INVESTMENT QUARTERLY

TAX ALERT - THE STEALTH TIME BOMB IN BIDEN'S PROPOSED TAX PLAN

As we head to the finish line in the 2020 elections, we are seeing further analysis of the competing  party’s platforms. We are somewhat reconciled to the idea that spending will increase no matter  which party wins. The Biden campaign has specified a number of changes they will hope to make,  particularly on taxes paid by high wage earners. There are triggers for tax increases at $400,000  and $1 million for different income sources. The impression the public is left with is that tax increases will only affect the top earners and that the middle class will be left untouched. 



Perhaps the most significant example of this “tax the rich” approach is the proposed change to  the estate tax exemption. Currently, on death, an individual is allowed an exemption from  Federal taxes of $11.58 million which amounts to $23 million per couple. Estate values above this  amount are taxed at 40%. Biden’s plan calls for a reduction of $8.58 million in the individual credit  to $3 million and a raise in the rate on the excess to 48%. This will allow a couple to have a  combined exemption of $6 million if the estate is correctly set up. However, the increased rate  on the excess, which will start at a lower dollar level, will result in a tax increase of over $4 million  versus the tax on today’s $11.58 million estate. This is not chump change. The odds of this passing  if there is a Blue Wave are pretty high. If Democrats control both the House and Senate in  addition to the White House there won’t be much, if any, resistance to this revision. 

To most people these issues don’t raise much concern or even interest. It is not our money and  our estates are still in a $0 tax position. For those who are blessed with a higher net worth these  proposals should cause them to schedule a meeting with their estate planning attorneys to see  what they can do to lessen the tax bite. 

You may wonder why this Quarterly is titled “The Stealth Time Bomb”. Well, there is another  change, less widely published, that is part of this tax plan. Present estate tax regulations allow  the cost of investments to be adjusted to their value on the date of death. This means that a  stock you bought for $2 a share that is worth $100 at the time of your death would have its cost  basis adjusted up to $100 upon your death. If an heir sold the stock at that time they would have  no gain or loss so the $98 capital gain would be avoided. At a tax rate of 20% this would result in  a Federal tax saving of $19.60 per share. In Massachusetts one would have state capital gains  taxes that would be avoided by the stepped-up cost basis as well. As a result, estates below the  exemption amount pay no estate or capital gains taxes if the beneficiaries sell the investments 

at the time of death. If they continue to hold and sell later there may be some tax ramifications  but it will only be based on the gain or loss from the stepped-up basis of the investment. 

Your parents may have bought a house years ago for $50,000 and it is now worth $400,000 at  the time of their death. Under current regulations you would be able to take that $350,000 gain  tax free. The changes under consideration would disallow the stepped-up basis going forward.  This would mean you would have to pay a capital gains tax on the estate’s appreciated property  whenever you sold it. This could amount to a significant tax payment and reduction in the net  amount heirs receive from an estate. Perhaps the largest gains for most people of modest means  would be their home. In our example above of a $350,000 gain, reversal of the cost basis step-up  rule would result in a federal tax of $70,000 plus Mass state tax of over $17,000. For many heirs  a family inheritance is used to fund children’s college costs. A loss of $87,000 equates to 2 years  of college expenses solely because of eliminating the stepped-up cost basis. After paying for  college the balance of the inherited funds are frequently used to supplement retirement for the  heirs. So ultimately this will make a comfortable retirement unreachable for more middle/lower  income families. 

Despite claims that Biden’s tax plans will only affect the rich, those with over $400,000 of income,  or estates over $3,000,000, the estate tax change would surprisingly hit a number of lower  income estates that are exempt from taxes under current rules. There may be some strategies  that will be developed over time to help alleviate this tax should it come to pass, but nothing is  being discussed at this time. 

A similar plan was originally proposed in the 1980’s but failed to get support because of the  perceived difficulty in administering it. Old records to support cost basis would likely be difficult,  if not impossible to locate. The IRS assumes that if you can’t support a cost, your cost basis is  zero. This could mean that an entire estate, with the exception of savings deposits, would be  subject to capital gains taxes. If the approach is proposed today, a more liberal and progressive  party could garner more support in an “end supports the means” world. Be on the alert and ready  to write your senator and congress person if you see or hear that this proposal has seen daylight. 

Looking ahead, most market forecasters are projecting equity returns of 3 to 5 percent and bond  returns of 1 to 1 1/2 percent over the next few years in the US. Internationally the forecasts are  not much better. The sage Jeremy Grantham’s 7-year projection calls for negative equity returns  with the exception of emerging markets. Most of his bond projections are negative because of  the potential for rising rates. Covid and government stimulus will be key determining factors. 

At the ninth month marker the Dow Jones Industrial Average has returned (0.91%); the S&P 500  has returned 5.57%; the Russell 3000 has generated a return of 5.41% and the Bloomberg 1-5  year US Govt/Corp Credit has returned 4.20% so far this year.

Robert B. Needham, CFA