Tax Changes

Forced Recognition of Gain in Democrat Proposed Tax Changes

In our recent webinar with the Business Journal, we reviewed in detail the major income and estate/gift tax changes proposed by the Biden Administration and the Democratic Congress.  We noted the loss of the “step-up” in tax basis at death, the reduction of the amount of a tax-free estate from $11.7 million to $3.5 million and the increase in the capital gains rate from 23.8% to 43.4% for gains in excess of $1,000,000.  In this article I would like to emphasize the final point of the webinar—the proposed recognition of gain on transfer. 

Currently, if I gift a child IBM stock I purchased years ago for $10 and she immediately sells it for $110, she incurs a long-term capital gains tax on $100 a share.  In other words when talking about gifts, a donee takes the tax basis of the donor, which is called “carry-over” basis.

By contrast under current rules, if my daughter inherits the IBM shares from me and immediately sells it for $110, she pays no tax because she receives a step-up in tax basis to the fair-market value of the stock at my death.  This salubrious rule has been a mainstay of family business succession planning for generations.  Indeed, one of the first things an estate planning attorney will advise a business client is placing low tax basis assets into the name of the spouse with the shortest life expectancy—usually the husband. 

Not only do the Democrats proposed to do away with carry-over basis and step-up in basis at death, they also want to tax appreciated gain on transfer.  In the examples above, either my gift to my daughter or my bequest to her would trigger the (greatly increased) capital gains tax—whether my daughter subsequently sold the shares or not.  

What about the transfer into a trust?  Let’s say that a mother wants to transfer a portion of the family business into an irrevocable trust for her son, a minor not old enough to receive a gift.  The new law would tax any appreciation of company stock when moved into the trust and then (later when Junior was of appropriate age) when it comes out and is given to him.  What about stock that is already in a trust?  The House bill would tax appreciated assets in trusts every 30 years, the Senate bill every 21.  Biden’s bill would trigger a tax for the first time in 2030.

What strategies are suggested if such a tax on transfer is implemented?  First of all, there is a $1,000,000 ($2,000,000 for a couple) exemption from the tax.  This suggests “smoothing” will become a key concept.  For instance, if a person were selling a business for $4,900,000, he/she might structure the deal as a 5-year installment sale, such that he/she would receive five payments of $980,000, rather than one payment of $4,900,000 (which would have triggered a 43.4% tax on the amount over $1,000,000).

With tax-on-transfer a taxpayer would want to avoid forced recognition of massive gains.  This would recommend taking building gains more frequently to inhabit lower tax brackets.  One might arrange this by transferring to a controlled trust or family member. 

Finally, where the patriarch/matriarch is approaching the end of life, it might be prudent to arrange an installment sale of appreciated assets so that one could spread out the tax on appreciated assets over a number of years, rather than having the estate having to write a big check.

Legal Strategies is sponsored content produced by Johnson & Johnson Law Firm in Canfield.

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