As a general rule, when you have one child in college it's unlikely that your child will qualify for financial aid if:
- you are married and file jointly
- your adjusted gross income (AGI) exceeds $140,000 for an in-state public college, or your AGI is $210,000 or higher for a private college
Part 1 which was highlighted in last month’s Your Financial Life newsletter helps you understand the impact that equity grants have on financial aid eligibility. Part 2 is a continuation of that and focuses on reviewing the basics of gift tax and the tax treatment of various forms of stock compensation.
Gift Tax Basics
You own outright the stock you acquire from your stock grant, whether through exercise, purchase, or vesting. You can then make individual gifts to your child (including transfers to UGMA or UTMA accounts) of up to $14,000 yearly, or joint gifts with your spouse of up to $28,000 yearly, without any gift tax consequences. When your children are minors, the only way they can own such assets is through custodial accounts (UGMA and UTMA) or trusts. Gifts to individuals under the age of 18 are held in UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act) accounts on behalf of the minor, and a custodian maintains legal control of the account until the minor reaches age 18 (age 21 in some states if elected when the account is established). Gifts to individuals 18 years of age and older can be made outright to the individual.
With the national average cost of a four-year private college exceeding $58,000 per year, an annual gift of $28,000 will fall well short of funding the cost. So many parents choose to begin gifting the maximum of $28,000 (jointly) per person to their children while the children are still under the age of 18 in order to accumulate enough money in the child's account to pay for college. Money paid directly to the college does not count towards the yearly gift amount totals.
Gifts of stock are based on the stock's value at the time of the gift and not on your tax basis. The basis and holding period of property acquired by gift are carried forward to your child. The kiddie tax, discussed in Part 3 next month, determines the tax rate that applies to your child when the stock is sold.
Grant Type Affects Tax Strategies
The tax status of the underlying shares of company stock after grant, vesting, purchase, and/or exercise is the most important factor in determining whether the shares can be used efficiently to pay for college. Ideally you want appreciated stock which you can gift to a child in a qualifying disposition (described below) that will effectively transfer a large portion of the capital gain at sale to the child. Even with the changes in the kiddie tax detailed in Part 3 next month, this can be an effective strategy when combined with other approaches. The purpose behind gifting appreciated stock to a child is to take advantage of the child's typically lower tax bracket by having the child sell the stock and pay the tax at the child's tax rate instead of yours. This is called income-shifting.
The disadvantage of using nonqualified stock options (NQSOs), stock appreciation rights (SARs), and restricted stock or restricted stock units (RSUs) to fund college costs is that you have to pay ordinary income tax on the spread at exercise (or with restricted stock and RSUs at vesting) before you can gift the stock to your child. The amount of taxable income realized, plus the exercise cost with stock options, is the tax basis carried over to your child. These forms of equity compensation can be a good source of college funds, particularly if you have not allocated the gains from your stock grants to other financial goals, but generally are not the most tax-efficient types of grants to use.
Incentive Stock Options (ISOs)
ISOs, on the other hand, are not considered compensation income for regular tax purposes upon exercise when you hold the shares. At sale you can receive favorable long-term capital gains treatment for the full amount of the sales price over the exercise price if you comply with the holding requirements of two years from grant and one year from exercise. You want to avoid gifting the ISO stock too soon, as this has unusual tax consequences similar to those of a wash sale. When your gift is a qualifying disposition (i.e. it meets these holding periods), the ISO stock can then be sold at lower capital gains rates.
At first, ISOs always seem an effective way to gift appreciated stock through a qualifying disposition, while having the child pay the tax on the gain at sale. However, when you exercise and hold ISOs, you may trigger the alternative minimum taxtax (AMT). When you sell ISO stock, you have an AMT adjustment that helps you use up the credit generated at exercise. You do not have the same AMT income adjustment for gifting ISO stock.
Employee Stock Purchase Plans
Tax-qualified Section 423 ESPPs let employees purchase shares of company stock at regular intervals using after-tax dollars. These plans commonly are administered through payroll deductions and can allow employees to buy shares at a discount to the market price on either the offering date or the purchase date. Shares purchased through a Section 423 ESPP can receive favorable tax treatment if you meet holding requirements of one year from the purchase date and two years from the offering date.
Assuming you sell the stock at a gain, most of the spread between the discounted purchase price and sale price is capital gain, with no tax on the discount at the time of purchase. You do owe some ordinary income at sale for the discount at purchase, usually calculated from the stock price at the start of the offering period. If your ESPP is not a Section 423 plan (nonstatutory), the difference between the purchase price and the market value of the stock on the purchase date will be treated as ordinary income in the year of purchase and subject to income tax withholding at that time (i.e. the tax treatment is similar to that of NQSOs).
As with ISO stock, you do not want to gift ESPP stock that has not met the holding period requirements. Otherwise, it will be taxed as a wash sale. After holding the ESPP stock long enough, when you gift the shares you still pay ordinary income tax on the discount from the offering price, as with any sale of ESPP stock held for the required period (assuming the stock appreciated above the purchase price). From a tax standpoint, at the worst, if you purchase shares through a Section 423 ESPP with a 15% purchase price discount and the market value at the time of a qualifying disposition shows a gain of 20%, you will have to pay only ordinary income tax on the 15% purchase price discount from the stock price at the start of the offering. If you dispose of the shares by gift to your child, his or her tax basis will be the purchase price plus the 15% that you paid the ordinary income tax on. The additional 20% of capital gain from market appreciation is effectively shifted through the gift. When the child sells those shares they will be taxed to the child.
Similarly, restricted stock can be gifted, effectively shifting embedded capital gains to the recipient, but the overall tax efficiency of this strategy depends on whether you choose to make an 83(b) election (not available for RSUs) at the time of grant.
With grants of restricted stock the entire amount is taxed as ordinary income to you, unless you choose to make an 83(b) election or unless you have an RSU grant with a deferral election. By making an 83(b) election at the time of grant you choose to pay ordinary income tax on the market value on the date of grant. Any future gain is taxed as capital gain. Upon vesting, however, if you chose an 83(b) election and it paid off for you because the stock price went up in value, you could gift those shares to your son or daughter, effectively shifting that capital gain to the child.
Part 3 to be featured next month will finalize this article series by examining specific tax-efficient strategies that, in combination with tax credits, can help you use stock grants to pay for college.
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Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Clients should consult their personal tax advisor for tax related matters and their attorney for legal matters.
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