As U.S. President Joe Biden looks for revenue sources to fund his proposed social spending programs, America’s richest people are facing the possibility that popular methods of passing enormous wealth from generation to generation while avoiding taxes could be disappearing.
The Biden administration has made no secret of its belief that capital gains — money earned from the sale of assets, like stocks, that have appreciated in value — don’t deserve to be taxed at a lower rate than earnings from labor as they are under current law.
Capital gains are taxed at a maximum of 20%, compared with a maximum federal marginal tax rate of 37% for income acquired through labor.
However, raising tax rates is a politically poisonous task in Washington.
As an alternative, the administration is pushing an effort to make more capital gains subject to taxation in the first place, and it is tying that effort to the president’s American Families Plan, a legislative initiative that would fund child care, early childhood education, higher education, health care and more.
'People want to get ahead of this’
The outline of a plan to capture taxes on capital gains has come into sharper focus in recent weeks, and appears to go further than many observers realized at first.
In March, the Treasury Department revealed a proposal to do away with a controversial treatment of inherited assets — called the “step-up in basis” — and paired it with proposed changes to the tax treatment of trusts, the estate planning vehicles that the wealthy would most likely turn to as an alternative.
As a result, attorneys who help wealthy individuals with estate planning are being besieged by clients demanding to know what to expect in the future and how to minimize the impact of any pending changes.
“It’s the busiest I’ve been in 25 years,” said Randall A. Denha, who runs a boutique estate planning firm in Michigan. “There are a lot of people asking questions, especially those that have a more substantial estate, because people want to get ahead of this.”
Under current law, appreciated assets that are passed from generation to generation receive special treatment that eliminates what, in some cases, would otherwise be huge tax obligations for wealthy Americans.
Purchased for $315 in 1980, a single share of Berkshire Hathaway, the giant holding company run by billionaire Warren Buffett, would have been worth nearly $420,000 when the markets closed on June 30 of this year. If the owner were to sell that stock today, he or she would have to pay capital gains tax on the difference between the current share price and the “basis” cost —the $315 that was paid for it in 1980.
If that same owner were to die today and pass the share on to an heir, the gain would be effectively wiped away because of what is called a “step-up in basis.” Heirs inherit an asset at its market value at the time of inheritance. If an heir sold that share of Berkshire Hathaway immediately on receipt, the $420,000 would be the heir's virtually tax-free.
By eliminating the step-up in basis, hundreds of thousands of dollars suddenly become taxable where previously they were not.
A rich person’s problem
Practically speaking, the changes the Biden administration is considering would have no real effect on the overwhelming majority of Americans. The proposals being considered would exempt the first $1 million in gains from capital gains taxes, a far larger amount than the entire value of the average estate.
For the very wealthy, one way of shielding assets from taxation is to place them in a trust, which is a legal entity that holds the assets on behalf of beneficiaries without transferring ownership. Some, known in the financial industry as “dynasty” trusts, can span generations, allowing enormous wealth to grow tax-free for decades.
In a world in which the step-up in basis rules cease to exist, trusts would be the obvious solution for wealthy individuals looking to protect valuable assets from taxation — something the Biden administration has plainly anticipated.
The reason, said Beth Shapiro Kaufman, a partner with the law firm Caplin & Drysdale in Washington, is simple: “The trust never dies.” And the Biden administration, she said, “doesn’t want trusts to be the loophole if they go forward” with changes to capital gains taxes.
New treatment of trusts
Under current law, assets held in trust are not taxed as they appreciate, and even when the trustee decides to transfer ownership of some of the trust’s assets, such as stocks, to a beneficiary, no tax is paid on the gains until the beneficiary actually sells the asset.
The Biden administration proposes treating that interim step — the transfer of ownership — as a “realization” event, requiring the beneficiary to treat the transaction as income subject to capital gains tax.
Even more significant for the extremely wealthy is a requirement that all trust assets be taxed on their appreciation once every 90 years. It’s a way of getting around the fact that the trust never dies by effectively creating the equivalent of a “death” once in what amounts to a longer than average lifetime.
If the administration is able to push these changes through, it will face some challenges implementing them, warned Garrett Watson, senior policy analyst at the Tax Foundation in Washington.
“There have to be adequate provisions for folks who don’t have the cash to pay taxes when there is a ‘realization event,’ ” he said. Additionally, there will inevitably be cases where heirs have no way of knowing the basis for an asset that they have inherited. “Is there going to be sufficient protection in the law for those folks who are in good faith in a situation where they don't have that information?” he said.
And further, he pointed out, what policymakers in Washington do during one administration can be undone in another, meaning there is no guarantee that changes in the tax treatment of inherited wealth will endure.
“I think even advocates will want to make sure they get it right, because they are relying on it as a revenue source to fund permanent programs,” he said.