The Biden administration’s tax proposal to treat certain transfers as income tax realization events would create significant administrative issues for individual taxpayers and their financial advisors.
If enacted, taxpayers will need to track — and prove — their tax basis in assets they gift during their lives or transfer at death and clients will expect their financial advisors to have this information at the ready for them.
Under current law, neither a gift during life nor a transfer at death is subject to federal income tax (although either transfer may be subject to federal gift, estate and generation-skipping transfer tax). Under the new tax proposal, gain — equal to the excess of the fair market value of the asset over the donor’s basis on the date of gift or death — would be considered taxable income to the donor or decedent and would be reported on a gift or estate tax return or on a separate capital gain return.
When you combine such a realization event with the Green Book proposal to increase the capital gains tax rate for individual taxpayers with adjusted gross income over $1 million to 43.4% (39.6% + 3.8%), the impact to individual taxpayers is significant, especially if the taxpayer is not already tracking basis in transferred assets. In some cases, if a taxpayer is unable to prove a positive basis in assets, the basis may be presumed to be zero. As a financial advisor, it will be critical for you to discuss this with your clients.
Case study No. 1
Susan and Beth, both age 48, own a grocery store chain in State A, which has a 7% income tax rate. They are 50-50 partners and have built the business up to a current value of $20 million. But they don’t know their tax basis. Beth suddenly dies. If the Biden tax proposal is enacted, Beth’s estate may owe federal income tax on the transfer of her interest in the business, worth $10 million. If her basis is assumed to be zero, and all her capital gain that year is taxable at the higher ordinary income rates proposed, Beth’s estate may have an income tax liability as high as $5,040,000 resulting from her death ($10M × (43.4% + 7%)), ignoring lower bracket amounts and any proposed exclusions or deferrals. Assuming Beth’s estate still has her full estate tax exemption amount available, no estate tax would be due. However, Beth’s estate would have to seek the liquidity necessary to fund the $5,040,000 to pay federal and state income taxes.
Case study No. 2
Mark, who resides in Texas, which has no state income tax, inherited ABC stock from his uncle in 1996. Mark is unaware of his basis in the stock. He decides to gift it to his children in 2022. The ABC stock is now worth $10 million. If Mark has not tracked his basis and assumes it is zero, his federal income tax on the gift may be as high as $4,340,000 ($10M × 43.4%), ignoring lower bracket amounts and any proposed exclusions or deferrals. He will also owe a potential 40% gift tax for another $4 million (assuming he used his lifetime exemption already), totaling a potential of $8,340,000 of tax on his $10 million gift.
In both case studies, not knowing the respective basis in assets for each taxpayer creates a significant tax issue. In addition to potential tax exposure at the time of a gift or death, there are many other reasons to track basis in assets, including the possibility of utilizing losses or taking tax-free cash distributions against the basis when the asset is an interest in a pass-through entity.
Now is the time to counsel your clients on tracking basis — especially if a realization event is likely — while records are still available or can be readily recreated.
