The Benefits of Gifting Stock With Built-in Gains

Estate Planner May-Jun 2000
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The IRS recognizes that a company with built-in capital gains (tax on the appreciation of a corporation’s capital assets) may be worth less than a similar company without such gains. This means that for transfer-tax purposes, a company’s value may be reduced by some or all of its inherent capital gains tax liability. Accordingly, giving away stock of closely held companies that have built-in capital gains could enable you to reduce the size of your taxable estate.

Know Your Discounts

You may take a discount for gifts of shares of corporations with built-in capital gains tax liability — but determining the discount is not simple. The capital gains tax discount will be reflected in the discount allowed for lack of marketability of the closely held company’s stock. That discount is based on the idea that a willing buyer will pay less for an asset that cannot later be easily sold.

As noted, selling a business that has a built-in capital gains tax problem may be more difficult than for the owner of a business without such problems. This greater difficulty justifies a lower value — and a lower value allows you to pass on more assets at a lower transfer-tax cost.

Should You Liquidate?

You may also be able to deduct the full amount of the tax liability if a liquidation of the corporation stock is imminent at the time of the gift. But the IRS will usually value the discount amount at less than a dollar-for-dollar reduction in value because of the uncertainty that the capital gains tax would ever be paid. Even when liquidation is planned, current law prevents you from totally avoiding paying capital gains tax on the asset liquidation of a regular C corporation.

Because you may possibly postpone capital gains tax for a long time, a full discount is not allowed in valuing corporate stock. Even if the tax payment can be deferred indefinitely, you have incurred a loss, such as the loss of cash flow and income from assets that are not sold because of the capital gains tax that would be incurred.

Understanding the speculative nature of the tax payment is important because it will be reflected in the final determination of the company’s value in the real world and for transfer-tax purposes.
The law is continuing to evolve in the complicated realm of valuation. For instance, it is not yet clear whether a discount will be allowed when the built-in capital gain tax liability is a result of the conversion to an S corporation from a C corporation.

Develop Your Plan Now

If you would like help in developing a plan to cost-effectively transfer assets out of your taxable estate, please call us. We are available to help you select a plan that fits your needs.

Consider the Impact of Taxes

Suppose you are to receive a gift of 100 shares of stock worth $100 each for a total of $10,000. You would prefer shares having a basis of $100 per share rather than $10 per share. Why? Because even though the shares are worth the same for gift-tax purposes, if you sell the stock you must pay capital gains tax on the difference between the sales price and the basis, $100 vs. $10. Similarly, the potential purchaser of a business would consider the net after-tax proceeds of a future sale of the business assets.