United States: State Of The Union Surprise: President Targets Inherited Assets In Middle-Class Tax Reform

After the American Taxpayer Relief Act of 2012, many in the estate planning community thought that tax law dealing with estates and trusts was settled for some time. President Obama's earlier budget proposals calling for a higher rate and a lower exemption (among other changes) and the Republican support for the repeal of the estate tax were seen by many as pro forma budgetary proposals. But on January 17, 2015, in anticipation of his January 20 State of the Union address, President Obama released his tax relief proposal for middle class families. Included in the plan are expanded childcare, education, and retirement tax benefits and other tax credits to support working families. To pay for these provisions, the President proposes to:

  • Eliminate the "stepped-up" basis rules in the Internal Revenue Code, treating bequests and gifts as realization events subject to capital gains tax;
  • Increase top capital gains and dividend tax rates; and
  • Impose a fee on the liabilities of large U.S. financial firms.

This new proposal comes at the start of a new Congress, with both the House and Senate controlled by Republicans unlikely to give such a plan any room on the legislative agenda. These selected individual tax changes signal a rhetorical, if not a substantive, shift for the White House from the common ground of comprehensive business tax reform to the perceived inequality of the individual income tax system.

Deconstructing the Trust Fund Loophole

With some rhetorical license, the White House fact sheet describes Internal Revenue Code section 1014 as the "trust fund loophole" and goes on to suggest that it may be "the largest single loophole in the entire individual income tax code." This Code section provides that "the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent ... be the fair market value of the property at the date of the decedent's death ..." The basis of an appreciated asset is said to be "stepped-up" at death.

The fact sheet describes a situation where a person inherits stock worth $50 million. Working with that example, if at a mother's death she passes that stock to her daughter, the daughter's basis in the stock will be $50 million. Under current law, if the daughter immediately sells the stock no capital gains tax will be paid because the basis was stepped-up at the mother's death. The fact sheet fails to point out that the estate of the mother would pay somewhere between $15.6 million and $20 million in federal estate tax at a 40 percent rate, depending on the availability of the deceased mother's unified credit against estate tax available. And in any one of 19 states (and the District of Columbia), the mother's estate would owe state estate tax as well. Under President Obama's proposal, the mother's death would not only trigger the payment of estate tax, but it would be a realization event giving rise to possible capital gains tax.

Revenue by Realization Event

Under current law, capital gain is treated as income and taxed only when property is disposed of or sold. The regulations under IRC section 1001 identify capital gain income (or loss) as "the gain or loss from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or extent." Gifts are not sales, and unless the transfer of stock is in fulfillment of a specific bequest or dollar amount, transfers at death are not realization events. Under current law, no capital gains tax is paid when those transfers occur.

In order to raise more revenue and to raise it immediately, the President's proposal must change this rule and treat the transfer of assets by gift or at death as realization events. If the proposal alone eliminated the stepped-up basis regime, no capital gains tax would be due until assets were sold. A stated goal for the new regime would be to unlock this capital. To unlock capital, and to raise revenue immediately, the capital gains must be realized at the time of these transfers. And if transfers by gift and at death are realization events, capital gains taxes would be owed on the appreciation – the difference between the basis and the fair market value – at the time of the transfer, regardless of whether the asset is in fact sold or exchanged.

Continuing the example from above highlights the impact of this proposed rule on taxpayers. The transfer at death, from mother to daughter, would be a realization event. In addition to the estate tax paid by the mother's estate, an estimated $11 million in capital gains tax would be due at the time of transfer. The proposal is unclear if the capital gains tax will be paid by estate of the mother (or the transferor, if it had been a gift) or the daughter. But it is clear additional tax will be due. This proposal seems to resemble the current Canadian system of taxing capital gains at the death of each decedent. Canada replaced its estate tax system, in part, by enacting the system of taxing capital gains any time an asset is transferred (by gift, at death, on sale, or upon removal from Canada) in 1971.

The Administration's proposal may also increase taxpayers' exposure to state income tax in those states that tax capital gains based on federal income.

Increasing the Tax Rate

Having restored the tax on earned income to higher rates previously seen under President Clinton, this proposal turns to President Reagan for the historical benchmark for the highest rate on capital gains. In addition to imposing the capital gains tax on these transfers, the President proposes to increase the total top capital gains and dividend tax rate to 28 percent.

Middle Class Protection

The President intends this proposal to target "those at the top" and provides exemptions that are designed to benefit middle-class taxpayers.

  • The fact sheet implies that transfers between spouses would be exempt from the realization treatment. Like the marital deduction eligible for gifts or transfers at death, this exemption would effectively defer the payment of capital gains tax until the death of the second spouse unless the asset is sold in the interim.
  • The fact sheet states that gifts at death of appreciated assets to charity would be exempt from this capital gains tax.
  • Each married couple would be allowed to transfer up to $200,000 of capital gains ($100,000 for an individual taxpayer) free of capital gains tax. The exemption is described as automatically portable between spouses.
  • In addition to the basic exemption (described above), each married couple would have an additional $500,000 exemption for personal residences (or $250,000 for an individual taxpayer).
  • Tangible personal property (other than "expensive artwork and similar collectibles") would be exempt from capital gains tax, freeing families from the burden and expense of creating inventories and appraisals for income tax purposes.
  • Tax on inherited family owned and operated businesses would not be due unless the business was sold, and closely held businesses would have the option to defer tax on capital gains over time.

What's Next for Taxpayers

The fact sheet released by the White House falls short of a detailed legislative proposal. More details on how the plan would be implemented are expected when the budget process starts in February. What is clear now, however, is that the proposal will face strong objection in the 114th Congress.

While it is unlikely to be part of any comprehensive tax reform, this proposal will join other proposals from the Obama Administration, including limitations on grantor trusts and a minimum term for GRATs, in the library from which ideas for raising revenue may be drawn in the future. It will also form part of the tax reform debate for both Democrats and Republicans headed into the 2016 election cycle.

For more on the future of tax reform in the 114th Congress, see our Tax Policy Update.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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