Donald Pease

Donald Pease

If there is anything I like less than taxes, it is stealth taxes.  One such stealth tax was first instituted in 1990 under the direction of Congressman Donald Pease of Ohio.  Remember this was during the reign of George Bush I, who was elected under the famously parodied phrase “Read my lips…no new taxes.”  Raising taxes (even on high-earners) was very politically unpopular at the time, so it was important that any tax increases be disguised so most people wouldn't realize what was going on.  These “Pease taxes” are actually a decrease in your deductions, rather than an increase in your marginal tax rate.  These taxes were gradually eliminated from 2006 to 2010, but as part of the recent “fiscal cliff” deal, they were re-instated starting in the 2013 tax year.  So how do these work and how will they affect most physicians?


Tax Exemption Phase-out

Exemptions are the money you get for being alive, being married, and having kids.  In my case, for 2013, I get a $3900 exemption for myself, for my wife, and for my 3 kids for a total of $19,500.  That means I don't pay taxes on $19,500 of my income, which given my projected federal plus state marginal tax rate of 38%, means a tax savings of about $7410 per year.  The Pease Law phases out for an Adjusted Gross Income (line 38 of the 1040, basically your income before you apply your exemptions and below the line deductions) of between $250,000-372,500 ($300,000-422,500 married).  For every $2500 I make over $300,000, I would lose 2% of my exemption.  So if I happened to work really hard and had a fantastic year and I made $400K, I'd lose ($400K-$300K)/2500*2%*$19,500= $15,600  of my exemption, resulting in a tax increase of ~$5928.  A spine surgeon (or a two doctor couple) with an AGI of $600K will lose the entire exemption.


Itemized Tax Deduction Phaseout

This phaseout isn't nearly as drastic as the loss of exemptions.  It has a much lower income limit (which is bad) but a much slower rate of phaseout (as well as a maximum phaseout of 80%).  It will affect most physician families, but not very much.  The income limit above which the phase-out starts will be inflation-adjusted in the future, but for 2013 is set at $250K ($300K Married).   In order to calculate how much of your deductions are phased out, you subtract $175K from your AGI, then multiply it by 3%.  So if you were single and your income  were $450K, you'd calculate it like this:  ($450K-$250K)*3%= $6000.  If you had $50K in itemized deductions, then you lose $6000 of it.  At a 38% marginal tax rate, that would be an increased tax bill of $2280.

You have to make more than most physicians for the “80% rule” to kick in.  A single person with an AGI of $3 Million and $100K in itemized deduction might hit the 80% rule.  ($3M-$250K)*.03= $82,500.  The 80% rule would limit his phaseout to $80K instead of $82,500, so he'd still get a $20K itemized deduction.  If you are reduced to an amount below the standard deduction ($12,200 married filing joint in 2013), you can just take that instead.


One Benefit To Paying AMT

The good news is that if you're already paying Alternative Minimum Tax, this probably won't affect you.  The Pease limitations only apply to the regular tax code, not the AMT system.  Remember that under the AMT system, everyone gets an exemption of $80,800 ($51,900 Single) no matter how many kids they have.  It has its own phase-out starting at $153,900 ($115,400 Single).  I suppose it is possible for the Pease phase-outs to cause your AMT to be completely eliminated by increasing your tax due under the regular code, but this would seem to be a pretty rare problem, and at least you could console yourself with the fact that you no longer owe AMT!


The Bottom Line of Stealth Taxes 

Many physicians won't be affected at all.  A married doctor making $300K won't owe more tax due to either phase-out.  A married physician with an AGI of $400K will have a higher tax bill due to a slight decrease in his itemized deductions and a big decrease in his exemptions.  The real loser here is the doctor with an AGI of $600K and 10 kids.  His federal income taxes could go up as much as $23,500!  When you combine this tax with the higher top income tax rate (35%–>39.6%), the new Obamacare taxes (2.9%–>3.8%), and California's millionaire tax (10.3%–>13.3%) the most well-to-do among us really took it in the shorts this year.