This article originally appeared in the March 15, 2021, issue of Tax Notes Federal.
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Daniel I. Halperin is the Stanley S. Surrey Professor of Law Emeritus at Harvard Law School. He was the Treasury deputy assistant secretary for tax policy from 1978 to 1980. He thanks Alvin Warren and Tom Brennan for their help and Rebecca Friedman for her excellent research assistance.
In this article, Halperin proposes an innovative way to achieve realization, without any added tax burden at gift, death, or sale: collecting an equivalent tax in present value during the period the asset is held.
The Biden administration has indicated that it would end the egregious step-up in basis at death under section 1014.1 The step-up, combined with lack of gain recognition on property transferred to charities,2 allows wealthy households to escape taxation on a substantial percentage of their income. Importantly, measuring effective tax rates, without adding unrealized gains to the denominator, significantly understates the actual effective tax burden on those who hold appreciated assets until death or transfer them to charity to avoid tax on gains.3 In fact, those who have great wealth may have little or no reason to sell appreciated property. Risk can be mitigated by a charitable gift, a like-kind exchange for real estate,4 or the creation of an offsetting position that falls short of triggering a constructive sale.5 It is long past time to eliminate this enormous tax loophole.
A traditional argument against making death a realization event, however, is that it would trigger a large tax at death.6 Therefore, as a first step, this article proposes an innovative method of achieving the result of realization, without any additional tax burden at gift, death, or sale, by collecting an equivalent tax (in present value) during the period the asset is held. Although there would be an annual tax, unlike accrual taxation, this approach would continue the benefit of deferral, which accrual taxation would eliminate.
I show that, apart from the effect of a rate change, taxing the unrealized gain to basis each year, including the year of sale, can achieve the same result as a pre-death sale, even if property is not sold before death. (This is the “return-to-basis” approach.)7 As shown in Section I of this article, this can easily be achieved with marketable securities for which neither measurement nor liquidity would pose a problem. Section II explores alternatives for extending this treatment to nonmarketable assets as well.
If the return-to-basis approach is not enacted or is limited to marketable securities, as an alternative, I suggest (in Section III) substantially expanding the scope of so-called income in respect of a decedent (IRD),8 which denies the basis step-up. The current definition implies that the basis step-up should, for example, be denied for income that the decedent was entitled to before death when the tax on that income is deferred by a nonrecognition provision or an accelerated deduction, such as expensing or accelerated depreciation.
I conclude in Section IV with a brief discussion of the transition to the return-to-basis system.
I. Return-to-Basis-Marketable Securities
A. The Proposal
As stated above, in lieu of postponing tax until realization, we could achieve the same result as a pre-death sale of appreciated property, apart from the effect of a rate change, by taxing the unrealized gain to basis each year. The unrealized gain would be reduced by currently taxable income and could take account of income distributions within two and a half months of the end of the year. Therefore, if there were income, which is taxed annually, this treatment would continue. Under this approach, there would be no additional tax burden at either death or sale, and the tax advantage of the basis step-up would be eliminated.
The key to understanding why this is so is to recognize that the benefit of deferral in a realization-based income tax is effectively an exemption of the return on reinvested income. On the other hand, deferral does not exempt the return on the original investment (basis). Accordingly, the result of realization, including realization at death, could be achieved by an annual tax on only the portion of currently unrealized income attributable to the return to basis. The return on the reinvestment of the unrealized gain would not be taxed.
B. Simple Example
To show how this works, let me start with a simple example. Assume property is purchased for $100 and increases in value by 10 percent a year before being sold at the end of year 2 for $121. If the capital gain rate is 20 percent, the investor would owe $4.20 on the $21 profit, retaining $116.80 after tax.
Suppose that instead of postponing tax until gains are realized, we imposed an annual tax, at capital gain rates, on the unrealized return to basis, here 10 percent per year or $10 on the $100 basis. At 20 percent, the tax would be $2 per year,9 which, for now, I assume is paid by liquidating a portion of the investment.10 The $2 tax would reduce the value of the investment at the end of year 1 to $108, which, at a 10 percent return ($10.80), would grow to $118.80 at the end of year 2. The payment of the $2 tax in year 2 would reduce the value to $116.80, the same result as under the current realization system. This affirms the equivalency described at the outset.
