By Mike Schudel, CFP
When it comes to financial planning, we are at an interesting but potentially unsettling moment in history, a time when unusually low tax rates could soon balloon into extraordinary increases – and not necessarily for whom you might think.
During his campaign, President Joe Biden discussed tax hikes with his proposals focused on the estate tax and other areas that, at first blush, appear to affect mainly the wealthiest of the wealthy.
But it’s not just the Jeff Bezos and Elon Musks of the world who need to be concerned. Many of these tax proposals could deal a crushing blow to Americans operating family farms and small family businesses.
Let’s take a look at four proposals and what the consequences could be:
● Elimination of stepped-up cost basis. This could have extraordinary repercussions for anyone inheriting a family farm or business. Currently, spouses and children are eligible for what’s called a “stepped-up cost basis” when they inherit certain assets, including family farms and family S-Corporations. What does that mean?
Let’s say John purchased his farm 40 years ago for $650,000 and today the farm is worth $2.3 million. The farm employs John's daughter as a family business. If John sold the farm for $2.3 million, he would owe capital gains taxes on $1,650,000 – the difference between what he bought it for and what he sold it for. But if John left the farm to his daughter upon his death, she would "step into" the current fair market value of $2.3 million. If she sold it immediately at that price, she would owe no capital gains taxes at all and would keep all $2.3 million.
Biden's tax plan would eliminate this benefit. That means, in this case, the daughter would owe taxes on the $1,650,000 capital gain.
● Elimination of the long-term capital gains rate for incomes over $1 million. If you sell an asset such as a stock, a business, or land, you pay a capital gains tax on the profits. But there are special tax rates when you hold those assets for more than a year. They are 0%, 15%, or 20%, depending on your taxable income and filing status. Biden wants to eliminate those long-term rates for incomes over $1 million and replace them with ordinary tax rates, a move that would cripple much of the incentive for long-term investing. People will think twice about investments if they ultimately have to pay ordinary income tax rates, which could be as much as 37% instead of at most 20%.
Let’s look at how this might play out by using the previous example with the daughter, the family farm, and the stepped-up cost basis. If the $1,650,000 was taxed at 37%, the already disastrous situation would evolve into an almost guaranteed liquidation of the family farm. The same issue would apply to shares of a family S-Corporation. Many small businesses are owned as S-Corporations and, currently, the shares receive a stepped-up basis when the owner dies and passes the business on to their family.
If this change is made, anyone who wants to see a farm or business stay in the family’s hands from one generation to the next will need to accumulate a pile of cash equal to the tax bill.
● Increase of the top marginal Income tax rate. Biden has proposed increasing the current top income tax rate to 39.6%, up from 37%, for those with taxable incomes exceeding $400,000. Look back at the previous examples of proposed changes I mentioned and you can see how this could add even more tax pain to an already disquieting situation.
● Make changes to the estate tax. When you inherit money or assets, the federal estate tax doesn’t kick in unless the value of the estate tops $11.5 million. But another change proposed would reduce the exemption to $3.5 million. At the same time, the highest estate-tax rate would increase to 45%, up from 40%. Once again, let’s revisit our previous example, but with a caveat. Farmland or shares of an S-Corporation appreciating to $2.3 million hardly tells the full story. A farm or business with that kind of value likely comes with other things that add to the value, such as equipment, inventory, or intellectual property. Total everything up and the value could easily exceed $3.5 million, so the farm or business that wouldn’t trigger an estate tax right now would under the proposed change.
Certainly, something must give with the nation’s tax situation because the federal deficit continues to grow, with pandemic relief efforts just adding to the problem. Back in the 2008 recession, the financial bailout amounted to $800 billion. Add up all the relief packages from last year and this year, and they total more than $4 trillion.
At some point, to bring the deficit under control, the federal government must cut spending or raise taxes – and which is more likely?
But don’t think that just the wealthiest of the wealthy will be affected. Any tax hike could have far-reaching implications for many more people than just the nation’s financially elite. It’s going to come home and make family farms and businesses make hard decisions on how to pay the taxman while trying to pass the family enterprise to their sons and daughters.
About Mike Schudel, CFP®
Mike Schudel is a financial advisor with Retire SMART (www.retiresmartomaha.com), a financial firm in Omaha, Nebraska. Schudel has earned a number of financial services designations, including CERTIFIED FINANCIAL PLANNER™, professional, Chartered Life Underwriter®, Chartered Financial Consultant®, Chartered Advisor for Senior Living, Certified Annuity Specialist and Certified Fund Specialist. He has a bachelor’s degree in history and a law degree.
Retire Smart, LLC is an independent financial services firm that utilizes a variety of investment and insurance products. Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC (AEWM). AEWM and Retire Smart, LLC are not affiliated companies. A PR firm was paid to assist with media placement. This article is intended for informational purposes only. It is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual’s situation. Retire Smart, LLC is not permitted to offer and no statement made during this article shall constitute tax or legal advice. Our firm is not affiliated with or endorsed by the U.S. Government or any governmental agency. The information and opinions contained herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Retire Smart, LLC. AE Wealth Management provides services without regard to political affiliation and the views of individual advisors are not necessarily the views of AE Wealth Management. 868664 – 4/21
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