In Part II of my analysis of Vice President Biden’s tax plan, I am examining his proposed changes to the estate tax portion of the Internal Revenue Code.* Unlike my previous article that dealt with income tax issues, this article details Biden’s proposals for estate tax changes. These are fairly dramatic compared to the last several decades of tax law, particularly with respect to ending the concept of stepped-up basis. At the end of this article, I will offer some options for families who want to plan around these changes in the event that these tax proposals become reality.**
One quick note: Vice President Biden’s plan does not advocate lowering the estate tax exemption amount or increasing the estate tax amount from the current rate of 40%. Those ideas have been previously introduced by the Democratic Party as legislative proposals, but they are not part of the current Biden tax plan. My anecdotal belief is that it may not be worth a political fight right now given that in 2026 the estate tax exemption reverts to $5 million from the current $11.58 million adjusted annually for inflation. Of course, that is not to say whether a future Biden administration would or would not consider a graduated increase in the estate tax amount or a decrease in the exemption amount, but it is not an explicit part of his platform as candidate for president.
What is a Step-up in Basis?
Currently, heirs are able to avoid or minimize their tax liability when they sell assets they have inherited from someone due to the step-up in basis rule (see Internal Revenue Code § 1014(a)). Under this rule, individuals can hold onto an asset and allow it to appreciate over their lifetime, then pass it onto their heir(s) at death.
The heir will then receive a step-up in basis, meaning the assets will be valued for future tax liability according to their worth at the time of death (or six months afterward if the executor elects the alternative valuation date). When the heir sells that asset, that individual will only pay tax on the appreciation of the asset since it was received from the estate. This prevents families from liquidating land, real property and businesses to cover the tax burden.
What is Biden’s Plan?
Biden’s plan calls for repealing this stepped-up basis rule and taxing the unrealized appreciation at death, subjecting the heir to taxes at transfer regardless of whether they sell the asset. Originally, the Obama administration unsuccessfully proposed doing away with the stepped-up basis method and instead taxing at death, which produces immediate revenue for the government if the estate meets a certain size. Taxing at death means that a tax is due immediately, so either it must be paid out of the estate, by the beneficiary (out of pocket), or by liquidating portions of the estate (property, businesses etc.).
While many opponents of the Biden plan would argue that is difficult to value assets/property at death, that seems like a flimsy premise given that larger estates already must receive valuations at death to ascertain what tax, if any, is owed. That said, there are a couple of significant challenges/problems with changing the basis rules that have existed for several decades.
First, it is important to acknowledge that determining the initial basis of assets purchased in a decedent’s lifetime is extremely difficult to do. Under our current system, it’s relatively easy for the IRS to determine what the value of an estate is at death. For example, a jewelry appraiser can provide a relatively reliable market value estimate for grandma’s jewelry based on the sales of similar items. Conversely, it is much more difficult to establish an initial basis by ascertaining the purchase prices of assets made over many decades.
So what happens if you cannot prove the basis of an item you received? Technically, the IRS can require you to count the entirety of the sale as a gain and tax all of it – though the IRS may be willing to work with families toward creating a reasonable purchase value if they can recreate the basics of the amount for which the item was purchased.
That creates an obvious enforcement challenge, which will require the IRS to become much more involved – from both an oversight and litigation perspective. Valuing assets in large and medium sized estates will likely be a cumbersome regulatory burden for the government to parse through and enforce.
To ease the enforcement issue a bit, no clawback provision exists in the current tax plan that is set to sunset in 2025. In fact, the IRS confirmed it will not attempt to clawback any gains gifted to a trust under the current tax plan.
Some Additional Considerations (trigger warning: an opinion or two)
On one hand, the current tax structure is the most accommodative toward wealthy families that it has been in modern history. Moreover, US debt is set to exceed the size of our economy (as measured by Gross Domestic Product) for the first time since 1946; revenue must be generated and spending cut to offset the effects of deficit spending for many decades and exacerbated by COVID-19.
On the other hand, the estate tax is a third, or even fourth, layer of tax on a given dollar of income, after individual income taxes, corporate income taxes, and the other types of taxes paid over a person’s lifetime (capital gains, sales tax, property tax etc.). Taxing assets at death arguably further punishes those who save diligently throughout their lives and discourages saving by future generations for their families.
The Bottom Line:
Because the estate tax threshold is so high, few Americans (less than .01% of those who will die this year) have to worry about paying it. In other words, taxing the wealthy is a hot button political talking point that has little practical consequence for the vast majority of Americans. That said, the estate tax rate is set to drop by 2026 to a minimum of $5 million (and potentially much lower in the interim depending on Congress), so this issue could easily affect closer to 10% of the country as it used to 20 years ago.
That leaves American families who have accumulated wealth in their lifetime with a few viable options, some of which I will highlight briefly as I conclude this article:
· From a planning perspective, taxpayers facing higher estate tax bills at death might consider selling most of their assets to a grantor trust in exchange for a promissory note, so that appreciation takes place outside the estate and they can retain an income stream of cash payments for life.
· Alternatively, an irrevocable trust for estates larger than $10 million created prior to the estate tax sunset at the end of 2025 makes sense to avoid challenging estate tax basis situations.
· Another option would be to create a charitable trust to donate assets that have potentially serious additional tax consequences (like a traditional IRA or 401k) at death, thereby avoiding including those assets in a person’s estate and paying taxes on the unrealized gains within them that is now required thanks to the SECURE Act.
* As with my first article, the sources I relied on during my research based their analysis on Biden’s campaign rhetoric, and then further refined those assumptions based on feedback they received from the Biden Campaign on their initial analysis. To ascertain the entirety of Biden’s proposals, I only used bi-partisan or non-partisan sources to prevent bias; my sincere intent is to offer an apolitical analysis of Biden’s proposed changes to the code offering the reader both sides of the issue.
** Nothing in this article should be construed as tax or legal advice. They are purely intended for illustrative purposes to place the current laws and proposed changes into layman’s terms to foster a better understanding of these issues.