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April 29, 2021
President Biden has proposed a huge increase in an important tax rate for the highest-income Americans. As part of what he calls the American Families Plan, he proposes to almost double the federal capital gains tax rate on those who earn more than $1 million a year. What tax rates are being proposed and when might higher rates take effect? Will these changes have a predictable and negative effect on the performance of the stock market? We will consider these and related questions.
Let’s begin by differentiating rates subject to small changes and rates subject to big changes. The Biden plan doesn’t substantially change the tax rates on earned or “ordinary” income. The current top federal rate is 37%, and Biden wants that to go back to the same 39.6% that prevailed prior to the 2017 tax cuts. Whether their ordinary tax rate is 37% or 39.6% at the margin, successful Americans will have pretty much unchanged financial incentive to go to work and sell more widgets.
Biden’s plan largely focuses on profits earned on the sale of assets, such as publicly traded stocks or privately held businesses – or houses, for which the first $250,000 ($500,000 for married couples) of gain on the primary residence will remain exempt from taxation. These are “capital gains” and at the federal level this type of income is currently and always taxed more leniently than is ordinary income. The highest capital gains tax rate is currently 15% for joint filers with taxable income above ~$80,000/year, and 20% for joint filers with taxable income above ~$500,000/year. There is today no level of taxable income that results in a capital gains tax rate higher than 20%. If the Biden plan becomes law, however, those with incomes above $1 million will pay a federal capital gains tax rate of 39.6%.
It does not end there, of course. At the federal level, joint filers with taxable income above $250,000 are also subject to a 3.8% “Obamacare” tax on investment income, including not just dividends and income but also capital gains. And, finally, residents of states such as California must pay state income tax. California’s tax rate for all income above $1 million -whether ordinary or capital gains- is 13.3%. While sympathy for those who earn more than $1 million in a single year may be in short supply, some very successful Californians might be looking at a marginal capital gains tax rate of 39.6% + 3.8% + 13.3%, or 56.7%. Those selling Facebook stock owned for just 12 months might still count themselves lucky. Those selling businesses they nurtured for decades will likely express varying degrees of outrage.
As of this writing it is impossible to know when these changes would take effect even in the event Biden’s proposal were to be passed by Congress. Most tax rate changes take effect tomorrow, as it were, rather than yesterday. However, history suggests that any tax legislation enacted in the 2021 calendar year could apply to transactions already completed. The Taxpayer Relief Act of 1997, for example, was signed in August of that year but was deemed effective as of that same year’s January. That law reduced the maximum capital gains tax rate but there is no assurance that Congress won’t take the same principal and precedent of retroactivity and apply it to higher rates. This means that even those inclined to sell assets immediately so as to pay taxes at today’s lower rates may find themselves outsmarted.
Forecasts about the outcome of congressional deliberations may not be especially reliable but as of now most “experts” seem to be of the opinion that whatever tax rate increases come about are likely to apply no sooner than next year. If this is so, high-earning owners of appreciated stocks may have reason to sell this year, before their tax rates rise. This may be true even if rates rise less than President Biden has proposed, which many observers regard as likely.
So Should I Sell My Stocks Before Others Sell Their Stocks?
If we had observed prior circumstances in which higher future tax rates caused a meaningful and presumably predictable decline in the stock market, then we might be wise to sell stocks prior to the application of higher rates. There are few supporting data points for this, however, as capital gains tax rates have not risen dramatically for many decades. The most recently relevant circumstance involved the American Taxpayer Relief Act of 2012. That bill indeed increased the capital gains tax rate on high earners, was introduced in the middle of the year, and was expected to (and did) take effect at the beginning of the following year. In this instance, everyone rightly suspected that the prevailing 15% capital gains tax rate was going to increase to 20% for the highest earners. What happened in 2012? At the worst of times in the fourth quarter of 2012, the U.S. stock market, as measured by the S&P 500, fell by about 7%, but that same 7% was retraced before the end of the year. Stocks then gained more than 30% in 2013. Those who sold their stocks and sat on the sidelines to watch the carnage they feared a 33% increase in the federal capital gains tax rate might precipitate made a costly market timing decision. (Because stocks rise most of the time, market timing is costly most of the time.)
Another of the many reasons we can’t rely upon tax-averse investors to sell a lot of stocks before rates rise is simply because many owners of stocks will not pay U.S. taxes when they sell them. According to a 2020 study by the Brookings-affiliated Tax Policy Center, in 2019 about 40% of U.S. corporate equity was owned by foreign investors.1 Foreign investors may pay income taxes in their local countries when they sell U.S. stocks, but they are not subject to U.S. taxes and thus they are not likely to be in any special hurry to sell before the end of this year for their own, personal tax reasons. About another 30% of U.S. stocks are owned within IRA and other retirement accounts of U.S. households. IRAs aren’t subject to capital gains taxes, either. Rather, IRA account owners are subject to ordinary income tax rates only at such time they make withdrawals from their accounts. Given this, owners of IRAs can buy and sell their accounts’ contents as often as they like and without any regard for current tax consequence. Nonprofit entities also own a chunk of the stock market. Subtracting all of these key players suggests that only about 25% of the U.S. stock market is owned by taxpaying American entities.
