Capital Letter No. 52
By Ronald D. Aucutt
Lakewood Ranch, Florida
June 4, 2021
GREENBOOK INCLUDES DEEMED REALIZATION
The Treasury Department’s General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals includes some details, but not a full explanation, of the Administration’s proposal to tax unrealized appreciation at the time of gifts, death, and other occasions.
Dear Readers Who Follow Washington Developments:
The Treasury Department released its General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (which is popularly called the “Greenbook”) on May 28, 2021. It proposes no changes to the estate and gift taxes. In contrast, the previous Greenbook, for Fiscal Year 2017, released on February 9, 2016, by the Obama Administration (the Trump Administration did not publish a Greenbook), included eight proposals under the heading “Modify Estate and Gift Tax Provisions” (at pages 177-89): (1) Restore the estate, gift, and GST tax parameters in effect in 2009; (2) Expand requirement of consistency in value for transfer and income tax purpose; (3) Modify transfer tax rules for GRATs and other grantor trusts; (4) Limit duration of GST tax exemption; (5) Extend the lien on estate tax deferrals where estate consists largely of interest in closely held business; (6) Modify GST tax treatment of health and education exclusion trusts (HEETs); (7) Simplify gift tax exclusion for annual gifts; and (8) Expand applicability of definition of executor. We are missing out on all that this year.
But the Fiscal Year 2017 Greenbook (at pages 155-56), like the Fiscal Year 2016 Greenbook before it (at pages 156-57), also included, under the general heading of “Reforms to Capital Gains Taxation, Upper-Income Tax Benefits, and the Taxation of Financial Institutions,” a proposal labeled simply “Reform the Taxation of Capital Income.” That proposal would have increased the top rate on capital gains and qualified dividends from 20 percent to a whopping (we thought) 24.2 percent, which, with the 3.8 percent tax on net investment income, would have produced a rate of 28 percent. It would also have treated a gift or transfer at death of appreciated property as a realization event, subjecting the unrealized appreciation to capital gains tax. Imagine that!
Well, it’s back. And in the four years it was absent, it put on a lot of weight.
BUILD-UPS AND TEASERS AND RATES (OH MY!)
On March 29, 2021, Ways and Means Committee Member Bill Pascrell, Jr. (D-New Jersey) introduced H.R. 2286, described as a bill “to amend the Internal Revenue Code of 1986 to treat property transferred by gift or at death as sold for fair market value, and for other purposes.” On the same day, Senator Chris Van Hollen (D-Maryland), joined by Senators Cory Booker (D-New Jersey), Bernie Sanders (I-Vermont), Sheldon Whitehouse (D-Rhode Island), and Elizabeth Warren (D-Massachusetts), issued a statement calling “the Stepped-Up Basis Loophole” “one of the biggest loopholes in the U.S. tax code, which subsidizes America’s wealthiest heirs,” citing a Joint Committee on Taxation estimate that it will cause a loss of $41.9 billion of tax revenue in 2021 alone. The statement was accompanied by a 32-page “discussion draft” of statutory language titled the “Sensible Taxation and Equity Promotion (“STEP”) Act of 2021,” with the acronym of “STEP” evidently designed to recall the “stepped-up basis” that its authors attacked.
On April 28, 2021, a White House “fact sheet” stated: “Today, the Biden Administration announced the American Families Plan, an investment in our kids, our families, and our economic future.” After discussing education, child care and paid leave, nutrition, employment insurance, and tax credits, it concluded with a section titled “Tax Reform that Rewards Work – Not Wealth” that offered three points: Revitalize enforcement “to make the wealthy pay what they owe”; Increase the top individual income tax rate to 39.6 percent; and “End capital income tax breaks and other loopholes for the very top.” Here we saw references to ending “the carried interest loophole,” reforming the 3.8 percent Medicare tax to apply more consistently, and, of course, eliminating “the loophole that allows the wealthiest Americans to entirely escape tax on their wealth by passing it down to heirs.” And the White House got our attention.
Then, on May 28, 2021, citing the need to “reduce economic disparities among Americans,” the current Greenbook (at pages 60-62) presented proposals to increase the top marginal individual income tax rate to 39.6 percent (as it was before the 2017 Tax Act), effective January 1, 2022, and to tax capital gains at the same rate as ordinary income for taxpayers with adjusted gross income greater than $1 million, effectively making their capital gains tax rate, taking into account the 3.8 percent tax on net investment income, 43.4 percent. And if that isn’t enough to hold our attention, it makes that increase effective “for gains required to be recognized after the date of announcement” (presumably April 28, 2021, when, according to the White House fact sheet, the Administration “announced the American Families Plan.”
