On May 28, 2021, the Biden administration released its fiscal year 2022 budget proposal and the Treasury Department released the General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (the “Green Book”). The budget consists of the American Jobs Plan and the American Families Plan, along with additional proposals and, according to President Biden, lays out the essential investments his administration has proposed.
The proposals under the American Families Plan includes several changes to estate and gift taxation that could significantly alter tax planning.
Capital Gains Tax Imposed at Time of Death or Gift
The main change to the estate and gift tax regime in the American Families Plan is the taxation of unrealized gains at the time of death or gift. Under the proposal, the donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer. The amount of gain realized would be the excess of the asset’s fair market value over the donor or decedent’s basis in the asset. The realized gain would be taxable income to the decedent on the federal gift or estate tax return, or on a separate capital gains tax return.
One of the arguments against imposing a capital gains tax at death is the practicality of determining an asset’s tax basis, especially one that has been owned for many years or was received through prior gifts or inheritance. The Green Book indicates that the Treasury Secretary would be granted authority to issue regulations that could include safe harbors for determining the basis of assets in cases where complete records are unavailable.
The decedent’s estate may deduct any tax imposed on capital gains realized at death on the estate tax return. Further, in the decedent’s final income tax return, capital losses and carryforwards from transfers at death may be used against capital gain income and up to $3,000 of ordinary income.
The proposal also applies to trusts, partnerships, or other non-corporate entities that own property that has not been subject to a recognition event within the prior 90 years. With the testing period beginning January 1, 1940, the first possible recognition event would be December 31, 2030.
The proposal essentially repeals the current law that allows the adjusted basis to be “stepped up” to the fair market value of the asset at the date of the decedent’s death subject to certain exceptions. As a result, for inherited assets, appreciated asset gains accrued during the decedent’s life would be subject to capital gains tax.
Valuation of Asset Subject to Capital Gains Tax
An interesting aspect of the proposal is the way in which a taxpayer would value the asset subject to gain recognition. The Green Book indicates it would be valued using the methodologies used for gift or estate tax purposes, but a transferred partial interest would be its proportional share of the fair market value of the entire property. In essence, it would eliminate marketability and minority interest discounts.
Additional Recognition Events
Transfers of property into, and distributions in kind from, a trust, partnership or other non-corporate entity (other than a wholly owned, revocable grantor trust) would be recognition events. Under this provision, transfers to defective grantor trusts would be recognition events, seemingly overriding Revenue Ruling 85-13, which stands for the proposition that transactions between a grantor trust and its grantor are not recognized for tax purposes.
In the case of a revocable grantor trust, the deemed owner would recognize gain on the unrealized appreciation in assets distributed from the trust to any person other than the deemed owner or the U.S. spouse of the deemed owner, other than a distribution made in discharge of an obligation of the deemed owner. In addition, realization would occur on the date of the deemed owner’s death, or any other time when the trust becomes irrevocable.
The following are excluded from gain recognition:
- Transfers by decedent to a U.S. spouse. Capital gains would not be recognized until the spouse disposes of the asset or dies.
- Transfers to charity.
- Transfers to split-interest trusts – exclusion is allowed based on the charity’s share of gain.
- Any gain on tangible personal property such as household furnishings and personal effects (excluding collectibles).
- The proposal would allow a $1 million per person exclusion on property transferred by gift or held at death. This exclusion would be indexed for inflation after 2022 and would be portable to the decedent’s surviving spouse. The recipient’s basis would be the property’s fair market value at the decedent’s death.
- The $250,000 per-person exclusion under current law for capital gain on a principal residence would apply to all residences and would be portable to the decedent’s surviving spouse.
- Capital gains on certain small business stock (under section 1202) that are excluded under current law.
Payment of Tax and Deferral of Payment
Tax payments on appreciation of certain family-owned and operated businesses would not be due until: 1) the interest in the business is sold, or 2) the business ceases to be family-owned and operated. The proposal provides for a 15-year fixed rate payment plan for the tax on appreciated assets transferred at death other than liquid assets and businesses for which the deferral election is made. To continue this deferral, the IRS would be authorized to require security at any time when there is a reasonable need.
Other Potential Legislative Changes
The Green Book indicated that the following legislative changes would be included in order to facilitate and implement the proposal:
- Allowance of a deduction for the full cost of appraisals of appreciated assets;
- Imposition of liens;
- Waiver of penalty for underpayment of estimated tax to the extent that underpayment is attributable to unrealized gains at death;
- Grant of a right of recovery of the tax on unrealized gain;
- Rules to determine who has the right to select the return filed;
- Achievement of consistency in valuation for transfer and income tax purposes;
- Coordinating 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; and
- A broad grant of regulatory authority to provide implementing rules.
Notably absent from the American Families Plan is a reduction in the estate and gift exemption amount. The current exemption amount is $11.7 million and is scheduled to be reduced to $5 million (indexed for inflation) in 2026. President Biden’s campaign proposals included a reduction in the exemption amount to $3.5 million. It remains to be seen if a reduction in the estate and gift exemption amount will become part of this legislation or other legislation in the future. The For the 99.5% Act introduced by Senator Bernie Sanders earlier this year contained provisions reducing the estate exemption to $3.5 million and the gift tax exemption to $1 million.
The proposal would be effective for gains transferred by gift and on property owned by decedents dying after December 31, 2021. It would be effective on certain property owned by trusts, partnerships, and other non-corporate entities on January 1, 2022.
There is still a long road ahead before the enactment of any of these proposals. They, along with others, will be the subject of negotiation among all the parties involved and, even if not passed as part of the first round of legislation, could be part of subsequent rounds.
Please contact your Mazars professional for additional information.