President Obama SHOULD Make Death a Taxable Event

I recently stumbled across a Forbes article complaining that President Obama would like to make death a taxable event. The article was referencing a January 17th, 2015 press release that called for, among other things, a new realization event when appreciated property is received by gift or bequest.

Vocabulary

In tax law terminology, if you own property that increases in value (or “appreciates”), you have “income” because your net wealth has increased. But, the tax code doesn’t usually make you “realize” that income (and pay taxes on it) until you actually sell the property and “realize” the income.

Why? We are concerned that you won’t have money to pay the tax, or the value of the property might go back down before you sell it, or we didn’t have an easy way of accurately measuring its value in the first place. It just wouldn’t be feasible or enforceable.

The tax law has both “realization” events and “recognition” events. You have to both realize income and have the tax law recognize that you realized the income, otherwise you don’t have to pay tax — yet.

The amount of money you pay for a property is its “basis.” Basis gets adjusted by certain things, and so your “adjusted basis” is supposed to represent your investment in a property. The actual fair market value of the property minus the basis equals the amount of income/gain that is built into the property, and which can be realized/recognized at an appropriate event.

So what is the problem? 

Americans decided long ago that 1) people shouldn’t pay taxes at death; and 2) the heirs shouldn’t have to pay taxes on appreciation that occurred when they didn’t have control of the appreciated property. Hence, the “stepped-up basis” rule. When you die, the basis in the property is automatically “stepped up” to fair market value at the time of death.

Ordinarily, realization and recognition rules only ever delay taxation on income. But, the stepped-up basis rule means that if you can hold off on selling those stocks of Apple that you bought back in the 1980’s long enough, then neither you, nor anyone you know or love will EVER have to pay taxes on your gains.

Take, for example, a hypothetical guy named Larry. Larry decides to found a massive corporation and call it Moracal. Since he built it from the ground up, his basis in his personal Moracal shares is approximately $0. Decades later, Larry’s net worth is around $50 billion. But Larry is getting old. He knows that if he can just hold out for a few more decades, he will have built a massive empire to last his family through the next, say, 20 generations+, all without ever paying any income tax whatsoever.

Suppose Larry wants to buy an island. He locates one that costs about $1 billion. Larry would have to sell over $1.2 billion worth of shares in order to generate $1 billion in after-(capital gains) tax return. Then, he would have to fork over about $250 million to the government. Larry would rather have his kids inherit that $250 million. So, Larry decides to take out a loan from his friend, Bill, instead. Larry agrees to pay 5% interest (capitalized into the loan), with the full principle and any accumulated debt payable one year after Larry’s death. Larry puts up $1 billion of Oracle stock as security for the loan. Larry has successfully purchased his island and avoided paying any income taxes ever. In fact, if Larry wants to, Larry can set up shop and run a tourism business on his personal island to help defray the interest expense from his $1 billion loan.

So what is the solution?

There are a number of possible solutions.

1. We could put a cap on the amount of time that an asset could appreciate without being taxed (say ten years or five years).
2. We could simply tax all gain every year, and do away with these rules.
3. When we DO finally collect taxes, we could charge interest on any tax that might have been levied, but was instead deferred (this is actually the best solution, in my book, for reasons that I will explain in a later post; in particular, it would seriously undermine the current incentives to waste billions of dollars on clever tax-planning).
4. Or, we could get rid of the stepped-up basis rule and make billionaires who have deferred taxes their entire lives finally pay a tax on their estate when they die.

So what is wrong with this last solution, which Obama has proposed? 

Nothing. There’s not a damn thing wrong with it, unless you happen to be a billionaire looking for ways to avoid ever paying a fair tax on your income.

As previously mentioned, I have plenty of other ideas about how the tax code could be improved. But that simply isn’t and can never be a criticism of a completely rational, non-partisan, sensible, and obvious solution to a single, discrete problem in the tax code.