Wealth-based taxation would change financial advice

With our national debt recently passing $22 trillion, politicians are searching for ways to fund existing and new government programs. Democratic presidential candidates such as U.S. Sens. Elizabeth Warren and Bernie Sanders have proposed IRS changes to allow taxation of wealth rather than income.

If any of these attempts succeed, for better or worse, part of the job of financial and tax advisers will be to help clients understand these new taxes and how to react to them.

Sen. Warren’s plan calls for a 2% annual tax on the wealth of individuals with over $50 million and a 3% tax on individuals with over $1 billion in wealth. Sen. Sanders’ plan calls for a graduated tax starting at 1% per year on wealth over $32 million and going all the way up to 8% for wealth over $10 billion. The fact that only the ultra-wealthy would pay this tax may make it a politically viable way to raise trillions of dollars over the next 10 years, though many others consider it an unfair tax, since it penalizes successful individuals who save rather than spend.

When advising households just over the cusp of being subject to wealth or estate taxes, it gives an adviser the opportunity to propose acceleration of any planned charitable legacy giving, so the donor can see the benefits of their generosity while alive, avoid the taxes and get the charitable donation tax deduction immediately. Advisers may also want to discuss how a wealth tax up to 8% may make it less appropriate to hold low-return assets such as money market funds, bank CDs or government bonds that currently have modest 1%-3% yields.

More conservative clients may feel forced to invest in riskier and higher-returning assets to stay above water after factoring in the taxes. Advisers will also need to make sure clients have sufficient liquidity to pay their taxes. A client required to pay up to an 8% wealth tax each year can’t have 95% of their net worth in an illiquid private company stock that they can’t sell to raise cash to fund the tax (though some proposals allow temporary postponement for this situation).

Wealth is defined broadly in these proposals and includes almost everything of financial value such as real estate, art and privately-owned businesses, in addition to standard financial assets like bank accounts and mutual funds. This broad definition is required to limit tax loopholes, such as investing money in rare collectibles to avoid the tax, but it is also a downside to these wealth-based proposals, because they require regular valuations of often illiquid and hard to price assets, such as business ownership or rare art. There would be significant paperwork and expenses involved in regularly valuing a complicated estate. Advisers could offer to help coordinate these regular valuations and locate the required appraisers.

Several European countries have attempted to enact wealth taxes, but most have been repealed because revenues came in lower than expected due to tax avoidance strategies or attempts by wealthy citizens to leave the country and not pay the taxes. Most European wealth taxes were also enacted at lower levels of wealth — with many starting around $1 million — making them much less popular. Some variants of the current proposals also have an additional expatriation or “exit tax” for individuals who try to renounce their citizenship to avoid a wealth tax. Advisers should be careful to not give advice that would result in unexpected exit taxes.

For now, we have to wait and see the results of the 2020 general election, what any passed tax proposals look like, and then wait through the expected court challenges to a wealth-based tax.

Editor’s note: Erik Berry is a partner and investment adviser with WealthPath Investment Advisors in Rogers. His work at the firm focuses on financial planning, portfolio management and research. The opinions expressed are those of the author.