Proposals to Change Foundation of Tax Law

Proposals to Change Foundation of Tax Law

The Blue Wave may not have hit our proverbial shores after the last election, but Democrats did obtain control of the Senate by tying their ranks with the Republicans. There are 48 Democratic senators (plus 2 Independents who caucus with them) to the Republicans’ 50. Thus, in the event of an even number of votes on either side, the Vice President, herself a Democrat, breaks the tie. So in effect, the composition of the Senate right now leans ever-so-slightly left, 51 to 50. That means items which have been on Democratic wish lists, including changes to eliminate tax breaks in the Internal Revenue Code, suddenly have a much higher prospect of passage—at least higher than zero, as it had been when Republicans controlled.

Proposals are coming from multiple fronts. One such proposition, the Sensible Taxation and Equity Promotion Act (the “STEP” Act) contains a number of elements, any one of which alone would be a large enough change to warrant you re-assessing your estate plan (e.g. raising the capital gains rate, drastically reducing the estate tax exemption, etc.). This blogpost will only scratch the top layer of the surface of one of these monumental, proposed changes: elimination of step-up in basis at a person’s death. We are trying to make this understandable to the average person, not cover every single nook and cranny of the bill.

Under current law, if a person invests in property and it goes up in value, no tax is due until they sell it. Upon sale, they are taxed on the difference between the higher sale price and the lower amount they bought it for, known as the “basis.” For example, if I bought stock in Tesla for $100 and held onto it till it was worth $500, when I sold it then, I’d pay tax on $400.

What a lot of people don’t know, is that if I do not sell that stock, die, and then give it to my daughter, her basis goes from what I paid for it ($100) to what it’s worth on my date of death ($500). When she sells it shortly thereafter, her taxable gain is $500 amount realized minus $500 basis = $0 taxable gain. She gets that stock tax-free. This jump from $100 to $500 is known as “step-up in basis.” The basis is stepped-up to the date of death value. If you are a taxpayer holding appreciated assets, this is one of the niftiest provisions in the tax code, since it allows you to hold onto (and benefit from) assets during your whole life, and then pass them income tax-free to your beneficiaries.

The STEP Act would essentially eliminate this tax-free step-up. The proposed law, as it’s written right now, would treat a person’s death as a sort of deemed realization event. In other words, their death is treated as a sale, and any gain recognized from it would be reflected on the deceased person’s final tax return. Taxes would be paid, beneficiaries would inherit a lower amount net of the income tax, and then if the property appreciates in value again, and the beneficiary later sells it, they’d pay tax again at that point, now on the difference between the sale price and the basis of the property as they inherited.

Luckily, there is a large cushion proposed here, in the form of a $1,000,000 exemption to the taxation of the capital gain triggered at death. So my total assets would have to appreciate substantially – over $1,000,000 – before tax would be paid on them when I die. For business owners, investors, or farmers that have more than $1,000,000 in built-in capital gains, though, this is a very, very big deal.

It is important to note that we do not currently know if these changes will be made retroactively—that is, if they’ll apply to transactions that have occurred before the passage of the law in addition to those that occurred after it —or indeed, whether these proposed laws will even be passed, and with or without changes negotiated during congressional debates. As mentioned, the Democratic shift is as lean as it can possibly get. However, the proposed change would be such a radical departure from the way things have been for basically the past 50 years, that our firm felt it was important to alert you prospectively.

As I said above, for purposes of easy readability, we have barely begun to touch on the multiple complexities and exceptions to this rule, so don’t take this as gospel or perfect legal advice. Our intention is only to alert you to the possibility of these changes so that you may be better suited to adapt to them if and when they take place. If you have any questions or concerns about how this law may affect your estate plan, or the sale of your business, please don’t hesitate to reach out to us at Stock Legal.

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