Jim de Bree | Tax Reform Must Include Capital Gains

Jim de Bree
Jim de Bree

For now, this is the last in my series of columns discussing tax issues that Congress is likely to consider in the coming months. One of the most important of those issues is the capital gains tax.  

A capital gain is the appreciation in value of an asset. Capital gains are generally taxed when that asset is sold. If the asset was held for over a year the gain is taxed at a special low rate, currently 20%. Since World War II, those capital gains tax rates have varied from 15% to 45%.  

Capital gains are taxed at a lower rate to encourage investment. Not surprisingly, according to IRS statistics in 2018, the top 1% of households recognized 69% of capital gains that were favorably taxed, while the top 20% recognized 90% of such gains. 

Those favoring low capital gains rates argue that our capital gains rates must be competitive globally in order to attract foreign investment. As a tax professional who structures transactions with foreign investors, I know that virtually all foreign institutional investment is structured using offshore tax haven intermediaries that are specially designed to prevent foreign investors from paying U.S. tax. Therefore, the capital gains tax rate is irrelevant to them.  

Furthermore, most Americans hold the majority their investments in retirement funds and will never be taxed at capital gains rates. If they own a Roth IRA, they will never be taxed; if they own their investments through a traditional IRA, 401(k) or pension fund, they will be taxed at ordinary rates when the finds are withdrawn. Again, the capital gains tax rate is irrelevant to those investors. 

Wall Street and other wealthy individuals have benefited from loopholes in the tax law to convert income that would otherwise be subject to income tax at ordinary rates to favorably taxed capital gains. Instead of paying income at rates approximating 40% plus Social Security taxes, they pay tax at a 20% rate. (Sometimes they also pay an additional 3.8% Obamacare tax to help fund health care costs for poor people.) 

About 10 years ago, I worked for a client that was planning to go public. We structured their affairs so that, when the company went public, the executives’ compensation would be a function of the IPO proceeds and would be taxable at capital gains rates. The company’s chief financial officer received $20 million that was taxed at the then 15% capital gains rate. She complained that she had to pay $3 million in tax, which she felt was outrageous, yet she paid taxes at a lower marginal rate than a married couple earning $80,000.  

Prior tax increases have been targeted at the top 10% of the population — the so-called “rich” folks. As I have written in previous columns, the top 10% includes households having income of approximately $120,000. 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.  

According to information published by the IRS, the 400 tax returns with the highest reported income paid less than 20% of their income in tax.  

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. 

There are two ways of dealing with this. The first is to try to eliminate the tax advantages of various structures designed to convert ordinary income into capital gains. This is a whack-a-mole strategy that has a low probability of success because brilliant tax strategists will continue to devise transactions that circumvent the rules.  

The second is to change the capital gains tax rate for mega-wealthy people so that, like the ordinary income tax rates, capital gains taxes would become more progressive. That is precisely what President Joe Biden has proposed. Biden’s proposal would increase capital gains tax rates to ordinary tax rates for taxpayers earning more than $1 million. Thus, taxpayers earning more than $1 million would be placed in a similar tax position as those earning $120,000-$1 million.  

Biden’s proposal also eliminates the possibility of creative tax professionals devising tax avoidance strategies. This may prove to be unfair to those selling a family business who have one year of income exceeding $1 million, so perhaps an exception similar to those provided in the estate tax rules can be made available to them. 

It is far too soon to determine whether the Biden capital gains proposals will be enacted, but until we see meaningful capital gains reform, many middle-class taxpayers will continue to bear a disproportionate share of the tax burden. 

Jim de Bree is a semi-retired CPA who resides in Valencia.

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