The tax of $4.20 under the realization system, which appears to be a tax on the entire $21 gain, can be shown to be equal only to the future value in year 2 of the annual tax on the return to basis payable under the return-to-basis approach. Thus, the year 1 tax of $2, at the 10 percent internal rate of return, is equal to $2.20 in year 2.11 When added to the year 2 tax of $2, this equals $4.20, the tax paid under the realization system. Despite the annual tax, the true tax burden is not affected. In both cases, only the return to basis is taxed.
In contrast, if mark-to-market applied,12 although the year 1 tax would remain $2 (the entire $10 gain is a return to basis), the tax in year 2 on the gain of $10.80 would be $2.16, reducing the net value to $116.64. The 16 cents difference, as compared with realization, is the year 2 tax, paid under an accrual system, on the 80 cents return to the reinvestment of the $8 of after-tax earnings in year 1. The suggested approach, like realization, exempts this gain, retaining the advantage of deferral, except for the effect of a change in the applicable tax rate.
C. Effect of the Proposal
Because deferral effectively exempts the return from reinvestment of the unrealized gain whether or not the property is sold, a sale before death would tax only the return to the original investment. The basis step-up at death or a charitable gift would eliminate this tax, but that tax avoidance is prevented when we tax the gain to basis annually whether or not the property is sold. An additional advantage of this approach is that it eliminates the opportunity to realize gains only when tax rates are favorable, as well as the burden of a potentially higher tax rate when selling becomes unexpectedly necessary.
Because we would end the benefit of the basis step-up without increasing the tax burden at death, it can no longer be argued that an income tax on unrealized gains at death, in combination with the estate tax, amounts to double taxation or that it would impose an undue burden at the time of death.13 So-called lock-in should also be much less of a problem under this new approach.14 First, there would be no tax on sale. Second, because tax forgiveness under section 1014 would be unavailable whether or not property is sold, those who delay selling solely to obtain this advantage would have no reason to wait. Although a sale would end the advantage of the tax-free return on the reinvested profit, just as a sale does under the realization system, the effect is likely to have less salience when it is not accompanied by the requirement to pay some immediate tax.
Under return-to-basis taxation, because there is no tax on sale, basis is only relevant in measuring the annual tax. Under current law, a sale, in addition to imposing a current tax, would end the advantage of the tax-free return on the reinvested profit because any replacement property would have a basis equal to current value. This would increase future after-tax income under the return-to-basis approach, as well. To achieve equivalence with a pre-death sale, property should also take a basis equal to fair market value upon transfer at death or gift and, preferably, other tax-free transactions as well. Continuation of the carryover basis for transfers by gift would create a preference for lifetime transfers and an incentive to postpone selling as long as possible, which would unduly benefit the super wealthy.
To recapitulate, because the return from reinvestment of the unrealized gain is effectively exempt whether or not the property is sold, we can duplicate the result of a sale and end the forgiveness of tax on the unrealized gains at death by taxing the unrealized return to basis annually.
D. An Extended Example
To further establish the equivalence, shown in Section I.B of this article, the following example extends the holding period to three years (which confirms that the result would follow regardless of how long property is held) and varies the rate of return over time. Assume property is purchased for $100. The property doubles in value in year 1 and increases by 10 percent in year 2 and 20 percent in year 3. The capital gain rate is 20 percent, and any tax is paid by liquidating a portion of the investment.
Under the current realization approach, as shown in Table 1, if the property is not sold until year 3, it would increase in value to $264, netting $231.20, after a tax of $32.80 on the $164 gain.
| Beginning Value | Increase in Value | Value at End | Taxable | Tax at 20 Percent | Net Value |
|---|---|---|---|---|---|---|
Year 1 | $100 | $100 | $200 | $0 | — | $200 |
Year 2 | $200 | $20 | $220 | $0 | — | $220 |
Year 3 | $220 | $44 | $264 | $164 | $32.80 | $231.20 |
Suppose in lieu of realization, the return to the original investment of $100 was taxed each year so that taxable income was $100 in year 1 (at 100 percent), $10 in year 2 (at 10 percent), and $20 in year 3 (at 20 percent). See Table 2. The tax in year 1 would be $20, leaving $180 after tax. In year 2, at 10 percent, the value increases to $198, and the tax would be $2 for a net value of $196. After a 20 percent gain in year 3 ($39.20) and a tax of $4, the net value would be $231.20, the amount in Table 1 under current law.
