STEP Act: The Critical First Blow to Millionaire Income Tax Avoidance

New legislation would put an end to an income tax windfall for millionaires and their descendants.

[Cross-posted from Inequality.org]

America’s income tax system is based the principle that income derived from both work and wealth is subject to tax. Just as workers pay tax on their wages, wealthy individuals should pay tax on their investment gains.

The system is working splendidly for taxing workers. For taxing wealth gains, not so much.

University of Southern California law professor Ed McCaffery uses three words to describe how America’s wealthy avoid income tax: Buy – Borrow – Die.

He’s right. Take Leona Lot, a fictional super-rich real estate mogul. When she buys an asset, she pays no income tax. That part makes sense. When the asset’s value grows and she borrows against it, Leona still pays no tax. Here, it starts to get a little crazy. But not as crazy as when Leona dies, and all that appreciation in value disappears for income tax purposes. Leona’s kids can sell the asset, pay off the borrowing, and live well, really well, off of what’s left. Without paying a dime in income tax.

They can also use some of those sales proceeds to start the Buy – Borrow – Die process all over again. And when they die? Yup, more appreciation disappears for income tax purposes. They can leave even more untaxed gains to Leona’s grandkids. And so on.

For decades, Congress has watched this process unfold. And done nothing.

We’ve reached the point, McCaffery writes, where the federal income tax is a tax only on the little people – you know, those who work for a living. That may work for Leona’s grandkids, but it’s terrible for our country. When all that millionaire income goes untaxed, wealth concentrates at the top. We now have 650 or so billionaires – about .0005 percent of our households — sitting on over $4 trillion of wealth.

One of the things they buy with just a tiny fraction of those trillions is access to our political leaders. That’s why a century ago Louis Brandeis observed that “we can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can’t have both.” Brandeis’ words are as true today as they were when he spoke them.

But don’t despair. This craziness might be coming to an end.

Senator Chris Van Hollen (D-MD) has introduced legislation, the Sensible Taxation and Equity Promotion (STEP) Act, that would put an end to Buy – Borrow – Die. Millionaires still will be able to die – we can’t stop that – but under the STEP Act, dying will no longer be an income tax windfall.

Under the STEP Act, when a rich person dies, his estate will pay income tax on all his previously untaxed gains, the same way he would have had he sold his assets a month before his death.

Leona’s grandkids and the rest of the dynastic wealth crowd no doubt will squeal about this. “It’s double taxation!” they’ll scream, because about 0.1 percent of America’s estates are subject to estate tax. But it isn’t double taxation, even for that tiny group. The income tax paid by the estate on previously untaxed gains will reduce the amount subject to estate tax. Under the STEP Act, the overall tax treatment of a super-rich person who sells assets before he dies and one who holds them until her death will be identical.

Which gives the STEP Act something our tax law currently lacks: fairness.

We’ll also hear screams about how the STEP Act will force the sale of family farms and small businesses. It’s nonsense. The STEP Act allows the first million dollars of appreciated assets to pass at death without triggering income tax. And family members who inherit farms or small businesses they intend to continue operating will have 15 years to pay any income tax.

Truth is, the fictional plight of farmers and small business owners is a red herring, a disingenuous distraction invoked by a group of millionaires and billionaires with an out-of-control feeling of entitlement.

Our advice: Ignore the squealing of the super-rich. But should you find yourself feeling sorry for them, think of it this way: With death no longer being an income tax avoidance event, our super-rich will have more reasons to live.

The STEP Act also would treat gifts of appreciated assets the same as sales for income tax purposes.

The STEP Act has provisions that should prevent the use of trusts to circumvent the requirement that the gain on appreciated assets be taxed at least once per generation.

Will the STEP Act be the end of Buy – Borrow – Die? Yes, although we’ll still have Buy – Borrow. That’s a problem, but don’t fret. Help may be on the way on that front as well. Stay tuned.