Published: October 2, 2024
“Tax The Rich! Make the Rich Pay Their Fair Share!” These are the rallying cries of
many political activists in the US.
The problem for these activists is, the way the US tax system is set up, it’s very difficult
to tax the rich directly. Americans are generally taxed not according to how rich they
are: They are taxed according to how much income they report annually. These two
metrics – wealth and annual income – aren’t perfectly correlated. It’s possible to have a
lot of assets but no income and vice versa.
Given that the base metric in this US system is reported income, if you don’t want to pay
taxes, the trick is to reduce your reported income. Sometimes, this reduction is achieved
illegally, like when a corner store only accepts cash and underreports how much it
earns. Sometimes, however, it is done entirely legally, like when assets appreciate in
value but are not sold. The appreciation in unsold assets creates what is called an
unrealized gain. Wealth has increased, but the gain will not be realized or reported until
the asset is sold.
Unrealized gains can occur naturally, like when someone owns the house they live in for
twenty years and the property appreciates in value. Sometimes, however, unrealized
gains can be a deliberate tax strategy that many view as a loophole. Some very wealthy
people like Jeff Bezos and Elon Musk own a lot of stock in their businesses and see
their assets appreciate greatly without paying taxes on them. If Bezos or Musk need
cash, they don’t sell their stock: That would create a gain. Instead, they borrow against
their stock. This borrowing doesn’t count as income, and the stock gains remain
technically unrealized (though Bezos and Musk of course realize the cash they receive
from the bank). Kamala Harris has a proposal to end this tax avoidance strategy.
While she has subsequently walked back some elements of them, Kamala Harris’s
campaign endorsed President Biden’s proposed 2025 tax increases which include
taxing unrealized gains at 25%. So, if Jeff Bezos’s 1 billion shares of Amazon increase
in value during the year by a total of $650 million, his tax bill will increase by $162.5
million – sale or no sale.
As proposed, this tax will only impact taxpayers with net assets in excess of $100
million. However, other taxes were initially implemented to only target a minority of the
population and eventually broadened in impact. For example, the Alternative Minimum
Tax (AMT) grew from impacting 155 taxpayers in 1969 to 5.2 million taxpayers in 2017.
The federal income tax impacted only the top 3% of earners when it was implemented
in 1913. Today, if you’re reading this article, you’re probably paying federal income tax.
But let’s further evaluate this $100 million proposed threshold: How do you know if you
have net assets in excess of $100 million? Herein lies a privacy concern and our first
valuation problem. The government doesn’t receive balance sheets from individuals
recording all their assets. This is going to require collecting a lot of private and sensitive
data. Taxpayers with $100 million will also have a lot of illiquid assets. They might own a
couple buildings, their own business, some venture capital investments, etc. Unlike
Amazon or Tesla stock, there are not readily-available publicly-traded prices for these
illiquid assets. That means there’s going to need to be valuations of these: Appraisers
are going to be in high demand.
The net asset threshold is problem number one. Problem number two is figuring out the
unrealized gains in each year. Again, figuring out the year-over-year change in the value
of Amazon or Tesla stock is pretty straightforward. But what about non-tradable assets?
Harris’s proposal states that non-tradable assets would be assumed to increase at the
five-year Treasury rate plus two percentage points (currently 6%). However, the IRS
may offer avenues for taxpayers to appeal valuations, such as through appraisal. So,
any year these affected taxpayers think any of their assets have increased by less than
6%, they must obtain appraisals to prove it. Again, if this passes, we’re going to need a
lot more appraisers!
While this proposed rule may close one loophole, it is also going to create its own
loopholes. Here are a couple that immediately come to mind:
(1) Avoid ending up in the $100 million category: Any time an individual
approaches this category, they may place their assets in an irrevocable trust or
some other vehicle so that they avoid this proposed treatment.
(2) Take advantage of swings in the capital markets: Any student of the stock
market will be familiar with large crashes followed by speedy recoveries. For
example, the market ended 2022 down 20%. But by 2020 it was up 25%. Would
the taxpayer only need to obtain a 2019 report showing that the value decreased
20% this year and then fall back on the statutory increase of 6% (instead of 25%)
for 2020 and beyond? That would avoid realizing the gain for several years and
fail to achieve the stated goal of the policy.
The idea to tax income was once radical – government principally earned revenue via
tariffs. Today, the federal income tax has become a widely-accepted political reality. It
may be that taxing assets follows a similar trajectory of acceptance. Before we
implement this massive change, however, we should first think through the
consequences of doing so. One of the consequences would clearly be the increased
importance of appraisal. At least I’ll have an easier time at cocktail parties explaining
what I do for a living.
Eric Sundheim, ASA Principal Mercovus Valuations
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