While the first draft of the reconciliation legislation didn’t include Biden’s proposal to eliminate the tax-free basis step-up, which included a $1 million per-person exclusion (in addition to the current capital gain exclusion for a principal residence) and exceptions for family-owned business such as farms, many voices have echoed this sentiment from The Wall Street Journal's September 17 story, "Democrats Seek Backup Plan on Taxing Capital Gains": “I don’t think that the Ways and Means proposal is the end of the story for taxing gains at death or eliminating step up.” This logic stems from the last major reconciliation legislation, which was enacted in 2017.
The Senate version of the Tax Cuts and Jobs Act included many large changes absent from the House bill, for example: (1) reducing individual tax rates, including a shift in the maximum rate from 39.6 percent to 37 percent; (2) the 20 percent passthrough deduction under section 199A, and (3) reducing the individual mandate penalty to $0 to dismantle Obamacare. The legislative process is indeed slow and last-minute changes are common.
Given the growing popularity of fixing tax law inequalities that exacerbate the wealth gap and considering how the TCJA played out it, it is far from clear, just yet, that Congress is passing up a chance to close a tax loophole. It would be quite surprising if President Biden’s proposal were in fact dead, but rather it could very well step up out of the tax legislation grave and carryover into the Senate proposal.
In this installment of Willis Weighs In, Benjamin M. Willis of Tax Notes and Jed Bodger of Sierra Nevada Corp. make predictions for tax legislation, focusing on taxing income through realization at death and the elimination of section 1014’s basis step-up.
Below are a few highlights from their discussion, edited for length and clarity.
Benjamin M. Willis: What are your thoughts on the odds of tax provisions getting inserted into law this year?
Jed Bodger: Like a true tax attorney, I'm going to tell you, “It depends.” I think there is a very good likelihood that tax legislation passes in 2021. I think the real question becomes how much of the Biden administration agenda is included.
Realization at death has become a very hot button issue of late. I think it will be very tight considering the margins the Democrats currently hold in the House and Senate. Also, considering how close we're getting to the 2022 election cycle and how contentious I believe that election cycle will be, people may be risk adverse.
What do you think?
Benjamin M. Willis: I think that we're going to have some major tax legislation enacted through reconciliation this year. It's clear that there's a lot of lobbying going on.
We're focused on section 1014 of the code and whether or not we're going to have the elimination of a tax-free basis step up at death. This is one of the most frequently cited provisions for expanding the wealth gap. It is also one of the ways that the Biden administration has proposed to fix some of the inequalities in our code.
Do you think eliminating the tax-free basis step up at death and causing a realization event would create more equity in the code?
Jed Bodger: I do. And the reason for that is because the utilization of what's commonly referred to as the lock-in effect has allowed for generational wealth to transfer many times over without the application of tax to built-in gain. The lock-in effect is effectively the ability of individuals holding assets that have substantial built-in gain to transfer via some sort of testamentary transfer at death to achieve a step up in basis and elimination of that built-in gain tax free. This eviscerates dollars from the U.S. tax net every year.
If you had to choose between fairness and revenue raising in designing this legislation, which is more important to you?
Benjamin M. Willis: Given this is a reconciliation bill, like the TCJA, that has more revenue constraints than traditional bipartisan legislation, revenue is clearly important. At the same time, I think that there's a huge focus on creating a fairer tax code by eliminating inequities. I would argue you're accomplishing both goals through the elimination of the tax-free basis step up.
Do you think family farms should prevent these goals from being realized?
Jed Bodger: I think when we talk about tax legislation, we are inherently talking about the common good. The intention of tax is to provide revenue for the U.S. fisc. to run and operate at the most consistent and well-funded basis available.
To the point of revenue raising that you just made, estimates are around $40 billion a year that this elimination of the basis step-up would raise. When you keep that in perspective, and you look at the family farm consideration, I think the good outweighs the bad. Absolutely. But there are mitigation options that Congress can use to address illiquid businesses and address this concern.
Benjamin M. Willis: I'm curious as to your thoughts on realization at death and the burden being placed on the decedent. Do you think that is fundamentally fair and consistent with the tax principles?
Jed Bodger: I do for a number of reasons. Primarily because the decedent is the individual that held the asset. The decedent is the individual that experienced the appreciation in value, the accession to wealth, if you will.
If you were to think about it in reverse and say, "How would you move the realization event onto the beneficiary?" that is where I've got a little bit of a conceptual issue and a problem with things like a carryover basis.
If you trigger gain at death, the decedent or the estate will pay the tax on the asset, which would fully basis the asset up to the fair market value. The beneficiary would receive effectively the exact same thing that they receive now, except you would not have eliminated this significant amount of built-in gain in the tax system.
Is that how you think about this as well?
Benjamin M. Willis: I like the way you described it. It's almost a continuation of the ownership of property, or you're thinking about it as it transitions.
