The Strategist
3rd Quarter 1995 - Volume 2 Issue 4
The Kenan-Flagler Business School at the
University of North Carolina - Chapel Hill is conducting a four day educational
conference for entrepreneurs from November 29th thru December 2nd in Orlando,
Florida.
The conference will have over 45 workshops
covering a wide range of important business and finance topics including bank
financing, compensation issues, legal issues, wealth transfer planning, and
personal finances.
I am pleased to announce that I have been
asked to speak at this conference and will address many of the wealth transfer
planning issues involved in family businesses and high net worth families.
If you would like further information about
this conference, please contact our office.
The IRS has recently issued a Private Letter
Ruling that may be of benefit to many of our clients. The ruling involved the
potential of gifting stock options. Let me provide a little history first.
In the past decade, and in particular the
last five years, stock options have become a very popular way of compensating
key employees and even directors of public corporations. Many times
corporations will issue a long term (i.e., 10 year) stock option to an
executive that allows the executive to purchase shares in the corporation at
today's price even though the option potentially may not be exercised for 10
years.
Assume ABC corporation is currently trading
at $25 per share. Also assume that the board of directors decides to issue an
option to purchase 10,000 shares of stock at $25 per share to their president.
The option period will be for 10 years.
If 10 years from now the stock is valued at
$125 per share and the executive exercised the option, the corporation will
generally receive a tax deduction for the executive's paper profit
($1,000,000). The executive will report the $1,000,000 transaction as bonus
income and be subject to maximum tax brackets on the gain. If we assume that
the executive is in a 40% tax bracket, the executive will net $600,000 after
tax. The $600,000 is includable in the executive's estate when he dies.
However, what happens if the executive dies
prior to exercising his option? The value of the option will be included in his
estate, however, the estate may not be able to exercise the option until the
end of full 10 year period. This means the attorneys may have to keep the
executive's estate open until the option is exercised at the end of the 10 year
term.
Under this scenario, the estate would be
faced with a double taxation that would include in respect of a decedent
(ordinary income tax on the potential $1,000,000 gain) and an estate tax. This
brings us up to the Private Letter Ruling.
Suppose the executive, upon receiving
notification of the option to purchase stock, irrevocably gifted away this
option to his child immediately. 10 years from now when the stock is at $125
per share, the child would have the ability to exercise the option to purchase
the shares and will have an immediate $1,000,000 gain. This gain will be
outside of Dad's estate but Dad may be subject to bonus income treatment on the
$1,000,000 appreciation if the corporation takes a deduction for this.
Our advice is to contact a qualified
accountant to determine the full income tax implication. However, the bottom
line is that your heirs will be better off since the value of the stock will
not be included in Dad's estate at the time of his death.
There are other key issues that must be
addressed including certain rules established by the Securities and Exchange
Commission.
For those of you interested in reading more
about this, pick up the September 25th issue of Forbes magazine or contact a
qualified attorney or accountant.
A special kind of irrevocable trust can be
used to transfer your home to your children at a significantly reduced gift tax
cost and with no estate tax, yet allow you to continue to live in the home for
as long as you wish. This special type of trust is known as a qualified
personal residence trust (QPRT). Here's how it works.
During your lifetime, you transfer your home
to the trustee, who can be yourself. The trustee must allow you to continue to
use the home rent-free for a fixed number of years specified in the trust
instrument (the "fixed" term), which should be a term you are likely
to survive. During the fixed term, you will continue to pay mortgage expenses,
real estate taxes, insurance, and expenses for maintenance and repairs, and
will continue to deduct mortgage interest and real estate taxes on your
individual income tax return. If the home is sold during the fixed term, the
trustee can roll over the proceeds income tax free by purchasing a replacement
home within two years for you to use. When the fixed term ends, the home is
distributed to your children, or remains in further trust for them.
Even after the fixed term ends, you can
continue to use the home in one of three ways. First, rather than immediately
distributing the home to your children, the home can be retained in trust for
your spouse's lifetime, thus assuring that the home is available indirectly to
you. Second, you can repurchase the home from the QPRT before the end of the
fixed term. You then will be free to live in the home for as long as you wish,
and the proceeds paid to the trustee will go to your children without any
additional gift tax and with no estate tax. Alternatively, you can enter into a
lease with your children which will allow you to live in the house for as long
as you wish.
If you survive the fixed term of the QPRT,
the value of the home will not be included in your estate for tax purposes.
Although your transfer of the home to the trust is a taxable gift, you are
allowed to subtract from the value of the home the deemed rental value for the
term you have retained. Generally, no gift tax will be due as a result of your
gift to the trust since the gift (after subtracting the rental value of the
home for the term you have retained) would be unlikely to exceed your available
$600,000 exemption against the gift and estate tax.
A QPRT is an extremely effective way to
remove a home's value from your estate at a greatly reduced gift tax cost.
At this time of year many of our clients are
considering charitable gifts. I thought it would be appropriate to briefly
review an example of the charitable rules.
If you are planning to make a relatively
substantial gift to a charity, college, etc., you should consider donating
appreciated stock from your investment portfolio instead of cash. Your tax
benefits from the donation can be increased and the organization will be just
as happy to receive the stock.
This tax planning tool is derived from the
general rule that the deduction for a donation of property to charity is equal
to the fair market value of the donated property. Where the donated property is
"gain" property, the donor does not have to recognize the gain on the
donated property. These rules allow for the "doubling up," so to
speak, of tax benefits: a charitable deduction, plus avoiding tax on the
appreciation in value of the donated property.
Example: Tim and Tina are twins, each of
whom attended Family University. Each plans to donate $10,000 to the school.
Each also owns $10,000 worth of stock in ABC, Inc. which he or she bought
several years ago for just $2,000.
Tim sells his stock and donates the $10,000
cash. He gets a $10,000 charitable deduction, but must report his $8,000
capital gain on the stock.
Tina donates the stock directly to the
school. She gets the same $10,000 charitable deduction and avoids any tax on
the capital gain. The school is just as happy to receive the stock, which it
can immediately sell for its $10,000 value in any case.
Caution: While this plan works for Tina in
the above example, it will not work if the stock has not been held for more
than a year. It would be treated as "ordinary income property" for
these purposes and the charitable deduction would be limited to the stock's
$2,000 cost.
If the property is other ordinary income
property, e.g., inventory, similar limitations apply. Limitations may also
apply to donations of long-term capital gain property that is tangible (not
stock), and personal (not realty).
Finally, depending on the amounts involved
and the rest of your tax picture for the year, taking advantage of these tax
benefits may trigger alternative minimum tax concerns.
The
Wealth Transfer Group, Inc. is not engaged in the practice of law or accounting
nor are any of its employees, representatives, or agents. Tax and legal advice
should be obtained from qualified personnel.
(c) 1995 The Wealth Transfer Group, Inc.
283 Cranes Roost Boulevard, Suite 145, Altamonte Springs, Florida, 32701 (407)
339-5787
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