Joe Biden wants to cut a cherished tax break:
Stepped-up basis for inherited property. Currently, a decedent’s unrealized gains aren’t hit with income tax at death, and heirs step up their basis in the assets they receive, equal to fair market value on death. Biden’s plan calls for an end to the effects of stepped-up basis for many wealthy individuals.
What would Biden’s proposal do exactly?
It doesn’t adopt a carryover basis regime by which the heir would take the same tax basis in the asset as the decedent. That rule applies to gifts.
It would instead treat death as a realization event for income tax purposes … essentially a deemed taxable sale of the decedent’s assets at fair market value, with any gains and losses reported on the decedent’s final individual tax return. The heirs would continue to get a fair-market-value basis in assets they receive.
Gains of less than $1 million would not be taxed. Plus other exceptions: Property donated to charity would be exempt. Family-owned businesses and farms would escape tax, provided heirs run them. And the existing gain exclusion of $250,000 (or $500,000) on sales of primary residences would continue to apply.
Let’s illustrate the current rules and Biden’s proposal with a simple example. John’s mother owns stock that she bought years ago for $500,000. When his mom dies, John inherits the stock, which is worth $3 million. Under current law, neither John nor his mom owe income tax on the $2.5 million unrealized gain, and John’s basis in the shares is stepped up to $3 million. Let’s say John sells the stock five years later for $3.6 million. John pays tax at that time on his $600,000 long-term capital gain. If Biden’s proposal is enacted, the stock would be deemed sold upon the death of John’s mom. Her final tax return would reflect gain of $1.5 million ($2.5 million less $1 million exemption) and would show capital gains tax due from the deemed sale.
There’s a somewhat similar but broader Democratic proposal in the Senate. As with Biden’s plan, the STEP Act would tax unrealized gains upon death, subject to a $1 million exemption and the $250,000/$500,000 main-home exclusion. More specifically, the STEP Act would treat property as sold when transferred by gift, bequest or to certain trusts. There would be exceptions for tangible personal property other than collectibles and transfers to spouses and charity. Losses at death could be claimed. The tax attributable to nonactively traded assets could be paid over 15 years. And there would be special rules to prevent tax dodges through trusts.
Taxing unrealized capital gains at death may sound simple, but it’s not.
There are lots of complexities that come along with such a sea change: Figuring basis would be tricky, especially for nonmarketable assets owned many years. Liquidity issues could lead to forced sales of assets to pay income tax due at death. Asset valuation. A slew of logistic and administrative difficulties. Last but not least, getting all Democrats on board to curtail one of the biggest tax breaks is not a given.
Upper-Incomers
Two Obamacare Medicare surtaxes apply to upper-income individuals:
The 0.9% surtax on earned income, which kicks in for single taxpayers and heads of household with earnings over $200,000 … $250,000 for joint filers.
And the 3.8% levy on net investment income of singles with modified AGIs over $200,000 … $250,000 for couples. Investment income includes taxable interest, dividends, capital gains, passive rents, annuities, royalties and similar items. Income from a passive activity is NII and subject to the 3.8% surtax if the recipient doesn’t materially participate in the operations, even if the income is from a business.
Biden wants to expand the 3.8% NII surtax to cover other types of income.
But how? He has given no details, but this is what we think he means: Currently, an individual’s share of business profits that flow through from an LLC, limited partnership or S corporation, in which he or she is actively involved, is exempt from both the 3.8% surtax on NII and the 0.9% surtax on wages. Biden’s proposal would apparently expand the 3.8% surtax to cover income derived by individuals from pass-through entities in which they materially participate. There is a caveat, though. This idea would apply only to individuals with incomes over $400,000.
The 3.8% surtax hits dividends of shareholder-employees of C corps, IRS attorneys say in a memo to the field. The facts involved constructive dividends from a closely held corporation to an individual shareholder who is also an employee of the firm. The shareholder, whose modified AGI exceeded the NII threshold, argued that because he materially participated in the company as an employee, the dividend income is derived in the ordinary course of a trade or business that is not a passive activity. However, C corporations aren’t pass-through entities, so his involvement in the firm’s business isn’t relevant for purposes of the 3.8% surtax.
