Estate and gift tax legislation - oh what a relief it is?

The Taxpayer Relief Act of 1997, signed into law on Aug. 5, 1997, offers family businesses estate tax relief, along with mind-numbing complexity and political fanfare.

The first two columns of the table on page 685 show the scheduled increases for the girt and estate tax exemption. The increases are heavily "back-ended," meaning that taxpayers will have to wait until later for most of the relief. The exemption tops out at $1 million in 2006 and is not indexed for inflation. Because the exemption offsets the estate tax at the lowest brackets, the $400,000 increase translates into no more than a $153,000 estate tax savings (which can be doubled for married couples).

The current $600,000 exemption came into existence in 1986; increasing the exemption to $1 million 20 years later puts a taxpayer about even if his estate grows at 2.6% per year over this period. If investment performance (including inflation) is better, the government comes out ahead.

The keys to maximizing this exemption have not changed. First, it should be used as early as possible. Doing so means that a taxpayer's family will save transfer taxes on post-gift income and appreciation. The potential $220,000 savings increases dramatically if the years of appreciation can be shifted to the taxpayer's children or grandchildren. If circumstances permit, the incremental amount should be gifted as the exemption phases up. Second, a married taxpayer should scrutinize his and his spouse's wills to make sure they are properly worded to use any exemption remaining at death.

Family Business Exclusion

The big news is the new "family owned business exclusion The maximum exclusion is $1.3 million minus the gift and estate exemption. The table's third column shows how the family business exclusion declines as the $600,000 exemption increases.

The new exclusion is available only at death for people who die after 1997. For taxpayers who die in 1998 and are in the 55% estate tax bracket, the potential savings is $371,250; for those who live until 2006, the maximum savings drops to $165,000.

A spouse's estate also can qualify for the exclusion, potentially doubling the savings. However, the spouse must own enough stock (either outright or through a qualified terminable interest property marital deduction trust) to meet the percentage tests discussed below. If the spouse does not own stock, and dies before the taxpayer, the Spouse's exclusion is lost. For families that prohibit or discourage spousal ownership, giving stock to a spouse may require a major cultural change.

Who can use this new exclusion? What are the disadvantages? The answers can be found only by exploring the labyrinth of qualification tests:

[] The decedent must be a U.S. citizen or resident.

[] If the decedent is married, the goal is to reduce the bequest to his spouse by the amount of the exclusion and leave it to others (i.e., his children). If the decedent leaves the exclusion amount in a trust that may pass to grandchildren, the new exclusion will not stop the imposition of the generation-skipping transfer tax (GSTT). Although not mentioned in the new law, an outright bequest of the exclusion amount to grandchildren may avoid GSTT

[] The business must be active. Stock and bond investments, royalties and most rental activities are excluded. In fact, there is a complicated test that disqualifies the portion of a business's value attributable to cash and marketable securities "in excess of reasonably expected day-to-day working capital needs." Funds accumulated within the company in anticipation of future business investments or stock buybacks will not qualify for the exclusion. The obviously unfortunate consequence is that this rule discourages savings for two important needs--business expansion and repurchasing stock from heirs who do not want to be owners.

[] The business must not have been publicly traded within three years before the decedent's death.

The remaining requirements implement Congress's desire to restrict the exclusion to family-owned businesses that are a substantial portion of a decedent's estate and in which the decedent's family actively works.

Qualified Business Interest Requirement

The exclusion is intended only for family-owned businesses. Therefore, at least:

--50% of the business must be owned (directly or indirectly) by the taxpayer and members of his family, or

--70% must be owned by members of two families, or

--90% must be owned by members of three families.

In the two- and three-family scenarios, the taxpayer and his family must own at least 30%. While most family businesses will meet this test, the details could cause a problem for fourth- and later-generation businesses (the owner's family relationships may be too distant), and businesses with substantial employee ownership and businesses with several significant unrelated owners.

50% of Estate Requirement

The business interest must be at least 50% of the value of a taxpayer's estate. A majority of the respondents to a recent Arthur Andersen/MassMutual American Family Business Survey indicated that 40% or more of a family's wealth is outside of the business; thus, a large portion of the country's business owners apparently fail (or nearly fail) this requirement.