| Beginning Value | Increase in Value | Value at End | Taxable | Tax at 20 Percent | Net Value |
|---|---|---|---|---|---|---|
Year 1 | $100 | $100 | $200 | $100 | $20 | $180 |
Year 2 | $180 | $18 | $198 | $10 | $2 | $196 |
Year 3 | $196 | $39.20 | $235.20 | $20 | $4 | $231.20 |
Although at realization it appears that the entire gain, in this case $164, is taxed for a tax liability of $32.80, it can be said (as described in Table 3) that the taxable income ($164) is limited to the future value in year 3 of the return to basis. The $100 return to basis in year 1, as increased by the internal rate of return of 10 percent in year 2 and 20 percent in year 3, would have a value of $132 in year 3. Similarly, the $10 return to basis in year 2, as increased by the internal rate of return of 20 percent in year 3, would have a value of $12 in year 3. The sum of $132, $12, and the $20 return to basis in year 3 is $164. Under that assumption, only the return to basis is taxed under the realization approach, and the return to reinvestment of the untaxed appreciation is effectively tax-free.
| Value in Year 1 | Value in Year 2 (10 percent increase) | Value in Year 3 (20 percent increase) |
|---|---|---|---|
Year 1 | $100 | $110 | $132 |
Year 2 | — | $10 | $12 |
Year 3 | — | — | $20 |
Total Year 3 | — | — | $164 |
E. Possible Complications
I next explore the effect of differing tax rates, losses (including the effect of distributions in excess of current income), and the payment of tax without liquidating the investment.
1. Change in tax rates.
Under the realization system, only the tax rate in the year of sale matters. This inappropriately allows investors to choose a low-tax year to sell or may saddle investors, unable to choose, with high tax rates, which would offset part or all of the benefit of deferral. If the tax rate were the same in all years, return to basis and realization would continue to produce the same result. For example, if the tax rate were always 30 percent, the tax on sale under realization (Table 1) would be $49.20 (in lieu of $32.80) for a net value of $214.80. The tax under return to basis at 30 percent, as shown in Table 4, would increase to $30, $3, and $6, in years 1, 2, and 3, respectively. Accordingly, the net value would be $214.80, as under realization.
| Beginning Value | Increase in Value | Value at End | Taxable | Tax at 30 Percent | Net Value |
|---|---|---|---|---|---|---|
Year 1 | $100 | $100 | $200 | $100 | $30 | $170 |
Year 2 | $170 | $17 | $187 | $10 | $3 | $184 |
Year 3 | $184 | $36.80 | $220.80 | $20 | $6 | $214.80 |
If tax rates varied over time, the return-to-basis approach would not produce identical results as realization because for the latter, only the tax rate in the year of sale matters. For example, if the tax rate in Table 2 were 30 percent in year 2, the tax would be $3 in that year, reducing the investment to $195 (as opposed to $196). After a 20 percent return ($39) and a $4 tax payment, the accumulation at the end of year 3 would be $230 or $1.20 less. This is explained by the $1 in additional tax in year 2 plus the loss of the 20 percent pretax return on that amount in year 3. As noted above, there are advantages to reducing the importance of the tax rate in the year of realization.
2. Effect of losses.
Losses for this purpose would include a reduction in the unrealized gain caused by distributions in excess of income. The identical results between realization and the return-to-basis method are not affected by losses if the losses are recognized and lead to tax refunds. Assume a 10 percent loss in year 2 in lieu of a 10 percent gain. Under realization, the value at the end of year 3 would be $216. See Table 5. The tax would be $23.20 on the gain of $116 for a net value of $192.80. As shown in Table 6, return to basis produces an identical result if the $10 loss recognized in year 2 (10 percent of the original basis of $100) leads to a refund of $2.
