Vermont shifts tax burden to self-employed

Beginning next year, employees will enjoy a considerable advantage over the self-employed when property-tax credits are computed, because they can still deduct expenditures that will no longer be deductible for the self-employed.

To understand this looming inequity, you need to know a little about how the credit system works. Under the income-sensitivity formula, if household income is less than $90,000, a homeowner need pay only a certain percentage of household income in property tax on their house site (their dwelling and up to 2 acres). Anything in excess of this limit is paid by the state in the form of a credit that shows as “state paymt” on the homeowner’s property tax bill. The percentage ranges from 1.8 percent to 3.83 percent, depending on the town of residence, and the credit is capped at $8,000.

Household income is the total of all household residents’ income (taxpayer, spouse, relatives, roommates, etc.), but it is not the same as federal total income (line 22 of Form 1040).

The calculation of household income starts with total income from the 1040 and adds many forms of nontaxable income, such as child-support payments received, Social Security, social welfare, veterans’ benefits, cash gifts, municipal bond interest, and capital gain on the sale of a primary residence.

Then losses from businesses, rental properties and capital transactions that reduced total income on the federal return are added back. As a result, a Vermont homeowner’s household income can be significantly higher than federal total income.

The calculation of household income allows few deductions. Federal itemized deductions (Form 1040, Schedule A), the standard deduction and exemptions are not allowed to reduce household income. Deductions allowed for household income are contributions to Social Security and Medicare and child-support payments made to someone else.

The last category of deductions that are allowed to reduce household income are referred to as adjustments. These are a group of specific deductions on the federal return that can be taken by anyone who qualifies for them (lines 23-36 on Form 1040). The result is called adjusted gross income.

The most common adjustments include traditional IRA contributions, moving expenses, student loan interest, alimony paid, college tuition and fees, self-employed health-insurance premiums, contributions to health savings accounts, and self-employed contributions to SEP-IRAs, Simple IRAs and other retirement accounts.

Summarizing: Household income equals federal total income, plus nontaxable income, plus business losses, plus rental losses, plus capital losses, minus FICA taxes (Social Security and Medicare), minus child support paid, minus federal adjustments.

The calculation of household income (reported on Vermont Form HI-144) is not a trivial task, and for most homeowners the result is considerably different from federal total income.

An observation: Ideally, household income is a measurement of funds available to pay property taxes. Whether these funds are taxable is not relevant to this measurement. Deductions from household income are limited to those one might have no choice about and never see in the first place (such as FICA taxes).

Why are certain deductions to household income allowed in the form of federal adjustments, whereas other deductions such as property taxes, mortgage interest and charitable contributions are not? The answer isn’t clear, but the question is moot because the Legislature eliminated most of the adjustments in the recent session.

What changed: H.783, an act relating to miscellaneous tax provisions (also known as Act 160), was passed 111-16 on the last day of the 2010 legislative session and signed into law by the governor on June 4. Included in this act is a provision to significantly reduce the federal adjustments that can be excluded from household income. This can be found on page 20 of the bill at http://bit.ly/bfFsZH.

This revision in the calculation of household income eliminates the deduction of all but a few federal adjustments, such as the tuition and fees deduction and alimony paid to another individual. This could result in dramatically increased property-tax bills for affected homeowners. It is estimated that the state will save $6 million in property tax credits.

On the surface this looks like a reasonable change. Why should federal adjustments be excluded from household income? These are discretionary expenses. Many other expenses that for years have been considered as discretionary, such as mortgage interest and property taxes (no one forced you to buy your house), have never been excludable from household income.

Unfortunately, this relatively simple change will have a disproportionate impact on the self-employed compared to employees and will harm small business owners, the backbone of the Vermont economy. How is this possible?

As stated earlier, federal adjustments allowed to be deducted from federal total income include health-insurance premiums, contributions to health savings accounts and contributions to retirement plans, expenditures routinely deducted by the self-employed.

Employees generally are able to make these types of contributions as pretax deductions from their pay. Indeed, that is why they are on a federal tax return in the first place: To allow the same pretax treatment for the self-employed that many employees enjoy.

When calculating household income, these adjustments are already subtracted from an employee’s taxable wages (box 1 of the W2), which is what the employee reports on form HI-144, whereas the self-employed homeowner subtracts these same items from household income in the “adjustments” section of HI-144. The Legislature has now eliminated these adjustments from the calculation of household income for the self-employed.

However, no revision in what employees report as wages was included in this legislation. The self-employed will no longer be able to reduce their household income by expenditures that will still be deductible by employees.

This change occurred at the very end of the legislative session. It wasn’t in the version passed by the House on March 26 (http://bit.ly/chaibP) and it was not in the Senate proposal of amendment passed on April 27 (http://bit.ly/cYgWH2). This imbalance first appeared in the conference committee report on May 10, two days before the end of the legislative session. The miscellaneous tax bill passed overwhelmingly.

Last winter, Rich Westman, then tax commissioner, delivered a presentation across the state about problems with the statewide property tax system. He said, “We have eroding equity; we have added Band-Aid after Band-Aid.”

This recent legislation is a further example of that erosion. Self-employed homeowners will suffer as a result of this latest Band-Aid.

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Steve Cairns owns Advisor Tax Services in Stowe.