Updated: Jul 21
Dear Clients and Friends,
Without a doubt, the hottest question over the last two weeks has been: what’s the deal with President Biden’s proposed capital gains tax law? Though there have been other tax-related initiatives from the White House, this one seems to be generating the most concern. So, today we are going to explain and simplify what this proposal entails, and who it will affect. In addition, we will explore a few other details within this proposed legislation, such as an income tax hike on higher-income earners, and the “basis step-up” which has also generated quite a few questions.
Before we get into the weeds, I need to go off on a short Ramer-style rant. The news media has gone completely off the deep end with this subject. I recently saw an article claiming that this capital gains tax adjustment could affect up to 75% of Americans, which is completely preposterous. At most, it would affect 25% of Americans, and if you focus only on the effects while someone is alive, it may be as low as 0.35% of Americans. So, if you have seen an article about the changes to the capital gains law, and terror began to set in, take a deep breath, sit back, and enjoy this article. Yes, there are some concerns, but the concerns are manageable, and not really all that terrible for the vast majority of those affected, if you consider the law in context.
The four most notable parts of this legislation are:
An increase in the long-term capital gains tax rate to match the short-term capital gains rate for taxpayers earning more than $1,000,000 per year.
The removal of the “cost basis step-up.” This affects your heirs, not yourself.
Decreasing the estate tax threshold (the amount of money that can be passed from a decedent’s estate to their beneficiaries without being subject to estate tax) from $23.4 million to $3.5 million.
An increase in taxes for income earners above $400,000. Or, as President Biden put it: “No one making less than $400,000 will see an increase in their income taxes.”
Let’s start with #1 – an increase in the capital gains tax bracket
Because this increase in the long-term capital gains rate would only affect those making more than $1,000,000 in earned income per year, the increase would go from roughly 20% to roughly 40%, because, at that level of income, your marginal tax bracket is 40%.
To put this in perspective: according to Bloomberg research, to be in the top 1% of income earners in the US at the beginning of 2020, you had to make $515,371 - about half of what you would need to make to be affected by the increase in the capital gains tax rate. According to research conducted by CompliQ, only the top 0.3% of income earners make more than $1 million per year. So, for the most part, most Americans will not be affected - not even close. In fact, very few of our clients are affected, because the highest net-worth clients are mostly retired and, therefore, have very little earned income. This includes clients who are well into 8 figures of net worth.
BUT, it does affect some of our clients, so let’s discuss the cross-section of Americans who should be concerned. First, though not a majority, we do have plenty of clients who earn more than one million dollars per year. That’s pretty straightforward. But the bigger issue is small business owners who plan to sell their business during their working years. Let’s talk about those people.
Many small business owners consistently reinvest in their business; therefore, the growth in their net worth comes from the growth in the value of their business. Many of these people choose not to recognize earned income specifically to delay its taxability. We use strategies like deferred compensation and retained earnings specifically to delay the taxability of taxable income. The ultimate goal of the client is to sell their business towards the end of their career thereby pulling out significant wealth. If that were to happen, much of that legacy growth would be considered to be capital gains and, therefore, would potentially be subject to this increase in capital gains tax. Basically, it would reduce the ultimate payout by 25% - from roughly 80% (after the current 20% capital gains liability) to 60%! This can be mitigated by closing the business sale immediately after the new year so that the final “real” year of earned income is the year prior. This would expose the capital gains during their first year of retirement, when their income level is low.
The potential caveat to this mitigation technique would arise if the new higher capital gains rate were triggered by either earned income or capital gains recognized. For instance, if a person with low earned income were to recognize more than $1 million in capital gains, would that also trigger the higher cap gains rate? If so, simple techniques like this would not help much. But that is not something anyone can predict at this point.
Now, let’s move on to #2 - a step-up of cost basis upon one’s death:
As of now, a beneficiary who inherits an appreciated asset has the benefit of resetting the cost basis to the date of death of a decedent. What does that mean? Consider a parent who purchased Amazon stock 30 years ago and it’s up 14 bazillion percent. If a child were to inherit and sell the stock, they would only owe tax on the growth of that stock from the date they inherited it. If they sold it shortly after inheriting it, the capital gains tax would likely be de minimis. Under the newly proposed law, the original cost basis would apply. For the average investor, there is a valid argument as to why the current law makes no sense. For example: on Monday, Mom owned a highly appreciated stock with lots of capital gains exposure. If she passed away, the child would have no tax liability the next day. Many people say this is just another thing that increases the wealth gap and promotes dynasty-type wealth.
On the other hand, if a family is exposed to a federal estate tax, then a beneficiary may have to sell a highly appreciated asset to pay the estate tax. Therefore, the beneficiary may potentially lose 75% of the value of the inherited asset. Let me explain. Consider an asset that has massive gains over several decades. In fact, we’ll pretend that the asset is up 100% and the entire asset is subject to capital gains. Under the current law, if the parents’ net worth was above the estate tax limit, then the estate would owe 40% in estate taxes and the child would be left with 60%. But imagine if they had to pay a 20% capital gains tax on a highly appreciated asset in order to come up with the estate tax bill. Thus, the child would be down to 80% because of the 20% capital gains bill, which would be followed by estate taxes of 40% on the original asset value, leaving only 40%. Now, let’s go another step… Imagine if the child had to pay a 40% capital gains tax with this new legislation. That would leave 60% after the capital gains tax bill, then another 40% on the original asset value in estate taxes, leaving only 20% left!! Anyone know what the letters “WTF” stand for?