Determining whether the 50% test is met is complicated. It is an artificial calculation that does not actually change an estate's value for tax calculation purposes. Lifetime gifts of family business stock are added back to the estate. This avoids discouraging lifetime gifts, which otherwise would dilute the stock portion of the estate and make it harder to reach the 50% threshold. On the other hand, Congress foresaw the potential for taxpayers to circumvent the test by giving away assets other than family business stock during their lifetime. Therefore, all gifts made to one's spouse during the 10 years preceding the taxpayer's death must be added back to the taxpayer's estate. In addition, any other gifts made within three years before the taxpayer's death must also be added back to the taxpayer's estate.

Unfortunately, the 50% test can discourage otherwise useful actions. For example, financial dependence on the business can hinder an aging owner's willingness to pass responsibility and control to successors. Therefore, owners should build wealth outside of the business. In addition, inactive or uncooperative children should inherit assets other than stock. This strategy also can be implemented by parents building outside wealth. In each case, actions necessary for the business's and family's health can be counterproductive to qualifying for the new exclusion.

Material Participation Before and After Death

The taxpayer or at least one member of the taxpayer's family (i.e., a parent, descendants of parents and spouses of such descendants) must own the business and "materially participate" in its operation for at least five of the eight years before the taxpayer's death. Further, at least one family member must materially participate in the business for at least five years within any eight-year period during the 10 years after the taxpayer's death. The post-death requirement would be failed if, for example, family members materially participate during years 1-3 and 8-10 after the taxpayer's death. In that case, the five-year overall requirement is met (they participate for a total of six years), but the required five work years do not fall within an eight-consecutive-year period.

Material participation is a subjective standard that undoubtedly will trigger disputes with the IRS. The legislative history states that "[p]hysical work and participation in management decisions are the principal factors to be considered." Regulations can be expected requiring either full-time work (i.e., at least 35 hours per week) or the amount of time necessary to "fully" manage the business.

Situations in which the material participation requirements will not be met include:

[] An owner retires or becomes disabled more than three years before death, unless a family member takes over to materially participate during that time.

[] A deceased business owner's children are too young to materially participate in the business within the required 10-year period.

[] No family member works full time in the business and, for legitimate business reasons, the family decides to give Management responsibility to nonfamily employees. This can be particularly damaging, because it could encourage unqualified family members to assume management responsibility

If the post-death material participation test is failed within the first six years after death, the savings from the new exclusion must be paid to the government in its entirety, plus nondeductible interest. A declining portion of the estate tax savings must be paid if the material participation test is failed within seven to 10 years after death. Similarly, if an heir transfers the stock to a nonfamily member within 10 years, the same portion of the tax savings is lost.

Note: Heirs will not receive an income tax basis step-up in the stock for the amount of the exclusion; thus, if they later sell the stock, they will give back 20% of the excluded amount in capital gains taxes. Even worse, if the exclusion is claimed and then must be recaptured (because the heirs fail the material participation test or dispose of the stock), the basis step-up will still be denied. The result is an increased capital gains tax on sale even though the new exclusion resulted in no or only partial estate tax savings. Moral: The exclusion should not be claimed if &re is a reasonable chance that the children will sell the business or not work in it during the 10 years after the parent's death.

The new exclusion will be beneficial for small to mid-size family businesses if it is clear that the family will retain ownership and at least one family member will be very active. Larger businesses and families that are not as certain about future ownership or involvement probably will not find the exclusion worth the effort.

Scheduled Increases in the Gift and Estate Tax Exemption
(and Decrease in the Family Business Exclusion)

Year                 Gift tax and               Family
                  estate tax exemption    business exclusion
1997                     $ 600,000            $      0
1998                       625,000             675,000
1999                       650,000             650,000
2000                       675,000             625,000
2001                       675,000             625,000
2002                       700,000             600,000
2003                       700,000             600,000
2004                       850,000             450,000
2005                       950,000             350,000
2006 and later            1,000,00             300,000

From Ross W. Nager, CPA, Houston, Tex.