| Beginning Value | Increase (Decrease) | Value at End | Income (Loss) | Tax at 20 Percent | Net Value |
|---|---|---|---|---|---|---|
Year 1 | $100 | $100 | $200 | $0 | — | $200 |
Year 2 | $200 | ($20) | $180 | $0 | — | $180 |
Year 3 | $180 | $36 | $216 | $116 | $23.20 | $192.80 |
| Beginning Value | Increase (Decrease) | Value at End | Income (Loss) | Tax at 20 Percent | Net Value |
|---|---|---|---|---|---|---|
Year 1 | $100 | $100 | $200 | $100 | $20 | $180 |
Year 2 | $180 | ($18) | $162 | ($10) | ($2) | $164 |
Year 3 | $164 | $32.80 | $196.80 | $20 | $4 | $192.80 |
If tax refunds are deferred until equal gains are realized in the future, parity with realization can be maintained by increasing the refund by the internal rate of return. See Table 7. The value at the end of year 2 would be $162, which increases to $194.40 at the 20 percent rate of return. The year 3 tax of $4 would be reduced by the carryover of the year 2 refund ($2 increased by 20 percent (the year 3 gain) to $2.40) for a net tax liability of $1.60, again producing a value of $192.80.
| Beginning Value | Increase (Decrease) | Value at End | Income (Loss) | Tax at 20 Percent | Net Value |
|---|---|---|---|---|---|---|
Year 1 | $100 | $100 | $200 | $100 | $20 | $180 |
Year 2 | $180 | ($18) | $162 | ($10) | [$2] deferred | $162 |
Year 3 | $162 | $32.40 | $194.40 | $20 | $1.60a | $192.80 |
a$4 - $2.40 = $1.60. | ||||||
The same result can be achieved, without increasing the tax refund, by reducing the basis, on which the taxable return is based, by the $10 disallowed loss, reducing the basis to $90, until the loss is allowed. See Table 8. In this case, the taxable income in year 3 at 20 percent would be $18 (as opposed to $20) for a tax of $3.60, which after allowing the $2 deferred refund from year 2, would make the net tax $1.60. By reducing the basis by $10, at the 20 percent return, taxable income is reduced by $2, which reduces tax liability by 40 cents, the amount of interest that would be due on a delayed refund.
| Beginning Value | Increase (Decrease) | Value at End | Income (Loss) | Tax at 20 Percent | Net Value |
|---|---|---|---|---|---|---|
Year 1 | $100 | $100 | $200 | $100 | $20 | $180 |
Year 2 | $180 | ($18) | $162 | ($10) | [$2] deferred | $162 |
Year 3 | $162 | $32.40 | $194.40 | $18 | $1.60a | $192.80 |
a$3.60 - $2 = $1.60. | ||||||
3. Tax paid from other sources.
If the taxpayer did not wish to liquidate a portion of the investment to pay the annual tax, it would be necessary to borrow funds to pay the tax or forgo or liquidate another investment. Whether this turns out to be a better choice would depend on the difference, if any, between the interest rate on the borrowed funds (or, if relevant, the “lost” rate of return on the asset that was sold (or never purchased)) and the internal rate of return on the investment in question.
If tax is paid by liquidating other assets or from borrowed funds, however, the property under consideration would continue to provide a tax-free return on the amount that would have been used to pay the tax. To eliminate this advantage, we should assume that the taxpayer did liquidate a portion of the investment to pay the tax and a like amount was invested in that asset from the funds apparently used for the tax payment. This would keep the taxpayer’s overall basis, which would determine the amount of annual taxable income, at the same level as if the taxpayer did liquidate a portion of the investment to pay the tax and invested the funds used for the tax payment in a new investment.
II. Investment in Nonmarketable Assets
A. In General
Measurement of gain or loss or sufficient liquidity to pay tax could pose a problem for nonmarketable assets. Parity with marketable assets could be achieved, even if we continue to postpone taxation on nonmarketable assets until realization, as long as unrealized gains are taxed at death. However, to limit the tax impact at death or sale, it would be preferable to extend return-to-basis taxation to nonmarketable property as nearly as possible, to spread the tax burden over the life of the investment.
If only liquidity is viewed as a problem, we can, as the installment sale provision does in some circumstances,15 defer the tax with interest. This would, of course, impose a tax at sale or death and should be avoided if possible.
