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Jul 1, 1996 12:00 AM
Most printing company owners are familiar with the concept of gifting shares to their children. Often advisors recommend it as an estate planning technique or method for making children shareholders in the company.
Is gifting a good idea? What are the benefits and pitfalls?
Gifting assets without triggering gift taxes can be accomplished under two provisions outlined in the tax code.
Under the first provision, parents may gift $10,000 of assets (including stock in a business) to each child annually without paying any gift taxes. For example, if a husband and wife have four children, both parents could make gifts of $10,000 to each child for a total of $80,000 annually.
If the amount exceeds the $10,000 limit, gift taxes must be paid on the additional value. Gift tax rates start at 18 percent of value in excess of $10,000 and progress to 55 percent for gifts of more than $3 million.
Under the second provision and in addition to annual gift exclusions, each individual has a one-time exemption of $600,000 of assets, which may be transferred without paying estate or gift taxes. Although this often is used at the death of a parent, it may be used while the parent is alive. Since both husband and wife have an exemption, a total of $1.2 million can be gifted without paying taxes. Any amount in excess of either spouse's $600,000 exemption is subject to the federal estate/gift rates. A parent may use the entire $600,000 exemption and also make $10,000 in gifts each year.
Let's assume two parents own a printing business equally and want to transfer stock to their son who is active in the firm. They each can gift $10,000 of stock or sell $10,000 of stock. If the son is to purchase the shares, where will he get the cash? In most cases, the money must come from the corporation. The son must have $33,333 in bonus money before taxes, assuming a combined federal and state rate of 40 percent, to provide $20,000 cash to buy stock.
Unfortunately, this represents only the first level of taxes. Once parents receive $20,000 for the stock, they must pay capital gains tax on the difference between the purchase price and the original basis in the stock.
Their company is a regular or "C" corporation and the basis is $500 ($250 each). The difference between the $20,000 and $500 ($19,500) will be a capital gain. Assuming a combined federal and state rate of 33 percent, the taxes would be $6,435.
To transfer $20,000 in stock, $19,768 in taxes must be paid, with net proceeds to the parents totaling $13,565. The advantage of this strategy is that mom and dad receive $13,565 in cash. If the shares were gifted, they receive nothing for them. So, is the purchase, after all the analysis, a better way to go?
Remember the company had to pay $33,333 to the son to buy the shares, and the parents had to take $33,333 ($20,000 after tax) less in compensation to pay for it. The accompanying table compares the net tax consequences of the buy versus gift options.
Although both strategies accomplish the same objective, the parents have $6,435 more to invest for retirement.
However, is this savings permanent? Actually, it is not. When stock is gifted, the giftors transfer their basis to the recipients. The son's basis in stock is $500, and when he sells the shares, the gain not paid by the parents will be paid by the son. Presumably, this will be 20 to 30 years down the road.
In addition to transferring shares without paying taxes on the gain, gifting removes assets from the parent's estate, which eventually will be subject to federal estate taxes upon the death of both parents. Also, the more rapid the appreciation in the value of the company, the greater the eventual savings.
What concerns should parents have about gifting? The first is valuation. Shares must be valued and the IRS often is predisposed to assume the shares are undervalued. Why? The taxpayer's incentive is to value the shares as low as possible in order to transfer more stock sooner and minimize the value of the business for estate and tax assessment purposes.
Also, some parents object to gifting because they are giving away shares in the organization they built. Although tax costs are higher, some parents want children to purchase stock even if the source of the funds is the company.
Gifting shares in a business is a relatively simple and tax-efficient method for passing ownership to children. Taxes and other advantages should be weighed against the drawbacks when making these decisions. As always competent tax and legal advice should be sought before proceeding with any stock transfer program.