When President Obama delivered his State of the Union Address last month, no doubt every estate-planning attorney in the country sat up and took notice when he proposed ending the “step up” provision in the capital gains tax.  If Congress agrees (a big “if”), it could mean sweeping changes in how inheritances are taxed—and how estate attorneys help their clients deal with that.

The president’s proposal would eliminate a significant tax benefit in the treatment of inheritances.  The plan would tax capital gains on the decedent’s basis, instead of the current system that allows a step-up in basis for assets passed on to heirs.  The change, if enacted, would have wide-ranging effects on many families—making it much harder to shield assets from taxes.  To do so would require a great deal more planning and a lot of help from estate-planning attorneys and accountants.

Trust-Fund Loophole

The president says that his proposal closes what he calls “the trust-fund loophole” and will ensure that the wealthiest Americans pay their fair share on inherited assets.  But, in reality, this term is a misnomer (in fact, it would result in more assets being funneled to trusts—but more on that later).  And the proposal would impact more than just the rich. To put it simply, it’s essentially a brand new tax on inheritances that would take money out of the pockets of beneficiaries and result in a host of unintended consequences.  For example, heirs would need to determine the original cost basis for all of the assets they inherit.  Think about that. That means every share of stock, every piece of property and every valuable would need to be traced back to the original cost. That would be a nightmare.

Current Step-Up Rules

But before we get into the details about what the proposal would mean, let’s look at an example of how the current step-up rules work.  Say your client bought shares of GE stock 15 years ago for $500.  At the time of his death, that stock is worth $2,500. That represents a gain of $2,000 that your client has paid no taxes on.  If your client had left those shares of GE stock to one of his children, his child’s cost basis would be $2,500. That means that whenever his child sells the stock, she’ll only owe tax on capital gains that accrue over the $2,500 cost basis.  However, under President Obama’s proposal, any capital gains, if not exempt, over the original $500 he paid would be taxed.

Investment Assets

The president’s plan does allow married couples to bequeath investment assets with capital gains up to $200,000 tax-free.  Further, a couple can bequeath a home to a child, and $500,000 in capital gains wouldn’t be taxed.  (The amount that can pass without tax is half for individuals.)  However, even with these exemptions, the elimination of the step-up” can put a large financial burden on some heirs.  Though the proposal isn’t clear on how the tax would be implemented, the bill may be due on the death of the parents, reducing what transfers to the children and potentially putting a significant economic burden on a transferred business.  This impacts estates and families that may have far fewer assets than the current federal estate exemption of $5.43 million, because it significantly broadens the tax base and the type of tax applied.