If the tax due under the return-to-basis approach is paid by liquidating a portion of the investment in question, it may be appropriate to treat the sale price as determining the market value of the asset. If so, we can apply the normal rules for marketable assets. However, if the tax is paid from other sources, as would be expected for nonmarketable assets, it may be too difficult to measure the gain on nonmarketable assets.16 If so, we could impute a rate of return for the purposes of the annual tax. The annual imputed return would be reduced by any realized income.
Normally, there would be no tax on sale or death under the return-to-basis approach because the annual tax captures the full return to basis over the life of the investment. However, if the annual tax on the return to basis is based on an imputed return, there would need to be a true-up at sale (or a transfer by death or gift) to reflect the actual gain.
One possibility is to compute the gain or loss as we would under the realization system by measuring the difference between original basis and market value at the time of the realization event. The tax so determined would be reduced by the prior tax paid under the return-to-basis system increased by the “applicable” interest rate. The tax burden at sale would be the same as it would be under realization if the interest rate is “appropriate.” I would suggest we use a risk-free rate to limit the possibility of increasing the tax advantage of realization.
Another possibility is to continue to apply the return-to-basis system in the year of sale or death by comparing the assumed value based on the imputed return with the actual market value at that point. The portion of the gain or loss so determined, which is attributable to basis, will be taken into account under the return-to-basis system. This approach does not require an interest rate assumption, but its accuracy in matching the result of realization depends on the imputed rate of return. If the imputed rate is too low (which to me seems more likely), we would increase the tax advantage of deferral, which is undesirable. This leads me to prefer the first choice.
B. Depreciable Property
Property that can be expensed or depreciated represents a special species of nonmarketable property because there can be an unrealized gain even if value does not exceed the original purchase price. If the FMV of that property exceeds basis because of excess depreciation or immediate expensing, there is an unrealized gain, which would trigger return-to-basis taxation. Imposing an annual tax on this amount appears difficult, however.17 Therefore, it may be necessary to rely on IRD to disallow a basis step-up for an expensed item and for potential depreciation recapture, as suggested in Section III of this article, which proposes an expansion of IRD. If that proposal is adopted, the opportunity for a basis step-up would be limited to depreciable real estate. Accordingly, if we include nonmarketable property in the return-to-basis system, an annual tax on unrealized gain in excess of the original cost of real estate would be appropriate.
C. Corporate Stock
Because deferral effectively exempts income that represents a return on unrealized reinvested gain, if a dividend is deferred, a shareholder will be effectively exempt, at the shareholder level, on the return earned during the deferral period on the reinvestment of the earnings for which the dividend tax has been deferred. Only the corporate-level tax will apply to this income. On the other hand, if there is a taxable dividend or sale, the shareholder will continue to bear the full burden of both corporate and individual rates on the return to the original capital investment or basis.18 If there is an intervening death, however, this income will be exempted by section 1014.
The return-to-basis approach will prevent this result by annually taxing shareholders on the return to the original capital or basis, even if there is no distribution. If this approach is limited to marketable securities, an alternative, as I have previously argued,19 is to reduce the step-up in basis by the deceased’s allocable share of the undistributed income. This is clearly IRD, as described in the following section.
III. Expanding IRD Under Section 691
Section 1014(c) denies a step-up for any “amounts to which a decedent was entitled as gross income but which were not properly includible . . . under the method of accounting employed by the decedent” before death.20 That income, so-called IRD,21 is not allowed to escape taxation. Although, a decedent will not be considered as “entitled” to income attributable to appreciation of property until that property is sold, it seems clear that many more items of income can be added to IRD, substantially expanding the scope of that provision, just by applying the implications of the current definition. If return-to-basis taxation is not enacted or is limited to marketable securities, that expansion should be considered for assets not subject to the return-to-basis system.
In three articles published in Tax Notes in August and September 2017, as part of what he calls the Shelf project,22 professor Calvin H. Johnson recommended a series of limitations on the step-up, most of which strike me as reasonable. My intention here, however, is to focus solely on items of gross income that we can fairly say the decedent was entitled to before death within the meaning of section 691.
For example, Johnson has suggested that, consistent with section 691,23 the basis under section 1014 should be reduced by realized but unrecognized gains as a result of corporate reorganizations24 and like-kind exchanges.25 Although the code provides that this gain should not be recognized, it states that it is realized, putting these items clearly within the scope of IRD.
