318 Planning and Forecasting
tax. This gift tax supplements the federal estate tax, which imposes a tax on the
transfer of assets from one generation to the next. Lifetime gif ts to the next
generation would, in the absence of a gift tax, frustrate estate tax policy. Fortu-
nately, to accommodate the tendency of individuals to make gifts for reasons
unrelated to estate planning, the gift tax exempts gifts by a donor of up to
$10,000 per year to each of his or her donees. That amount will be adjusted for
inf lation as years go by. Furthermore it is doubled if the donor ’s spouse con-
sents to the use of her or his $10,000 allotment to cover the excess. Thus, Mor-
ris could distribute up to $20,000 in excess cash each year to each of his two
children if his wife consented.
In addition, the federal gift tax does not take hold until the combined
total of taxable lifetime gifts in excess of the annual exclusion amount exceeds
$675,000 in 2001. This amount will increase to $1 million in 2002. Thus, Mor-
ris can exceed the annual $20,000 amount by quite a bit before the government
will get its share.
These rules may suggest an alternate strategy to Morris under which he
may transfer some portion of his stock to each of his children and then have
the corporation distribute dividends to him and to them directly each year.
The gift tax would be implicated to the extent of the value of the stock in the
year it is given, but, from then on, no gifts would be necessary. Such a strategy,
in fact, describes a fourth circumstance in which the subchapter S election is
recommended: when the company wishes to distribute profits to nonemployee
stockholders for whom salary or bonus in any amount would be considered
excessive. In such a case, like that of Victor, the owner of the company can
choose subchapter S status for it, make a gift to the nonemployee of stock, and
adopt a policy of distributing annual dividends from profits, thus avoiding any
challenge to a corporate deduction based on unreasonable compensation.
MAKING THE SUBCHAPTER S ELECTION
Before Morris rushes off to make his election, however, he should be aware of
a few additional complications. Congress has historically been aware of the po-
tential for corporations to avoid corporate-level taxation on profits and capital
gains earned prior to the subchapter S election but not realized until after-
ward. Thus, for example, if Morris’s corporation has been accounting for its
inventory on a last in, first out (LIFO) basis in an inf lationary era (such as vir-
tually any time during the past 50 years), taxable profits have been depressed
by the use of higher cost inventory as the basis for calculation. Earlier lower-
cost inventory has been left on the shelf (from an accounting point of view),
waiting for later sales. However, if those later sales will now come during a
time when the corporation is avoiding tax under subchapter S, those higher tax-
able profits will never be taxed at the corporate level. Thus, for the year just
preceding the election, the Code requires recalculation of the corporation’s
profits on a first in, first out (FIFO) inventory basis to capture the amount