Chapter 42: Family-owned business deduction.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001) repealed the family-owned business deduction (1) for 2004 to 2009, as the estate tax unified credit exemption equivalent increased above $1,300,000. EGTRRA 2001 also repeals the estate tax for one year in 2010.
For decedents dying in 1998 to 2003 or after 2010, the deduction is available for up to $675,000 of qualified family-owned business (QFOB) interests. (2) The family-owned business deduction applies only to the estate tax. If the deduction is taken, then the estate tax unified credit exemption equivalent (applicable exclusion) is equal to the lesser of the regular unified credit exemption equivalent or $1,300,000 minus the deduction. The benefit of the deduction is generally recaptured if qualified heirs dispose of the interest or fail to materially participate in the business within ten years after decedent's death.
When available, this provision can be a very real benefit to owners of small and medium businesses. Because of the numerous requirements for qualification for this benefit, careful planning must be done for the estate.
WHEN IS THE USE OF SUCH A DEVICE INDICATED?
1. When a substantial portion of the estate will consist of an interest in a family-owned business; and
2. When the decedent or decedent's family has materially participated in the business for five of the eight years preceding decedent's death; and
3. When the intention is to pass the business on to "qualified heirs," who will continue to operate it for ten years following the decedent's death.
WHAT ARE THE REQUIREMENTS?
1. Decedent must die in 1998 to 2003 or after 2010.
2. The decedent must have been a U.S. citizen or resident at death. (3)
3. The executor must elect the application of IRC section 2057 and file an agreement with the estate tax return, which provides for the payment of additional estate tax upon the occurrence of certain recapture events within ten years of the decedent's death, and prior to the death of the qualified heir. (4)
4. The value of all qualified business interests, plus certain gifts made of such interests, must exceed 50% of the adjusted gross estate. (5)
5. A qualified family-owned business interest is defined as either: (a) a proprietorship, or (b) an interest in an entity carrying on a trade or business. (6)
6. In the case of an interest in a trade or business, 50% of the entity must be owned by the decedent and decedent's family, or 70% by two families, or 90% by three families. In the case of the 70% and 90% tests, the decedent and decedent's family must own at least 30% of the entity. (7) Interests held by entities, including trusts, are subject to special attribution rules. (8) The decedent or decedent's family must have materially participated in the business.
7. A qualified family-owned business interest does not include: (a) a business whose principal place of business is outside the U.S.; (b) any business whose stock or securities was readily tradable within three years of the decedent's death; (c) any business if, during the tax year including the date of the decedent's death, more than 35% of adjusted gross income of the business was personal holding company income; (d) that portion of a business interest attributable to certain assets which produce personal holding company income, or foreign personal holding company income; or (e) that portion of a business interest attributable to excess working capital.
8. The qualified family-owned business interest must pass to a "qualified heir." This classification includes not only members of the decedent's family but also any individual who was actually employed in the trade or business for at least 10 years prior to the decedent's death.
9. After qualifying for the deduction, certain "recapture events" must be avoided within ten years after the decedent's death, but before the death of the qualified heir(s), or an additional estate tax will become payable. These events include: (a) the failure by the heir or his family to materially participate in the business for at least five years out of any eight year period; (b) the disposition of the business, other than to a family member or through a qualified conservation contribution; or (c) loss of U.S. citizenship by the heir (although a transfer into a qualified trust may be made in this event).
HOW IT IS DONE--AN EXAMPLE
Although the calculation of the qualified family-owned business deduction itself is reasonably simple, the determination of a decedent's eligibility is not as obvious. As noted above, adjustments must first be made to the value of the qualified family-owned business interest and to the gross estate, before calculating whether the adjusted value of the interest exceeds the 50% threshold of the adjusted gross estate. Assuming qualification, the availability of the deduction will then be limited to the lesser of $675,000 or the actual value of the adjusted qualified family-owned business interest.
Qualification for the family-owned business deduction is best illustrated through an example. Charles is single, and has two children. Charles owns and operates a dried fruits business, Nuts-4-U, Inc., which he manages and in which he participates on a full-time basis. The business is incorporated, and he and his children are the only shareholders. Charles died in 2003, leaving a gross estate of $1.8 million. Charles bequeathed his stock in the corporation equally to both children. The children are "qualified heirs" under the statute.
At his death, Charles was liable under an unsecured note to his brother, in the amount of $12,000. He also owned his home, and owed $60,000 under a mortgage at his death.
Charles made gifts of stock in Nuts-4-U, Inc. to both children in 1997 and 1999, within his annual exclusion amount, totaling $40,000 in fair market value as of his death. The value of Charles' interest in Nuts-4-U, Inc. was $1.4 million at his death.
Figure 42.1 illustrates the calculation that determines the adjusted value of Charles' interest in the business. Certain debts and expenses reduce the adjusted value.
