Obama’s Tax Reform Proposal; A Closer Look at the Trust Fund Loophole Adjustment

The day before the President’s State of the Union address, the White House released a “fact sheet” on what they call his “proposed reforms for a simpler, fairer tax code”. Are these proposals really intended to make the code simpler? Are they really fair?

Let’s take a look at one of them – Trust Fund Loophole.

In their words, the plan would “eliminate the biggest loophole that lets the wealthiest avoid paying their fair share of taxes”. Further, “hundreds of billions of dollars escape capital gains taxation each year because of the stepped-up basis loophole that lets the wealthy pass appreciated assets onto the heirs tax-free”.

Really? As a tax accountant, I think they are playing a bit loose with their description. First off, you have to be willing to die to take advantage of this windfall. Second, the White House fails to mention that the people targeted as “wealthy” if you recall, are the same people on whom the estate tax is imposed. So to call the basis adjustment rules a loophole for the wealthy is misleading at best.

Section 1014 of the Code provides (generally) that the tax basis of property received from a decedent is the fair market value at the time of death. So, yes, if the value at death is greater than the tax basis was in the hands of the decedent, there is a gain that will not be subject to income tax. But if the basis is more than fair market value, there will be a loss that is never recognized either.

The reason that Congress enacted Section 1014 in the first place was with the intention to be fair. They recognized that the value of that property would be subject to Estate tax at the time of death. Section 1014 has additional provisions that tie the basis adjustment to the value included in the gross estate. Congress felt that it would not be fair to subject the same property to both income tax and estate tax at the same time, especially when there may be no intention to sell the property and the estate tax is levied on the value before tax.

Taking the example included in White House fact sheet; an individual leaves stock worth $50 million with a tax basis of $10 million to an heir, who immediately sells it. The twenty percent income tax on the gain if sold by the decedent would have been $8 million. But because of Section 1014, there is no gain recognized. However, the $50 million is subject to estate tax at 40%, or $20 million in tax. And, of course, stock is going to have to be sold in order to pay the $20 million in estate tax plus the income tax on the gain in the stock that has to be sold to pay tax. So what really passed here? $24 million or a little over half of the original value ($20 million in estate tax, plus $4 million in income tax). Under the President’s proposal, instead of only half the stock being considered sold, it would be all of it. And in addition, the capital gains rate would be 28% percent instead of 20%. So, there would be estate tax of $20 million plus income tax of $11 million for a tax bill of $31 million. The net amount passed would be only $19 million on the original $50 million. That’s fairer?

It may seem that the president is pretending to simplify our complex tax code by focusing on the high-net worth income; But after evaluating the details and applying them, achieving a fairer investment through it so the country can responsibly invest in the middle class may still indicate his plan is a work in process.

Article contributed by Paul Steckel, CPA, MKS&H Tax Partner

About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by advising them regarding their financial, technology and human capital management needs.

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