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Planning for the Warren Wealth Taxes

Planning for Warren wealth tax a balancing actNormally, we don’t blog about proposed tax legislation. Especially something like Elizabeth Warren’s wealth tax proposals.

She hasn’t even won her party’s nomination. And even if Senator Warren won the presidency, who knows whether enough moderate Democrats and Republicans would support her proposals.

However, because her wealth tax works so differently from the way income taxes work, and because other presidential candidates are talking “wealth taxes,” I’m going to describe the Warren wealth taxes.

After that, I want to discuss how these taxes impact small business entrepreneurs. Their effect will be seismic.

But this note: This blog isn’t a political news or opinions blog. The blog covers practical tax, business and financial issues.

Accordingly, I’ll describe and discuss how the Warren wealth tax works. Not whether or not the Warren proposals make policy sense…

Warren Wealth Taxes in a Nutshell

Senator Warren proposes three wealth taxes: a tax on all of the folks in the one percent, a tax on people she labels “ultra-millionaires,” and a tax on billionaires.

The One Percent Wealth-triggered Income Tax

The highest impact wealth tax proposed by Senator Warren is actually an income tax triggered by someone enjoying top one percent wealth.

That wealth-triggered tax works like this. If a taxpayer’s wealth puts them into the top one percent of the population, the taxpayer must use “mark-to-market” accounting and thereby pay income taxes on investment gains when the gains occur rather than when an investment gets sold.

Further, these top one percent taxpayers don’t use the capital gains tax rates (so maybe 0% but usually 15% or 20%) that people outside the top one percent use. Rather, they use ordinary income tax rates (so probably 40%-ish.)

Example 1: A top one percent taxpayer named George owns a small business. If it increases in value by $1,000.000, he owes income taxes on the $1,000,000 of “appreciation.” Probably the tax rate runs about 40 percent the way the Senator’s math works. So about $400,000 in taxes.

You can compare this to the situation someone outside the top one percent encounters for better understanding.

Example 2: George’s friend Martha also owns a small business that increases in value by $1,000,000. Martha doesn’t pay taxes on this increase in value however if she’s not part of the one percent. She will probably pay a 20% capital gains tax, so roughly $200,000, if she later sells the business.

A couple of wrinkles to note about the one percent tax.

The first wrinkle: Retirement accounts count toward net worth, but the mark-to-market accounting doesn’t apply to retirement accounts.

Example 3: George from example 1 also holds $2 million in his 401(k) plan. And that $2 million counts toward his net worth. But fluctuations in the 401(k) account balance don’t trigger mark-to-market accounting or taxes.

The second wrinkle: The mark-to-market accounting works both ways.

Example 4: After experiencing explosive growth last year, George from example 1 sees his small business’s value shrink by $500,000. This $500,000 “depreciation” in value should result in a refund of the previous year’s wealth-triggered taxes. If the tax rate runs 40 percent, that refund equals about $200,000.

Who Falls into the Top One Percent?

Simple math says about 1.7 taxpayers fall into the top one percent.

But some disagreement exists about the wealth threshold that determines one percent status.

In the Senator’s discussions, I’ve been unable to find a specific dollar amount that triggers the mark to market requirement.

But the two economists advising Warren on the wealth tax, Emmanuel Saez and Gabriel Zucman, have written a lot about wealth. And in a relatively recent 2014 paper (see here) they pegged the threshold to one percent status at about $4 million. That sounds about right to me.

The Ultra-Millionaire Tax

Senator Warren labels top one percent taxpayers with $50 million or more in wealth “ultra millionaires.”

And she proposes levying an additional two percent wealth tax on the wealth in excess of $50 million that these folks hold.

Example 5: Abigail enjoys a net worth equal to $60 million, so $10 million in excess of the $50 million threshold. She therefore pays a two percent tax on that $10 million, or $200,000.

A note: Abigail as a member of the “top one percent” also uses the mark-to-market accounting rules and pays income taxes on asset appreciation.

The Billionaire Tax

Taxpayers with more than $1 billion in wealth pay the 2 percent ultra-millionaire tax on $950 million (so the wealth they hold in excess of $50 million but less than $1 billion). And then they pay a six percent wealth tax on the wealth they hold in excess of $1 billion.

Just to clear up a point of possible confusion: The six percent wealth tax actually combines two three percent wealth taxes. One three percent tax proposed in early 2019 (see here) to reduce wealth inequality, and then a second three percent tax proposed in late 2019 (see here) to pay for part of the Senator’s Medicare for All proposal.

But mechanically, the billionaire tax works pretty simply.

Example 6: Thomas enjoys a net worth equal to $2 billion. Under the Warren wealth tax proposals, therefore, he pays a two percent tax on $950 million and then a six percent tax on the second $1 billion. His total wealth tax equals $79,000,000.

Again, billionaires also pay the one percent wealth-triggered tax due to mark-to-market accounting rules. Obviously, a billionaire falls within the top one percent.

Grossing Up the Ultra-millionaire and Billionaire Wealth Taxes

One other note about the two percent and six percent wealth taxes.

If taxpayers subject to the two percent and six percent wealth taxes need to sell appreciated assets (like stock in Microsoft, Facebook, Amazon, Google, or Berkshire Hathaway) to actually pay the wealth taxes, that taxable sale amplifies the tax burden.

I mention this point because some of the early commentary seems to miss this subtlety.

Example 7: Thomas from example 6 sells founders stock to pay the $79 million of wealth tax he owes. He pays a combined federal and state income tax rate of 50 percent on the sale proceeds, however. As a result, he sells $158,000,000 of stock. He uses one half of the money to pay the income taxes he owes. He uses the other half to pay the wealth taxes he owes.

