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Pave the tax way for business successors

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in Centerpiece,Small Business Tax,Small Business Tax Deduction Strategies

young bossSooner or later, you’re going to start thinking about handing over the reins of the business to the younger generation. Typically, you might arrange to sell shares of company stock to the successors you anoint, or simply give the stock to them. But that could cost a steep tax price.

Strategy: Set up a stock bonus plan. As the name implies,  your  company issues stock to your successors as bonuses for work performed for the company.

If you handle things right, this can be a tax-favored way to transfer full or partial ownership of the company. For one thing, you avoid paying capital gains tax on the sale of your shares. Currently, the maximum federal tax rate on long-term gains is 15% (20% for certain upper-income taxpayers). For another, you won’t erode any part of the unified estate and gift tax credit available for assets ($5.25 million in 2013). Unlike a straight gift of stock, there are no gift tax concerns with a stock bonus plan.

Usually, it takes some time to complete a wholesale transfer. In other words, if this is your goal, start the ball rolling now.  

When you use this technique, the bonuses and any other compensation paid to your children are taxable, but the value may be discounted for minority interests in a company. Have an independent professional do the appraisal to avoid any potential conflicts of interest.

Example: Suppose your company is valued at $2 million. You want to transfer ownership to your two children through a stock bonus plan. So you begin by giving each child 5% of the shares this year.

Even though 5% of $2 million comes to $100,000, an independent appraiser might value the interest at, say, $75,000. Assuming that each child is in the 33% tax bracket, the 2013 federal income tax bill comes to $24,750 per child, for a total of $49,500 for the two kids. To lighten their tax load, you might “gross up” the bonuses by paying them enough additional compensation to put them in the same tax position as they were before. If you continue in the same manner, after 10 years all of the company stock will be transferred to your children.

What’s more, your company can deduct the additional stock bonus compensation it pays to your children. If your company is in the top 35% tax bracket, the annual federal income tax deduction for the bonuses is $52,500 (35% of $150,000). In addition, your company may also deduct additional compensation under the “gross up” method.

Caution: There is one potential “fly in the ointment.” The total compensation paid to your children by the corporation—including any stock bonus payments, salary and any other benefits—must be “reasonable” for services actually performed. But this shouldn’t be a problem if your children are already helping you run the show.

Nevertheless, it’s important to document changes in the hierarchy. Update your corporate minutes to protect against any challenges from the IRS.

Tip: Each child’s basis in the shares is equal to the fair market value, not the original cost. Thus, if the child sells the shares in the future, the taxable capital gain is reduced.

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