You've got the decedent on one hand and the beneficiary on the other. When the decedent passes a carryover basis over to the beneficiary it would cause that burden related to the built-in gain to shift over to the beneficiary.
I can't help but think that's likely where this came up in our code. Who do we place the burden of this gain on? Isn’t this the last clear chance to tax the owner before the gain leaves the tax net?
I think the decedent is indeed the last clear chance to tax that asset when the legal entitlements change as it shifts and transfers from one owner to another. I'm with you on that.
Jed Bodger: I think the other piece to that is it eliminates the contribution to the wealth gap that this provision continues to exacerbate. I think there's a very clear correlation between the wealth gap in America and the ability to transfer assets with built-in gain without realization of that gain.
If you think about it, anybody that's taking inherited assets has effectively received built in gain tax-free. Whereas their counterpart is starting from a diminished perspective because every dollar that they earn is going to be subject to tax, via the income tax system, because the wage earner was unable to benefit from the giveaway that allows large gains to escape taxation.
Benjamin M. Willis: Do you think that this lock-in effect creates a true economic friction? Does it impact their decision as to whether or not they should freely sell assets or hold on to them?
Jed Bodger: Yes, I absolutely believe in it. I believe it is real. I believe that to the extent you have people that are near death that are starting to engage in significant estate planning tactics, the clearest way to minimize your effective tax rate (ETR) within your total estate value, to the extent that you're under the taxability threshold, then holding assets until death is the absolute easiest way to eliminate tax. You've effectively created negative ETR because you've got built in gain that escapes taxation while the asset is given a full step up in basis.
Benjamin M. Willis: Let's try to give some practical advice to Congress. Lofty goal, I know.
If they try to eliminate economic frictions and create an economy where assets move more freely, without their direction being dictated by the current lock-in effect, how could Congress address some of the concerns that folks are raising right now relating to farms and illiquid businesses?
I'll expand on farms and say there's other equitable areas that Congress is probably keeping their eye on, including mission-based organizations, community reinvestment companies, startups, and other illiquid businesses. All could have the same ability to pay issue. The “I might have to sell the family farm in order to cough up money for this bill” concern could apply to many illiquid taxpayers who exceed the million plus dollar exemption.
Are there thoughts that you have as to how Congress can remedy some of these issues?
Jed Bodger: Absolutely. You're right, it's not just family farms. It's going to be small businesses, S corps, things that are potentially high value businesses but not necessarily significant cash driven businesses, meaning they wouldn't necessarily have the cash on hand to pay the tax on the appreciated gain.
There are two that come to mind immediately for me that if I was in Congress, I would be arguing for, in order to rebut the claims of the disparate effect on family farms and small businesses.
One would be one to build in an election mechanism. Should you have an asset that is going to trigger a significant amount of gain at death, the beneficiaries or the estate would have the ability to make an election to not trigger the tax immediately, but to transfer the asset with a carryover basis. Transfer the basis to the beneficiaries and allow them to pick up that built-in gain tax burden when they trigger a sale or some other realization event on the assets. That's one.
I think the other way to do it is to recognize that you've got a cash payment obligation due to the realization, and at that point you can put in a deferral mechanism so that you have five years, eight years, whatever, to put yourself on a payment plan.
These could have a value limitation of say $10 million or $50 million. Anything under that amount should have the opportunity to either elect into a carryover basis regime or potentially elect into a tax deferral mechanism that allows them to stretch the payments over a number of years. Those are the ones that come to my head.
Would those convince you if you were on the other side of the aisle from me?
Benjamin M. Willis: I think that would certainly help. I'm going to add one to your list too.
I really liked the idea of the election that you're talking about. I think that makes a lot of sense. If the decedent is willing to take that burden on, I can see a valid argument for saying, "OK, in these instances, if there's a liquidity concern, if you're a business under certain size, we can see transferring a carryover basis." That provides some equity too.
What I would do for a third option would be to shift the burden to the IRS. This isn't unprecedented. I think a private letter ruling or more general guidance that the IRS could issue, whether it be through regulations, notices, or procedures consistent with congressional intent for the IRS to approve in some instances, through confirmation that this gain will be picked up, there could be built in for those limited exceptions.
Jed Bodger: I guess to close this out today, my question to you would be how confident are you that any of this passes? Are you willing to make a 20-pushup bet with me right now as to whether or not this goes forward?
Benjamin M. Willis: On realization at death, 20 pushups in, I'm betting that's happening. So, if it doesn't get passed, you'll see me doing them. How about you?
Jed Bodger: I agree. In order to take the other side of the bet to make it a fair bet if it doesn't go through, I'll do my 20 as well.
But I absolutely hope you're right. I think you are spot on with the analysis and the rationale for this. I think it makes good tax policy sense. I think it makes good revenue generation sense. I think it helps to make the fairness aspects and the intention of the Biden administration to bring some fairness and equity back to the tax code.