Health Care
The annual ceilings on deductible payins to HSAs are slated to go up in 2022 to $3,650 for account owners with self-only coverage and to $7,300 for those with family coverage. People born before 1968 can put in an extra $1,000 next year.
Eligibility for HSAs is restricted. You must have a high-deductible health plan to qualify. The minimum policy deductible for 2022 is $1,400 for self-only coverage and $2,800 for family coverage. And out-of-pocket costs, including copayments, can’t exceed $7,050 for individual coverage and $14,100 for family coverage in 2022. People enrolled in Medicare don’t have an HDHP, and thus can’t contribute to an HSA.
Benefit Plans
Some relief for health and dependent-care flexible spending arrangements: Employers may opt for FSAs to permit carryover of unused balances from 2020 to 2021, and from 2021 to 2022, and to give a 12-month grace period for unused funds. Also, working parents can contribute more to dependent-care FSAs in 2021. They can put in up to $10,500 of pretax wages … up from $5,000 … if the plan allows. See IRS Notices 2021-15 and 2021-26 for more details on these statutory changes.
State Taxes
Arizona’s 3.5% surtax on high-income individuals is under dispute. In the Nov. 2020 elections, Ariz. voters approved the 3.5% surtax on income over $250,000 for single taxpayers and $500,000 for joint filers, with the revenues to be used for increased public education funding. State Republican lawmakers and others filed a lawsuit, arguing that the initiative violates the Ariz. constitution and is unenforceable. Earlier this year, a lower court denied their request for a preliminary injunction to bar Ariz. from collecting the tax.
Virtual Currency
IRS is upping its game in its quest to seek out users of virtual currency. A district court granted it permission to issue a summons to Kraken, a digital currency exchange in the U.S., which would allow the Service to get names of U.S. customers who conducted at least $20,000 in transactions from 2016 to 2020.
Estate Taxes
The value of Michael Jackson’s name and likeness at death is $4.15 million, the Tax Court says after the late star’s estate disputed estate tax adjustments that IRS made to Form 706. The estate claimed that the value of Jackson’s name and image on death was $3 million, while IRS first argued it was $434 million and later cut it to $161 million. The Court criticized the testimony of the IRS expert and mostly sided with the estate. The case also addressed the value of Jackson’s share in two trusts holding intangible assets (Estate of Jackson, TC Memo. 2021-48).
Exempt Groups
Exempt organizations must operate to serve the public interest.
A group ostensibly founded to display art learned this the hard way. The organization was formed in 1999 to promote African artifacts owned by a doctor through exhibits and received tax exemption. Years later, IRS revoked its exempt status after auditing the Forms 990. The Tax Court agreed with IRS that the group’s activities are neither charitable nor educational but instead benefit the doctor’s private interest. The art was never transferred to the organization, and any efforts by the group to authenticate the artifacts or increase their value benefited the doctor. Additionally, the group has had only one art exhibit in 20 years (Tikar, TC Memo. 2021-53).
Tax Disputes
A lucky taxpayer gets to keep a refund paid to him in error by IRS. The agency erroneously mailed a $491,000 check to the man in May 2017. When IRS asked him to return the money, he eventually paid part of it back. The agency filed suit in March 2020 to recover the remaining balance plus interest.
Normally, IRS must file suit within two years of paying an improper refund.
The two-year period begins on the day the check is received by the taxpayer, a district court says, following the legal precedent in the U.S. Court of Appeals for the Ninth Circuit, to which this case is appealable. It rejected IRS’s argument that the statute-of-limitations period begins to run when the check is cashed, a position that is taken by two other U.S. appellate courts (Page, D.C., Ariz.).
Business Taxes
Related-party transactions in closely held corporations are eyed on audit.
Take this case involving rent paid by a company to its shareholders.The corporation operated a drugstore in a small town in Mont. and paid $192,000 in annual rent to lease space in a building owned by the firm’s shareholders. On audit, IRS argued the rental value was $60,000 and recharacterized the excess as a nondeductible dividend. The Tax Court reviewed both parties’ expert testimony and calculated the annual fair rental value at $171,000, which is much closer to the taxpayer’s figure than that of IRS (Plentywood Drug, TC Memo. 2021-45).
