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Monday, April 18, 2022

You shouldn't have your cake and eat it too

Two Pathways to a Major Tax Reform

By Gerald Scorse 

A proposed tax reform—left for dead in the ruins of Build Back Better—isn’t dead after all. In fact it could still happen, in two separate ways. 

Both would curb the stepped-up basis, a giveaway that allows capital gains to pass untaxed from generation to generation. Its elimination would bring tens of billions into the Treasury, give a huge boost to tax fairness, and take a huge bite out of pass-along fortunes. 

Taxing the unrealized capital gains of the ultra-wealthy has taken center stage as one of the possible methods. The Biden Administration’s 2023 budget would “establish a 20% minimum tax rate on all American households worth more than $100 million,” including any appreciation in the value of investments that haven’t yet been sold. 

Daniel J. Hemel thinks the federal government has long had a better, simpler solution. A professor at the University of Chicago Law School, Hemel  explained everything in a seven-page letter sent early this year to Rep. Bill Pascrell of New Jersey, chairman of the Way and Means Subcommittee on Oversight. 

At an Oversight hearing, Pascrell asked a multi-billion-dollar question: “(W)hat specific steps could Treasury and the IRS take to prevent high net-worth individuals and families from avoiding…taxes on intergenerational transfers of wealth?” 

Now for Hemel’s multi-billion-dollar answer. From here on in, pretty much everything you see stems from his letter (including some dives into the weeds of tax policy). 

The easiest way to understand the issue comes from a phrase that everybody knows, “having your cake and eating it too.” In this case it’s turned into a high-stakes game for some of America’s richest families. 

They’re using and abusing the laws to claim an ongoing exemption from capital gains taxes—first for the original owner, then for the next, and on and on. Over and over, gains and taxes are being wiped away and fortunes are being fattened. 

The abuses involve irrevocable grantor trusts holding stocks, real estate or other assets. 

“If the trust is properly structured, the property will not be included in the individual’s gross estate at death (and thus will not be subject to estate tax.)” No problem so far; Hemel see this as having-your-cake, using a grantor trust to shield the assets from estate taxes. 

But, he says, one tax break should never beget another: “High-net-worth individuals and families can have their estate tax ‘avoidance’ cake but cannot eat the income tax benefits” as well. In other words, beneficiaries should be liable for taxes on the accumulated capital gains of the assets they inherit. 

In recent years, however, “a handful of estate and gift tax lawyers have suggested that high-net-worth individuals and families may be able to have their cake and eat it too: to claim the estate tax benefit…while also obtaining the income tax benefit of stepped-up basis at death.” 

Ironically, the idea owes its momentum to an IRS opinion. A 2012 ruling “appeared to imply” that grantor trusts automatically qualify for a double tax exemption: no estate tax on the value of the trusts, no tax on the capital gains when the trusts are passed on. 

Here’s Hemel summing up the reaction: “Tax practitioners described the…ruling as ‘astonishing’ and noted that it ‘gives comfort’ to taxpayers pursuing the have-your-cake-and-eat-it-too gambit.” The ruling also contradicts an earlier IRS memorandum that speaks to exactly the same issue.  

Long before 2012, through “a vibrant industry of tax shelters,” transactions between grantors and the trusts they created were routinely stiffing the taxman. Hemel again faults the IRS, pointing to a “disastrous” 1985 ruling: “Revenue Ruling 85-13 allows high-net-worth individuals and families to obtain the very same have-your-cake-and-eat-it-too result…”  

There’s a simple IRS fix for 85-13, and estate lawyer Turner Berry is all for it: “They could just revoke it….You don’t need congressional legislation to do [it], either; just stand up, be an American, and revoke the ruling.”  Tax scholars Jay A. Soled and Mitchell Gans called for the same action over a decade ago, arguing that “the IRS should not allow itself to be a wallflower, passively watching as the federal coffers are drained.”

The draining won’t completely stop until Congress enacts comprehensive stepped-up basis reform. In the meantime, as Hemel’s letter shows, there’s really no need to wait: the IRS could get the reform underway almost immediately.

Gerald E. Scorse helped pass the bill requiring basis reporting for capital gains. He writes on taxes. His articles have appeared often in Progressive Charlestown.

© 2021 Gerald E. Scorse