Why is “Basis” so Important?

Clients often ask whether they should or should not give an asset away during their life.  The short answer is: it depends.  The “basis” your donee in a gift receives is your basis for income tax purposes.  This can have negative income tax consequences for the donee.

Let’s say Jack bought 100 shares of XYZ corp. stock at $10 per share when he was in his 20’s (worth $1,000) and he is now in his 60’s and XYZ corp. stock is trading at $100 per share (worth $10,000).  Let’s sat Jack wishes to give it to his grandson, Alex.  It is now worth $10,000, so the transfer to Alex is not creating a gift tax problem for Jack.  However, Alex’s basis in the $10,000 worth of XYZ is Jack’s basis (or $10 per share).  This is known as “carry over basis”.  Result: If Alex later sells XYZ stock given to him by Jack, his basis is $10 and his gain (if he sells at $100) is $90.  Alex will be required to pay capital gains tax on this $90 of gain.  That’s not the best result considering the fact that if Jack leaves the stock to Alex when he dies (instead of a gift during life), Alex’s basis would be the date of death value of XYZ stock.  So if that value was $100 and then Alex later sold it for $100, Alex would pay no income tax. Why? Alex’s basis is same as sale price.  That results in no capital gain.  You see, when you give something away during life, the donee gets your basis.  If you leave something at death, the devisee or beneficiary gets to use the date of death value as his basis.

Now, let’s consider Jack’s financial advisor convinces Jack to sell the XYZ stock to buy an annuity.  Jack will have to pay capital gain tax on that sale.  If Jack could use another asset with a higher basis (less inherent gain) to sell to raise the capital necessary to buy the annuity, the result would be much better.  Why?  Less capital gain tax due to raise the capital to buy the annuity, and the XYZ stock will give his devisee or beneficiary under his will or trust, a basis equivalent to date of death value.

The moral of the story is that there are income tax consequences to giving assets away.  Of course there can be gift tax consequences, but the income tax consequences also need to be considered.  Every case is unique and there needs to be an analysis of different approaches to accomplish desired objectives. These different approaches should always consider the consequences in terms of: estate tax consequences, gift tax consequences, and income tax consequences. 

Contributed by Mark F. Winn, Attorney at Law