Yesterday, Senators Collins (R-ME) and McCaskill (D-MO) introduced legislation to extend the payroll tax holiday, among other things, and to pay for it with a mixture of tax hikes. Primary among the tax hikes is yet another modified version of the millionaire’s surtax. By our count, this is the fifth surtax considered in the Senate in the last three months.

In this case, the surtax is two percent and would apply to incomes exceeding $1 million, excluding small business income where the taxpayer works at the business. The goal of this exception is to avoid the charge that the surtax would fall heavily on small business and its owners. As Senator Collins stated in the introduction of the bill:

“A substantial number of Republican senators have said that they oppose the surtax because of the impact on small business. So our bill eliminates that argument.”

Well, not really. Throughout the “rate debate,” spanning the expiration of the top two marginal tax rates at the end of last year, the imposition of a new, 3.8 percent investment surtax as part of health care reform, and now this new millionaire surtax - we have been struck by how the two sides in the debate talk past one another: one side focuses on who is being taxed, while the other focuses on what is being taxed.

Advocates for higher rates consistently point out that the taxes would be shouldered only by the wealthy – the one, two, or three percent of taxpayers who can afford to pay more. Opponents, on the other hand, including S-CORP, point out that what is being taxed is a substantial portion of business income, i.e. business activity.

For the debate over the top two rates, somewhere between one-fourth and one-third of all business income would face higher rates, which means less business investment and less job creation. The target is the wealthy, but the burden would be shouldered by the broader economy. In the case of the millionaire surtax, four out of five of the affected taxpayers are, by Treasury’s latest data, business owners with significant business income.

The Collins-McCaskill carve-out attempts to exempt those business owners, but because they are focused on the who rather than the what, they missed. The who they are trying to protect are active shareholders at active businesses - i.e. “real” business owners. But their approach is flawed.

Consider the case of two shareholders who each own fifty-percent of an S corporation, and one shareholder runs the business while the other works elsewhere. Under the Collins-McCaskill plan, both taxpayers would pay the surtax on their wage income, but only the passive shareholder pays the surtax on his S corporation income.

Why? There’s no economic difference between the profit and loss attributed to one shareholder over the other. The active shareholder gets paid a salary by the business, after all, and under reasonable compensation rules must pay himself a market salary for his work. Any business earnings over that amount are a return on his capital investment, not a return on his labor; in other words, the same type of return as earned by the passive shareholder. But under the Collins-McCaskill carve-out, only the passive shareholder’s business income is subject to the surtax.

The Collins-McCaskill carve-out raises other issues as well. It doesn’t appear to exempt profits from the sale of a business, so decidedly middle-class business owners could get hit when they sell their business and their annual income spikes. The surtax would last nine years, while the payroll tax relief lasts only one year. At the end of 2012, will these same sponsors be back with yet another surtax to pay for another extension?

Finally, and perhaps most importantly, these rate hikes will drain capital from Main Street businesses. S corporation shareholders must pay taxes on any income earned by the business — whether the income is distributed to the shareholders or not. This is an important feature of S corporation taxation that many observers fail to grasp completely. Moreover, since S corporations are allowed only one “class” of stock, all earnings must be distributed evenly.

In the 50/50 ownership example above, if the S corporation made $200 dollars in a quarter, each shareholder would be required to pay taxes on the $100 in earnings attributed to them - regardless of whether the shareholders actually received any distribution. Most S corporations make sure to distribute at least enough earnings each quarter to cover the shareholder’s taxes. In this case, both shareholders are in the 35 percent bracket, so the business would distribute $35 to each to cover their taxes, and retain the remaining $130 as working capital for the business.

Under the Collins-McCaskill approach, the passive shareholder’s tax level would rise to 37 percent, so the business would need to distribute $37 to both shareholders. (Even though the active shareholder is exempt, distributions must reflect ownership share, not tax burden.) As a result, the business’ working capital is reduced to $126.

This may seem like a small amount, but consider that this surtax is just one of an avalanche of rate hikes facing pass-through businesses. First, it’s this surtax, then the scheduled expiration of the current marginal rates, and then the imposition of the 3.8 percent investment surtax enacted as part of health care reform -all beginning January 1 of 2013. The net result will be to raise the top marginal rate on S corporation shareholders from 35 percent to around 47 percent. With those rates, our business’ working capital would be reduced from $130 to $106, a reduction of 18 percent!

The authors of the proposal appear to understand that raising tax rates on business income is bad policy, but in their attempt to define “who” was going to pay the tax, they ended up with a solution that addresses neither side’s concerns. If the focus is on who gets taxed, then advocates of the surtax need to be comfortable raising taxes on a significant amount of business activity. That’s who the wealthy are.

If instead, they choose to focus on what gets taxed, as in not raising taxes on investment and job creation, that approach would lead them towards comprehensive tax reform and the need to fix our entire tax code. That’s where the Chairman of the Ways and Means Committee would like to go, and we support his efforts.

In the meantime, we are going to be subject to serial tax hike proposals, one after another, each with slightly different details, but all embracing the same theme: Let’s raise taxes on these taxpayers because of who they are, and ignore completely what they do.