Who Will Pay For Joe Biden’s Ambitious Expenditure Plan? – Part 2 of 3

In this article, I will explain why  estate taxes and gift taxes should be abolished. I will propose a simpler and fairer tax structure that will still place most of the burden on the “1%”  and, at the same time,  do away with former President Trump’s tax changes that  currently permit up to $22 Million of assets to pass tax-free between generations.

I am not making  my recommendation to eliminate estate and gift taxes because I am in the pocket of the mega-wealthy.  Rather, I believe that existing capital gains legislation can be expanded very easily to make estate and gift taxes redundant.

First, here is some background.  I previously mentioned that I hold a CPA designation in both the U.S. and Canada and have an understanding to the income tax structure of both countries. Before 1972, Canada had a very simple tax structure. Capital gains were totally tax-free. In that year, the Canadian tax system underwent a major reform. Most of the Canadian tax changes were either copied from, or were modifications of, rules in the U.S. Internal Revenue Code.

One major difference, however, was that, when the Canadian government introduced its proposals to tax capital gains, they were able to eliminate the country’s previous estate and gift tax laws.

Here’s the reasoning. It is based on the premise that every dollar you have in your pocket represents after-tax income. (Even if you earn a very low income, it would theoretically be taxable if there weren’t other rules that erase your potential liability through deductions and credits.)

Once income is taxed, it is unfair to tax that same income a second time. The current tax system in the U.S. first taxes people when they make capital gains. Then, although there is presently an extremely liberal estate tax exemption, in many cases, at least part of the same original gain is taxed a second time when the person dies.

Here is an example that illustrates the double-taxation issue. (It ignores the fact that estate tax in the U.S. can be deferred-but not eliminated- if property is bequeathed to a spouse.)

Assume a wealthy individual makes a $1 Million investment that is eventually sold for $25 Million several years later. The tax on a $24 million capital gain at an assumed rate of 20%* is about $5 million. The after-tax gain is therefore $19 million.

When the individual dies:

Amount of after-tax income included in estate           $19 Million

Current approximate  lifetime estate tax exemption   $11Million

Amount subject to estate tax                                    $8 Million

Tax at current rate of 40%                                     $3.2 Million

*The current maximum tax on long-term capital gains

In the above example, the total tax on the original gain of $24 Million becomes $8.2 Million ($5 Million + $3.2 Million), or 34%- not much less than the current top tax rate of 37% on ordinary income.

The bottom line is that  the concept of an estate tax is unfair. Note that, under current U.S. tax law, large gifts made in one’s lifetime are added back and included in the base for estate taxes. Since cash gifts also represent income that was previously taxed, the idea that an estate tax is unfair extends to a gift tax as well.

Of course, one might ask the question, if gift and estate taxes were eliminated, what would stop anyone from holding on to property that has appreciated in value until death. or gifting it in his or her lifetime ,to children or grandchildren to avoid paying taxes on the accumulated capital gains?

The Canadian authorities solved that potential problem by incorporating a concept called  “deemed dispositions” directly into their capital gains legislation.

In Canada, if one dies holding capital property (including shares and  real estate), it is deemed to have been sold at fair market value in the instant before death (unless the property is “rolled over” to a spouse, in which case, the deemed disposition is deferred until the second spouse’s death, if it is not sold before then).

The deemed disposition triggers capital gains or losses that are reported on the deceased person’s final tax return.

There are special rules that allow family farms to be passed on without taxation to children or grandchildren, as well as a special rule that exempts up to about $900,000 of capital gains (during one’s lifetime or on death) arising with respect to Canadian-owned small business corporation shares. I suggest similar exemptions should apply in the United States if the estate tax is repealed and the capital gains legislation is extended.

In Canada, if one makes a gift of capital property (including stocks and  real estate) to anyone other than a spouse, this also triggers a deemed disposition at market value and the gain, if any, is reported on the transferor’s tax return for that year. Capital losses on transfers of property to close relatives are not permitted, as is the case already in the U.S.

To summarize, I recommend that U.S. estate and gift taxes be repealed and replaced with deemed disposition rules to

1. trigger capital gains at the time growth property is gifted to anyone other than a spouse,
2. trigger a deemed sale at market value of growth property at the time of death, unless property is left to a spouse (or a trust where the spouse receives all the income as long as (s)he lives).

In all cases of non-spousal transfers, the recipient’s cost for tax purposes would become an amount equal to the transferor’s deemed proceeds. This would prevent the same gain from being taxed twice.

In fact, if the deemed disposition concept were adopted, total U.S. tax revenues would actually increase.  This is because these rules would apply to everyone who owns growth property (other than a primary residence, or a small businesses/family farm, where exemptions would apply).  Under the present estate tax rules there is a total exemption for estates worth less than around $11,200,000.  (This is DOUBLED  if there are two spouses.) This exemption would be scrapped automatically if all the Estate Tax and Gift Tax provisions were eliminated.

 For example, if one had a  modest stock portfolio with a tax cost of $100,000 and it was worth $300,000 when that  person died, a $200,000 gain would be reportable on the final tax return (unless the portfolio is bequeathed to a spouse.)  On a long-term capital gain, the tax would be $40,000. The heirs would assume a $300,000 cost for tax purposes since their inheritance would come to them in the form of tax-paid assets. Some part of the portfolio may have to be sold to pay the tax on the deemed capital gain. The deemed disposition concept actually lifts some of the tax burden from the shoulders of the very wealthy

In 1996, two university professors, Thomas J. Stanley and William D. Danko, wrote a best-selling book called “The Millionaire Next Door”.  By surveying high-income zip codes, they were able to characterize the “typical” American Millionaire.

Perhaps surprisingly, the profile that they compiled was not that of the high-flying financial wizard or tech guru. It was the second or third generation mid-western business owner who lived frugally and spent wisely.

What is interesting is that the authors postulated that the special Millionaire characteristics of drive, thriftiness etc. were  not being passed on by parents to their children. In an effort to reduce potential estate taxes, Millionaires generally took advantage of the fact that it was acceptable to make annual tax-free gifts to any person of up to (at that time) $10,000 a year.

Thus, if wealthy parents had a recently-married son or daughter, they could each give $10,000 to both their child and his or her spouse. According to Professors Stanley and Danko, $40,000 a year of tax-free support often eliminated any incentive for the children to succeed on their own. Now, the annual allowance for tax-free gifts is $15,000 a year. Eliminating estate taxes would remove the incentive of gift-giving simply to “beat” the system.

In the final installment of this series, I will suggest a few  meaningful corporate tax changes that would contribute substantial amounts  towards President Biden’s initiatives, while, at the same time, lead to a much fairer tax system.