The new family-owned business exclusion.

When discussing estate and gift taxes, most individuals were familiar with one dollar figure: the $600,000 exemption for lifetime gifts. That was the total dollar amount of gifts a taxpayer could make, during his or her lifetime and at his or her death, that would generate no federal estate or tax. However, because this figure had not been adjusted since 1986, when it was enacted, it was no surprise that the Taxpayer Relief Act of 1997, among other provisions, increased the amount to $625,000 in 1998. The exemption will be increased gradually over the next 9 years, ultimately reaching $1 million in 2006. While this increase may be the most highly publicized change in the estate and gift area, another change may prove more significant for many taxpayers.

FAMILY-OWNED BUSINESS EXCLUSION

After 1997, there will be a new exclusion for a US. citizen or resident who dies and passes on interests in a qualified family-owned business that makes up a substantial portion of the estate and in which his or her family actively works. If certain requirements are met, up to $1.3 million of the value of a decedent's business (minus the estate and gift exemption) can be excluded from his or her estate.

This exclusion will benefit small to midsize family businesses in which the family will retain ownership and at least one member will be active. However, larger businesses, or families less certain about the business's future ownership or involvement, will not find this new exclusion as valuable.

Several requirements must be satisfied to take advantage of this new exclusion.

Qualified family-owned business interest. The business interest must be either

1. An interest in a trade or business carried on as a proprietorship.

2. An interest in a trade or business in which at least 50% of the entity is owned (directly or indirectly) by the taxpayer or members of his or her family, or 70% owned by members of two families or 90% owned by three families. In the two- and three-family scenarios, the taxpayer and his or her family must own at least 30% of the business. This requirement could be a problem for businesses with substantial employee ownership or several significant unrelated owners.

Fifty percent of ownership requirement. The value of the business's interest must be at least 50% of the total value of the decedent's adjusted gross estate. All gifts made to a spouse over the 10 years before the decedent's death and all other gifts made within 3 years of the decedent's death and any lifetime transfers of qualified business interests to other than the decedent's spouse must be added back for purposes of this calculation.

Material participation before and after death. The taxpayer or at least one member of his or her family (that is, parents, descendants of parents and spouses of such descendants) must own the business and "materially participate" in its operation for at least 5 of the 8 years before the taxpayer's death. In addition, at least one family member must materially participate for at least 5 years within any 8-year period during the 10 years after the taxpayer's death. While "material participation" has not been defined yet for these purposes, Congress did note that physical work and participation in management decisions are the principal factors to be considered.

These requirements could be a problem for a business in which an owner retires more than 3 years before death and no family member takes over to materially participate during that time; or when a deceased owner's children are too young to materially participate in the business within the 10-year period; or when, for legitimate business reasons, a family decides to give management responsibility to nonfamily employees.

If the postdeath material participation test is failed within the first 6 years after death, the savings from the exclusion must be paid to the government in its entirety, with (nondeductible) interest; if the test is failed within 7 to 10 years after death, a portion of the savings must be repaid. Similarly, if an heir transfers stock to a nonfamily member within 10 years, the tax savings win be lessened or lost, depending on the year of the transfer.

For a discussion of this new provision and other current developments, see the Tax Clinic, edited by William Ciesar, in the November 1997 issue of The Tax Adviser.