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If you watched or listened to the State of the Union address (or perhaps heard follow-up reports) you might have been surprised to hear a reference to a loophole that you didn’t know existed.

As you may have noticed, “spinning” the concept has become the heart of many policy proposals. What this proposal boils down to is a capital gains tax imposed at death on the untaxed appreciation represented in assets transferred to heirs and beneficiaries including trusts. In essence it would be a capital gains tax imposed in addition to the estate tax. Most estates are not subject to estate tax in light of the current exemption, so this new tax would apply on a broader scale – not just the wealthy, but many in the middle class with aggregate investments (in other than qualified retirement benefits) of less than $1,000,000.

Where is the loophole that needs to be closed?

As you may know, the value of an asset transferred at death becomes the new cost basis for the determination of capital gains and all gains are deemed to be long term, even though the deceased owner acquired them less than a year prior to death. The capital gains tax is paid when the heir or beneficiary sells the inherited asset, so it may be several years before the tax is paid. Wealthy individuals often use trusts to transfer assets to their beneficiaries – hence, the “trust fund loophole”.

As proposed, all heirs and beneficiaries (individuals and trusts alike) would have their inheritance reduced by a capital gains tax assessed on the decedent’s final return (or on a separate return) based on the value at date of death less the cost basis of the deceased individual, with modest exclusions of appreciation for $100,000 for any decedent or $200,000 per couple (similar to the deceased spouse unused estate tax exemption). As proposed, the capital gains exclusion for a personal residence would carry over ($250,000 or a total of $500,000 for a married couple). Assets passing to a spouse would have a carryover basis with tax being deferred until the spouse sells an asset or dies. Some gains are excluded (certain small business stock) and some deferred (certain small family-owned/operated businesses) until sale of the business or no longer family operated. There is also a 15-year fixed rate payment plan for the tax on other than liquid assets. The new tax would apply to decedents who die after December 31, 2015.

Where does this fit in the overall taxation of wealth transfers?

With the FET exemption at $5,430,000 for 2015 (and likely over $5,500,000 in 2016 after the inflation adjustment), significant capital gains tax would be payable in many situations before any estate tax is due. For example, a typical profile for a $6,000,000 man or woman might look like this:


$1,500,000 cost basis -0- all subject to tax
Residence $500,000 cost basis $300,000 gain $200,000
Investments $4,000,000 cost basis $2,500,000 gain $1,500,000

The estate tax would be $228,000 (40 percent of $6,000,000 - $5,430,000). The IRA would be totally subject to ordinary income tax as withdrawn at the rates of the beneficiary.

Under this example, there would be no tax on the gain in the residence under the exclusion; the $1,500,000 gain in the investments less the $100,000 exclusion would be subject to capital gains tax at a rate of 24.2% + 3.8% net investment income tax (if applicable) or $392,000 (this proposal is part of an increase in the capital gains rate from a current maximum of 23.8 percent to a maximum of 28 percent, both of which assume the 3.8 percent net investment income applies). The total taxes on the transfer of this Estate (excluding the unknowable tax on the IRA as distributed to beneficiaries and taxed at their respective tax rates – federal rate + state rate) represent 10.33 percent of the gross value owned at death, leaving a net to heirs/beneficiaries of about 90 percent.

But wait...

The President’s “hot off the presses” budget proposal would roll back the FET exemption to $3,500,000 beginning in 2016 and increase the rate to 45 percent. Under that proposal, total taxes would increase to $1,573,000 or 26.2 percent of the total, reducing the net of heirs/beneficiaries of 73.8 percent. This can be compared to only an estate tax of $228,000 or about 4 percent under the current law.

This is a significant policy-shift after only two-plus years of relative certainty as to the transfer tax system. For many individuals, this tax would be the only transfer tax payable and would likely hit many “middle-class” taxpayers and be more impactful on those with estates exceeding the current $5,430,000 estate tax exemption (twice that for married couples). Here is another example: The tax payer dies with $500,000 of investment securities with a basis of $100,000 – the tax, taking into account the $100,000 exclusion, would be over $72,000 assuming other income is low enough that the 3.8 percent Net Investment Income Tax doesn’t apply, but if it did the tax would be $84,000.

More thoughts on the policy and implementation issues and the impact on behavior will be addressed in the next installment on these proposals. It looks to be a very complicated process.

Estate Planning