Step Right Up: A Primer in Sidestepping Taxes

Photo by Pixabay from Pexels

By Mark Mamerow

Them that’s got shall get

Them that’s not shall lose

So the Bible said and it still is news

“God Bless the Child”, Billie Holiday and Arthur Herzog Jr.

The muckraking site ProPublica recently published an expose on the ridiculously low levels of income taxes paid by the superrich. Using data apparently leaked from the IRS, the article asserts that the wealth of Mike Bloomberg, Warren Buffet, Jeff Bezos and their ultra-wealthy peers increased dramatically between 2006 and 2018, while the income taxes they paid over that time frame were absurdly modest. ProPublic’s methodology was to calculate a “true tax rate” as the total of income taxes paid, divided by these billionaires’ increase in wealth.  For example, Warren Buffet’s wealth–the value of all his assets–increased $24.3 billion between 2014 and 2018, while he paid $23.7 million in income taxes. That works out to ProPublica’s “true” tax rate of .1%–that’s one-tenth of 1%.  Nice work if you can get it!

There’s only one problem with the ProPublica analysis. The US government does not tax wealth. It taxes income. So, it’s not exactly front page news that some ultrarich taxpayers, with access to a standing army of tax attorneys and financial planners, were able to manipulate their income downward to avoid paying taxes. President Donald Trump, in his days as a real estate investor, used writedowns to avoid paying income taxes for 18 years, starting in the 1990s. According to former NYC mayor and all-around Trump lickspittle Rudy Guiliani, “It shows what a genius he is.” By that measure, the upper level  of the US economy is full of geniuses.

An increase in any asset’s value is known as a “capital gain”. Under US tax code, unless and until the asset is sold, this build-up in wealth is an unrealized capital gain, and it is not subject to income tax. Any homeowner is familiar with the concept. As the value of your home increases, you do not pay taxes directly on that increase in value (though it’s true that your property taxes may get bumped a little). A hot real estate market doesn’t force you to come up with cash to pay income tax on that unrealized capital gain–because the gain in value it is NOT considered income. Once you sell the home, you may need to pay taxes on the gain. And these gains get special treatment, most notably a tax rate lower than the income tax rate.  

This special treatment of capital gains infuriates many progressives. Why, they ask, should wages–earned by the sweat of a worker’s brow–be taxed at a higher rate than a rich person’s earnings from an investment? The government has many pressing social and infrastructure needs, and progressives see these untouched, untaxed capital gains as a potential source of revenue. 

So, should we force the owners of assets to pay up now for increases in the values of their assets? Despite the attractiveness of taxing unrealized capital gains when we think about Jeff Bezos (soon to be astronaut), Warren Buffet (soon to be a deceased rich investor), and Elon Musk (already an obnoxious doofus), there is zero chance that this could be applied to the middle class. The screaming of home and business owners would be enough to take rust off the Titanic, kind of like Fran Drescher’s voice.  

And it turns out that, for the wealthy, there’s yet another special treat in the tax code. Wealthy individuals can bequeath their assets–stock, bonds, a business, real estate, a farm–to their heirs, and the asset goes to the beneficiary on a “step up basis”.  The heir gets to record the asset at its current market value, without regard to how much it may have appreciated in value already. This means that the build-up in value–the unrealized capital gain of the asset–is NEVER taxed.   

For example: an individual purchases a block of stock for $500,000. For tax purposes, that $500k is considered the cost, or “basis” of the property. Over time, a rising stock market drive the value of that stock to $750k. The $250,000 difference between the market value ($750k) minus the cost basis ($500k) reflects the increase in the asset’s value. This is an unrealized capital gain.

The original purchaser dies and wills the stock to his adult child. That child beneficiary is now allowed to set the basis of the property at its current market value, $750k. For tax purposes, the $250k increase in market value–the capital gain–is never recognized or taxed by the government. This entire tax maneuver is known as the “step up basis”.  

The “step up basis” has been settled tax law for decades. But the Biden Administration, looking for funding for its ambitious American Families Act, proposes to eliminate, or at least greatly minimize, the use of the step up basis maneuver. Under the Biden proposal, the unrealized capital gain WILL be taxed upon the death of the asset’s owner.  Effectively, this means that the inheritor of an asset (stock, real estate, business) will need to come up with cash — potentially, a substantial amount of cash–in order to pay the tax bill on the capital gain.

This tax proposal has sent shudders through the estate planning industry. Financial planners are scrambling to come up with ways to avoid the tax hit. Note that, in addition to  eliminating the step up basis, Biden also proposes to increase the capital gains rate significantly–from 23.8% to 43.4%.  

There’s no question that this has the potential to change behavior.  The heirs of a large stock grant have the option to sell some of those shares, in order to pay the taxes on the capital gain.  That really doesn’t bother anybody.  But consider the case of a family farm, or a small business. (As you consider, remember that the addition of the adjectives “family” and “small” have the rhetorical effect of removing these profit-making enterprises from the unsavory, grubby realm of grasping, avaricious business,  into a kind of holy, righteous state of high integrity and unquestioned morality.)  The beneficiaries who inherit a small business or a family farm may be unable to come up with the cash for the tax bill.  In this case, they’ll be forced to liquidate the entire enterprise. Recognizing the potential impact on small business and farms, the Biden plan does offer significant exemptions to the elimination of step up basis for smaller business and properties.  The first million in unrealized capital gain will NOT be taxed upon inheritance.

Elimination of the step up basis may be doable, but politically, it’s tricky.  Taxes involving inheritances have been relentlessly and successfully and relentlessly demagogued by Republican politicians since the heyday of Newt Gingrich.   Republicans have already convinced millions of Americans that they are one congressional vote away from the horrible Democratic “death tax” (which is the brilliant conservative rebranding of the inheritance tax).  But the truth is that estates must exceed $11.7 million before any inheritance tax is payable.   I can guarantee that 99.9% of the readers of this opinion piece will never have to worry about the estate tax.  But in the world of Fox News and AM conservative talk radio, the “death tax” is a clear and present danger to all real Americans.

Thus it will be with the elimination of the step up basis.  Imagine the TV commercials that will be run against it. Hordes of hardworking, gritty farmers, dressed in Carhartt overalls, hands calloused and necks burned red from working the land, will testify how the radical, socialist new tax on the built up gain in the family farm will drive them from the land, destroy their family traditions,  and put them directly into the poorhouse.

The real truth is that the taxpayers affected by this change are, and will continue to be, extremely comfortable. After the free candy handed out in the 2017 Trump tax cut, most knowledgeable high end taxpayers acknowledge that they’re soon to feel some level of pain.  Helena Jonassen, a wealth manager, is quoted in the Wall Street Journal stating that “there’s a lot of nervousness that’s being generated by all the proposals.”  Yet she concedes,  “Our clients are resigned to the fact that taxes will go up.”   Meanwhile, tax attorneys and financial planners will make a small fortune revising estate plans, dreaming up ever more clever and sophisticated new strategies.  

The fate of the Biden proposal is uncertain. It’s queued up behind a number of other administration priorities, including the infrastructure bill, and it’s subject to the Mitch McConnell filibuster and the perfidy of moderate Senate Democrats like Joe Manchin and Kirsten Sinema. The ProPublica piece on the “true tax rate” misses the mark, but perhaps it will help build pressure to reform and rebuild some of the US tax provisions that favor “them that’s got”.