It is important to note that a married couple would need to have a net worth in excess of $23.4 million in order to be exposed to the federal estate tax. (husband and wife, wife and wife, husband and husband… married is married) Even then, the tax only applies to money over that amount. So, a couple worth $30 million would have a 40% estate tax bill on $6.6 million. Of course, it’s hard to use the term “only” when referring to $6,000,000. However, our clientele does not represent mainstream America. Thus, in my humble opinion, it’s important for all of us to at least consider what $23 million looks like to the median American household, which earns $69,000 per year (according to the census bureau).
This problem is exacerbated if we consider children inheriting a family business. A business can’t just be sold at a moment’s notice. Thus, consider a situation where the majority of one’s net worth is wrapped up in their business, and this highly appreciated business is the only thing that can be sold to satisfy the estate tax applied to their parents’ estate. This would not just be a problem; it would devastate the family business completely (assuming the business is worth more than $23 million). But what if this business is worth $100 million, and employs 1,000 workers? Then the family business is destroyed, and 1,000 people lose their jobs. Of course, we use significant estate planning strategies to protect families and their employees from this type of circumstance. But reducing the estate and gift tax threshold by 80% infinitely complicates this process.
Wait, I’m not even done!
#3 – Reducing the estate tax threshold (the amount of money that can be passed from a decedent’s estate to their beneficiaries without being subject to estate tax) from $23.4 million to $3.5 million.
We discussed above what the estate tax threshold is, and how it works. Consider the family business example we just illustrated; however, imagine that the limit was $3.5 million instead of $23+ million. Game over.
Interesting thing to note for people who may do some of their own research: according to Business Insider, the average net worth of an American household is roughly $750,000. But the median US household net worth is only $121,700. I mention this because if you do a Google search, the “average” is much more prominent in the search results than the median. However, the average is skewed dramatically by ultra-high net worth families. Everyone knows what an average is. The median, on the other hand, is a number where 50% of the subjects analyzed are above and 50% of the subjects are below. An analogy: 10 vehicles travel across the country at 65 miles per hour while 1 vehicle (the SR22 Blackbird spy plane) travels at 4,000 mph. To say that the average vehicle maintained a speed of 422 mph is accurate, but misleading.
#4 - An increase in taxes for income earners above $400,000.
This one we are going to save for another day due to its extreme ambiguity. President Biden has said over 100 times that “No one making less than $400,000 will see an increase in their income taxes.” In my dictionary (yes, I still have one on my shelf, mostly because it looks cool) the definition of ‘no one’ is ‘no person.’ However, in a recent interview, Jen Psaki said something different. A reporter asked for a definition of “anybody”: “To clarify, did he mean individuals or households? Because it wasn’t very clear.”
“Families,” Psaki replied.
Now, just hold on a minute. Pledging to not raise taxes on a person making over $400k or a family making over $400k are two very different things. To be honest, I always assumed that it was “household income” that was meant. However, ambiguity still abounds, and we will hold off on discussing this until more details are clear.
I have good news, folks: none of this is going to pass. Most open-minded authorities believe that this is a low-ball starting point. President Biden wants a long-term capital gains rate increase of 20% for income earners above $1 million; maybe he gets a 10% increase for income earners above $10 million for assets held more than one year but less than 5 years - sort of a mid-term cap gains rate, but only for taxpayers with extraordinarily high income.
He wants a decrease in the estate tax threshold from $23.4 million to $3.5 million; maybe it changes to $10 million or $15 million. That would still sting in my world, but it would be better than $3.5 million.
But the most important thing to understand for today is this:
Neither the increase in the capital gains rate, nor the step-up in basis, affects the average American, nor does it affect most of our clients. Period.
The small percentage of Americans who this would affect may be destroyed by these changes.
There is no sense in reading the mainstream media discussion of this legislation because a) it’s misleading, and b) we don’t really know where this conversation will lead over the next few weeks/months.
Rest assured that as this legislation evolves, we will keep everyone posted with accurate details, including what you need to worry about and what you don’t.
The one thing we can expect with a high degree of certainty is that every single one of our clients will likely need to revise their estate plan sometime within the next year or two (oh boy, I can’t wait for that!).
In the meantime, the weather is improving, and the world is starting to open. Go get vaccinated and let’s get this world back to normal.
With love, your family here at MORWM
Matthew Ramer, AIF®
Principal, Financial Advisor
MOR Wealth Management, LLC
1801 Market Street, Suite 2435
Philadelphia, PA 19103
P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 |
601 21st Street, Suite 300
Vero Beach, FL 32960
email@example.com | www.morwm.com
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