NEW YORK (CNN/Money) -
My father would like to give each of his two grandsons $10,000. But he's unsure whether he should give them this money in the form of stocks or whether he should cash in the stocks and give them the cash. What do you think is the best way to handle this?
-- Diane B., Roscoe, New York
As in most matters dealing with taxes, the answer is, "It depends" -- on the market value of the stocks, how much your father paid for them and what your father wants to achieve in giving the gift.
Let's start with a few basics about giving gifts to individuals. First off, gifts are not considered income for the recipients, so they never have to pay income or gift taxes.
As for the donor, he can give an amount up to the annual gift tax exclusion without incurring any gift tax. That exclusion was $11,000 for 2003 and is pegged to inflation. (FYI, anyone can make gifts of any size to a spouse without incurring gift tax.)
Even if the gift exceeds the annual exclusion amount, the donor still probably won't owe gift tax. The reason is that the tax rules give each of us a rather large lifetime credit for gift giving. Although you must file a gift tax return if your gift to any one person exceeds the annual exclusion, you don't have to actually pay gift tax until you use up this sizeable credit. For more on this aspect of the gift tax rules, go to the Publications section of the IRS Web site and get Publication 950: Introduction to Estate and Gift Taxes.
Stocks vs. cash
Cash is clearly the simpler transaction as far as your sons are concerned. No muss no fuss, for the boys at least.
But since your father will be selling stocks to get the cash for the gift, he'll have to pay taxes if the stocks had gained in value. Conversely, if your father sold the stock at a loss, then he would get the tax benefit of the loss.
The situation gets more complicated if your father gives the boys stock worth $10,000 (though that doesn't necessarily make it worse).
Let's assume that the stock each boy receives was worth $5,000 when your father bought it several years ago. That would mean your father is giving each boy a gift worth $10,000, but that has a basis of $5,000.
If your sons turn around and sell that stock, each would get $10,000, but then owe tax on a $5,000 gain. In effect, your father has passed on the tax liability with the gift.
The situation is different still if your father is sitting on a loss on the stocks. Let's say, for example, your father paid $15,000 for the stock. In this case, tax rules won't allow your father to pass along the loss with the gift, the loss in this case being $5,000 for each son. Only your father can sell and take that loss.
Your sons' profit or loss depends on the sales price they get. If your sons sell for a price that's higher than what your father originally paid -- say, $16,000 -- then they would have to pay income tax on a $1,000 gain, the gain being the difference between your father's original purchase price ($15,000) and the $16,000 sales price.
If your sons sell the stock for less than its value when it was given to them, their loss would be the difference between the sale price and the market value at the time of the gift. So if your sons sold the stock for, say, $8,000, they would book a loss of $2,000. For a more thorough treatment of the tax treatment of gifts of stock, click here.)
The bottom line
So what's the best course for old granddad to follow?
Well, if he is sitting on a loss in the stock, he may want to consider selling, taking the loss and giving your sons cash. This way, your father gets the benefit of the loss. Your sons would then have the choice of buying the same stock or using their ten grand to create a new diversified portfolio.
If granddad is sitting on a gain, then he may want to consider gifting the shares. Unless the shares fall below what your father originally paid for them, someone's going to pay tax on the shares when they're sold. So why not postpone the tax bite till later. Yes, your father is effectively lowering the value of the gift by shifting the tax burden onto your sons. But he can compensate for that if he wishes by giving them more stock or cash in subsequent years.
Besides, if your sons are in a lower tax bracket than your father, then gifting them the appreciated shares lowers the government's take on the appreciated assets.
Let's say, for example, your father paid $5,000 for the stock and it's worth $10,000 when he gifts it to your sons. If your father is taxed at the maximum long-term capital gains rate of 15 percent, he'd owe $750 in taxes. If your sons' incomes are low enough, they may face only a 5 percent tax rate on long-term capital gains, which means they'd pay only $250 in taxes.
In fact, if your sons wait until 2008 to sell the stock, it's possible they could owe no tax since the rate on long-term capital gains for lower-income taxpayers are scheduled to go to 0 percent for 2008 (although, unless Congress changes the tax law, tax rates will revert back to where they were before the passage of last year's tax bill).
Depending on how generous he was feeling grandpop could pass all or some of this tax saving onto your sons.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.