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January 6, 2020

The 2020 Campaign and Taxes Part 8: Taxing Capital

Taxing Capital Gains

More details are emerging about 2020 presidential hopefuls’ tax plans. Former Vice President and current 2020 presidential candidate Joe Biden released his tax plan in early December 2019, and while it mostly flew under the political radar, it does signal that, at least for voters in the Democratic primary, the so-called Overton Window on taxing capital has shifted.

The Overton Window is the term generally used to describe the set of policies that are acceptable to voters, or in this case a subcategory of voters. The idea of taxing capital has generally been outside the proverbial window since the time of Ronald Reagan’s presidency. The common arguments are that high taxes on capital will hamper investment, and reduce savings. The latest policy arguments employed by the Democratic candidates do not focus on those issues, and instead are founded on concepts of inequality. While Candidate Biden’s tax plan is not as progressive as the plans of Sen. Elizabeth Warren (D-MA) or Sen. Bernie Sanders (I-VT), it firmly links the mitigation of inequality with the taxation of capital.

Why Taxation of Capital Is Getting Attention

We have previously discussed the effect of inequality itself on the 2020 presidential candidates’ drive for tax increases. The underpinnings for each prospective proposal so far eschew the goal of “distributional neutrality.” Instead of preserving the equal distribution of tax policy (or changes thereto) across all wealth classes, only certain of the wealth classes are targeted for tax increases. The virtue of such an approach depends in part on one’s political or philosophical leanings, but an understanding of the candidates’ desire to move away from distributional neutrality illuminates the reason for targeting the taxation of capital.

A Closer Look at the Taxation of Capital

Capital gains have been taxed at lower rates than ordinary income for many years. This makes capital investment an attractive option for taxpayers who are not dependent entirely on earnings from compensation or business operations, which are taxed at the higher ordinary income rates. Capital gains also make for an attractive tax planning strategy in appropriate circumstances.

One such strategy involves the grant of a “carried interest” in a business that is taxed as a partnership. For instance, an individual can be granted an interest in the future profits of the partnership in exchange for services that the individual previously rendered to the partnership. This carried interest often appreciates over time, and the later sale of the carried interest is generally taxed at the favorable capital gains rates. In the end, the individual incurs tax at capital gains rates on a form of earnings the individual received in exchange for services (which normally are taxed at higher ordinary tax rates).

The tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) imposed new restrictions on this tax strategy by requiring a three-year holding period in order to obtain the favorable capital gains rates, but in many cases the three-year holding period is easily met by the individual.

Certain viewpoints champion the notion that the tax savings from the lower capital gains rates are reinvested into the overall economy. In turn, this generates new revenue that can be taxed, which offsets the loss to the government from the lower capital gains rates. And while this is a hotly debated topic, there is little clear evidence to support or discredit this theory.

Taxation of Capital and the 2020 Election

The Democratic 2020 presidential candidates’ proposals to increase taxes on capital do not focus on a possible correlation with the overall economy, but instead focus on the beneficiaries of the lower capital gains rates. Each candidate differs on his or her approach, but they, and the evidence, agree that it is overwhelmingly the wealthy who benefit most from low capital gains rates. The Congressional Research Service, the non-partisan research arm of Congress, has cited studies that indicate as much as 92.5% of the benefits of low capital gains rates are received by the wealthiest 20% of Americans. The progressive argument (i.e., against distributional neutrality) is that not enough of this benefit “flows down” to middle and lower class families, and therefore those who benefit most should bear the burden of the proposed tax increase.

Biden’s Approach to Capital Gains Tax

In Biden’s case, the approach is not as aggressive as a wealth tax, or a bottom-up system like fellow Democratic candidate Andrew Yang’s Freedom Dividend. Biden’s plan would require taxpayers who make more than $1 million per year to pay taxes on capital gains at the higher ordinary income tax rate, which would also be restored to the pre-TCJA rate of 39.6%. Conceivably, this could lead to a significant number of assets being “locked up,” as taxpayers might hold on to assets to avoid taxation.

Another way Biden’s tax policy would move away from distributional neutrality by taxing capital is with his proposal to eliminate the basis step-up for inherited assets. This step-up allows individuals who receive inherited property to increase the tax basis of the inherited property to its current fair-market value. The impact of this step-up can be seen with a simple example.

Consider an individual who inherits a $5 million dollar property from a parent. The individual’s parent originally bought the property for $100,000 40 years ago. Assume the beneficiary sells the inherited property the day after it was received. With the basis step-up, the beneficiary pays $0 tax on the inherited property, and if the parent’s estate was below the estate tax threshold (which most taxpayers currently are, or can be through effective tax planning) the parent pays $0 in estate taxes. The result in this case is a $4.9 million gain with $0 in taxes paid.

Under Biden’s plan, the beneficiary would pay the tax on the $4.9 million gain, or to avoid having the beneficiary pay the tax, the parent could sell the property, pay the tax, and then bequeath the cash to the beneficiary.

Taxation of Other Forms of Capital in the Biden Tax Plan

Another of Biden’s tax proposals that is a potential tax on capital involves his plan to institute a minimum tax on corporations with more than $100 million in net income in the United States. This minimum tax would require that corporations pay at least a 15% tax on their book income each year, regardless of the corporation’s amount of taxable income. For example, bonus depreciation and net operating loss carryforwards would reduce taxable income, but not book income. Hence, this tax would function like the now-repealed corporate AMT, acting to ensure that corporations pay a minimum level of taxes based on the revised net income. Like Sen. Warren’s “real corporate profits tax,” it appears that it would be calculated on a corporation’s financial statement income; however, the 15% rate is higher than Ms. Warren’s 7% rate. This particular provision is in contrast to the more moderate positions generally taken by Biden.

What Biden’s Tax Plan Means for the 2020 Presidential Election

Overall, these proposals (and other proposed tax increases not directly related to taxing capital) place Biden on the more moderate side of tax policy. But they still signify a major shift in the candidates’ view of how tax policy should work, as compared to historical presidential candidates. Biden’s tax policies would arguably be the first true tax increase since 1993. Remember, tax increases under President Obama were a result of the expiration of previous tax cuts rather than new taxes, with the exception of the net investment income tax and the additional Medicare surcharge.

As the field of Democratic presidential candidates narrows during 2020, tax policy details may be refined for those candidates who remain. For more information on the 2020 candidates’ tax plans and how they could affect you or your business, please contact your local CBIZ tax professional.

Explore Our 2020 Campaign and Taxes Series

2019 Individual Tax Planning Supplement

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