Legal costs to defend patent infringement suits are deductible expenses, the Tax Court says in this case in which a drug manufacturer sought approval from the Food & Drug Admin. to market and sell generic versions of brand-name drugs. As part of the approval process, the firm had to certify the status of any patents and send letters to the manufacturers of the brand-name drugs and any patentees. Some notice recipients then bought patent infringement suits against the company. The legal costs of preparing the notice letters must be capitalized as amounts paid to acquire an intangible asset. The litigation expenses, on the other hand, are deductible as ordinary and necessary business expenses (Mylan, 156 TC No. 10).
More reporting on tap for U.S. partnerships with foreign partners or activities.
Ditto for S corporations with international tax items. IRS released drafts of new Schedules K-2 and K-3. The forms are designed to provide greater clarity to partners and shareholders on how to compute their U.S. income tax liability with respect to international tax items, such as foreign tax credits, deductions, etc. As with Schedule K-1, the new K-2 and K-3 will be issued by the entity to each partner and shareholder. IRS says the new schedules will apply starting with the 2021 tax year.
In Congress
Keep an eye on a bipartisan House bill dealing with retirement savings.
The chances of this or something similar passing this year are very good. The bill is sponsored by Rep. Richard Neal (D-MA) and Rep. Kevin Brady (R-TX), two of the lawmakers who spearheaded passage of the SECURE Act in late 2019.
Among its many proposals: Indexing to inflation each year the $100,000 cap for qualified charitable distributions from traditional IRAs. Letting people age 62 to 64 stash more money in their 401(k)s. Requiring employers to offer automatic enrollment in their 401(k)s with employee opt-out, subject to exceptions for firms in business for less than three years and for employers with 10 or fewer employees. Upping the age for first taking required minimum distributions to 73 in 2022, 74 in 2029 and 75 in 2032. Plus giving small firms a larger credit for adopting a retirement plan.
Foreign Accounts
The penalty for willful failure to report foreign accounts is constitutional, a court says after IRS assessed a $3.1 million penalty against a man who willfully didn’t file the FBAR form to report his Swiss account for 2009 until 2011. He argued that the penalty violates the excessive fines clause of the Eighth Amendment. The court rejected his claim, finding that the penalty is remedial and not punitive, and is not subject to the limitation on excessive fines (Landa, Ct. of Fed. Claims).
Expect to see more of these arguments in the future. Only a few lower courts have ruled on this issue so far, with IRS coming out victorious in those decisions. Neither the Supreme Court nor an appeals court has yet to directly address this.
The standard for willfulness in this context includes recklessness, another court says. The foreign account owner’s claim that the proper standard for willfulness is the violation of a known legal duty fell on deaf ears (Rum, 11th Cir.).
Payroll Taxes
The Social Security Admin. will stop mailing notices on W-2 mismatches. The SSA has sent letters to firms that submitted W-2s with employee names and Social Security numbers that didn’t match the information in SSA’s records. The SSA is ceasing these notices and instead educating employers on tools available on its website that allow employers to view and correct mismatches electronically.
Tax Forms
Digital signatures on some mailed-in tax forms are allowed through Dec. 31. The relief applies to about 40 forms, including Form 706, Estate Tax Return; Form 709, Gift Tax Return; Form 1120-H, Return for Homeowners Associations; Form 3115, Application for Change in Accounting Method; Form 8283, Noncash Charitable Contributions; and Form 8832, Entity Classification Election.
IRS
A common office problem plagues IRS: Printers and copiers on the blink. The Service estimates that 42% of such devices at its processing centers are unusable, while others are damaged but working. Many devices are out of ink or have a full waste cartridge, normally easily fixable issues. IRS has a new contractor to handle these problems, but the coronavirus pandemic has prevented the contractor from visiting IRS processing sites. The agency says it is working to resolve the matter.
These issues are more than a nuisance. They are adding to IRS’s inability to reduce its processing delays and mail backlog, according to Treasury inspectors.