The Greenbook (at pages 62-64) also provides details focusing, clarifying, and expanding the proposal for the “deemed realization” of capital gains foreshadowed by the Obama Administration’s Greenbooks, Representative Pascrell’s H.R. 2286, and Senator Van Hollen’s STEP Act. The following is a summary of that proposal to the extent the Greenbook reveals it.
The proposal would take effect on January 1, 2022, like H.R. 2286.
Like both H.R. 2286 and the STEP Act, the proposal would tax past appreciation, not just appreciation following enactment. This contrasts with the 1969 proposed “Taxation of Appreciation of Assets Transferred at Death or by Gift,” which stated that “only appreciation occurring after the date of enactment would be subject to tax.” “Tax Reform Studies and Proposals, U.S. Treasury Department,” Joint Publication of the House Committee on Ways and Means and Senate Committee on Finance, at 335 (91st Cong., 1st Sess., Feb. 5, 1969).
It also contrasts with the 1976 enactment (which proved to be temporary) of carryover basis, which provided a “fresh start” valuation on December 31, 1976, and a proration of appreciation over the entire holding period of nonmarketable assets acquired before that date. Section 1023(h), added by section 2005(a)(2) of the Tax Reform Act of 1976, Public Law 94-455 (94th Cong., 2d Sess., Oct. 4, 1976).
Interestingly, the Greenbook proposal does not contrast as sharply with the “aggregate basis increase” and “spousal property basis increase” provided by the second (also temporary) enactment of carryover basis in 2001, taking effect in 2010, which was not as clearly tailored to sheltering pre-enactment appreciation. Section 1022(b) and (c), added by section 542(a) of the Economic Growth and Tax Relief Reconciliation Act of 2001, Public Law 107-16 (107th Cong., 1st Sess., June 7, 2001).
Gain would be explicitly recognized on transfers by gift or at death, equal to the excess of an asset’s fair market value on the date of the gift or death over the donor’s or decedent’s basis in that asset. Losses obviously would also be recognized if basis exceeds fair market value because the Greenbook refers to “the use of capital losses … from transfers at death” as an offset. The Greenbook does not mention holding periods or distinguish short-term and long-term gain. The Greenbook also does not specifically incorporate the alternate valuation date for transfers at death, although it does state generally that a transfer “would be valued using the methodologies used for gift or estate tax purposes.”
TAXPAYER, RETURN, AND DEDUCTIBILITY
The Greenbook states that the gain would be reported “on the Federal gift or estate tax return or on a separate capital gains return.” Reassuringly, however, the Greenbook confirms that the gain “would be taxable income to the decedent” and, consistently with that characterization, explicitly adds that “the tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent’s estate (if any).”
Tangible Personal Property
“Tangible personal property such as household furnishings and personal effects (excluding collectibles)” would be exempt. There is no mention of explicit application to property held for investment as in H.R. 2286 or property related to the production of income as in the STEP Act.
Transfers to Spouses
The Greenbook would exempt “transfers by a decedent to a U.S. spouse,” without explicitly exempting lifetime gifts to a spouse as both H.R. 2286 and the STEP Act do. There is no elaboration of the term “U.S. spouse” (for example, citizen or resident), and there are no special provisions targeted to spousal trusts. Typically the effect of exempting transfers to spouses will be simply to defer the application of the deemed realization rules until the spouse’s disposition of the asset or the spouse’s death.
Transfers to Charity
The Greenbook would exempt transfers to charity.
But it adds that “the transfer of appreciated assets to a split-interest trust would generate a taxable capital gain, with an exclusion allowed for the charity’s share of the gain based on the charity’s share of the value transferred as determined for gift or estate tax purposes.” This will require further elaboration.
The Greenbook proposes a single unified exclusion of capital gains for transfers both by gift and at death of $1 million per person, indexed for inflation after 2022 and “portable to the decedent’s surviving spouse under the same rules that apply to portability for estate and gift tax purposes.” The Greenbook adds that this would “mak[e] the exclusion effectively $2 million per married couple,” without explaining exactly how that would be accomplished for lifetime gifts when there has been no “decedent” or “surviving spouse.” The Greenbook does not address whether the use of the exclusion for lifetime gifts is mandatory or elective.
