Using a Gift Program to Shift Control to Family Members

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor’s note: This case study has been adapted from "PPC Tax Planning Guide—Closely Held Corporations," 12th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter-Craig, Lewis A. Siegel, Joan Wilson Gray, Richard L. Burris, James A. Keller, and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2000.

Facts: Webster owns 80% of the outstanding stock of Webster, Inc., the corporation he founded 17 years ago. The remaining 20% of the stock has been sold over the last few years to top-level employees as part of an incentive program. Webster, Inc. has only one class of outstanding stock (voting common stock). Webster’s basis in his stock is $32,000 (8,000 shares at $4 per share); the fair market value (FMV) of the stock is $600,000. The corporation has been successful but, because of recent capital investments, it does not have a large cash reserve. Webster, Inc. has reached its credit limit in borrowing from the bank. * Webster has not been in good health during the past year. He has been steadily decreasing his involvement in the corporation’s daily management and plans to retire soon. Although he has confidence in the corporation’s current top-level employees, he does not wish to completely terminate his involvement. Therefore, he would like to act as a consultant to the corporation and be paid for any consulting work he does. * Webster is married and has a married son, Don, who is interested in becoming active in the corporation after he graduates from college next year. The corporation represents a large portion of Webster’s estate, and he wants to transfer his shares to Don at the lowest possible tax cost. However, Webster is reluctant to transfer all of his stock to his son at once because Don has relatively little business experience. Webster also wants the top-level employees to retain their proportionate interest. Because Don is finishing school, he does not have funds at this point with which he could buy the stock outright. * Webster has investment income of $95,000 a year from fixed obligation securities worth approximately $1 million. He feels this is adequate to maintain his standard of living in retirement. Issue: How can Webster transfer his stock to his son while avoiding payment of any tax on the transfer?

Analysis

Shifting control of a closely held corporation can be accomplished in several ways, including redemptions, stock sales or gifts.

In this situation, a redemption of Webster’s stock is not appropriate, because (1) the corporation does not have a cash reserve to fund the redemption, (2) control would not pass to Webster’s son because he does not own any stock and (3) Webster would be taxed on his gain on the stock. Because a redemption is not the answer for Webster, other alternatives should be considered.

A stock dividend or recapitalization is also inappropriate because Webster’s son does not own any stock.

Selling his stock to Don would meet one of Webster’s objectives. However, this is not viable, because (1) the stock sale would create taxable capital gain for Webster and (2) Don does not have the funds to pay for the stock.

Thus, it appears gifting the stock is the best option. Gifts do not result in an income tax liability for either a donor or donee. The donor does not receive anything in exchange for the gift; accordingly, no gain or loss is realized on the transfer. Similarly, a donee realizes no gain or loss, because neither property nor services has been exchanged for the gift received. In this respect, a gift may require documentation to ensure it is not recharacterized as compensation or payment for goods.

Although there are no income tax ramifications, gifts are taxable transactions for purposes of gift tax. However, gift tax is seldom due, because:

1. The annual exclusion allows individuals to gift up to $10,000 annually (indexed for inflation) to each individual without paying gift tax.

2. A gift-splitting election allows a husband and wife to treat a gift from either of them as being split between them. Thus, a donor and spouse can double the exclusion and give an individual $20,000 without incurring gift tax.

3. The unified credit can be applied against both gift and estate taxes. Individuals can give up to $750,000 in 2000 (increased to $1 million by 2006), during their lives or at death without incurring gift or estate tax liability. This amount is in addition to the $10,000 ($20,000 for a husband and wife) annual exclusion.

Gifting generally removes the asset from a donor’s estate and, accordingly, prevents the inclusion of future appreciation in the estate. When property is gifted, a donor’s basis in the gift generally becomes a donee’s basis. However, if a donee recognizes a loss on a subsequent sale of gifted property, the basis for computing recognized loss is the lesser of (1) the donor’s basis or (2) the property’s FMV at the date of the gift.

A donor’s holding period for an asset also generally carries over to the donee. Other tax attributes of the gifted asset may be transferred to a donee as well.

No funds are required if the transfer is structured as a gift. This is important because Webster’s son is in college and has no personal funds, and the corporation has no cash reserves.

One disadvantage of gifting the stock is that a donor gives up a potential income-producing asset. Therefore, the donor needs sufficient additional "replacement" income. Because Webster already informed his tax adviser that his investment income will meet his retirement needs, this aspect of a gift is not detrimental in this situation.

Unlike a redemption, a gift does not change the proportionate ownership of the other shareholders. This is important, because Webster wants the top-level employees to retain their proportionate interest. Additionally, Webster can continue to be involved in the corporation. However, stock received as a gift may restrict a later redemption option.

Once the tax adviser and Webster have decided that giving the stock as a gift is the best alternative, they must determine the timing of the gifts; this can affect the amount of gift or estate tax ultimately payable in connection with the stock. By electing to split the gift with his wife and giving stock both to Don and Don’s wife, Webster can transfer $40,000 (indexed for inflation) of stock each year, without incurring gift tax or decreasing his unified credit. (Because Webster, Inc. only has one class of stock, the restrictive rules for valuing transfers of interests in corporations to family members do not apply.) Two variations of this plan can meet Webster’s objectives:

1. Webster and his wife can give a gift of stock of up to $40,000 each year. The transfer of minority stock interests to Don initially would allow Webster and his wife to use a valuation discount for this stock, as it would represent a noncontrolling interest in the corporation. Once he is satisfied Don can run the company, Webster can transfer his remaining stock. The unified credit will offset the tax on the transfer of the remaining stock, allowing Webster to transfer all of the stock without incurring any gift tax. Because of the stock’s future appreciation, spreading the gift over several years might increase the amount of unified credit used or estate tax paid.

2. Alternatively, Webster could immediately transfer a larger block of stock to his son, followed by annual transfers equal to the annual exclusion. The $40,000 exclusion plus the unified credit allow the initial transfer to be tax-free. This precludes the inclusion of the stock’s future appreciation in his estate. However, this alternative might transfer control to Don before he has the experience or maturity to successfully run the business.

Form, Elections and Implementation

Under Sec. 2513, both spouses must consent to treatment of a gift made by one spouse to be treated as made by both the husband and wife. Regs. Sec. 25.2513-2 provides guidance on how and when to make the consent. If the consent is made, it applies to all gifts made during the calendar year while the two are married to each other.

Conclusion

The tax adviser should recommend a gift program to transfer Webster’s stock ownership to Don. The timing of the gifts depends on the relative risk of transferring the stock to Don, compared to the potential appreciation in the stock’s value if Webster retains it (i.e., the value could exceed the unified credit if the value of the stock appreciates substantially). When presenting the plan to Webster, the tax adviser might find it helpful to prepare projections of the value of the gifts, the stock’s expected appreciation and the estate tax under both alternatives.