the top is the chance node reflecting uncertainty about whether the government enacts H.R. 1586. Whether or not it does, the bonus recipient decides whether to keep the bonus or return it to the employer. (Congress may have the ability to impose confiscatory taxes, and State attorneys general can threaten public humilation or abusive legal action, but neither can directly compel employees to return their bonuses.)

Reflecting the social welfare views of the House, President Obama, and several state attorneys general, green and red fill represents "right" and "wrong" decisions. The application of the tax code follows below. Green and red are now used to represent "right" and "wrong" decisions from the perspective of the bonus recipient. Note that what is deemed "socially best" is unambiguously worse from the recipient's perspective, both under current tax law and H.R. 1586.

Taranto, who writes an entertaining and insightful opinion column for the Wall Street Journal, said that any bonus recipient who responded to political pressure by returning his bonus was a "sucker." Neutral Source strives to provide a different product -- objective analysis delivered without opinion. Nevertheless, we can say that under both current tax law and H.R. 1586, an employee will face a large financial penalty if he returns his bonus. Obviously, he will first lose compensation to which each of the political actors admits he is legally entitled.

Second, he might have to pay taxes on the bonus as if he had kept it. Returning the bonus subjects him to a marginal tax rate of about 135% under current law and 160% if H.R. 1586 were enacted. These marginal tax rates rise if State and local income taxes are taken into account.

There is an even greater irony: As long as he keeps the bonus, an employee like DeSantis under pressure to return a bonus may be much better off if H.R. 1586 is enacted. Returning his bonus under current law results in a net loss of $260,000. Keeping the bonus and paying the punitive 90% tax in H.R. 1586 results in a net gain of $298,000. If DeSantis is representative of bonus recipients as a class, they might be better off lobbying Congress to pass the bill -- an outcome few supporters of H.R. 1586 probably intended.

 

Showing Our Work

 

 

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