APPEALS COURT REDUCES GIFT VALUES BY RECIPIENT’S POTENTIAL INCOME TAXES

For many people having a taxable estate (meaning equity exceeding $650,000 increasing to $1.0 million by 2006), steps are frequently taken to reduce the size of that estate through well-planned gifting strategies. Sometimes, those gifts are of closely held corporate stock in, say, a corporation owning a parcel of income producing real property. A federal Appeals Court recently decided in reversing a decision of the United States Tax Court that the value of the stock gifted, for federal gift tax purposes, may be reduced by taking into consideration the potential tax liability which would result from a sale of the stock by the recipient of the gift.

A gift is valued as of the date it is made. The value of the gift is the price at which such property gifted would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. In reversing the Tax Court, the Appeals Court concluded that the potential tax liability would indeed be a relevant fact and must be taken into consideration in determining the value of the gift. This means that taxpayers can reduce the size of their estates more than they may have thought possible by making gifts of assets which if sold would require the payment of a capital gains tax. This results in avoiding or reducing future gift and estate taxes.

For example, say that A owns stock in a C-corporation which owns a parcel of real estate. The tax basis of the stock is $100,000 and a fair market value of the stock is $1.0 million. $900,000 is the built in taxable gain subject to tax assuming the stock were sold for $1.0 million. Say the taxes resulting from such a sale would be 25% (consisting of the potential federal income taxes and New York State and New York City or other local corporation taxes) on the $900,000 or $225,000. It would now seem that all or some substantial portion of the $225,000 tax liability would reduce the value of the stock A might want to gift to his children or others since those persons would be taking the gift of the stock subject to those potential tax liabilities. The result of the reduction in value means that more of A’s estate will avoid taxation at death. Its important to note, however, that this same rule does not hold true if the stock is not given away until death since the built in capital gains tax is automatically avoided at the time of death owing to other provisions of the law. The problem of waiting until death to do estate planning is that all of the stock will be included in the gross taxable estate and be subject to estate tax without any reduction for potential taxes. Furthermore, the appreciation in value over time will result in a greater taxable estate.

This decision could be enormously advantageous to taxpayers who are serious about avoiding estate and gift taxes.