Bonus tax: Feels good, but is it?

Running on grassroots rage, House passed a bill to recapture dollars from AIG bonuses. Senate is next. Tax experts weigh in on whether it's a smart move.

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By Jeanne Sahadi, CNNMoney.com senior writer

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What should the government do about AIG bonuses?
  • Tax them
  • Make AIG pay them back
  • Nothing, a contract's a contract

NEW YORK (CNNMoney.com) -- Public outrage can be a potent agent for change, but it doesn't always make for great policy.

Nevertheless, that rage is a main driver behind the bonus tax legislation that the House approved on Thursday in a 328-to-93 vote.

It was drafted in the wake of news that insurer American International Group -- which has been given access to $182 billion in taxpayer aid so far -- doled out $165 million in retention bonuses to employees in its financial products division. That division was ground zero for AIG's costliest mistakes.

"Stop the thievery at Americans' expense," said House Ways and Means Chairman Charles Rangel, D-N.Y., on the House floor before the vote.

The House legislation calls for a 90% surtax to be imposed on any bonus paid after Dec. 31, 2008, by a company that received $5 billion or more in taxpayer dollars from the Troubled Asset Relief Program. The tax would need to be paid by any employee or former employee whose family income exceeds $250,000 ($125,000 for married recipients filing separately).

Here's how it would work: Affected individuals would calculate what their federal tax bill would be without the bonus and then add to that amount 90% of the total bonus received, said Tom Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants

They'd need to add another 1.45% for the Medicare tax owed on the bonus, said David Lifson, president of the New York State Society of Certified Public Accountants.

On top of that, they would have to pay regular state and local income tax. That won't leave much in the wallet.

In fact, after factoring in state and local taxes, some people would end up owing more than they got.

"A New York City resident would have a tax greater than the bonus," Lifson said.

Feels like justice, but is it good tax policy?

From Lifson's point of view, the House tax bill isn't really tax policy. "This is bankruptcy and financial policy," he said.

His argument: If the government had allowed AIG to go bankrupt, employee contracts could have been renegotiated, or the employees could have lost not only their bonuses but their jobs.

"When the government rescued AIG for the sake of the financial system it inadvertently rescued all the contracts AIG entered into with executives," Lifson said.

What Congress is trying to do now is reclaim the bonuses through the tax code.

Of course, if tax legislation becomes law it would be seen as tax policy. And in that regard it doesn't get high marks from tax experts.

"If Congress wants to limit bonuses for employees of bailed-out companies, it should just do it. But using the Internal Revenue Code is a truly terrible idea," the Tax Policy Center's Tax Vox blog editor Howard Gleckman wrote.

To those who say it's okay because taxpayers effectively own AIG, Gleckman said: "Do we really want Congress to micromanage the business practices of this firm? That's the quickest way I know to drive the value of the company's remaining assets to zero and guarantee taxpayers will get no return on their investment."

Ochsenschlager said "it's bad policy because you're taxing [the same type of] income at a different rate than you and I are taxed at."

Not that there aren't other examples of that in the tax code.

For example, the Alternative Minimum Tax, originally intended to capture the wealthy few but now threatening to ensnare those much farther down the income scale, taxes income at different rates than the regular tax code. Lawmakers on both sides of the aisle have argued that the AMT should be overhauled or eliminated altogether. "It hasn't served its original purpose," Ochsenschlager said.

Is it legal?

Some Republicans in the House were claiming that the bonus tax measure is unconstitutional.

The tax would be retroactive to Jan. 1, 2009, and it would apply to bonuses already paid out as well as future ones. It would be limited to a group of companies that took at least $5 billion in government aid. And at least in the case of AIG, it would target bonuses received as a result of contractual obligation.

No question of constitutionality is ever resolved quickly or even conclusively. But constitutional expert Laurence Tribe of Harvard University suggested that such a provision could pass constitutional muster.

The ultimate fate of the House bill is not clear. The Senate Finance Committee on Thursday introduced its version of a bonus tax, which differs in some key ways from that of the House. For one thing, it would impose a 35% tax both on the company giving the bonus and on the individual receiving it.

Under the Senate bill, individuals would calculate their normal federal income tax bill, including the bonus, and then add 35% of the value of the bonus.

"We must act quickly on this proposal -- for the sake of the American taxpayer, for the sake of what's right to do," said Sen. Max Baucus, D-Mont., the Senate's top tax writer. "I will work with my colleagues in both the House and Senate to make sure that's what happens." To top of page

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