Proposed Changes to Capital Gains Could Have Significant Impact on Estate Planning

September 16, 2021

President Biden recently proposed major tax changes with the aim of generating billions in additional revenue to fund the $1.8 trillion American Families Plan.  If enacted, the proposal significantly changes the capital gains tax and would drastically affect the costs of family inheritance at death.  Passing on the family business or cottage could suddenly be a costly affair.

This proposal would eliminate a familiar concept in capital gains tax – the step-up in basis.  Under current law, if an owner sells an asset at a gain, capital gains tax applies to the difference between the owner’s original cost (cost-basis) and the sale price.  If the property is inherited, the basis is not the owner’s cost-basis, but the fair market value as of the date of death (step-up in basis).  Death of the original owner does not result in capital gains tax.  When the heirs finally decide to sell the property, capital gains tax only applies to the property’s increase in value from the date of death to the date of sale.  This results in a significant capital gains tax advantage on inherited property. 

There are few details but some plans provide for a capital gains tax exemption of $1 million per individual and $2.5 million for married couples, minus certain real estate exemptions.   The top capital gains tax rate under the proposal could be as high as 39.6%. 

It is unclear how the proposed elimination of the step-up in basis will impact estate planning and there remain many unanswered questions.  Does the Estate have to pay capital gains tax on the difference between the decedent’s cost-basis and the fair market value at date of death?  Or do the heirs take the property with a carryover cost-basis subject to capital gains tax when the heirs sell the property at a later date?  President Biden has not provided clarification, but a press release by the Department of Agriculture seems to indicate that the death of the owner requires the Estate to pay the capital gains tax.

Further questions remain about how the loss of the step-up in basis may impact family businesses.  The fact sheet released by the White House contains a single sentence: “The reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.”  There are no details on what these protections might be. 

For example, it is not clear if these protections only apply to heirs who are already running the business as of the date of the owner’s death, or if the protections also apply to heirs who step in after death.  It is also not clear if only heirs who participate in running the family business receive the proposed “protections”.

Let’s look at an example.  A father starts a construction business and builds it into a successful practice.  At his death, the business is valued at $500,000.  His daughter takes over and, under current law, receives the step-up in basis of $500,000 and does not pay any capital gains tax.  

Through hard work, creative ideas, and successful bids, the business takes off under the daughter’s leadership.  She has two sons – one who joins the business and the other who decides to pursue a music career.  At the daughter’s death, the business is valued at $5 million and has $4.5 million in unrealized capital gains during her lifetime.  In her Will, the daughter leaves everything she owns, including her business, to her sons equally. 

Under the current proposal, if the sons decide not to continue running the construction business after their mother’s death, it appears that their inherited business interests will receive no protection on the loss of the step-up in basis.  Does this mean that the Estate will have to pay capital gains tax on the $4.5 million in unrealized gains, or will the mother’s $500,000 cost-basis carryover to the sons until such time as they sell the business? 

If the one son decides to continue to run the business, will both sons’ shares be protected or will the musician need to join the company to avoid the capital gains tax on his share?  And how long does the business have to be run by the heirs in order to avoid the capital gains tax?  All of these questions remain unanswered.

 It is important to note that no tax reform has been enacted and a final bill could have very different provisions.  Other proposals have included reducing the estate tax exemption to $3.5 million (currently approximately $11.7 million per individual).  If the current capital gains tax proposal is not enacted, estate tax exemption changes may be forthcoming.

Our estate planning and tax teams are keeping a close eye on the progress of President Biden’s capital gains tax proposal. In the meantime, if you have any questions or concerns about making an estate plan (or updating an existing plan) to protect your assets and your family, please give me a call.

Katherine Liebner is an attorney at Gross Shuman P.C. Ms. Liebner focuses her practice in the areas of estate planning, estate and trust administration, and labor and employment law. She can be reached at 716.854.4300 ext. 236 or [email protected]