It is claimed that Ben Franklin said, “In this world nothing can be said to be certain, except death and taxes.” The implication here is that taxes would only have to be paid just once. It seemed like a fair bargain where a person earned money and paid the government some fee for providing other forms of protection. However, through taxes like the estate tax, it became possible that the IRS would try to take hard-working people more than once. Despite this, the tax was only supposed to be assessed upon death. Earlier this week, President Biden unveiled a significant twist when he proposed a “Billionaire Capital Gains Tax” assessed on those with net wealth above $100 million. Now, it is not our intention to highlight that this tax missed what it means to be a billionaire by a factor of ten. Instead, this post is devoted to dissecting the proposal and offering our unsolicited two cents.
Unrealized Capital Gains
Before delving into President Biden’s interesting proposal of an unrealized capital gains tax, we must dissect what a capital gain is. A capital gain is a gain on an investment or item that the US Treasury Department (and IRS) believes to be an investment. It does not include interest or other streams of interest-like income (it taxes these separately). Thus, an investment in a stock that is sold for a gain is a capital gain since the government decided to call stocks a capital asset. Likewise, an investment in a speculative real estate investment can be a capital gain if it is purely speculative. However, in each of these situations, there are many specific rules which come up, so please consult your own competent professional to assess your own situation.
Importantly, if an investment you make should be taxed as a capital gain (like a stock), you are taxed when you sell. This means that even if you have a capital gain of significant size if you don’t sell, you will not pay tax on this gain. Thus, it is referred to as an unrealized capital gain.
The President’s proposal seeks to change this. President Biden’s plan would have Americans worth more than $100 million pay taxes even if they do not sell an investment. This has the potential to be problematic for multiple reasons.
First, it will be hard to determine what something is worth. For example, if Elon Musk were asked to pay a 20% tax on his unrealized Tesla stock, he could have to sell a significant amount of stock. Thus, the supply of Tesla stock will flood the market, and his net worth figure would change with the drop in Tesla stock price. Of course, he would still be able to pay the tax, but this is purely for illustrative purposes.
Second, to avoid the results in the previous example, taxpayers may be encouraged to borrow. This has strange repercussions since they would borrow to pay the tax, but if they do borrow, the tax is assessed net of debts so that the actual net worth figure may change. Thus, the tax can be an implementation nightmare.
Third, this tax has significant compliance costs since it is unclear what many businesses are worth. For example, a family-owned business may never be able to sell for more than $100 million, but an IRS assessment of $100 million-plus worth would make a sole owner liable. Of course, the owner can dispute this, but it would come with significant headaches and costs associated with the disagreement. The core of the issue is that there is no good barometer to determine what something is worth in the absence of a functional market. Thus, private businesses are, by nature, more complex to value than public companies.
Finally, the unrealized capital gains tax is an expression of majoritarian power over a minority. Since the minority of taxpayers is so small, it is easy for the vast majority of Americans to shrug off this tax as something other people would pay. It seems great – someone can pay, and the benefit is distributed to the masses. However, what amount of tax is fair for this minority to pay? If some amount of wealth is so immoral that one should be penalized for it via the tax code, should anyone possess such an amount of wealth? Why not assess a 100% unrealized capital gains tax on that wealth? In other words, the unrealized capital gains tax has a slippery slope flaw in its morality. It creates an us-versus-them ethos and brings significant, additional value judgments into the tax code.
Illiquidity Discount
After all, at Bold Horizons, we help our clients incorporate and form LLCs. This blog post must then conclude by showing how they can help. In the scenario above, where we discuss how private businesses are hard to value, there is a tool that can be used that the IRS respects, which lowers the assessed value of a private business. This tool is called the Family Limited Partnership (FLP). In an FLP, one can place the family business in a partnership (like a limited partnership or limited liability company), and then one can distribute membership interests to various members of the family. By placing a layer between the wider public and the core ownership of the enterprise, the worth of the business is lower. Furthermore, since it would be challenging to take full control of the business by buying one FLP interest, one must hold that the assessed value of the business is lower. Thus, the FLP presents itself as an interesting option for private companies that may wish to lower their assessed values. At Bold Horizons, we specialize in forming the core entities needed, and we would be able to form these vehicles in any state. We are happy and excited to work with specialists to be a part of the team driving client solutions forward.
Disclaimer: None of this information is investment, tax, or legal advice. Bold Horizons Inc. strongly recommends seeking the advice of your own competent advisors who fully understand your individual circumstances.
