Turn the dial on the Wayback Machine to September 5, 1882. Most Americans work 12 hours per day, seven days per week, often in physically demanding jobs under unsafe conditions. “Helicopter parenting” doesn’t exist yet because the kids are working in factories, farms, and mines. A group of 10,000 men risk their jobs on a one-day strike to demand higher wages, shorter days, and a ban on prison labor. The New York Times reports, “The barrooms were never more resplendent,” and adds that “Liquidly, the first celebration of Labor Day may go down to history as an unqualified success.” Six years later, President Grover Cleveland signed a bill declaring Labor Day a national holiday.
Today, few Americans work 40 hours a week, and employers are experimenting with four-day weeks. Millions have ditched their commute for Zoom. Labor Day is mostly about barbecues, sales, and last-minute summer celebrations. And while you may thank Washington for the protections that make work less work, you may not realize that the tax code continues to throw shade at the workingman. That’s because there are two very different sets of rules for the income we earn from capital and the income we earn from labor.
“Capital” pays you for owning things. This includes the interest and dividends you earn in your investment accounts, the rents you earn from your real estate, and the gains you earn when you sell something for a profit. Much of this is taxed at ordinary income rates, ranging up to 37% plus a 3.8% net investment income tax. And some are taxed at special, lower rates, like 20% for qualified corporate dividends and long-term capital gains.
In contrast, “labor” pays you for the work you do. This includes salaries and wages you earn working for The Man, and income you earn from running your own business. That pot gets hit with an employment tax of 15.3% on your first $160,200 of income, plus 2.9% on anything above that. If you work for yourself, you’ll pay it yourself in the form of self-employment tax. If you collect a paycheck, you’ll pay half of it in the form of FICA. All of that is on top of your regular income tax.
The bottom line here is that the rich guy who makes his living collecting stock dividends and renting houses and apartments pays a smaller percentage of tax on his income than the working man who generates those corporate profits and pays those rents. Billionaire Warren Buffett has said for years that he pays less tax than his secretary. Employment tax is a big part of that problem, along with the lower rates on the dividends and long-term gains that make up most of his income.
Wanna get really fired up after this Labor Day holiday? Treasury regulations define a special kind of income called “carried interest,” which lets hedge fund and private equity fund managers avoid employment tax and pay capital gains rates on most of their income. There are only about 5,000 Americans who can squeeze through that loophole. But they include some of the highest-earning people in the country, like Citadel Fund founder Ken Griffin, who made $4.1 billion in 2022 alone. Donald Trump and Joe Biden have both called for slamming that door shut. And when was the last time those guys agreed on anything? If we still had peasants with pitchforks and torches, this is the sort of thing that would get them storming the castle in no time flat.
If you run your own business, you may be paying more employment tax than you need to pay. And regardless of how you earn your income, Labor Day marks the start of the official tax-planning season. Dust off those decorations, warm up Spotify’s “Tax Season Carols” playlist, and call us to see if you can pay less this year!
Happy tax planning!