For now, this is the last part of my series of columns discussing tax issues that Congress is likely to consider in the coming months. One of the most important of these issues is capital gains tax.
A capital gain is the increase in the value of an asset. Capital gains are generally taxed when this asset is sold. If the asset has been held for more than a year, the profit will be taxed at a particularly low tax rate, which is currently 20%. Since the Second World War, these tax rates on investment income have fluctuated between 15% and 45%.
Capital gains are taxed at a lower rate to encourage investment. Unsurprisingly, according to IRS statistics, in 2018 the top 1% of households posted 69% of low-tax capital gains, while the top 20% posted 90% of those gains.
Those who prefer low capital recovery rates argue that our capital recovery rates must be globally competitive in order to attract foreign investment. As a tax professional who structures transactions with overseas investors, I know that virtually all institutional overseas investments are structured with offshore tax haven brokers specifically designed to prevent overseas investors from paying US taxes. Hence, the tax rate on investment income is irrelevant to them.
In addition, most Americans keep the majority of their investments in pension funds and are never taxed at capital gains rates. If you own a Roth IRA, you will never be taxed. If they own their investments through a traditional IRA, 401 (k) or pension fund, they will be taxed at normal rates on redeeming the finds. Again, the capital income tax rate is irrelevant for these investors.
Wall Street and other high net worth individuals have benefited from loopholes in tax law to convert income that would otherwise be subject to normal income tax rates into favorably taxed capital gains. Instead of paying income at rates of around 40% plus social security taxes, they pay taxes at a rate of 20%. (Sometimes they also pay an additional 3.8% Obamacare tax to help fund health care costs for poor people.)
About 10 years ago I was working for a client who was planning to go public. We have structured their businesses so that executive pay when the company goes public is a function of the IPO proceeds and is taxed at capital gains rates. The company’s CFO received $ 20 million taxed at the then capital gains rate of 15%. She complained that she had to pay $ 3 million in taxes, which she found outrageous, but she paid taxes at a lower marginal rate than a married couple who made $ 80,000.
Previous tax hikes were targeted at the top 10% of the population – the so-called “rich” people. As I wrote in previous columns, the top 10% include households with an income of approximately $ 120,000. According to IRS statistics, households earning between $ 100,000 and $ 1.1 million pay the highest percentage of their income in taxes. Households earning more than this amount typically earn income that is taxable or otherwise protected with Capital Gains Rates.
According to the IRS, the 400 tax returns with the highest reported income paid less than 20% of their tax income.
It is not surprising, then, that many middle-class households will bear the brunt of these increases when tax increases target the top 10% while the extremely rich somehow manage to avoid paying extra taxes.
There are two ways to deal with this. The first is to try to eliminate the tax advantages of various structures designed to convert ordinary income into capital gains. This is a whack-a-mole strategy with a low chance of success as brilliant tax strategists will continue to develop transactions that bypass the rules.
The second is to change the capital gains tax rate for mega-wealthy people so that capital gains taxes become more progressive, like normal income tax rates. That is exactly what President Joe Biden proposed. Biden’s proposal would raise capital gains tax rates to normal tax rates for taxpayers earning more than $ 1 million. Taxpayers earning more than $ 1 million would be placed in a similar tax position as taxpayers earning $ 120,000 to $ 1 million.
Biden’s suggestion also rules out the possibility of creative tax professionals developing tax avoidance strategies. This can prove unfair to those selling a family business with annual income greater than $ 1 million. Therefore, they may be given an exemption similar to that provided for in the estate tax rules.
It is far too early to determine whether the Biden capital gains proposals will take effect, but until we see meaningful capital gains reform, many midsize taxpayers will continue to bear a disproportionate share of the tax burden.
Jim de Bree is a semi-retired CPA living in Valencia.