9022 / Should the transfer of stock to a successor generation pursuant to a family business succession plan be structured as gifts or compensation?

While each small business is different, many family-owned businesses prefer to structure the transfer of stock to the next generation as compensation, rather than making the transfer by gifts.

The compensation structure, while generating taxable income for the successor generation, offers a tax deduction to the company that will often offset any income tax liability that is created.¹ While the income tax liability may be deferred under IRC Section 83 if the transferred stock is subject to a substantial risk of forfeiture, in the family business context, the income tax liability incurred by the successor-employee can often be eliminated through a bonus or other additional compensation.

The compensation structure may be preferable to transferring stock to the successor generation via gifts because the successor-employee will receive a basis in the stock that is equal to its fair market value on the date of transfer.² Conversely, if the transaction is structured as a gift, the successor-employee will receive a basis in the stock that is equal to its basis in the hands of the transferor (a carryover basis).³ For stock that has appreciated with time, this can reduce any gains that the successor would be required to recognize should the stock eventually be transferred again in the future.

Further, the compensation structure eliminates any gift tax liability that would be incurred if the transfer were made through gifts. By structuring the transfer of company stock as compensation, the parent generation is not required to use up any of its gift tax annual exclusion or lifetime exemption amount by making the transfer—leaving it free to reduce its taxable estate further by making other gifts of property to the successor generation.

However, as a practical matter, the higher estate and gift tax exemptions are reducing the number of individuals who will have difficulties in transferring their business free of estate and gift tax. Also, with respect to the compensation approach to transferring the business, the taxpayer is essentially trading the estate tax for the income tax. Since the estate tax rate is currently 40 percent and the income tax rates are less, this approach can be viable to the extent the federal estate tax is applicable.