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Educational Resources

By Jeffrey R. Wolfe, Vice President and Manager, Estate Planning Strategies and Affluent Client

On Tuesday, Jan. 20, 2015, President Obama delivered his sixth State of the Union address to Congress and the world. In his address, he proposed several new tax increases for high-income earners to pay for multiple “middle-class tax breaks” such as free junior college and credits for working parents.

Whether you believe these middle-class tax breaks are worthwhile or not, it’s important to look at how this administration prefers to pay for most new government spending. More times than not, the high-income earners are the target for more taxes.

Many people far more involved with politics than me, believe most of the tax proposals from President Obama are “non-starters,” — especially with a Republican controlled Congress and only two years left in his term. However, it’s worth looking at these initial volleys from the head Democrat as it’s possible they could someday come to fruition.

Capital Gains and Qualified Dividend Rates to Increase
The first serve from President Obama is to increase capital gain and qualified dividend tax rates to 28% for high-income earners (currently defined as individuals earning more than $413,200; married couples earning more than $464,850). There is some evidence that the 28% rate could start at $500,000 of earnings for couples instead. For now, folks in these high-income categories are already paying 23.8% capital gains rates.

From my research, I haven’t found any articles that believe this proposal can pass — however, that doesn’t mean it will not pass. The President is quick to point out that the 28% rate is the same rate President Reagan agreed to in the 1980s (though he does neglect to point out that the highest ordinary income rate then was also 28%, not 39.6%). This type of rhetoric can sometimes take hold and push a proposal forward. In short, anything is possible.

Estate Tax Reform . . . Again, and Again and Again!
In my estate tax strategy piece titled “Here We Go Again – Estate Taxes Remain Volatile” (available through your Benjamin F. Edwards & Co. financial consultant), I discuss the “permanent” federal estate and gift tax laws. The American Taxpayer Relief Act of 2012 [1] (“ATRA”) made the estate and gift tax exclusion permanent at $5 million, and indexed it for inflation (currently $5.43 million). It also secured the “step-up in basis” rules, which means that regardless of what you paid for an asset, when you die your beneficiaries get a “step-up” in basis of all of your capital assets to fair market value at your date of death [2].

The President has long looked at estate taxation for more revenue. He proposed a decrease in the estate tax exclusion to $3.5 million four months after ATRA passed. He’s kept that idea in his proposed budget each year thereafter. In the latest State of the Union address, he has made an even stronger proposal to significantly modify the current estate tax laws.

The President has labeled the step-up in basis rules as a “trust-fund loophole” and some call it the “angel of death loophole.”  Since neither trusts nor angels are necessary for the current step-up to occur, both of these labels are misnomers. However, if step-up were eliminated, significant revenue could be raised, and significant administrative problems can be expected.

Eliminating step-up would capture “lost” tax revenue when someone passes away. It is true that some hold onto assets to take advantage of the step-up. However, the current estate tax regime is designed to have a limit on that “savings.”  Anything above the federal estate tax exclusion amount pays a 40% federal estate tax. To add a 28% capital gains tax on top of the estate tax could be devastating to the total value of an estate subject to both taxes.

Another aspect is that the current estate tax rules usually apply to less than 1% of all deaths per year.  However, eliminating step-up would affect every person that died with any capital assets. There are several proposed exceptions to the President’s new rules including:

  1. No tax is due until the surviving spouse dies;
  2. Capital gains of up to $200,000 per couple ($100,000 per individual) could still be passed free of tax;
  3. Couples would have an additional $500,000 exemption for personal residences ($250,000 per individual); and
  4. Potential special rules for closely held businesses so that they wouldn’t have to sell their business to pay the tax.

There are no details to these various exceptions and how they may apply in practice, but it sure sounds like a lot of potential federal estate tax/capital gains tax returns could be required.

Most important, though, is that tracking a “carry-over” basis would be very difficult for all involved.  Knowing what your parents paid for their home, the stock they bought in 1987, or any other capital asset can be almost impossible to determine. In a scenario where you’re looking at a potential tax owed, you’re going to have to prove your assertion for basis. This could cause a need for “forensic accounting” of investable asset histories, appraisals for homes, cars, etc.

We had carry-over basis proposed in estate tax law back in 1976, and it became so burdensome that Congress retroactively eliminated the program before full enactment in 1980. It also existed in 2010 when the estate tax “sunset” for one year.

What Now?
While these significant changes to the tax code are being proposed by the President, it seems extremely unlikely that they will pass through Congress to become law. For high-income clients, though, you may want to consider whether to harvest gains at today’s known rates compared to waiting for Congress and the President to come to some agreement.

On the estate planning side, clients need to remain diligent in reviewing and updating their plans should laws change. Without step-up in basis, estate planning strategies will be significantly different than the traditional planning we have today. Updating plans will likely be necessary.

The only thing permanent is change, and it appears our taxes will continue to evidence that saying. For now, sit tight and hold on!

Please remember that this is a summary, and not an all-inclusive detail, of proposed tax changes. This information was not intended nor should it be used as a solicitation of any product or service. Benjamin F. Edwards & Co. does not provide tax or legal advice. Please consult with your tax or legal advisor for your particular situation.

[1] Interestingly, the American Taxpayer Relief Act of 2012 was enacted on January 2, 2013, or what I’ve heard referenced as December 33, 2012.

[2] For certain estates subject to federal estate tax, an alternative valuation date six months after death may apply.

January 27, 2015 |