The basis step-up should also be denied for income that was accrued before death when the tax on that income is deferred by an accelerated deduction, such as expensing or accelerated depreciation. The amount that would be taxed on sale of the expensed item is the future value of the original amount exempted26 and should be taxed regardless of whether sale precedes death. Thus, any expensed item should be denied a basis step-up.27
Accelerated depreciation also shelters accrued income from tax to the extent that allowable depreciation exceeds the actual decline in value. Therefore, the basis step-up should be reduced by depreciation recapture, which would clearly represent previously untaxed income. For this purpose, I would determine the amount of depreciation recapture for real estate in the same manner as it is measured for personal property.
Further, because the corporate tax rate is now much lower than the individual rate, accrued corporate income is not subject to full tax at individual rates until distributed. Unless the shareholder is taxed, only the lower corporate tax rates will apply to this income. Accordingly, if return-to-basis taxation does not apply, the step-up for the shareholder should be reduced by the allocable share of the undistributed income.28 This follows the approach of the American Law Institute integration study that recommended that the basis of corporate stock determined under section 1014 be reduced by the decedent’s allocable share of undistributed corporate earnings.29
The ALI reasoned that “the increase in basis at death is intended to remove from the tax base, unrealized gains not previously realized gains. . . . Accordingly, some limitation is necessary to prevent integration from extending the exemption of section 1014 to pre-death corporate income.”30
Similarly, a partner is taxed on income when it is earned, regardless of whether it is distributed. In fact, payments to a retiring or deceased partner, other than in liquidation of the partner’s interest in property, are considered IRD.31 Thus, when heirs of a deceased partner retain a continuing interest in the income of the partnership, payment for goodwill and receivables are taxable, even though the amounts received do not exceed the date-of-death value.32
The ALI proposal is consistent with now-expired legislation in which Congress reduced the step-up by the undistributed, and therefore untaxed, income of a domestic international sales corporation33 and limited the basis of stock in a foreign personal holding company to the lesser of FMV or the decedent’s basis.34 The limit on the step-up should be extended to all corporate stock, at least as long as corporate income is not fully taxed at the corporate level.
IV. Transition
As to marketable assets, there should not be a problem with applying return-to-basis taxation to taxable income in years after enactment. At the sale of these assets, only the pre-enactment gain would remain to be taxed, which, as described above, regarding nonmarketable assets, can be achieved if the tax due on sale is reduced by the prior tax paid under the return-to-basis approach, plus interest. If the tax under the return-to-basis approach is paid by liquidating the property in question, the interest rate could be based on the internal rate of return from this investment from the time the tax was paid.35
If return-to-basis taxation is extended to nonmarketable assets, I would be inclined to grandfather-in existing assets and limit this approach to assets purchased after the effective date. As Treasury deputy assistant secretary in 1980, I experienced firsthand the angst over the application of carryover basis to assets purchased before the rule change in 1976. The claim that basis was often unknown and undeterminable, whether correct or not, undoubtedly contributed to the retroactive repeal of carryover basis.36 Therefore, it seems best to avoid this argument and focus on achieving better results in the future.
FOOTNOTES
1 See Harry L. Gutman, “Taxing Gains at Death,” Tax Notes Federal, Jan. 11, 2021, p. 269; Farrell Fritz PC and Louis Vlahos, “Biden’s Tax Proposals for Capital Gain, Like Kind Exchanges, Basis Step-Up and the Estate Tax — Tough Times Ahead?” JD Supra, Aug. 17, 2020.
2 See Daniel I. Halperin, “A Charitable Contribution of Appreciated Property and the Realization of Built-In Gains,” 56 Tax L. Rev. 1 (2002).
3 Emmanuel Saez, Danny Yagan, and Gabriel Zucman, “Capital Gains Withholding,” 1 (Jan. 2021) (unpublished manuscript) (on file with U.C. Berkeley).
4 See id.; section 1031.
5 See section 1259; Halperin, “Saving the Income Tax: An Agenda for Research,” 24 Ohio N.U. L. Rev. 493, 500-501 (1998).
6 See Gutman, supra note 1, at 272.
7 This proposal is based on work in progress with my colleague Thomas J. Brennan, which we refer to as “distributed deferral.” Paul Caron, “Brennan Presents Distributed Deferral Today at Toronto,” Taxprof Blog, Jan. 9, 2019.
