President Obama has proposed a couple of tax changes that will hurt upper income taxpayers and most beneficiaries of estates with unrealized capital gains.

Sherry Radmore, CPA

First, the more widely applicable tax proposal is another increase to the tax rate on capital gains. Currently the top tax rate on high income individuals is 20% plus a net investment income tax of 3.8%. As income increases some of the benefit of itemized deductions is also lost. When you add this reduction the true top rate for capitals gains is currently about 25%. The proposed tax that President Obama has recommended increases this rate to 28%.

The more surprising proposal will affect anyone who inherits appreciated assets.   This proposal will remove a long standing tax benefit known as a “step-up basis” at date of death. The way it works is that when someone dies, the assets passed on to their beneficiaries receive a “step-up basis”, meaning whatever the asset’s fair market value is on the date of death is what the person inheriting the asset treats as their tax cost for capital gain purposes when the asset is sold and there the tax is deferred until the asset is sold. For example, you own stock in a Fortune 500 Company. You bought the stock 35 years ago when it was $10 per share and own 10,000 shares. Your cost basis for tax purposes is $100,000. The stock has done well and is now worth $100 per share for a total market value of $1,000,000. If you were to sell the stock today you would have to pay tax on the gain of $900,000. At the current tax rate you could pay as much as $214,000 in federal tax. But if you pass away today and your family inherits the stock, they take on a “stepped-up basis” of $1,000,000 and if they were to sell the stock the next day there would be no gain and they would pay no tax.   If they decide to hold onto the stock they only pay tax on the additional appreciation in excess of the $1,000,000 when the stock is sold. If instead of getting the stock at your death you decide to gift it to your children under current tax law they do not get the step-up in basis but they don’t pay the tax until some point in the future when the stock is sold.

Under the new proposal, bequests and gifts would both be treated as immediate taxable events for capital gains purposes. So when you die and your family inherits that stock worth $1,000,000 they will immediately have to pay the $214,000 of tax that is currently avoided under the step-up rules of today. And if you gift the stock it will incur a tax liability now, not in the future when the stock is sold.

There are some exemptions under the proposal. Capital gains property of up to $200,000 per couple could still be inherited free of tax and personal residences would get an additional $500,000 exemption. Family owned businesses wouldn’t have to pay any capital gains until the business was sold and might have up to 15 years to pay the tax. To take it one step further, any capital gains tax caused by inherited property would be deductible from any estate tax liability. But since that liability is only on estates larger than $5.43 million dollars it will be of limited benefit to most individuals.

Only time will tell if these two proposals have any traction.

For more information call Sherry Radmore at LSL CPAs & Business Advisors at 714.569.1000.


LSL Staff

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