Taxing capital gains upon death at a higher rate than during life

President Joe Biden and Senate Finance Committee Chairman Ron Wyden (D-OR) have proposed different ways to tax unrealized capital gains each year. Their shared purpose is understandable, with trillions of dollars escaping income taxes under current law. But any plan raises serious administrative and legal problems. We propose a simpler, more effective approach: tax unrealized gains of the wealthy upon death at a higher rate than when assets are sold or given as gifts during life.

An unrealized gain is the appreciation of an asset, such as stocks, that has not yet been sold. It’s important to tax these gains because unrealized gains now account for more than half of the staggering amount of wealth of the very richest Americans, those with a net worth of at least $100 million.

Current legislation encourages the wealthy to keep their assets until death, when those profits permanently escape income taxes. This happens for two reasons. First, current law does not treat a bequest as a sale, so there is no income tax due on death. And second, heirs are allowed a “stepped basis” where they never pay taxes on any increase in property value during a decedent’s lifetime.

The results: Government loses a huge amount of revenue, wealth inequality is perpetuated for generations, and investors are encouraged to keep (or ‘lock’) ill-balanced and less productive portfolios. More than fifty years ago, two leading tax experts described the non-taxation of capital gains carried over upon death as “the most serious flaw in our federal tax system.”

To fix this long-standing flaw, our plan for the very wealthy (couples over $100 million and singles over $50 million) would tax unrealized death gains at the ordinary income tax rate — currently 37. per cent. But gains from sales or donations of assets during life would still be taxed at 23.8 percent. Transfers to spouses would be exempt from tax. And the very wealthy should be allowed to deduct their death tax income from their estate taxes.

Our proposal turns the existing incentive for valued assets on its head. Rather than encouraging people to keep their prized assets until death to avoid income taxes, our proposal encourages them to sell those assets before they die.

For example, imagine an entrepreneur who owns $100 billion of his company stock, which he paid nothing for when he founded the company. Under our proposal, if he held his stock until his death, he would owe $37 billion in income tax. But if he sells in his lifetime, he would owe $23.8 billion. And if he wants to transfer his shares to his children without paying the $37 billion, he can give his shares to them during his lifetime and pay $23.8 billion.

To determine the scope of our proposal, Rob reviewed data from the 2019 consumer finance survey, which he combined with Forbes 400 information (which was excluded from the survey). He estimated that taxpayers subject to our proposal will have unrealized gains totaling about $7.5 trillion by 2022.

If these households realize $6 trillion of their $7.5 trillion of that gain in their lifetime, and the remaining $1.5 trillion at death, our proposal would yield nearly $2 trillion over time. In the next 10 years alone, our plan could yield hundreds of billions of dollars, just like Biden and Wyden’s. (Our plan could end up paying more than theirs, since our death tax rate is higher than Biden’s and Wyden’s.)

For simplicity, we assumed that unrealized gains do not increase over time, which probably makes our estimates conservative.

Taxing the wealthiest households on their unrealized gains on death is much easier to manage than Biden’s or Wyden’s plans to tax them annually. Our plan would rely on existing tax returns and appraisals, which the wealthy already file, while Biden and Wyden’s plans would impose new annual returns on taxpayers over their lifetimes. While few taxpayers would pay Biden or Wyden’s taxes, many more should value all of their assets annually, as taxpayers close to the border can move in and out of regimes over time. How would the IRS determine if all of these taxpayers filed correctly?

Finally, our proposal to collect taxes on transfers by gift or bequest is well established in the US Constitution, but collecting taxes outside of transfers during their lifetime raises unresolved legal problems.

Today, older, wealthier taxpayers often hold onto valued assets during their lifetimes, waiting to hand them over upon death. Our plan encourages them to realize profits during their lifetime, which could lead to more balanced portfolios, broader ownership of these assets and the generation of much-needed tax revenue.

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