To the extent that exclusion applies, the Greenbook proposes to retain the current basis rules under sections 1014 and 1015. Thus, to that extent, “the recipient’s basis in property received by reason of the decedent’s death would be the property’s fair market value at the decedent’s death” (presumably subject to the consistent basis rules of section 1014(f) added in 2015), and the basis of property received by gift would be the donor’s basis in that property at the time of the gift. To the extent the exclusion does not apply, the recipient, whether of a gift or at death, will receive a basis equal to the fair market value used to determine the gain. The Greenbook leaves for further elaboration the manner in which those adjustments to basis would be allocated among multiple assets in a case of a lifetime gift or gifts where some but not all of the gain realized under this proposal is sheltered by the exclusion.
In addition, the Greenbook confirms that the exclusion of $250,000 per person of gain from the sale or exchange of a taxpayer’s principal residence under section 121 would apply to the gain realized under this proposal with respect to all residences, and it adds that that exclusion would be made “portable to the decedent’s surviving spouse.” In this case there should be no issue of the application of portability to lifetime gifts, because section 121(b)(2) itself doubles the exclusion to $500,000 for certain eligible joint returns.
Small Business Stock
The Greenbook also confirms that the exclusion under current law for capital gain on certain small business stock under section 1202 would apply.
NETTING OF GAINS AND LOSSES
For transfers at death, capital losses and carry-forwards would be allowed as offsets against capital gains and up to $3,000 of ordinary income, mirroring the current income tax rules in sections 1211 and 1212. There is no mention of relaxing the related-party loss rules of section 267 as there is in both H.R. 2286 and the STEP Act, but it seems very unlikely that it would be omitted from any provision for taking losses into account at death, where transfers to related parties are the norm.
As noted above, the Greenbook contemplates that a transfer generally “would be valued using the methodologies used for gift or estate tax purposes.” But the Greenbook adds that “a transferred partial interest would be its proportional share of the fair market value of the entire property.” In other words, no discounts. The Greenbook does not indicate whether “partial interest” is meant to be limited to undivided interests such as in tenancies-in-common, or whether it might include nonmarketable interests in entities like partnerships, limited liability companies, and corporations. Surely it would not include, for example, publicly traded stock, but attention in drafting might be required to confirm that.
SPECIAL RULES FOR TRUSTS AND ENTITIES
Generally mirroring H.R. 2286 and the STEP Act, the Greenbook provides that transfers into, and distributions in kind from, a trust would be recognition events, unless the trust is a grantor trust deemed wholly owned and revocable by what the Greenbook calls “the donor.” There is no mention of “grandfathering” irrevocable trusts in existence on the date of enactment, and therefore this Greenbook feature would apparently apply to distributions of appreciated assets to both current and successive or remainder beneficiaries of preexisting trusts, including, for example, both the grantor and the remainder beneficiaries of a pre-2022 GRAT. With regard to revocable trusts, the deemed owner would recognize gain on the unrealized appreciation in any asset distributed (unless in discharge of the deemed owner’s obligation) to anyone other than the deemed owner or the deemed owner’s “U.S. spouse” (again undefined), and on the unrealized appreciation in all the assets in the trust when the deemed owner dies or the trust otherwise becomes irrevocable.
But the Greenbook goes a lot farther. The rules about transfers into and distributions in kind from a trust also apply to a “partnership” or “other non-corporate entity.” This looks like a far reach, but the Greenbook does not explain further.
The Greenbook also states:
“Gain on unrealized appreciation also would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years, with such testing period beginning on January 1, 1940. The first possible recognition event for any taxpayer under this provision would thus be December 31, 2030.”
Ninety years for periodic “mark-to-market” treatment of trust assets is a surprising departure from the somewhat similar rules in H.R. 2286 (30 years) and the STEP Act (21 years), but it again would apply to assets of partnerships and other entities. And again the Greenbook does not explain further. Because 90 years from January 1, 1940, is January 1 (not December 31), 2030, it appears that the Greenbook contemplates recognition only at the end of the year, but the Greenbook does not clarify that.
