Higher Capital Gains Rates Could Suppress Business Growth; New Rules Could Lead to Compliance and Administration Problems; Proposed Carve-Outs Could Lead to Tax Avoidance
Washington, DC – As Congress continue to debate President Biden’s comprehensive Build Back Better legislation, a major sticking point remains over financing the package through higher taxes on the wealthy, including a proposed change to the tax treatment of appreciated assets when transferred to heirs in the event of death. A new report by the American Council for Capital Formation Center for Policy Research (ACCF-CPR) examines Biden’s proposal to end the practice of “stepping-up” the basis for gains on inherited assets in excess of $1 million ($2.5 million for couples when combined with existing real estate exemptions) and making sure the gains are taxed if the property is not donated to charity. The repeal could impact Americans beyond the targeted wealthy and, coupled with higher capital gains taxes, also lead to a number of tax compliance and administration problems.
“The potential tax increases from a repeal of step-up in basis or higher capital gains tax rates, could have unintended consequences for the much-needed investment and economic growth the Administration seeks,” said ACCF-CPR Executive Vice President and Chief Economist Pinar Çebi Wilber. “In addition to the chilling effect that higher capital gains rates could have on businesses, including downsizing and closures, the tax code becomes far more complicated with proposed special carve-outs that could result in creating more opportunities for gaming the system through tax avoidance strategies.”
The report takes a detailed look at the treatment of capital gains taxes and impact on businesses under President Biden’s American Families Plan, which has a $1 million exemption and the proposal by the Senate Democrats which includes a $5 million exemption. Under one scenario, a business with a $10 million fair market value (FMV) at time of death would see a $1.5 million increase in capital gains taxes (43.40%) under the Biden plan and approximately half of that amount under the Senate Democrats plan. Another scenario looks at a $20 million FMV business and factors in both capital gains tax increases (43.40%) and estate tax (40%) implications. Liabilities increase substantially, with the American Families Plan seeing a $4.7 million increase and the Senate Democrats Plan to see a $3.6 million increase.
These economic impacts from repealing step-up in basis could lead to significant economic consequences. Based on findings from prior economic analyses, the ACCF report concludes:
- Business and Economic Impact: Due to increased financial strains caused by higher tax liabilities, existing businesses may be forced to downsize or close. Modeling firm REMI estimates sustained annual job losses range from over 500,000 to almost 1 million (depending on how government spends the revenue) and GDP loss of $1 trillion over 10 years.
- Investment Discouraged: Additional taxes and increased capital costs and lower savings could discourage investment and prevent the opening of new businesses. Cost hikes would likely be passed on to consumers in the form of higher consumer prices.
- R&D Diminished: As private investment decreases, research and development (R&D) spending goes down, which could ultimately lower overall labor productivity. This reduces wages, economic growth, and living standards. REMI estimates a $600 billion reduction in private investment and a $6 billion reduction in R&D spending over 10 years.
Prior attempts to repeal or significantly change how the capital gains are taxed when transferred to heirs have failed of have been quickly repealed due to compliance and administration problems, including:
- Issues with Determining the Tax Base and Value: The repeal of step-up in basis, proper documentation of the original investment and improvements as well as current value are required for an accurate calculation of appreciation over the lifetime of the assets, even if they have been owned for decades. This could introduce significant tax compliance costs.
- Carve Outs Result in More Complications for an Already Complicated Tax Code: Many proponents of repealing step-up in basis, proposes carve-outs to diffuse the negative impacts of such repeal on family-owned businesses.
- More Opportunities to Game the System: As the tax code becomes more complicated with special carve-outs, it also creates more opportunities for tax avoidance strategies. Repealing step-up in basis could further fuel such behavior, especially among the wealthy targeted by the repeal, who have access to tax planning experts.
- Problems with Tax Administration and Additional Cost: Introducing an additional layer of complication to capital gains and estate tax calculations through repeal of step-up in basis could mean additional administrative and enforcement costs for the IRS, which is already facing an increased workload with funding that has changed very little over the years.
“Many of the impacted targets of the step-up repeal are small businesses, which have already suffered disproportionately during the pandemic. A further increase in tax burden due to repeal of step-up in basis could have additional negative impacts on the viability of these businesses, further slowing the potential growth of the U.S. economy,” Wilber concluded.
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