The repeal of step-up in basis and change in capital gains rates will adversely affect buy sell agreements
On April 28, 2021, the White House released The American Families Plan (the “Act”), which included new details about the Biden administration’s proposed 2021 tax reform. The tax changes are expected to be enacted this year but the effective date of the provisions are generally expected to be January 1, 2022. However, certain provisions, such as capital gains tax rate increases, may have proposed effective dates tied to committee action or the date of enactment.
For taxpayers whose income exceeds $1,000,000, capital gains will be taxed as ordinary income at rates that have no capital gain preference that is now available. Under the current draft of the proposal, the rate would nearly double from 23.8% to 43.4% when accounting for the Net Investment Income Tax of 3.8% on unearned income. When state taxes are included, the combined rate could exceed 50%.
In addition, at present the estate tax and lifetime gift tax exemption is $11,700,000 per person. The effective estate tax rates on amounts in excess of the exemption amount is 40%. More information about the proposed changes to estate, gift and generation skipping taxes under the “For the 99.5% Tax Act” is available on our website.
During his campaign, President Biden stated he would raise estate tax rates to “historic” levels, which the tax community believed to be similar to 2009, when the estate tax rate was 45% and the estate and gift tax exemption amount was $3,500,000 per person. Nevertheless, the proposals of President Biden also addressed an issue involving the tax basis for inherited assets. Under current law, when an individual passes, the “basis” for determining gain or loss is adjusted (or “stepped-up”) to fair market value upon the death of the decedent. This concern is addressed in another bill proposed by Congressman Bill Pascrell (D-NJ), H.R. 2286 (the “Pascrell Bill”).
The Pascrell Bill does not contain a plan to raise the estate tax rate from 40% to 45% or lower the estate tax exemption, but instead focuses on eliminating this so called “step-up” in basis at death. This bill states that it will end the practice for gains in excess of $1,000,000 and make sure the gains are taxed at death if the property is not donated to a spouse or charity. Both the Pascrell Bill and the Biden administration state there will be protections for family-owned businesses and farms which will not be taxed if given to heirs who continue to run the business.
The combination of an increased tax rate for capital gains and the loss of step-up basis will have a devastating effect on “buy sell” estate plan transactions common among many small business plans. For example, assume A and B, two unrelated individuals, each own 50% of the outstanding stock of Corporation X. Typically, counsel will recommend that they enter a Buy-Sell (or “Shareholder”) Agreement between them and the corporation to provide that upon the death of either shareholder, the remaining shareholder and/or the corporation will purchase all the stock of decedent at a price set forth in the Buy-Sell Agreement. Assume A & B each have a “cost basis” (the amount used to determine gain or loss on sale) in their Corporation X stock of $1,000,000 and that each of their interests in the Corporation is worth $5,000,000. In a common plan, if A dies, the agreement will require that B purchase A’s stock from A’s estate for $5,000,000. This is advantageous to B because he/she can be sure that he/she will have total control of the company in the future without interference from A’s family. This is advantageous to A’s estate because it provides a ready market for an interest in a closely held Corporation that may have few or no buyers. In addition, it can provide liquidity to A’s family for their on-going living needs.
Under current law, the basis of A’s stock would be “stepped-up” to $5,000,000, the fair market value at the date of death. When A’s estate sells the stock for $5,000,000 to B, there would be no taxable gain. Under the Pascrell Bill, there will be no step-up (or a very limited step-up) of the basis of A’s Corporation X stock upon A’s death. Accordingly, A’s estate would have a gain of $4,000,000 from the sale of the stock to B. In addition, the gain (or at least the amount over $1,000,000) would be taxable at ordinary income tax rates, i.e., up to a 43.4% tax plus any applicable state tax. Under current law there would be no tax on the sale. Under the Act the tax could be as high as $2,000,000. To the extent that there could be protections for certain business interests, such protections would be unlikely to apply since A’s estate would not be remaining in the business and usually, continued involvement is a prerequisite for the tax benefits. Note that B would get no deduction for the payments under current law to A. That would continue to be the case under the Act.
In planning for the death of a shareholder or equity owner, there are various ways to structure the payments. For example, the shareholders may enter into an agreement with the corporation while they are alive to protect the confidentiality of corporate information and to prevent a shareholder from competing for the rest of his or her life. The agreement could also provide for retirement benefits that what would include payment to the decedents family after death. These “retirement” type of payments would normally be taxed as ordinary income to the recipient, or the recipient’s estate, and would be deductible to the corporation. The disadvantage to the decedent’s estate under current law is that the payments are taxed as ordinary income. If capital gains are going to be taxed at the same rate as ordinary income and there is no step-up in basis, then there is no disadvantage to the estate under this structure. There are no competing tax interests between the estate and the corporation. It would be beneficial to the surviving shareholder to structure the payments in a manner that they are deductible to the corporation since the decedent’s estate will pay the same tax rate regardless of whether classified as capital gains or ordinary income. Stock redemption agreements will be more advantageous than cross-purchase agreements.
The repeal of the step-up in basis and the increase in the capital gains tax rates may also mean that the parties should consider acquiring additional life insurance. If the step-up in basis is repealed and/or the capital gains tax rates are increased, every Buy-Sell Agreement between owners of small businesses in existence should be re-examined and, most likely, restructured.