You may have heard chatter about the Biden Administration discussing a 25% unrealized gains tax. What is it? How would it work? Does it really affect me?
An unrealized gains tax subjects unrealized gains to annual taxation when an individual or taxable entity files its year-end tax return. While many think first of unrealized gains on stock market traded equity securities, an unrealized gains tax could be applied to all kinds of assets, including holdings of private entities or ownershitaxp of small businesses.
An unrealized gain is an estimated amount of value (on paper) regarding the worth of a business, calculated at a given point in time. This estimate of value changes for internal factors, such as revenues, profits, liquidity, research and development prospects for new products, etc., as well as external factors, such as how the overall industry is doing, how the market and economy is doing, interest rates, etc.
Changes in unrealized gains and losses don't impact an individual or entity’s access to cash or other assets. In order to access the value of an unrealized gain, the related asset would need to be sold.
Therefore, a tax on unrealized gains poses several logistical questions:
As the value changes constantly, how would the value to be used in the tax calculation be determined? Would it be the value as of the end of the year? An average value over the year?
What happens if the calculation results in a gain, but at year end or at the time to pay the tax, the value has decreased, or even gone into a loss position?
For traded securities, they provide an easily available calculation of value, but for non-traded securities, an estimate of value is not easily available and the valuation processes used to determine the value are often time consuming and costly to obtain. “Back of the envelope” calculations may be available, but less reliable and may not consider specific attribute of a specific business. What would the valuation requirements be?
How would an individual pay the tax? If they don’t have adequate cash on hand, the only way to access the value of the unrealized gain is to sell it. This alone poses a number of issues.
While traded equity securities are able to easily be sold on the stock market, other assets are not as easily sold as there is less of a market or may require the sale of other assets of the company or a sale of a company itself! The holder/owner may not be interested or ready to divest the asset as they want to continue to hold the position, own the business, or other regulatory/tax consequence that may ensue.
A mass sell-off of securities to pay an unrealized gain tax would destroy the market as it currently exists. This would significantly impact how the economy operates, further limiting who would have adequate liquid assets to invest. Institutional investor activity would decrease due to the tax consequences.
There would be significant costs to address logistics, litigate disparities, and to economic productivity as time and resources are redirected to address the complexities of reporting.
Small business ownership would decrease as owners would often not be able to pay the tax without selling their business.
What happens when the value goes down? Would there be a refund of previous taxes paid? How would the government be able to plan spending of this money if they may need to return large portions of it?
Many taut this as a tax on the wealthy, sighting the balance sheets of billionaires which consist of unrealized gains in investments of all kinds. Analysts of the current proposal indicate that the tax would only affect individual taxpayers with over $100 million in net assets, however it is important to note that certain supporters and authors originally expressed a much lower threshold, down to as little as $1 million in income or $10 million in wealth.
Also under the current proposal, taxpayers would report as of December 31 each year. The proposal would consider the built in gains on day one and would allow for the initial tax to be paid over nine years and subsequent years tax over five years. There are a few other deferrals and caveats for smaller taxpayers within those subject to the tax, however, this could completely change the economy and turn it upside down. While it's hard to visualize the full impact, our business environment would be unrecognizable. Things to consider when evaluating policies currently up for debate.
It's important to note that this tax has a challenging journey before it could become a reality. It faces strong disfavor with many investors and businesses. It currently has limited support in congress and would most likely face challenge in the supreme court even if it were to pass.
Even so, we encourage you to educate yourself on this and many other policies that could potentially impact your investments and businesses in the future. It's important to understand what our leaders are proposing and to participate in our governing processes to express our opinions to our representatives.
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