Biden presidency could mean big changes for taxes on death

During the 2016 presidential campaign, there was plenty of talk about estate taxes -- death taxes to use a common pejorative term. In 2016, Donald Trump wanted them repealed entirely, while Hillary Clinton and Bernie Sanders wanted them increased a lot, slashing the $11.5 million per person exemption to $3.5 million, and upping the tax rate from 40% to 65% for big estates. None of that happened, and in the 2020 campaign, there was little talk about estate tax. Even so, big change might be coming to taxes on death. Here's how.

With a $23 million allowance per married couple going free of gift or estate tax, only those over that number face taxes. That could certainly be lowered, and there's a good chance, especially if the Democrats take control of the Senate (which will not be decided until January). During his 2020 campaign, Sanders again said he wants to drop the $11.5 million exemption to $3.5 million. Joe Biden has been less clear, but he too has suggested that the current exemption is too high.

Yet far more important, President-elect Biden's tax plans reflect a massive change in how income and estate taxes interact. He has called for a massive tax increase that will transform income taxes on death. First, the obvious points. Biden has proposed taxing long-term capital gains and qualified dividends at ordinary income tax rates of 39.6% on income above $1 million.

But how about on death? This is where the change is much bigger, where Biden's plan cuts deeper on many more regular people for much higher income taxes once you die. After the Democratic National Convention, Biden pledged "no new taxes" on incomes under $400,000 and on mom-and-pop businesses, but some of the $4 trillion tax plan he previously rolled out suggests otherwise. Right now, up to $23 million per married couple can pass to one's heirs free of federal gift and estate tax.

But how about income taxes on and after death? Most people don't think about income taxes on death, but that's where President-elect Biden proposes big changes. Biden's plan could leave you paying higher income taxes after a death by repealing present law's step-up in basis. For generations, people have counted on getting an increase to the tax basis for inherited assets to their full fair market value on death. It is such a well-worn rule that everyone counts on it. What could be the much higher cost alternative?

Biden's tax plan calls for carrying over an asset's tax basis from the decedent to the next generation. No amount of estate tax exemption would help you, because this is a big income tax increase. The step-up in basis provides tax benefits for everyone passing down appreciated assets, including real estate, stock, family companies and more. Small businesses count on this too.

Whether it is your parent's house, vacation home, stock portfolio, horde of bitcoin, or just about anything else, it is what you expect. After all, if you inherit a $1 million house, you can live in it or sell it, and not think about taxes, except perhaps property taxes. For that matter, there's even a California property tax break for that.

Say you have a family business worth $20 million that you started from scratch. How is it taxed if the married couple dies? Right now, the business goes free of estate tax to the kids. If both parents die, the $23 million estate tax exemption should mean no estate tax for that $20 million business. So far, so good. And the business gets a step-up in basis for income taxes too.

Suppose that mom and dad die, and Junior gets the stock in the family company. No matter how small mom and dad's tax basis was in the stock when they started the company, the stock gets stepped up to market value on death, $20 million. That way, Junior can run the business, or can sell it for $20 million and should pay no income tax. Or, Junior could try running the business for a year or two -- it might even be worth $22 million then -- before he sells it.

Junior would pay income tax on the $2 million increase in value since his parents died. But remember, he has that $20 million date of death value basis. Of course, this example is simplistic, and ignores the fact that the business itself might make the sale. Most buyers won't buy stock, and insist on buying assets, and the business would be taxed. On a business sale, the company, owners or both may have to pay the IRS.

Still, as this simple example shows, step up in basis is a huge deal. Anyone in California who inherits a house or other real property from an aging relative knows how important step up in basis is. It is truly a hallmark of our estate tax system that everybody gets a stepped-up basis. How might it change if President-elect Biden pushes this idea and if Congress agrees?

It appears that the Biden proposal would tax an asset's unrealized appreciation at the time of transfer. By taxing the unrealized gain at death, heirs would get hit at the transfer, regardless of whether they sell the asset. My guess is that this part of the plan will not happen. However, to return to our example, that could mean Junior could get taxed whether or not he sells the business.

It seems more likely that if this proposal moves forward it would leave the historical tax basis intact, but not alter the timing, so Junior would not be taxed until he sold. But that is not clear. In any event, the idea that you could build up your small business and escape death tax and income tax to pass it to your kids is on the chopping block.

In total, President-elect Biden floated a $4 trillion tax plan, hiking income tax rates on households with taxable income over $400,000, according to a study done by the Tax Policy Center. Capital gains tax rates would soar too. Under current law, the long-term capital gain rate is 20% for those with over $441,451 in taxable income ($496,601 for married-filing-jointly).

Biden's proposal would subject capital gain to the same tax rate as ordinary income for incomes over $1 million. If subjecting appreciation in assets to income tax on death happens, small businesses and many other assets such as personal residences, could be in for even more income taxes. 