President Obama focused on middle class economics in his State of the Union address, but from my vantage point what was missing from a financial planning point of view was any discussion of retirement and, beyond a reference to closing loopholes for wealthier folks, specifics of his tax plan.
Nonetheless, administration officials did say the plan would increase the marginal capital gains rate to 28% (including the 3.8% surtax) and, perhaps more importantly, eliminate stepped-up basis of capital gains assets at death. It is an idea that has low rumblings of bipartisan support, making it worth the time to analyze the potential effects of capital gain changes.
Macroeconomic questions abound: Would closing this loophole mean more efficient transfer of assets? Would it mean fairness between those forced to liquidate capital gains assets at the end of their life for long-term care and those able to self-insure? These are important questions for lawmakers to ponder.
The question for financial advisors and their clients is: How could these changes potentially affect us? Which planning considerations would higher capital gains rates and an end to stepped-up basis at death impact? If these changes came to pass, those advisors serving owners of closely held businesses and clients holding significant, highly appreciated securities would have to rethink clients estate plans to avoid leaving heirs huge tax bills.
If changes to capital gains rules gain traction on Capitol Hill, advisors should keep this in mind:
- A heavy tax bill could force heirs to sell a business they do not want to sell. Children overwhelmed with a large tax bill upon inheritance may not have the liquid assets to satisfy what they owe, forcing a fire sale of the business that the grantor clearly wished to remain in the family. While the tax bill would be unavoidable, planning to transfer enough liquid assets to cover the costs could prevent this unfortunate occurrence. Advisors could address this risk by helping clients diversify their concentrated holdings before death, perhaps through a sale of restricted securities or an exchange fund.
- The inevitability of capital gains taxes might encourage business owners to form a more economically efficient succession plan. Its a fact that the children of an entrepreneur are often not the best successors to that business. Watching a business crumble under poor, inherited leadership is a movie we have all seen. Nepotism will always be around, but if avoidance of capital gains taxes was not possible, more owners of closely held businesses might be open to transferring ownership to worthy employees via an employee stock ownership plan or to an outside successor via a leveraged buyout.
- It could mean higher rates of charity donation. This would be the only remaining way of avoiding the heavy tax bill of highly appreciated securities.Higher capital gains taxes and elimination of stepped up basis could heighten the incentive to donate those assets to charity. The flexibility, low cost and accessibility of donor-advised funds which allow donations of highly appreciated securities could make them a great vehicle for the charitably inclined and the tax avoidant.
John Nersesian is managing director of wealth management services at Nuveen Investments.
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