Obama Plan to Lower Middle Class Tax at Expense of Rich is Non-Starter for GOP

Proposed tax hike on highly appreciated inherited assets gives wealthy families and their advocates a chill. Certain forms of trust arrangement have started looking better than ever.

[caption id="attachment_15665" align="alignright" width="359"] The other side of the bargaining table has yet to fill up.[/caption]

Rumor has it President Obama is going after inherited money to pay for new middle-class programs, but early chatter has already exposed the White House’s misunderstanding of how “trust funds” work.

It seems that Obama’s policy team considers the current practice of stepping up the cost basis of inherited assets when the original owner dies to be a trick trust creators exploit to cheat the IRS.

Dig in, however, and it’s clear that the families who are actually vulnerable to proposals on the table are the ones who pass on the bulk of their wealth outside trusts – those who already have more sophisticated estate planning in place may not pay much more tax than they did previously.

A rhetorical gambit

For the typical reporter, the phrase “trust fund loophole” probably conjures up images of vast wealth passed on since the Gilded Age and the arcane perks that perpetuate endless privilege.

The president is scheduled to further explain the plan on Tuesday night in his State of the Union address. With the Republicans running both houses of Congress, it's probably not going to go much farther.

"The notion that in order for some people to do better, someone has to do worse is just not true,” Florida GOP Sen. Marco Rubio told CBS’ “Face the Nation.” “Raising taxes on people that are successful is not going to make people that are struggling more successful. It would also be counter-productive."

But if you hear it in tomorrow night’s State of the Union address, it looks like the connection to trusts as opposed to more populist estate planning vehicles will be nebulous at best.

The “loophole” in question is simply the way the IRS overlooks accumulated capital gains when appraising the value of assets that pass down from generation to generation.

Right now, people who inherit stock, bonds or real propertystart the capital gains clock running when the previous owner dies. When they sell, the taxable gain only applies to appreciation since the initial bequest.

This is not actually a unique feature of passing on wealth via a “trust fund” instead of the probate system. If anything, several types of trust are disqualified from this rare gesture of IRS mercy, requiring additional handling to even the scales.

And this means that pushing the inherited taxable basis back to the price at which the assets were originally acquired will not punish elite trusts any more than upper-middle-class heirs.

What the White House team seems to be proposing is a general estate tax hike disguised as a “trust fund” tax – but given my experience with how eager they are to communicate in lowest-common-denominator terms, it’s no real surprise that the details got lost in translation.

Moving the goalposts

While the proposals would keep the formal estate tax threshold above $10 million per married couple, the fact that the heirs would immediatelyowe tax on all capital gains beyond $500,000 on the family home plus $200,000 in other assets brings the ball back to the upper edges of the middle class.

Small businesses get an exemption until sold, but the sweat equity embodied in a family company built up from scratch may still trigger the taxwithout ever crossing the $10 million estate line.

Vast fortunes passed down through probate pay a double toll from the estate tax and then the capital gain the heirs then have to pay. But the existing estate tax environment means most true trust fund types will be going around probate anyway.

That’s where the middle-class giveaway becomes a middle-class problem.

Property transferred into a trust generally inherits the capital gain position the original owner had built up. To get the step up in basis, the assets often need to be reabsorbed into the grantor’s estate and taxed on those terms – eliminating the estate tax advantages of the trust structure in the first place.

So if the truly rich weren’t getting the step up in the first place, the burden here falls on the mass affluent who die with more than $700,000 in total appreciation in their taxable estates.

Rumor has it the White House’s proposed changes to capital gains treatment and rates could rake in an extra $210 billion for the IRS over the next decade. The poor won’t feel it, but the extra tax load actually leaves self-made millionaires picking up the bill.

Difficult to manage the gap

The question is how many American families are in the gray area. Obama advisors are painting this as an additional tax on the legendary 1%, which means about 1 million households.

But there’s a world of difference within those 1 million households between true Silicon Valley and hedge fund billionaires and the retail investors who worked hard enough to build up $700,000 in capital gains over their lifetimes.

The billionaires might have to accept an extra 5% drag on their investment income if the Obama plan actually gets any traction – unlikely given the climate in Washington now, but you never know. Once again, their assets will probably move into trusts anyway, making the cost basis point moot.

A professional who bought $250,000 in index funds over a few decades might only die with $1 million and still trigger IRS bills while remaining far from estate tax territory.

The heirs might only owe around $15,000 in that scenario, but it’s still money they wouldn’t have had to pay under the existing system.

If they end up having to pay it, we can look forward to seeing new middle-class asset planning techniques emerge to donate enough highly appreciated assets to charity to get below the cap, or even carry tax losses to apply against the gains.

Otherwise, there’s not much help on the table here for these families.

And if the true “trust fund” types want to keep money in the family for generations, there’s not much here that serves as an added road block.



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