You may not realize how much you can often save by transferring stock during your lifetime.

By Stephen M. Chiles

Business owners have long known that it makes sense to pass along some stock during their lifetimes to their heirs. Most are aware that each parent is allowed to give every one of their children $10,000 a year, plus an additional total of $600,000 to all, free of gift tax. When an owner dies, the estate can exclude from estate tax whatever portion of that $600,000 has not been used in gifting. But if the company has grown during the parents' lifetime, the heirs will have to pay a lot more tax on the appreciated value of the stock at death than if they had received it in previous years.

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 after paying 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 also from the fact that the gift and estate taxes are calculated differently. Let's say the gift and estate taxes are 50 percent, which is close to the actual top rate of 55 percent. If a parent gives $100 worth of stock to a child, then the total cost to the parent is $150 — the amount of the gift itself plus 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 is itself subject to tax (the heir, in effect, pays $25 on the $50 used to pay the tax, then $12.50 on that $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 tax purposes, such as a grantor retained annuity trust (GRAT) or grantor retained unitrust (GRUT). While quite technical, these trusts allow the donors to receive some or all the income from an asset over a period of time, while preserving the asset in trust for their descendants. In determining the amount of the gift for tax purposes, the present value of the annuity or unitrust interest paid to the donor is subtracted from the total value of the transfer. Assuming the parent survives for the term of the trust, the gift tax cost is thus less than what the heirs would pay on the full value of the asset in the 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 another tax discount. If that interest is not easily marketable (often the case with shares in a privately held company) and is a minority interest in the business, valuation experts may reduce the value of the transfer for tax purposes by as much as 50 percent or more, depending upon circumstances. These discounts 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 may involve an investment calculation. By waiting to make the gift — and instead investing the money that would 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 the business is growing at the after-tax rate of 8 percent a year. Let's say Dad wants to give $1 million worth of shares to his son or daughter now (over and above the amounts he can pass free of tax). If the gift tax is 50 percent, he will pay $500,000 in tax currently. If he waits 10 years to make the gift and the value of the shares grows to $2.16 million, Dad will have to pay $1.08 million in gift tax.

But consider what would happen if Dad took the $500,000 and invested it now in an asset with a 10 percent after-tax rate of return. In 10 years, it will be worth $1.3 million-over $200,000 more than he would have to pay in gift tax upon transferring the asset at that time. From a purely economic point of view, investing the $500,000 elsewhere makes sense only if the growth in value of the investment 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, some capital gains may be incurred. If the next generation is likely to sell the gifted asset, they may pay relatively more in tax when they do than if they inherit the asset in the owner's estate. That's because the cost basis of an asset for income tax purposes is stepped up to its value at the time of death, which is likely to be higher than the cost basis of a lifetime gift that is sold (which reduces the amount of capital gains). Also, the heirs may benefit from favorable capital gains treatment accorded stock that is redeemed by the family company to pay taxes and certain administrative expenses on the estate.

The generation-skipping tax passed by Congress in 1986 is another reason that it often makes sense to transfer assets now. The law established a flat 55 percent tax rate on assets gifted to grandchildren or later generations. The business owner and his spouse are each entitled to pass a total of $1 million in assets free of generation skipping taxes either as a gift during their lives or at death (or some combination of the two). Outright gifts to grandchildren of $10,000 or less are also not subject to tax.

Prior to that legislation, business owners could set up trusts that protected wealth from taxation for a few generations. Under the new law, however, assets put in such trusts for grandchildren or subsequent generations are subject to the 55 percent tax in each generation (generally applicable after the beneficiaries in that generation die). As the table below shows, the cost of transferring assets subject to the generation-skipping tax can thus also be quite expensive compared with the estate tax cost.

The table below shows the substantial savings from lifetime gifts to both children and grandchildren. Yet many business owners never take advantage of the various ways of passing along ownership during their lives. One reason, of course, is that if they gift more than $600,000, they will have to provide the cash to pay taxes on the amount of the gift above that. Still, in some instances, especially if the asset is appreciating rapidly, it makes sense to borrow the funds to pay the tax.

But there are other non-financial reasons that make business owners hesitant to give their children stock. In many cases the problem is plain procrastination: We all have a tendency not to want to pay tax until absolutely necessary. But in other cases the parents are justifiably concerned about putting assets into children's hands, before they have learned to "make it on their own" and to use those assets productively. Or the parents may be uncertain about how they plan to divide future ownership.

Many simply do not plan to give up control of the business, or don't want to do so yet. A common solution is to create two classes of stock, voting and non-voting. The parent retains the voting stock, but gives non-voting stock to children, grandchildren, and other family members with whom he wishes to share ownership. If the owner intends to pass along control of the business later on, he may be able to reduce the tax cost by creating fewer voting than nonvoting shares. For example, if he reclassifies a single former share into one voting and four non-voting, control is lodged in only 20 percent of ownership. When the owner plans to give his children control, there are advantages to doing it gradually.

Gifting stock over a period of time gives him flexibility: For one thing, as he turns over more management responsibility to his successors, he can also give them some ownership to increase their stake in the success of the business. For another, if family circumstances change unexpectedly, he can revise his plan for the future division of ownership. Finally, while he is alive, he can defend the valuation 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 the Chicago office, he concentrates on estate Planning for family owned companies.


Tax costs of transferring 10 shares

 Gift to sonGift to granddaughterBequest to sonBequest to granddaughter
10 shares Family Business$1,000,000$1,000,000$1,000,000$1,000,000
Gift tax$550,000$850,000  
Estate tax  $1,200,000$1,900,000
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