Holding a concentrated position in low basis stock can be a dilemma for many investors. With federal long-term capital gains rates up to 20 percent, the 3.8 percent net investment income tax and state income taxes, the cost may be too high to justify selling the stock. Some will simply hold the stock until they die, providing their heirs with a step-up in basis resulting in little or no tax consequences. This could be risky. A drop in share price could result in a significant decrease in wealth. The potential for transactions that the investor cannot control (such as an inversion or other taxable event) pose additional risks. There are options, but none of the options is perfect.
The stock can be gifted to family members or other individuals. Using the annual gift exclusion, up to $14,000 worth of stock can be gifted to any individual in a calendar year without using up any of the lifetime transfer exclusion. Married individuals, together, can gift up to $28,000 to each person.
The recipient of the gifted stock will maintain the historical cost basis as well as the holding period. Even if the recipient sells the stock immediately, the tax cost may be less than if the original owner sold the stock. The current tax law provides for a 0 percent tax rate on the long-term capital gains for those individuals in the lowest tax bracket. The kiddie tax, which taxes a child’s income at the parents’ tax rates, needs to be considered when utilizing this strategy. Kiddie tax may apply to children as old as 23, if they are full-time students.
Another strategy that reduces the concentrated stock position, but maintains the low cost basis, is the use of exchange funds. An investor contributes the stock to an established “exchange fund” and receives a pro-rata ownership in the portfolio. This accomplishes the objective of reducing the concentration, but the investor’s basis in the new investment remains unchanged. As a result, this is a tax-deferral mechanism, not a tax elimination scheme. Upon exiting the fund (after the required seven year “lock up” period) the investor has in essence transferred his original cost basis from a single stock to a portfolio of stocks. A sale of any appreciated stock out of this portfolio would trigger a capital gain.
Any situation requiring the fund to sell or distribute a contributed security (e.g., the security is subject to a tender offer) will trigger a taxable event. The contributing shareholder will be responsible for the capital gain on the appreciation prior to contributing the stock to the fund. All shareholders bear a proportional tax liability for the stock’s appreciation from the time of contribution.
The stock can also be gifted to charity. This will avoid the taxation of the capital gain on the gifted stock and provide for a charitable deduction. The deduction will be based on the fair market value of stock at the time of the gift and will be limited to 30 percent of adjusted gross income (AGI) (20 percent if gifting to a private foundation). The unused portion of the charitable deduction can be carried over for up to five years.
Another way to use the stock to make a gift to charity is through a charitable remainder trust (CRT). When a CRT is established, the stock is gifted to the trust, and the donor (and/or another non-charitable beneficiary) retains an annuity interest in the property for a specified number of years or for the life or lives of the non-charitable beneficiaries. At the end of the term, the qualified charity specified in the trust document receives the property in the trust. The terms of trust must provide that 1) the annuity payments be at least 5 percent, but no more than 50 percent of the initial fair market value of the assets and 2) the charity’s actuarial interest be at least 10 percent of the assets transferred.
Gifts made to a charitable remainder trust qualify for income and gift tax charitable deductions. The charitable income tax deduction is allowed in the year of the gift and is based on the present value of the remainder interest that will ultimately go to the charity. The distributions can either be fixed (annuity trust) or based on the fair market value of the assets (unitrust).
The trust is tax-exempt and, therefore, will not pay any tax. The income and gains of the trust are taxed to the beneficiaries when they are distributed as part of the annuity payments. As a result, the tax consequences from the sale of the stock will be deferred and spread out a number of years. This deferral and spread may help investors manage their tax brackets and avoid the net investment income tax.
If you hold low basis stock, consult with your local CBIZ MHM tax professional to discuss the various options.
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