8 Section 1014(c).
9 The effect of a change in the rate of return over time and a longer holding period will be explored in Section I.D of this article. Because in this example the rate of return is the same each year and the tax rate remains 20 percent, taxable income and the tax due are the same in each year.
10 The effect of using other sources to pay the tax will be explored below.
11 In other words, by paying the tax in year 1, the investor loses 20 cents of income in year 2.
12 A mark-to-market taxation system would trigger tax on the difference between the basis of an investment and the unrealized gains on a security based on the year-end valuation. See Samuel D. Brunson, “Taxing Investors on a Mark-to-Market Basis,” 43 Loy. L.A. L. Rev. 507, 512 (2010).
13 Edward J. McCaffery, “Taking Wealth Seriously,” 70 Tax L. Rev. 305, 355 (2017).
14 Lock-in is the risk that investors will not trade securities because of high tax consequences. See Chris William Sanchirico, “Tax Inertia: A General Framework With Specific Application to Contemporary Business Tax Reform,” 69 Tax L. Rev. 135, 155 (2016).
15 Section 453(l)(3); section 453A(c).
16 In this case, the basis of the asset used to compute the annual tax should be increased by the tax payment. See Section I.E.3 of this article.
17 For a discussion of how this might be done, see Brennan and Halperin, supra note 7.
18 Halperin, “Corporate Tax Reform — The Issues and the Choices,” Tax Notes, Feb. 6, 2017, p. 705. This insight led to the surprising conclusion that, assuming distributions are fully taxed, when the combined rate on distributed earnings is roughly equivalent to the top individual rate, as under current law, the advantage of a corporate rate lower than the individual rate can be described solely as a permanent lower rate of tax on the return to reinvested earnings.
19 Halperin, “Mitigating the Potential Inequity of Reducing Corporate Rates,” Tax Notes, Feb. 1, 2010, p. 641.
20 Reg. section 1.691(a)-1(b).
21 Section 691.
22 The Shelf project is intended to develop several proposals that would be ready to go if significant tax reform is under consideration. Johnson, “Gain Realized in Life Should Not Disappear by a Step-Up in Basis,” Tax Notes, Sept. 4, 2017, p. 1305; Johnson, “Step-Up at Death but Not for Income,” Tax Notes, Aug. 21, 2017, p. 1023; Johnson, “Cut Negative Tax Out of Step-Up at Death,” Tax Notes, Aug. 7, 2017, p. 741.
23 Johnson, “Gain Realized in Life Should Not Disappear by a Step-Up in Basis,” supra note 22, at 1310-1311.
24 Section 361.
25 Section 1031.
26 Halperin, “Interest in Disguise: Taxing the ’Time Value of Money,’” 95 Yale L.J. 506, 522 (1986); see William Andrews, “A Consumption-Type or Cash Flow Personal Income Tax,” 87 Harv. L. Rev. 1113, 1127 (1974).
27 Johnson views the step-up for items that have benefited from expensing and accelerated depreciation as allowing a double deduction, which leads to a negative tax, and proposes that the double deduction be eliminated. (“Cut Negative Tax Out of Step-Up at Death,” supra note 22, at 741.) While this argument has force, I am relying here on the analogy to income under section 691.
28 Halperin, supra note 19, at 653-654.
29 Michael J. Graetz and Alvin C. Warren Jr., Integration of the United States Corporate and Individual Income Taxes: The Treasury Department and American Law Institute Reports 705-706 (1998); reg. section 1.995-4(e) (for an example of how to allocate earnings relating to a domestic international sales corporation).
30 Graetz and Warren, supra note 29, at 133-134.
31 Section 753.
32 Quick Trust v. Commissioner, 54 T.C. 1336, 1345 (1970).
33 Section 995(a); and section 1014(d).
34 Section 1014(b)(5).
35 Alternatively, the tax can be computed at the time of enactment, as if there were a hypothetical sale, and increased by the pretax return on the asset until the final sale.
36 Richard Schmalbeck, Jay A. Soled, and Kathleen DeLaney Thomas, “Advocating a Carryover Tax Basis Regime,” 93 Notre Dame L. Rev. 109, 110 (2017).
END FOOTNOTES