I have written this article for information purposes, and I hope you learn something from it. Though I would like to state it is current and up to date, in all candor, I can't. In most cases, the concepts are relatively accurate (except for obviously old and dated materials, primarily related to taxes). You should confer with your own lawyer about issues that affect you and your family.
A BRIEF INTRODUCTION TO DISCOUNT GIFTING
For several years, I have been asked by clients if there were any “understandable” articles which they might read, on the topic of discounting the value of gifts. There are, of course, hundreds of articles written on the topic, but none of them (to my knowledge) are concise enough to be understood by someone who is not an accountant, a lawyer, a CLU or a Registered Investment Advisor. For this reason, I am going to try, in as few words as possible, to do the impossible, and explain how the value of a gift can be discounted.
Part of the problem in understanding this subject ties directly to the terminology used. So let’s abandon the topic for a moment, and consider the Sunday newspapers. Most of the space is taken up by ads, and it is easy locate lots of sales being held at lots of businesses. For example, in last Sunday’s paper, a $30 golf club could be purchased for $15. From a legal point of view, the merchant is offering a “discount” in price. Thus, for the sum of $30, you are entitled to buy two golf clubs for the price of one.
The same principle applies in gifting. However, special techniques must be used in order to attain these same results.
Let me explain this. If I were to give one share of IBM stock to my son, the value of the gift would be about $200. Under the current Federal Gift Tax laws, I could give him 100 shares, which would be worth $14,000, without having to pay any federal gift taxes (the gift taxes begin when the value of the gift exceeds $14,000 a year). As you know, the gift tax rates begin at 18%, and increase to 40%, depending on the value of the gift made. Because these rates are substantial, I would prefer not to pay gift taxes, and simply give no more than $14,000 to my son each year (I am permitted to do so, without paying gift taxes – those gifts are not taxed, because they are equal to the “annual exclusion” amount of $14,000).
Suppose, however, that I form a small family company, and put 200 shares of IBM stock in the company, together with other property (such as, undeveloped real estate worth $100,000). The company is now worth $140,000 ($40,000 in IBM stock and $80,000 in real estate). When the company is formed, I will own all of the stock in my name. The purpose of the company is to manage the property, and increase its value over time.
At Christmas time, instead of giving my son some cash, or instead of making a direct gift of the IBM stock and some of the real estate, I decide to give him some stock in the family company. Because of the gift taxes, I do not want to make a gift worth more than $14,000. After all, who wants to pay gift taxes?
If I give him 10,000 shares of the family company stock, he would then own 10% of the company and I would owe no gift tax. But let’s explore the possibility of discounting the value of the stock, so that he receives more stock, but for gift tax purposes, the value of the stock is worth only $14,000.
Remember the two-for-one golf club example? For $30, I can buy two golf clubs, instead of one, because Academy Sports has discounted the price by 50%. That same principle is used in gifts. Hypothetically, I can give him twice as much stock in the family company (in terms of shares), but only value the shares at half of their worth.
Since we aren’t dealing with merchandise at a store, how am I permitted to give my son 20,000 shares of the family company, but only treat it as a $14,000 gift? First, my son, who receives these shares, will not be able to control the operations of the family company. He is a minority shareholder, and cannot control who is elected to corporate office (directors or officers), nor does he have any say so in determining the company’s policies in its business affairs. Furthermore, my son will not be able to sell his stock in the company. There is no ready market for these shares, and no prudent investor would buy them. In effect, my son owns a “worthless” asset. For these reasons, the shares aren’t worth very much, and in a gift tax setting, I can discount the value of the stock when I decide what it is really worth.
Stated differently, if the child owns 20,000 shares of IBM stock directly, my son will have some rights as a stockholder, in the sense that he may attend the annual shareholders’ meeting, vote for the directors, and reasonably expect to receive a financial statement, and perhaps even be paid a dividend. Those characteristics are not available in my family company, because I want to control all of its operations, and have designed it to accomplish that objective.
In addition to the “control of operations” issue, another reason to permit a discount in value of the family company shares is that the stock cannot be sold. If my son owned 20,000 shares of IBM stock, he would merely call his stockbroker and order the stock to be sold. In the family company, however, my son will not be able to sell the 10,000 shares, because they are not traded on any stock exchange or over the counter, and the company will have placed restrictions on transfer of its shares (in its bylaws). In addition, there is no ready market for selling those shares. If my son were to walk through the neighborhood and knock on doors, and attempt to entice the neighbors to buy his family company stock, he would have a difficult time. After all, who wants to own a minority stockholder interest in a company controlled by me?
For these reasons, the Internal Revenue Service reluctantly permits discounts in valuation, so that each year, a parent can gift $14,000 of property to numerous donees, without paying any gift taxes – by giving stock in the family company as the property that is given away, the recipient in effect receives more shares of stock, but the gift is treated, for gift tax purposes, as being worth $14,000 (remember, this is equal to the annual gift tax exclusion of $14,000, which means, there is no gift tax to pay).
Let me end this article with two other comments: First, families usually select a family company form other than a corporation. The most popular forms of organization are limited liability companies or family limited partnerships. The manager of the LLC or the general partner of a limited partnership is, in effect, an organizational dictator – the members of the LLC or the limited partners have few rights, and those forms of organization are generally taxed as a partnership, rather than as a corporation. Gifts are either made in “units” of the LLC or as limited partnership interests.
Second, the amount of the discount for gift tax purposes is normally not 50%, as illustrated in this article. The amount of the discount will usually be 15% to 40%.
©2014 James H. Beauchamp
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