Using stock bonuses to transfer control.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Closely Held Corporations, 17th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Keller, Gary W. Brown, James J. Mogelnicki and William R. Bischoff, published by Practitioners Publishing Company, For Worth, TX, 2004 ([phone]; ppc.thomson.com).

When a corporation's owner's successors are also its employees, ownership can be transferred by paying a bonus in stock, instead of cash. Assuming there are no unreasonable compensation issues, Rev. Rul. 69-75 allows the corporation to take a deduction for the fair market value (FMV) of the stock distributed. The recipients include the stock's FMV in gross income. (If the stock is subject to a substantial risk of forfeiture, it is included in an employee's income at its FMV when the risk lapses. A Sec. 83(b) election permits the employee to include the stock in income at its date-of-distribution value.)

A stock bonus increases the successor's ownership interest in the corporation relative to the senior owner's interest, because of the additional shares outstanding. Thus, the bonus effectively transfers ownership to the successors.

Example

Judy Ramos owns 100% of the outstanding stock (1,000 shares) of Fast Distribution, Inc. (FDI). Judy would eventually like to retire and transfer FDI's management and ownership control to her son, Mike, who is FDI's vice president of operations.

As part of a plan to transfer ownership to Mike, Judy authorizes the corporation to pay him a bonus of 10 shares of FDI stock as part of his compensation. After the bonus, Jane owns 99% (1,000 shares/1,010 shares), and Mike owns 1% (10 shares/1,010 shares) of FDI's outstanding stock.

Benefits

Using a stock bonus to transfer ownership may be more advantageous than gifting stock, for both the owner and the employee. Although an employee receiving a stock bonus pays income tax on the stock's value, the highest individual income tax rate is usually less than the owner's marginal gift tax rate. The corporation's compensation deduction reduces the net income tax on the bonus even further. Finally, with a stock bonus, the employee's basis is FMV; the employee takes a carryover basis if he or she receives a gift of stock.

Deducting a Bonus

According to Regs. Sec. 1.162-7(a), to be deductible, a stock bonus must be reasonable relative to the services rendered. Because all compensation is taken into account when determining reasonableness, the successor's need for cash compensation may also limit the amount that can be received in stock. Normal valuation rules (e.g., minority and marketability discounts) apply to value stock when used as a bonus to transfer ownership.

Example

Cliff, a widower, owns 100% of Big G, Inc. (BGI), currently valued at $10 million. Cliff would like to begin transferring BGI ownership to his son, Mark, and groom him to take over the business. Cliff has previously made $4 million in lifetime transfers to trusts for the benefit of his two other children and paid the gift tax thereon. In 2005, Cliff authorizes BGI to pay Mark a $75,000 stock bonus. Mark's marginal income tax rate is 35%.

Mark will pay $26,250 of income tax on the stock bonus ($75,000 x 35%). The corporation's tax benefit is $25,500 ($75,000 x 34%); thus, the net income tax is $750 ($26,250-$25,500). If Cliff had given Mark $75,000 of stock instead, the gift tax would have been $30,080 (($75,000-$11,000 annual exclusion) x 47%).

Alternative to Stock Purchase

A stock bonus may be an attractive alternative to using a stock purchase to transfer control. From an employee's standpoint, a stock bonus is preferable to a stock purchase. In both instances, the employee is using after-tax funds to acquire the stock but, with a bonus, the employee's cost is the tax liability on the shares' FMV, rather than on the full FMV. Further, because the stock is acquired as a bonus from the corporation and not purchased from the owner, the owner avoids recognizing gain on the sale. Although the recipient is taxed on the bonus income, the corporation takes a compensation deduction. Thus, if the successor is a family member, a transfer of ownership with a stock bonus, instead of a purchase, decreases the family's overall current tax liability.

Disadvantages

One of the drawbacks of a stock bonus program is that the employee needs cash to fund the tax liability. If necessary, the corporation can gross-up the employee's salary to provide funds to cover the tax.

It will usually take a number of years to transfer large amounts of stock to an employee, due to the reasonable compensation limits. As a result, using stock bonuses to transfer corporate control may be limited to situations in which the owner's retirement is several years away. More realistically, stock bonuses might be used to transfer ownership to children before a redemption of the senior owner's shares.

Given the dilution that can occur from transferring stock to employees, stock bonuses may be less desirable for owners who plan to convert stock into cash for retirement needs.

Editor:

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Arlington, Va