DEFERRAL OF TAX
The Greenbook reprises the Obama Administration’s Fiscal Year 2016 and 2017 proposals that “payment of tax on the appreciation of certain family-owned and -operated businesses would not be due until the interest in the business is sold or the business ceases to be family-owned and operated.” Providing that the payment of tax is not “due” (rather than merely providing for a section 6166-like “extension of time for payment”) implies at a minimum that there would be no interest charged (which can otherwise be a big problem, even for the no-more-than-14-year deferral of section 6166). The implementing statutory language might also provide that the realization event itself is deferred until ownership or operation of the business passes outside the family. That could increase the amount of tax if there is more appreciation, but it could also prevent the payment of tax to the extent the value of the business declines (which sometimes happens after the death of a key owner). That approach would apparently also tax the realization event at whatever the tax rates happen to be at the time. But if the cessation of family ownership results from the family’s sale of the business, that postponed realization approach would be the same as current law in subjecting any sale like that to tax, except apparently for the loss of a stepped-up basis at intervening deaths.
The enactment of this proposal or any close variation of it in a tightly divided Congress is by no means certain, and the long-term durability of such a provision enacted in such a political climate would not be guaranteed. That could create special challenges in cases where a tax on the succession of the family businesses is nominally imposed, but is suspended for many years, decades, or even generations.
And of course the statutory language implementing this Greenbook proposal should be expected to include definitions of a “business,” “family-owned,” and “family-operated,” as well as rules for the identification of assets that should be excluded from the deferral because they are not used in the business, and such rules might also create or aggravate challenges over a long-term suspension.
Other Nontraded Assets
In addition, like the STEP Act and the Obama Administration Greenbooks (and broader than H.R. 2286), the Greenbook proposal would allow “a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets such as publicly traded financial assets and other than businesses for which the deferral election is made.” Details about start dates and interest rates are not provided, but the proposal might resemble the STEP Act’s proposed section 6168, which in turn resembles section 6166 without the 35-percent-of-gross-estate requirement to qualify, with an interest rate equal to 45 percent of the normal annual rate as in section 6601(j)(1)(B), but without the “2-percent portion” as in section 6601(j)(1)(A).
As in H.R. 2286 and the STEP Act, the IRS would be authorized to require reasonable security at any time from any person and in any form acceptable to the IRS.
Following the Obama Administration Greenbooks, with a few additions, the Greenbook envisions (but without details) a number of other legislation features, covering topics such as a deduction for the full cost of related appraisals, the imposition of liens, the waiver of penalties for underpayment of estimated tax attributable to deemed realization of gains at death (which, of course, could not have been foreseeable), a right of recovery of the tax on unrealized gains, rules to determine who selects the return to be filed, consistency in valuation for transfer and income tax purposes, and coordination of the changes to reflect that the recipient would have a basis in the property equal to the value on which the capital gains tax is computed.
Treasury would be granted authority to issue any regulations necessary or appropriate to implement the proposal, including reporting requirements that could permit reporting on the decedent’s final income tax return, which would be especially useful if an estate tax return is not otherwise required to be filed. In a tacit acknowledgment of the harshness of proceeding with such a proposal without a “fresh start” for basis as in 1976, the Greenbook explicitly contemplates that the regulations will include “rules and safe harbors for determining the basis of assets in cases where complete records are unavailable.”
Taxing capital gains at the same rate as ordinary income for taxpayers with adjusted gross income greater than $1 million and the proposed “deemed realization” of capital gains together are estimated to raise $322 billion over the next 10 fiscal years. In contrast, the revenue estimate for the corresponding proposal in the Obama Administration’s Fiscal Year 2017 Greenbook was $235 billion.
The current estimate includes $1.241 billion estimated for Fiscal Year 2021, which ends September 30, 2021. That presumably results from the proposed retroactive effective date for taxing capital gains at the same rates as ordinary income, but evidently also contemplates increased estimated income tax payments by September 30. (This is the only proposal in the Greenbook that is estimated to have an effect on revenues in Fiscal Year 2021.)
Overall, the tax increases proposed by the current Greenbook are estimated to raise revenue over the next 10 fiscal years by about $3.6 trillion.
For the Government, that is. For estate planners, maybe not quite.
Ronald D. Aucutt
© Copyright 2021 by Bessemer Trust Company, N.A. All rights reserved.