If you’re preparing to transfer complete or partial control of your company, the most common method would be to sell or give your stock shares directly to your chosen successor(s). While this may be the simplest means of handing over your legacy, it comes with significant tax costs. These can be avoided by taking the time to create a stock bonus plan.
A stock bonus plan is a business structure where your company issues stock shares to your chosen successors as a compensation bonus for their work performed for the company. This structure helps you in two ways:
1) A straight sale of stock would trigger capital gains taxes—up to a 20% tax rate as of 2014. Stock dispensed as a bonus avoids these taxes.
2) The unified estate and gift tax credit—which has been raised to $5.34 million as of 2014—would decrease if the stock is simply given to another party as a gift. In the form of a stock bonus, this credit remains intact.
While the stock bonuses and other pay remain taxable to the recipient, it is possible for their value to be discounted while your successors remain minority shareholders in the business. Additionally, while using this system to manage the transition of your stock shares, the company can deduct the bonuses from its own annual taxes. Plus there are potential additional company deductions by using the “gross up” method.
It’s also worth noting that your successor’s basis in the stock shares is not the original cost of the shares, but the current fair market value—meaning that taxable capital gains are reduced if they sell those shares themselves later.
Although there are clear tax advantages to instituting the stock bonus plan, there are also two challenges to consider:
1) Due to the nature of this plan, completing the transfer of shares to your successor requires a longer period of time than a simple sale or gift. Start early!
2) For tax audit purposes, the business must show that the total payout of stock and other assets to the successor was appropriate to services that they provided to the company. Presumably, however, your successor has been a vital member of the business administration, and as long as changes in company leadership remain well-documented, you shouldn’t have concerns with an IRS inquiry.
Talk with your accountant about your succession planning.