Tax on Unrealized Gains?
How Long Before it Hits Every Investor?
A business associate of mine always tells me, “Until you’ve sold your stock, you haven’t made a dime.”
Sell that one to Janet Yellen.
Treasury Secretary Janet Yellen announced on Sunday that a proposed tax on unrealized capital gains, yes, gains from investments that haven’t even been sold yet, could help finance President Biden’s new $2 trillion social spending bill. Senate Finance Committee chairman Ron Wyden has come up with the idea that would be a landmark change to the way US citizens are taxed.
The effort would be an attempt to squeeze more taxes from America’s wealthiest families, by assessing a tax on assets that have appreciated but not yet been sold. Wyden’s plan would apply to those with over $1 billion in assets or three straight years of income over $100 million. Income is easily verified from tax returns, but assets, well, that becomes a bit more complicated. How the government would know your net worth is not yet clear.
Currently, the uber-rich can hold assets that are appreciating, not sell any of them, but finance their lifestyles by borrowing against their vast holdings. It makes perfect sense, since we’re in an extended period of near-zero percent interest rates. Well, not surprisingly, Congress is not happy about that.
It should be noted that the plan to tax unrealized gains is not the same as a “wealth tax” of the kind proposed by Sen. Elizabeth Warren. A wealth tax would be levied on the value of all assets, not just those that have appreciated in value. The two taxes are similar, but definitely different. House Speaker Nancy Pelosi, herself one of Congress’ wealthiest investors, said on Sunday, “We will probably have a wealth tax,” showing she doesn’t understand the difference.
Just How Complex Could This Tax Get?
As a CPA by trade, I think I can foresee many complications that may result from imposition of a tax on unrealized capital gains. First, every asset owned by these wealthy folks would have to be valued, every single year. Valuing a closely-held business is both a costly and time-consuming process. There is no way that these valuations could be done timely each year to be included in a tax return filing. (Think of someone like former President Donald Trump, who has interests in over 500 closely-held businesses.)
Second, not all assets are easy to value. Sure, everyone knows how much Jeff Bezos’ stock in Amazon appreciates each year, and ditto with Elon Musk. That’s easy, since the companies are publicly-traded. That’s low-hanging fruit for this kind of a tax. But, as with the closely-held businesses mentioned above, it’s also not easy to value assets such as artwork, wine collections, yachts, and airplanes. Who’s to say what that Picasso piece is worth this year? A lot of subjectivity involved, for sure.
Third, how would reporting of the value of these assets be done? Brokerage houses would be required to issue forms detailing the fair market value of all assets at each year end, which would no doubt prompt some pushback. Would other custodians have to report as well? Cryptocurrency exchanges, for example?
Where would all of this be headed? Audits. Long, drawn-out, complicated tax audits. Litigation, appeals, settlements. The wealthy can and do hire the best tax lawyers available, so this process will continue. Congress may be counting on the tax revenue to flow in smoothly to the government coffers, but there is no way it will play out that way.
Here’s another question surrounding such a tax. Would unrealized losses count in the taxpayer’s favor? Would those assets declining in value be netted against those that are appreciating, thus taxing the aggregate net increase in wealth? That’s not clear yet.
Would declines in value be able to be carried back against increases, thus generating huge tax refunds in future years? (Think about years of stock market crashes, a la 2008-2009.) These are enormously complicated matters that apparently have not been clearly thought out.
Another huge issue involving a proposed tax on unrealized capital gains would be enforcement. The Internal Revenue Service can’t even answer taxpayers’ or tax professionals’ phone calls right now. They can’t respond to correspondence within a year. Where would all of these enforcement agents come from? Not to mention, every business in the country is facing a shortage of workers.
The Constitutionality Test
The Sixteenth Amendment to the US Constitution authorizes the taxation of “income,” and that wording has resulted in a long history of court cases involving various forms of taxation. Case law has found that something defined as income has to do with the person having complete control over the source of money, and being able to use it as he sees fit. That doesn’t really fit in the situation of unrealized gains. Indeed, even to pay this tax, some liquid cash from the investment would be needed.
The text of the amendment, when taken literally, would seem to allow only taxes on income, and certainly not wealth. Whether an increase in wealth, on paper, represents income, will be a question for the courts.
Does it Stop at Billionaires? What About State Taxes?
The Revenue Act of 1913 imposed an income tax on individuals with an income of over $3,000. Adjusted for inflation, that’s about $75,000 in today’s dollars. The tax affected approximately 3 percent of US citizens. Obviously, the income tax grew and grew until it affected over fifty percent of citizens, and Social Security and Medicare taxes were added, so that just about every worker pays taxes. And that’s the fear with either a wealth tax or a tax on unrealized capital gains. How soon would this tax creep down to affect more and more taxpayers?
Taxing a few hundred billionaires is one step, but like the income tax, the real money is with the broader public. Tax increases on the wealthy can only bring in so much.
Here’s a scary thought: Could this tax one day be applied to the value of people’s retirement accounts?
Scary thought number two: Will the states follow suit?
What About Corporations?
Thus far, there has been no talk of this tax being applied to corporate assets. Rather, there is a proposal floating around that would impose a 15% minimum tax on all corporations, as the former Alternative Minimum Tax was repealed in 2017.
An unrealized capital gains tax on corporate assets could hit those with real estate especially hard, but companies with Bitcoin also come to mind. Michael Saylor’s publicly-held company MicroStrategy is currently sitting on unrealized gains of over $2 billion from its Bitcoin stack. The same for Tesla and Square, and many others.
Chances of passage?
At this point, there’s no indication of what the chances are that this tax will pass Congress. With Democrats holding slim majorities in the House and the Senate, it seems quite possible. And, with the spending bill already trimmed down from its original $3.5 trillion price tag, chances look better.
One thing is certain: When a tax is imposed, those affected will do anything in their means to get around it. Said Leonard Burman of the Tax Policy Center:
“If you have a threshold, you’re giving people a really strong incentive to rearrange their affairs to keep their income and wealth below the threshold.”
Issue No. 27, October 29, 2021
Rick Mulvey is a CPA, forensic accountant and crypto consultant. He writes about all things Bitcoin, and yells at the Yankees and Giants. He also runs marathons and makes wine, neither professionally.
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