Originally published on Forbes.com.
President Obama has issued a proposal for A Simpler, Fairer Tax Code That Responsibly Invests in Middle Class Families. This is one of those things that I would pass on since the rest of the tax blogosphere is all over it a lot quicker than I am. Bob Wood and Kelly Erb have already weighed in and I suggest you check them out for the whole picture. I am just going to focus on a piece of the plan. The reason is that there is a profoundly radical proposal in there. It would shake up the entire wealth and estate planning community.
As a matter of fact we should probably all thank the President, since many planners will be able to make some significant fees just from addressing the specter of this proposal . Here it is straight from the factsheet:
The largest capital gains loophole – perhaps the largest single loophole in the entire individual income tax code – is a provision known as “stepped-up basis.” Stepped-up basis refers to the fact that capital gains on assets held until death are never subject to income taxes. Not only do bequests to heirs go untaxed, but the “tax basis” of inherited assets used to compute the gain if they are later sold is immediately increased (“stepped-up”) to the value at the date of death – making the capital gain income forever exempt from taxes. For example, suppose an individual leaves stock worth $50 million to an heir, who immediately sells it. When purchased, the stock was worth $10 million, so the capital gain is $40 million. However, the heir’s basis in the stock is “stepped up” to the $50 million gain when he inherited it – so no income tax is due on the sale, or ever due on the $40 million of gain. Each year, hundreds of billions in capital gains avoid tax as a result of stepped-up basis. The President’s proposal would close the stepped-up basis loophole by treating bequests and gifts other than to charitable organizations as realization events, like other cases where assets change hands.
As they say on my favorite conservative Catholic blog – Popin Ain’t Easy HOLY SMOKES! There was an attack on stepped up basis in the Tax Reform Act of 1976, which instituted carryover basis for inherited assets. The provision was repealed before it became effective, partially because it was considered too complicated, Also in our infamous year without an estate tax – 2010-, estates could choose carryover basis rather than estate tax. Carryover basis, though, just means that the recipients have to pay capital gains tax when they sell the assets (also any depreciation deductions are limited to what the donor would have gotten). We already have carryover basis in the case of gifts and planners are often willing to live with it if it helps beat transfer taxes.
Why Did You Give Me A Defective Trust? On Purpose!
One of the coolest or, if you have a different viewpoint, most wicked concepts that planners ever came up with is the intentionally defective grantor trust(IDGT). The grantor trust rules were enacted to prevent people gaming the income tax system by using trusts to shift income to lower income tax brackets. Planners turned the tables on the government by using the rules to game the transfer tax system. A gift to an IDGT is a completed gift for transfer tax purposes, putting the trust corpus out of the grantor’s estate, but not a completed gift for income tax purposes so that any income taxes generated by the trust are paid by the grantor rather than the trust which enhances the value of the gift. The hardest thing about the IDGT is explaining to an elderly client that paying taxes on gains that benefit his heirs is a really good deal.
A Radical Proposal
This proposal is so radical because it goes far beyond carryover basis. It makes death and gifting realization events. If a family has an appreciated asset that will be held indefinitely one strategy would be to gift it gradually taking advantage of annual exclusions and perhaps aggressive valuations. This proposal would create the possibility of an immediate income tax event. Furthermore, this proposal would, in effect, be creating an estate tax for smaller estates.
Of course, we don’t have the devilish details yet. There is talk of a small business exception. You could come up with other examples that would work a hardship on a middle class family that has for example a cherished vacation home.