Note: I think the best way to model the impact of wealth taxes on “safe withdrawal rates” or “sustainable spend rates” is to treat the grossed up wealth taxes like an “asset  under management” fee. Which is an entirely different issue, so I won’t fall down that rabbit hole.

Assessing the Wealth Tax Impact on Small Business Entrepreneurs

Okay, so now let’s talk about how the Warren wealth taxes impact small business entrepreneurs. I spot three issues many small business owners and investors need to consider.

Don’t worry. I’ll make this quick…

Issue #1: One Percent Wealth-triggered Tax Impacts Big Group

A first issue for small business owners to consider: A really big group of business owners will feel the impact of the one percent mark-to-market accounting rules.

Obviously, the top one percent itself includes 1.7 million taxpayers.

But any business owner approaching one percent status needs to plan for and probably file wealth-tax related returns. These folks won’t actually know whether they owe taxes or not unless they “do the math.” Small business entrepreneurs close to one percent status may even want to file wealth-tax returns simply to document they don’t owe wealth taxes.

Further, even a small business owner outside the top one percent may need to deal with the mark-to-market complexity if the business owner “partners” in some venture with someone who is inside the top one percent. Or someone who is approaching the one percent classification.

Finally, the carryback and carryforward accounting the mark-to-market rules envision mean a former member of the top one percent may need to continue preparing wealth-tax returns to get tax refunds. (Peek back at example 4 to see a situation where this occurs.)

In short, the one percent wealth-triggered taxes surely hit millions of small businesses. Sometimes with actual taxes. Sometimes just with the cost of the red tape.

Issue #2: Wealth and Wealth-triggered Taxes Create Liquidity Puzzles

The Warren wealth taxes, and especially the wealth-triggered taxes that stem from the mark-to-market accounting rules, also create a puzzle.

That puzzle? Where affected taxpayers get the actual cash to pay the wealth tax.

Example 8: Sixty-year-old James owns a $1 million dollar home, holds nearly $2 million in his retirement account, and then owns a small hardware store worth $1 million and generating $150,000 in annual profits. If the store profits double to $300,000 and the store value to $2 million, James books $1,000,000 of mark-to-market income and owes $400,000 in wealth-triggered income taxes. James also owes regular income taxes on the $300,000 of income. As a guess, maybe around $75,000? So, on $300,000 of cash profits, he owes perhaps $475,000 of tax?

That level of taxation creates a really tricky situation for the small business entrepreneur.

The Warren wealth tax plan allows taxpayers to pay the wealth taxes and presumably wealth-triggered taxes over five years, charging them interest on the “loan” from the government. Further, the Senator’s plan says the IRS will also be able to write appropriate rules to deal with extreme situations where a taxpayer simply lacks the liquidity to pay the wealth tax. But this all seems pretty dicey.

Remember, too, the small business entrepreneur needs business profits not just to pay taxes but to pay his or her own family living expenses (housing, groceries and so forth) and to grow the business (additional inventory, fixtures and equipment, cash, and so on.)

The upshot of all this? The Warren wealth taxes require a business owner and his or his professional advisers to carefully plan for new giant tax liabilities.

One last comment, just to be fair to the economists who’ve advised Warren, apparently, on this wealth tax stuff. Saez and Zucman, in a 2019 research paper (available here) warn about this exact issue, saying “Taxing capital gains on accrual means a heavy tax on entrepreneurs growing a successful business and building up wealth.” They also warn in the same paper “Taxing capital gains on accrual means capricious taxation based on the ups and downs of volatile financial markets.”

Issue #3: Heavy Compliance Costs and Burden

One final issue to mention…

The work of annually valuing the odds and ends that make up the typical one percent taxpayer’s net worth? And then calculating the taxes? Gosh, that effort will prove costly and time-consuming.

The work and costs will start with the accounting and record keeping performed by taxpayers, their business advisers, and their small business’s employees. Most small businesses will need to do more and better bookkeeping.

Then, after that preparatory effort, taxpayers will shoulder additional costs for real estate appraisers, business valuation experts and then specialists required for valuing things like a boat, car or household items.

Finally, after the returns get filed? The various wealth tax proposals all suggest heavy auditing of wealth tax returns in the early years. That back-end cost will be expensive.

The bottom-line here? Affected taxpayers, their accountants and also the IRS need to plan for a massive increase in their workloads due to preparing tax returns that include both income and wealth taxes.

And then this sidebar comment. The oft-quoted-by-Warren economists, Saez and Zucman, say the valuation work should be easy based. Apparently on the notion that small businesses can be valued “by using simple formulas” employing data the IRS already collects. This assertion of simplicity is awkwardly incorrect, as any tax accountant or IRS auditor working with small businesses knows. And for a variety of reasons including the fact that small business tax returns usually don’t include Schedule L (a balance sheet) and often use cash basis accounting.

Two Thoughts to Close

A couple of thoughts to wrap up this discussion. First, I don’t think people potentially affected by these proposals do anything yet except to stay alert to the discussion.

No, no, I agree wealth taxes will impact targeted taxpayers massively. But reactions like renouncing citizenship and moving to some other country? Or getting divorced for tax reasons? Or quitting work and moving to the mountains in Colorado, a la Ayn Rand? At the very least, that sort of talk seems premature.

Here’s my second thought. If Congress enacts wealth taxes, those wealth taxes will require a massive rethinking of both small business entrepreneurs’ business plans and affected taxpayers’ retirement plans.

The mark-to-market rules surely impact firms growing with reinvested profits, for example. Further, these wealth taxes surely dramatically dampen “safe withdrawal” and “sustainable spend” rates.

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