But take note: Each of these options can carry a heavy tax price.
Strategy: Establish a “stock bonus plan,” instead. As the name implies, your company issues shares of stock to the intended successors as bonuses paid in partial compensation for working for the company. Done right, this is a tax-favored way to transfer full or partial ownership of the company.
With a stock bonus plan, you generally don’t transfer the business overnight.
For example, say your corporation gives out annual $200,000 stock bonuses to each of your two children. It would take five years to transfer stock worth $2 million to them, which may comprise a majority ownership interest, depending on how much stock you still own. So, if this type of plan meets your needs, start the ball rolling well before you expect to retire.
Common scenario: You’ve been grooming your child to take over the business. But you’d still like to keep your hands in the operation, so you decide to transfer about half of the stock in your company to your child.
If you simply give shares of your stock to the child this year, you may have to pay gift tax at a 46 percent rate. The $1 million lifetime gift-tax exemption can shelter part of that gift from tax, but that cuts into your estate-tax exemption. Plus, your child assumes your basis in the stock, so any future sale will be taxed heavily.
In effect, your child will be taxed on the entire appreciation since you’ve owned the stock.
On the other hand, you could sell the stock to the child to avoid gift-tax problems. That way, the child’s basis is bumped up to the amount paid for the stock. You’ll earn a big cash payoff that likely would be taxed at the 15 percent maximum federal rate on long-term capital gains.
Major drawback: Your child has to come up with the money required to buy out the stock. If your child is forced to borrow heavily to finance the deal, it could affect the family’s fortunes for years to come.
Solution: Instead of either of those options, you can have your company issue additional shares of stock to your child as compensation. The compensation is taxable to your child, but the value can be discounted for minority interests (see box below). Have the valuation prepared by a professional in the field.
Remember that the total compensation paid to your child by the corporation— including any stock bonus payments and his or her regular salary and —must be “reasonable” for the services actually performed. That shouldn’t be a problem if your child is already helping to run the show. But, it’s important to document the shift of power. Update your corporate minutes to protect against IRS challenges.
Bottom line: Your child’s basis in the stock is equal to its fair market value, not the original cost. So, if your child sells the stock down the road, the amount of the taxable gain is slashed. Finally, any subsequent gain is treated as favorably taxed capital gain.
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