As part of his 2023 budget package introduced in late September of last year, President Biden rolled out a new tax proposal to raise taxes on ultra-high-net-worth households of over $100 million. The proposal included a provision that would tax unrealized capital gains from assets such as stocks, bonds, real estate, and privately owned businesses. The unprecedented provision is highly controversial, to say the least, and would set the U.S. apart as the only country to tax the increase of asset values while investors are still holding the assets.
The so-called “Billionaire Tax” “provision is the result of an ongoing effort by Democrat politicians to ensure that the wealthiest Americans “pay their fair share of income taxes.” To accomplish this, where other measures have failed, a report from the Office for Management and Budget (OMB) redefines taxable income as “the increase in wealth from one year to the next.” Proponents insist that it only targets billionaires, but it includes households with assets of $100 million or more.
Currently, taxpayers owe taxes on the appreciated value of assets when they are sold. Realized gains on assets held for less than a year are taxed at ordinary income tax rates. Gains on assets held for one year or longer are taxed at the capital gains tax rate, which maxes out at 23.8%. Assets that pass through an inheritance receive a step-up in tax bases. The estate tax exclusion for individuals is $12,060,000 in 2022.
The new proposal sets a minimum tax rate of 20% that households with incomes over $100 million would be required to pay on an expanded range of taxable income that could include unrealized capital gains. After calculating their effective tax rate for the minimum tax, if it falls below the 20% minimum, those households would owe additional taxes on unrealized capital gains to bring it up to the minimum. That extra tax paid would be considered a “prepayment” of future capital gains tax liabilities.
For example, a household worth $200 million with $5 million in ordinary income and $10 million in unrealized capital gains from their privately owned business would have an ordinary tax liability of $1.8 million (based on 2022 federal tax tables). If the unrealized capital gains are included as income, the effective tax rate is 12%, which is below the minimum 20% tax rate.
To meet the minimum 20% tax requirement, the household would have to pay an additional $1.2 million in taxes, bringing the total to $3 million, which is required for $15 million of total income that includes unrealized capital gains.
The household could pay the extra tax in equal installments over nine years. The additional tax can be paid over five years for future unrealized capital gains. The additional taxes paid would be credited towards future capital gains tax liability when the asset is eventually sold.
Stock investors would be in a very precarious position if they were required to pay additional taxes due to significant unrealized gains on their portfolios. After paying the tax, what if a stock market crash sent their portfolio value into the negative? No reassessment would generate a tax refund.
Sound complex? It is, and the burden would fall on taxpayers to value non-tradable assets and determine how they would come up with the cash to pay taxes on unrealized gains of illiquid assets. And, what about the IRS, which is already overburdened?
The impetus behind the proposed tax changes is the perception that the wealthy don’t pay their “fair share” in taxes. Citing such examples as Warren Buffet, who supposedly pays taxes at a lower rate than his secretary, proponents point out that much of the income wealthy people generate is from dividends and capital gains from stock sales. As a result, they are taxed at a “preferred” rate of 20% (23.8% including the net investment income tax), which is substantially lower than the maximum ordinary income tax rate of 37% (40.8%).
There is a reason why capital gains are taxed at preferred rates—it incentivizes capital investment and entrepreneurship. Without this incentive, it would significantly dampen job creation and economic growth. A higher tax rate on capital gains would discourage the risk-taking that drives capital creation.
Another reason for taxing capital gains more favorably is it helps investors account for inflation. Reduced taxes on investments helps to offset the impact inflation has on long-term returns. If investors were forced to take inflation-adjusted losses on their investments, it could discourage further investing.
The fallacy of a proposal to tax unrealized capital gains lies in the assumption that household wealth comprises assets that can easily be converted to cash. Assets of ultra-wealthy families primarily comprise illiquid assets such as businesses, real property, and collectibles. These assets are highly illiquid, making it extremely difficult to sell and expect to get fair value. The more significant problem is that, unlike stocks and bonds, there is no way to determine their fair value at any given time. Most illiquid assets are only worth what someone else is willing to pay for them.
If it’s up to the government to assess asset values, that will open the door to unlimited legal challenges, ensnarling taxpayers, the IRS, and courts in constant litigation, while enriching tax lawyers. If it’s up to the taxpayer to assess their own asset values, it will open the door to gaming the system, leading to more litigation.
Democrats in Congress have been after the stepped-up basis loophole for years. This provision in the current tax code allows families to defer capital gains taxes in perpetuity by transferring their wealth to their heirs. Heirs receive inherited assets on a stepped-up basis, meaning their cost basis is reset to the fair market value of the assets the day they inherit them, virtually eliminating all the appreciation since the assets were initially purchased.
Under the proposed tax law, heirs will receive assets at their original cost basis, which would be a nightmare due to the difficulty in determining the assets’ original value. Would all the investment in property improvements or business development be added to the cost basis? How could that even be determined?
There are unintended consequences with any significant change in tax policy. But this tax proposal could lead to unmitigated disaster for investors and the economy. Here are several that could have the most severe impact.
According to the Tax Foundation1, the proposal would increase the tax burden on U.S. savers, who would look for other safe havens for their cash. However, foreign savers would be exempt from the minimum tax. So, as domestic saving shrinks, foreign savers would finance a larger portion of U.S. investment opportunities, leading to diminishing returns for U.S. savers.
High-net-worth investors may be motivated to liquidate their stocks, possibly triggering a prolonged decline in stock prices. This could have a ripple effect on all investors, including everyone saving for retirement in 401(k)s and IRAs who can’t remove funds due to early withdrawal penalties.
Waiting in the wings will be foreign investors who will be immune from the additional taxation. So, U.S. investment capital will flow toward other countries that will control a larger portion of our economy.
What investor will want to invest in private equity if they risk being taxed before they even realize a potentially successful investment? Wealthy U.S. investors will avoid equity investments, and foreign investors will fill the void.
The more favorable capital gains tax rate is an incentive for anyone who wants to start a business because it tilts the risk-return equation in their favor. It wouldn’t make sense for someone to invest in a startup because they couldn’t afford to keep investing in it if they were being taxed along the way.
Just as they have during previous periods of confiscatory tax rates and rules, the ultra-wealthy will seek relief by moving their wealth to safer tax-havens. They’ve been doing it domestically for years, moving from high-tax states such as California and New York to Texas and Florida. The new tax law would force wealthy families to search for foreign tax havens, taking a significant chunk of capital with them.
For all the reasons stated here, and just for being a radical change in tax policy, the proposed Billionaire’s tax is not likely to garner enough votes to pass it. Instead, the proposal will be a populist rallying cry to further villainize the wealthy.
Even if it were to be passed into law, likely, it would not pass constitutional muster. The Constitution limits the ability of the government to levy direct taxes, especially those targeting a specific group. The proposed tax would target a particular demographic with the resources to challenge it in the courts. Any attempts by Congress to dilute the proposed tax would likely make it even more complex, rendering it more unworkable than it already is.
Financial planning is an important process for anyone with significant assets, but it is especially important for high-net-worth and ultra-high net worth individuals. The team at Dechtman Wealth Management provides comprehensive financial planning and investment management services catered to your unique needs and circumstances. Contact us today to learn more about how we can help you reach your financial goals.
1Watson, G., & York, E. (2022, May 31). Proposed minimum tax on billionaire capital gains takes tax code in wrong direction. Tax Foundation. Retrieved June 1, 2022, from https://taxfoundation.org/biden-billionaire-tax-unrealized-capital-gains/
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