Big Tax Changes Proposed but Not Likely
By Gil Baumgarten, Segment Wealth Management, LLC
With the changing of the guard at the White House now complete, the new administration has turned its attention to our tax code. President Biden has proposed significant tax rate changes, including an increase in the highest bracket from 37% to 39.6%. He has also made a bid to raise the tax rate on dividends and capital gains for earners with over $1 million in AGI. Biden wants the current preferential rate of 23.8% to ratchet up to the ordinary income tax bracket for the wealthiest investors, again, 39.6%. Additionally, he wants to eliminate the step-up in basis rule, which resets the cost basis of assets with each successive inheritance. This step-up rule has been the law for decades, and many investment professionals like me, manage low turnover strategies with this rule in mind. There was an attempt in 1976 to eliminate the step-up rule, but it was repealed before ever taking effect.
Another tax change in the pipeline comes from Senator Elizabeth Warren, who proposes a 2% wealth tax for those with more than $50 million in assets. Current wranglings over it reveal an uphill battle for passage.
The biggest knock on these proposals is the sheer logistics. Warren defends her proposal as reasonable since estates already value their assets for the final tax return. However, a lifetime of investing culminates in a single such calculation. Imagine the cost and nightmare of doing so every year. The IRS gives estates 270 days to compile such information, with that complexity in mind. Preparing for tax time would get exponentially more complicated, even more so if coupled with eliminating the step-up rule. This complication would be particularly painful in the first years of a change in the rule. How would you know what Dad’s cousin, Mike, paid for the assets he gave him 41 years ago? Stock valuation is simple, but not so with partnerships, minority interests, private stock with or without voting rights, undivided real estate interests, etc.
Furthermore, what happens if an individual owns only illiquid property like raw land with no cash flow or liquidity? Foreclosing on Grandpa for taxes because he is “cash broke” will bring about nasty responses. What a nightmare. We haven’t even touched on the constitutionality of this proposal.
Article 1, Section 9 of the US Constitution limits both “capitation” (a tax per person) and “direct taxation” not based on “census or enumeration.” Some believe this means that individual groups like “rich folks” cannot be picked on. The US Constitution also states that any power not granted to the Federal government by the Constitution is reserved for the states. Senator Warren is apparently already lining up scholars to testify that her tax is not “direct.” Good luck with that.
Rules like these incentivize creative accounting and fraud; It also disincentivizes risk-taking and the commensurate payoff that eventually feeds the estate tax system. All this “new” revenue is not “net.” Investors and innovators alike would have an incentive to quickly get to $50 million in assets, then switch to the bond market with low risks and minimal compensation. Political leaders will eventually have to reckon with a future like Ayn Rand discussed in Atlas Shrugged, where dissenters need to be shackled to their desks once they’ve realized that they own 100% of their spare time but only half of their work pay. Tax policy strategists like Arthur Laffer nearly universally agree that taxes beyond 1/3 of compensation tend to reduce the size of the pot more than they increase revenue to the state.
Like Newton’s laws of physics, equal and opposite reactions will rise to oppose the force of new taxes, for man hath no creative thought more important nor immediately lucrative than reducing his tax bill.
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Read more of Gil Baumgarten’s articles at Segmentwm.com/blog