I have been a tax practitioner for nearly 50 years. During my career, I have seen numerous tax law changes and patterns to those changes.
Two recurring unheralded patterns fall below the radar screens of most, but are worth noting because we will see them in the next year or so.
The first is how the two political parties work in lockstep to increase our taxes.
When Republicans are in power, they lower the tax rates, but broaden the tax base by increasing the amount of income that is subject to tax. In other words, they pay for lower rates by repealing deductions or accelerating the taxation of income.
When the Democrats regain power, they restore the tax rates without changing how taxable income is computed.
The second is that tax increases are supposedly targeted toward the rich, who frequently are defined as being the top 10%. Different studies have come up with different income thresholds for the income earned by the 90th percentile, but most indicate that households earning $120,000-$125,000 are in the top 10%.
According to IRS statistics, households earning between $100,000 and $1.1 million pay the highest percentage of their income in taxes. Households earning more than that amount tend to earn income that is taxable at capital gains rates or is otherwise sheltered.
So it is not surprising to see that, when tax increases are targeted at the top 10%, many middle-class households bear the biggest brunt of those increases while the extremely wealthy somehow manage to avoid paying extra tax.
The Joe Biden administration has some interesting proposals that attempt to target the mega wealthy, but I am concerned about two provisions that promise to target middle-class households, including many Santa Clarita Valley residents.
The first pertains to estate taxes. Currently, when a person dies, the tax basis of their assets is adjusted from what the decedent paid for those assets (“tax basis”) to fair market value at the date of death. When the heirs sell those assets they are taxed only on the postmortem appreciation.
President Biden has proposed eliminating this adjustment with a regime where the heirs would step into the decedent’s shoes by inheriting the decedent’s tax basis. Biden is not the first to call for this. Politicians as diverse as Edward Kennedy and Paul Ryan have made similar proposals.
However, on March 30, a number of Democratic senators introduced the “Sensible Taxation and Equity Promotion Act of 2021,” which far exceeds the Biden proposals.
Under their proposal, when a person dies, for income tax purposes, they would be treated as if they sold their intangible assets, including stocks, bonds, family-owned businesses and collectibles.
Although the first million dollars of gains would be exempt from tax, many family-owned businesses are worth more than that amount.
Consider someone who passes away having an estate consisting of a $2 million stock portfolio. Let’s assume that they acquired these assets many years earlier at a cost of $400,000.
The deemed sale upon death would result in $1.6 million of capital gains.
Although the first million would be not be taxed, the remainder would be taxed at 23%. That would add almost $140,000 of additional tax on the decedent’s final income tax return.
While $2 million sounds like a large estate, according to various sources, it is estimated that 6% of American households have a $2 million net worth. That $2 million is substantially below the current estate tax threshold of $11.7 million and is well below the Biden proposed estate tax threshold of $3.6 million. This is a new type of death tax that is broader-reaching and would be imposed in addition to the estate tax.
The other issue that will receive considerable rhetoric is the reinstatement of the state and local tax (SALT) deduction, which the government really cannot afford to implement. Both House Speaker Nancy Pelosi and Rep. Mike Garcia have indicated a desire to re-establish the deduction.
Historically, when a deduction is repealed it never returns, but due to political sleight of hand, we may see a mirage claiming to be the SALT deduction. In the 1990s, Democratic Rep. Donald Pease from Ohio introduced a proposal that limited the benefit of itemized deductions. The so-called “Pease limitation” reduced itemized deductions by 3% of income over a certain level.
The Pease limitation was repealed in 2017, but the Biden tax proposals seek to reinstate it.
Increased SALT deductions would be subject to the Pease limitation and would not be fully deductible for many taxpayers.
The Pease limitation is a great example of how tax law has become more complicated for political reasons. Congress did not want to be seen as raising tax rates, so they added a complex calculation to increase the amount of income subject to tax.
I plan to write future columns explaining other emerging tax proposals.
Jim de Bree, a Valencia resident, is a semi-retired CPA and student of tax policy.
