Business owners have long known that it makes sense to pass along some stock during theirlifetimes to their heirs. Most are aware that each parent is allowed to give every one of theirchildren $10,000 a year, plus an additional total of $600,000 to all, free of gift tax. When an ownerdies, the estate can exclude from estate tax whatever portion of that $600,000 has not been used ingifting. But if the company has grown during the parents' lifetime, the heirs will have to pay a lotmore tax on the appreciated value of the stock at death than if they had received it in previousyears.
What many business owners don't realize is that it can also be advantageous to gift more than the$600,000 during their lifetimes. The overall cost of transferring additional shares now, even afterpaying gift taxes, can be far less than if the shares are left in the family estate.
The savings results not only from transferring the stock before it appreciates in value but alsofrom the fact that the gift and estate taxes are calculated differently. Let's say the gift and estatetaxes are 50 percent, which is close to the actual top rate of 55 percent. If a parent gives $100worth of stock to a child, then the total cost to the parent is $150 the amount of the gift itselfplus the tax. If he leaves the same $100 in his estate, the total cost of the transfer to his heir is$200. That's because the money used to pay the estate tax is considered part of the transfer and isitself subject to tax (the heir, in effect, pays $25 on the $50 used to pay the tax, then $12.50 onthat $25, and so on, adding up to another $50).
There are, of course, various other ways to reduce the value of a transfer of wealth for taxpurposes, such as a grantor retained annuity trust (GRAT) or grantor retained unitrust (GRUT). Whilequite technical, these trusts allow the donors to receive some or all the income from an asset over aperiod of time, while preserving the asset in trust for their descendants. In determining the amountof the gift for tax purposes, the present value of the annuity or unitrust interest paid to the donoris subtracted from the total value of the transfer. Assuming the parent survives for the term of thetrust, the gift tax cost is thus less than what the heirs would pay on the full value of the asset inthe estate. A GRAT may be especially advantageous if the family business is an S corporation.
When transferring an interest in a business during their lifetimes, owners can also claim anothertax discount. If that interest is not easily marketable (often the case with shares in a privatelyheld company) and is a minority interest in the business, valuation experts may reduce the value ofthe transfer for tax purposes by as much as 50 percent or more, depending upon circumstances. Thesediscounts may not be as great upon the death of an owner controlling the business.
The decision on whether or not to transfer some wealth and pay a tax now rather than later mayinvolve an investment calculation. By waiting to make the gift and instead investing the money thatwould have to be paid in taxes elsewhere an owner may be able to earn more.
The decision turns on the expected rate of growth in the business. For example, let's assume thebusiness is growing at the after-tax rate of 8 percent a year. Let's say Dad wants to give $1 millionworth of shares to his son or daughter now (over and above the amounts he can pass free of tax). Ifthe gift tax is 50 percent, he will pay $500,000 in tax currently. If he waits 10 years to make thegift and the value of the shares grows to $2.16 million, Dad will have to pay $1.08 million in gifttax.
But consider what would happen if Dad took the $500,000 and invested it now in an asset with a 10percent after-tax rate of return. In 10 years, it will be worth $1.3 million-over $200,000 more thanhe would have to pay in gift tax upon transferring the asset at that time. From a purely economicpoint of view, investing the $500,000 elsewhere makes sense only if the growth in value of theinvestment exceeds the growth rate of the family company.
The impact of capital gains must also be considered. If assets must be sold to pay gift tax, somecapital gains may be incurred. If the next generation is likely to sell the gifted asset, they may payrelatively more in tax when they do than if they inherit the asset in the owner's estate. That'sbecause the cost basis of an asset for income tax purposes is stepped up to its value at the time ofdeath, which is likely to be higher than the cost basis of a lifetime gift that is sold (which reducesthe amount of capital gains). Also, the heirs may benefit from favorable capital gains treatmentaccorded stock that is redeemed by the family company to pay taxes and certain administrative expenseson the estate.
The generation-skipping tax passed by Congress in 1986 is another reason that it often makes senseto transfer assets now. The law established a flat 55 percent tax rate on assets gifted tograndchildren or later generations. The business owner and his spouse are each entitled to pass atotal of $1 million in assets free of generation skipping taxes either as a gift during their lives orat death (or some combination of the two). Outright gifts to grandchildren of $10,000 or less are alsonot subject to tax.
Prior to that legislation, business owners could set up trusts that protected wealth from taxationfor a few generations. Under the new law, however, assets put in such trusts for grandchildren orsubsequent generations are subject to the 55 percent tax in each generation (generally applicableafter the beneficiaries in that generation die). As the table below shows, the cost of transferringassets subject to the generation-skipping tax can thus also be quite expensive compared with theestate tax cost.
The table below shows the substantial savings from lifetime gifts to both children andgrandchildren. Yet many business owners never take advantage of the various ways of passing alongownership during their lives. One reason, of course, is that if they gift more than $600,000, theywill have to provide the cash to pay taxes on the amount of the gift above that. Still, in someinstances, especially if the asset is appreciating rapidly, it makes sense to borrow the funds to paythe tax.
But there are other non-financial reasons that make business owners hesitant to give their childrenstock. In many cases the problem is plain procrastination: We all have a tendency not to want to paytax until absolutely necessary. But in other cases the parents are justifiably concerned about puttingassets into children's hands, before they have learned to "make it on their own" and to use thoseassets productively. Or the parents may be uncertain about how they plan to divide futureownership.
Many simply do not plan to give up control of the business, or don't want to do so yet. A commonsolution is to create two classes of stock, voting and non-voting. The parent retains the votingstock, but gives non-voting stock to children, grandchildren, and other family members with whom hewishes to share ownership. If the owner intends to pass along control of the business later on, he maybe able to reduce the tax cost by creating fewer voting than nonvoting shares. For example, if hereclassifies a single former share into one voting and four non-voting, control is lodged in only 20percent of ownership. When the owner plans to give his children control, there are advantages to doingit gradually.
Gifting stock over a period of time gives him flexibility: For one thing, as he turns over moremanagement responsibility to his successors, he can also give them some ownership to increase theirstake in the success of the business. For another, if family circumstances change unexpectedly, he canrevise his plan for the future division of ownership. Finally, while he is alive, he can defend thevaluation of the shares he turns over to the next generation against any challenge by the IRS.
Stephen M. Chiles is a partner in the law firm of McDermott, Will & Emery. Based in theChicago office, he concentrates on estate Planning for family owned companies.
Tax costs of transferring 10 shares
|Gift to son||Gift to granddaughter||Bequest to son||Bequest to granddaughter|
|10 shares Family Business||$1,000,000||$1,000,000||$1,000,000||$1,000,000|
|Generation skipping tax||$550,000||$550,000|
|Total cost of transfer||$1,500,000||$2,400,000||$2,200,000||$3,450,000|
Source: McDermott, Will & Emery