Today’s post is in two parts and was written by Virginia La Torre Jeker, J.D. John Richardson, J.D.

On March 28, President Joe Biden released the FY2023 Budget, also known as the Green Book, available here. The Green Book is not proposed legislation, but it might be viewed as a kind of reading of the tea leaves showing what may lie ahead in the not-too-distant future. Today’s post will discuss a Green Book proposal that would change the tax rules for unrealized capital gains when assets are gifted or passed at death.

This is the second time this proposal has been put forth by the Biden Administration. It may be sitting on the shelf for now, but the proposal is an enticing revenue-raiser and helps meet what society has been viewing as a call for a “fairer” tax code, by targeting higher-income and asset wealthy taxpayers. We bet it goes through in one form or another.

The Basics

First, some background.

It is common for tax systems to impose taxation when there is a transfer of property. Transfers of property can take place through a sale/exchange or through a gift/bequest. Transfers by sale/exchange are subject to taxation under the income tax rules found in Subtitle A of the Internal Revenue Code (Code). Transfers by gift/bequest are taxable under Subtitle B under the estate and gift tax provisions of the Code. In most cases a sale/exchange will attract immediate taxation; whereas a gift/bequest will either defer or eliminate taxation. The current law is explained below.

Sale/Exchange – The Income Tax Provisions Are Triggered

In the case of a sale/exchange, the owner of the property receives money or property in exchange for the transfer. The gain realized by the transferor is (with few exceptions) subject to taxation at the time of the transfer. The difference between the proceeds received and the acquisition cost is generally taxed as capital gain and reported as income on the tax return for the year of the transfer.

Gifts or Bequests – The Transfer Tax Provisions Are Triggered but May or May Not Result in Tax Owing

The Gift and Estate taxes are “transfer taxes” based on the fair market value of the gift, or in the case of an estate, the tax is based on the fair market values of the decedent’s assets that are part of the estate.[1] In the case of a gift/bequest there is generally no tax imposed on the recipient. [2]

In some cases there will be a “transfer tax” imposed on the transferor.

US citizens or residents currently have a lifetime exclusion of approximately 11 million USD before transfer taxes are imposed on the donor. This is a significant provision for US citizens who wish to renounce US citizenship and have a net worth of 2 million USD or more. They might consider making tax-free gifts of assets for the purpose of reducing their net worth to avoid “covered expatriate” status. More on this in next week’s blog post.

Although the donee-recipient does not pay a tax on the transfer when received, the donee will pay a capital gains tax when the donee later makes a sale/exchange of the asset. Capital gain is determined differently depending on whether the donee received the asset by gift or by bequest. When the donee acquires the asset by gift he assumes the “cost basis” of the donor (a “carry-over” basis). When an heir receives a bequest his cost basis is the fair market value of the asset at the date of death (a “stepped up” basis).

Notice that under the current law:

1. Assets received by bequest which are subsequently sold will attract a capital gains tax based on the difference between the sale price and the fair market value of the bequest when it was inherited.
2. Assets received by gift when subsequently sold will attract a capital gains tax based on the difference between the sale price and the carry-over basis of the original transferor.

Green Book Proposal

The characterization of transfers as gifts/bequests can result in the transfer of property either deferring or escaping taxation under current law. For this very reason a number of countries (including Canada and Australia) treat gifts and bequests as “deemed sales”. The effect of treating them as deemed sales means that the transferor is deemed to have sold the property for fair market value and that the property is taxed as though it generated capital gain. This also means that the recipient of the gift takes a basis in the property at fair market value. Countries employing this system do not have a separately imposed Gift or Estate Tax.

The Biden Green Book (starting at page 30) apparently proposes to follow the example of Canada and Australia by (generally) treating gifts and bequests as “deemed sales at fair market value” triggering a capital gains tax which would be payable with respect to the year of the transfer. In addition, the net investment income tax / 3.8% surcharge can certainly apply in addition to the capital gains tax (full detail on the 3.8% surcharge is here). There is no proposal in the Green Book to eliminate the Estate and Gift Tax rules, however. The proposal also does not include a reduction in the federal gift and estate tax exemptions or an increase in federal gift and estate tax rates.

It is not fully clear how the new proposal will work with the Gift and Estate tax regimes currently in place. Apparently, it’s not clear to the Administration either. Indeed, having a deemed sale rule upon a gift or death transfer, makes no sense if a Gift and Estate tax can simultaneously apply. A lot of regulations and clarification will be required to make both of these regimes work in harmony, and based on experience, if the proposal becomes law, it will be many years before anyone understands how the rules will ultimately work.

It appears that the proposal might apply in the following way:

1. Gifts/bequests of property would be treated as a deemed sale by the donor/decedent. This would result in immediate capital gains treatment.
2. The recipient would assume a basis in the property equal to the fair market value.
3. The Estate and Gift tax rules would continue with (for those subject to estate/gift tax) some consideration being given for having paid the capital gains tax, although how this will work is not at all clear in the proposal.
4. The net effect would be that: All donors would be subject to an immediate capital gains tax (unless an exception applied, to be discussed) and some would also be subject to the Estate and Gift tax regime.
Next week’s post will look at various nuances with this proposal, including exceptions and carve-outs and how the proposal would significantly impact the US individual abroad.

For those wishing to listen to a podcast in which John Richardson and I discuss the proposal, it can be accessed here.

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[1] The US Estate and Gift tax rules apply to a US person (US citizen or “resident”) differently than to a non-US person (non-citizen and non-resident). US persons are subject to these transfer taxes generally when making transfers by gift or bequest on their assets no matter where the assets are located at the time of the transfer. Non-US persons are generally subject to these taxes only on assets located, or deemed to be located, within the US at the time of the transfer. Many complicated “situs” rules apply that determine where an asset is located for Gift and Estate Tax purposes. (You can read details at earlier blog posts here and here ). Certain exemptions are available for lifetime gifts and transfers upon death, some of which apply very differently to US versus non-US persons.

[2] Internal Revenue Code Section 102 provides that gifts and bequests are not included in income. However, if the gift or bequest is from a “covered expatriate”, the recipient, if a US person, must pay a tax on the value of the gift or bequest, currently at a 40% rate. Full details here.

Posted April 14 2022