Thursday, October 22, 2015

Will vs. Living Trust - From a Stockholder's Standpoint

Numerous articles have been published regarding the differences between wills and living trusts - I'm not going to recap that here.  However, unfortunately, I have had to learn a thing or two about trusts in the aftermath of the passing of a relative.  The trust does not involve me, but I have been privy to some of the details of the settlement of the trust and, as I am intrigued by anything markets/investing/stock trading, I picked up a few gems that could save a bundle of cash (for you or your heirs) if handled correctly.  Keep in mind, I am not advocating that you set up one over the other; I am simply going to dissect the difference from a very specific perspective:  the giving of stock to relatives in the event of a death.

A trust is set up by a living person who wants to place stipulations on how their estate is handled.  For example, a trust can define the terms under which a child takes control of an asset - possibly stating that the child must turn 18 or earn a college degree.  A trust does not require settlement through "probate", meaning it basically stays out of the courts.  A will does enter probate (of course, there are some exceptions to the rule).  Also, a trust is worthless until it is funded with assets.  The trust and the assets may remain in control of the trustee until he/she passes away, then the beneficiary can take control of the assets.  Those are basic differences - many more specific technical differences can be researched here.

So, say you have an elderly parent ('Dad') who owns a significant portion of stock in a company whose share price has appreciated considerably from when he initially bought it in 1981 for $5 per share.  Dad chose to set up a trust when 'Mom' passed away in 1985 to ensure his estate was properly distributed when he was gone.  Now, Dad passes away this year and his estate has been settled.  You take control of your portion of the assets from the trust, including the stock, which is now selling for $50/share.  Unaware of the intricacies of your father's portfolio, this news comes as quite a nice surprise.  You have been running a little tight lately and so you sell your portion of the shares immediately for around $50 each.  Since you took control of the stock at $50 and sold them at $50, you don't have to pay any capital gains tax, right?  WRONG!

Your cost basis for the stock is what your father had paid for the stock - $5!!!  You owe capital gains tax on your sale of (likely - depending on tax bracket) 15% on the $45 of appreciation ($50-$5 cost basis)!!!  Wow!  Say your cut was 5,000 shares = sale income of $250,000.  $250,000 - $25,000 cost basis = capital gain of $225,000 . . . at 15%, you owe the government $33,750.  Ouch!

So, was the trust a bad decision for your father?  In this specific case, yes, since the beneficiaries are required to use the trustees cost basis for tax purposes.  Had you inherited the stock vial a will disbursement and sold immediately?  No capital gains tax.  The IRS allows you to "step-up" your cost basis to the day that you inherit the stock (the day of the passing of the relative). 

Another misconception is gift tax.  Gift tax, if paid at all, is typically paid by the donor - not the beneficiary.  A gift can be given up to the current annual limit of $14,000 per year without tax implications.  Anything over $14k per year has to be reported to the IRS, but only for tracking purposes
.  Anything over that $14k goes towards your lifetime allowable limit of $5.43 million (for 2015).  You only need to pay gift tax on an amount that exceeds the $5.43 million lifetime amount.  So, in our example of the $250k of stock that was given to you, no gift tax would need to be paid.

Paying attention to the intricacies of the tax code in situations like this can save you a small fortune.  Be sure to review the tax implications of a transaction before transacting to keep the tax man at bay!

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