President Obama to Propose Significant Changes to How Capital Gains and Investment Income Are Taxed Both During Life and at Death


On Saturday, January 17, 2015, the White House released a “Fact Sheet” entitled “A Simpler, Fairer Tax Code That Responsibly Invests in Middle Class Families” (the “Fact Sheet”). This Fact Sheet describes at least a part of the tax plan (the “Plan”) President Obama will present at his State of the Union Address on the evening of Tuesday, January 20, 2015.

As with all “fact sheets” the information presented on the Plan is superficial. As expected, it has already been criticized by the Republican leaders in Congress. Although the revenue and expenditures are not quantified, the Fact Sheet states the proposal expands the Earned Income Tax Credit, provides quality preschool for all children under four-years of age, provides expanded college financial assistance, and raises revenue to reduce the deficit by curbing inefficient tax breaks that primarily benefit the wealthy. In addition, the Fact Sheet states that the President will provide a framework for fixing the business tax system on a revenue neutral basis and use the transition revenue to pay for investments in infrastructure. This will include a fee that is applicable to the 100 largest financial firms. It appears there are additional reforms that are beyond the scope of the Fact Sheet that somehow provide revenue neutrality in the business tax system while funding additional expenditures for infrastructure.[1] The revenue is raised by:

Treating non-charitable gifts and bequests of capital assets as a “realization event” thereby triggering income tax at that time. The basis step-up is characterized as “perhaps the largest single loophole in the entire individual income tax code.” This Plan is similar to the Canadian system, although the Canadian system does not impose a federal estate tax in addition to an income tax. This characterization also ignores the fact that the step up in basis for assets in excess of the Unified Credit[2] compensates for the fact that these assets are taxed at a 40% estate tax rate and thereby avoids double tax. It also ignores the fact that the tax basis of gifts “carries over” to the recipient so that the capital gains tax is merely delayed, not avoided. There is a de minimis exemption for bequests of assets with $100,000 of capital gain. Also, personal residences would have a $250,000 exemption per person which is automatically portable between spouses. No tax would be due on inherited small, family-owned and operated businesses - unless and until the business is sold. Any other closely-held business would have the option to pay the tax imposed on gains over 15 years. By reducing the step up to $100,000 of capital gain, this provision effectively imposes an “estate tax” on the capital gains portion of the Unified Credit of $5,430,000 equal to the capital gains tax.[3]

Increase the maximum capital gains tax rate from 20% to 28% (a 40% increase). Under the Plan the new rate would apply on incomes over “about $500,000.“

Tax-Favored Retirement Assets Capped. The Plan caps the maximum aggregate retirement and IRA account balances at “about” $3.4 million. Above that level, no additional contributions or accumulations would be permitted. There is no mention of indexation or how excess benefits would be taxed.

Fee on Excess Borrowing by Large Financial Firms. The Plan reforms financial sector taxation by imposing a fee (not a tax) on the 100 largest financial firms with assets over $50 billion that finance their activities with undefined “excessive” borrowing. The fee is a 7 basis point annual charge on borrowings. This purports to incentivize the firms to make decisions more consistent with the economy-wide effects of their actions which will reduce the probability of major defaults that can have widespread economic costs.

New tax expenditures include:

Incentives for working couples in the form of a credit equal to 5% of the first $10,000 of earnings for the lower paid spouse (i.e., a $500 credit) phased out for income between $120,000 to $210,000 and benefiting 80% of two-earner families. Making permanent improvements to the Child Tax Credit of $1,000 that are set to expire at the end of 2017 and a doubling of the Earned Income Tax Credit for 13.2 million low income workers.

Child care, education and retirement tax benefits for middle-class families. This category includes tripling the maximum Child and Dependent Tax Credit to $3,000 per child under five for families with incomes of up to $120,000 (a reduction in income levels from current law) and although it is not clear, the present credit for older children and elderly and disabled dependents will presumably be retained. This is supposed to benefit 5.1 million families and 6.7 million children. The present Child Care Flexible Spending Account would be eliminated which has a maximum credit of $2,500 per parent to $5,000 total for a family.

Education tax incentives improved and consolidated. This is to assist 8.5 million families and students and simplify taxes for more than 25 million families and students. The Plan would revise and make permanent the American Opportunity Tax Credit with benefits indexed to inflation. The assistance is $2,500 per year for five years (one more year than current law) and students that are less than full time do not have to be a minimum of half time and would receive $1,250 with up to $750 refundable for up to five years. A person whose remaining student debt is forgiven under Pay-As-You-Earn would not have taxable income on the forgiveness. Lifetime Learning Credit would be repealed and for new borrowers, the interest deduction on student loans would be eliminated. Existing borrowers would continue to have the deduction. The expanded deduction for 529 plans would be “rolled back,” and the tax incentives for Coverdell education savings would be repealed.

Retirement Tax Incentives and Expanding Savings Opportunities. Employers with 100 employees or more and no retirement plan would be required to offer and automatically enroll workers in an IRA. Workers can opt out. Small employers with 100 or less employees that start an auto-enrollment IRA would be entitled to a start-up tax credit of $3,000 to defray administrative costs. Small employers that add auto-enrollment to plans already in place would receive a $1,500 start-up tax credit. The Fact Sheet states that only 37% of part-time workers have access to a workplace retirement plan. The Plan requires employers who offer retirement plans to permit employees who have worked for the employer for a minimum of 500 hours per year for three years or more years to make voluntary contributions to the retirement plan.

Waller will be closely monitoring tax law proposals from President Obama and the One Hundred Fourteenth United States Congress as they develop. For additional information, please contact Leigh Griffith, Richard Johnson, Mike Yopp or any member of Waller’s Tax practice at 800.487.6380.

[1] “In addition, the President has put forward a framework for fixing the business tax system on a revenue-neutral basis and using the transition revenue to pay for investments in infrastructure.” Page one of Fact Sheet.

[2] As of 2015, estates of $5,430,000 pay no estate tax but receive a step up in basis on those assets.

[3] For example, on an estate with $1,000,000 of securities and basis of $100,000, the tax would be $224,000 ($254,400 if the net investment income tax is applicable) instead of zero under current law.

The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.