25% is still a big number, but it seems unlikely that many of the wealthiest Americans will be inclined to sell stocks, book profits, pay taxes at today’s seemingly attractively lower rates, and then sit in cash. Surely some may be of the opinion that they are wise to sell stocks and be done with it, but most will presumably turn right around and buy stocks back. The tax code’s wash-sale rule does nothing to prohibit this. Per the wash-sale rule, if you sell a stock at a loss and buy it back within 30 days, you forfeit the ability to use the loss to reduce your taxes. As such, most investors who book losses do not repurchase that same stock for at least 30 days. But the wash-sale rule does not apply to profitable transactions. If you want, you can sell your Netflix investment at 10 a.m. tomorrow and then you can buy it right back at a close-to-identical price one second later.
Now if we have perhaps established good reason to delay a race to the exits of our worrisomely crowded and smoky theatre, that does not mean it is fruitless to think ahead. This is because to the extent there may be some tax-related selling, we can perhaps guess where opportunity might present itself. Consider some very high earners, for example, who, enviably clever though they may be, never imagined that their Tesla stock might rise 1300% in 18 months. These investors might decide to sell their Tesla stock and then use the proceeds to buy stock in different companies, those they perceive as having more upside potential than their portfolio’s curiously expensive holdings. If this is so, then while a dramatic increase in the capital gains tax rate might not provide reason for high earners to exit the stock market entirely, it might provide reason for some of them to take profits at “this price won’t last” tax rates and then reallocate the proceeds. Every last textbook on prudent investing recommends rebalancing but investors are understandably reluctant to pay the tax man to do it. But for investors who might know that rates are going to rise next year, selling some of their outsized, highly appreciated shares and redeploying the proceeds may make a lot of sense.
Whither the Step Up?
If a capital gains tax rate increase from 20% to 40% is huge, consider an increase from 0% to 40%, which is what the Biden plan now asks some families to consider. 0% is the rate which effectively prevails when heirs (such as the kids, or a surviving spouse) sell inherited shares and other assets which received a “step-up in basis” upon the death of their benefactor. And just as the state and local tax (SALT) deduction that Trump’s 2017 tax plan mostly eliminated was of most value to high earners, the step-up in basis loophole provides the biggest savings to those who inherit valuable, low-basis assets. The Biden plan seeks to eliminate all but $1 million of step-up. Older and wealthier Americans sitting atop millions of embedded portfolio gains have long had a powerfully dynastic reason not to sell. If the step-up goes away, the math for both the owners and their children will be very different, as the big prize for holding onto appreciated assets until death will largely evaporate.
We have up until now considered the Biden plan’s potential influence on the behavior of owners of publicly traded stocks. But if you happen to have acquaintances who are quite wealthy, odds are good that many of them are owners of businesses. And many of these business owners are also going to be thinking about selling their companies before rates rise. We recall that the owner of Apple shares can easily sell and buy back their shares and still own Apple (or any other publicly traded stock) because the transaction cost and time required to sell and buy are virtually zero. Things are entirely different for those who want to sell the family business, however. Here it might take many months to identify and negotiate with a good-faith buyer. Legal and accountancy fees can run into the hundreds of thousands of dollars. And even if a good transaction can be put to bed before the end of the year, it may mean the end of the business owner’s career. This is because buyers of small businesses often ask sellers to sign agreements which prohibit them from starting new, competing businesses. Such agreements often prohibit sellers from reaching out to the customers who helped them build their businesses. The “buy it back right after you sell it” strategy that may appeal to stock market investors will be prohibitively expensive and even legally impossible for many small business owners.
Following the intricacies of tax legislation is intellectually stimulating and also professionally imperative for advisors eager to provide prudent and comprehensively informed investment counsel. As such, we will be following potential changes to our tax rates very closely throughout the rest of the year. If and as appropriate, we will surely have updated guidance for our clients.
1 Steven M. Rosenthal and Theo Burke, “Who Owns US Stock? Foreigners and Rich Americans,” Tax Policy Center, October 20, 2020
Cerity Partners LLC (“Cerity Partners”) is a registered investment adviser with offices in California, Colorado, Florida, Illinois, Ohio, Michigan, New York, Massachusetts, and Texas. Registration of an Investment Advisor does not imply any level of skill or training. This commentary is limited to general information, and should not be construed as personal tax, legal, or investment advice. There is no guarantee that the views and opinions expressed in this piece will come to pass. The information is deemed reliable as of the date of this commentary, but is not guaranteed, and subject to change without notice. It should not be considered as an offer to sell or a solicitation of an offer to buy any security.
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