Figure 42.2 illustrates the means by which the adjusted value of Charles' gross estate is calculated. Certain excluded gifts, including gifts of qualified family-owned business interests made within the annual exclusion, are brought back into the estate for purposes of calculating eligibility. (9)
As Figure 42.3 illustrates, once the values of the estate and the business interest have been established, determining eligibility for the deduction and the amount of the deduction is relatively straightforward. The actual amount of the deduction to the estate is also illustrated in Figure 42.3.
WHAT ARE THE TAX IMPLICATIONS?
1. The decedent's taxable estate is reduced by the qualified family-owned business interest deduction.
2. The benefit of the deduction is generally recaptured if qualified heirs dispose of the interest or fail to materially participate in the business within ten years after decedent's death.
IMPLICATIONS AND ISSUES IN COMMUNITY PROPERTY STATES
Since an important consideration in qualifying for the deduction involves determining the percentage of the business owned by the decedent, the question arises whether a surviving spouse's community property interest in the business is also included in this calculation. Under the IRC, interests owned by the decedent's family members are included in the calculation. (10) Thus, this attribution test results in the inclusion of a surviving spouse's interest for purposes of the 50% ownership test, whether that spouse's interest is community or separate property.
QUESTIONS AND ANSWERS
Question--Who is liable for the possible recapture of the estate tax deduction following the decedent's death?
Answer--In the event that a qualified family-owned business interest is not held for the required period following the decedent/transferor's death, the qualified heir who is responsible for triggering the recapture (generally through sale of his interest to a non-qualified heir) must pay his own proportionate share of the tax. Moreover, this responsibility will carry over to any transferee-qualified heir during the recapture period. Such transferees must also sign a new recapture agreement with the IRS. Any additional tax liability accrued as the result of a recapture event is due six months following such event.
Question--If the decedent failed to meet the material participation test with respect to the qualified family-owned business interest, but had owned a family business prior to the enterprise for which the deduction is sought, can the decedent's participation in the prior business be "tacked on" for purposes of the test?
Answer--Yes. Tacking by the estate of the decedent's material participation in a family business is allowed, where the family business for which the deduction is sought was acquired through an IRC section 1031 or 1033 tax-free exchange.
Question--Is a trust for a qualified heir eligible to receive a qualified family-owned business interest?
Answer--Yes. Section 2057 references the rules under IRC section 2032A(g). It appears that all successive trust beneficiaries must be qualified heirs. (11)
Additionally, under the special use valuation rules, a power in the trustee to divest a qualified heir of his interest, in favor of a disqualified heir, would bar an election under that IRC section. Thus, in anticipation of the future application of those rules to qualification under Section 2057, the conservative estate planner may consider providing that the trustee has no power to transfer qualified family-owned business interests to a disqualified heir. Moreover, considering the recent introduction of Section 2057, the trustee should also be given the power to amend a trust that holds a qualified family-owned business interest to comply with the section.
Question--Should trust documents make special provision for the allocation of a qualified family-owned business interest, following the death of the first spouse?
Answer--Yes. Since the new law provides for a deduction, allocation of the qualified family-owned business interest, which is nontaxable property, to a "Bypass" trust, or trust holding the decedent's unified credit exclusion equivalent amount, will not waste the decedent's credit.
ASRS: Sec. 54, 44.5(e).
(1.) IRC Sec. 2057.
(2.) IRC Sec. 2057(a)(2).
(3.) IRC Sec. 2057(b)(1)(A).
(4.) IRC Secs. 2057(b)(1)(B), 2057(h).
(5.) IRC Sec. 2057(b)(1)(C).
(6.) IRC Sec. 2057(e).
(7.) IRC Sec. 2057(e)(1)(B).
(8.) IRC Sec. 2057(e)(3)(A).
(9.) IRC Sec. 2057(c).
(10.) IRC Sec. 2057(e)(1)(B)(i).
(11.) IRC Sec. 2057(i)(3)(L).
Figure 42.1 ADJUSTMENTS TO BUSINESS VALUE 1. Value of Qualified Family-Owned $1,400,000 Business Interest 2. Plus: Gifted Business Interests 40,000 3. Less: Total Debts ($72,000) 4. Subtract from Total Debts (line 3): Residence debt (to the extent deductible under IRC [section]163(h)(3)) $60,000 Qualified educational / medical expense debt 0 Other debts ($10,000 cap) 10,000 70,000 5. Total Debt Adjustment (line 3 minus item 4) (2,000) Adjusted Value of Qualified Family-Owned 1,438,000 Business Interest Figure 42.2 GROSS ESTATE FOR QUALIFIED FAMILY-OWNED BUSINESS PURPOSES Gross Estate (including business) $1,800,000 Less: Usual Deductions (100,000) (debts, administration, etc.) Adjusted Assets 1,700,000 Plus: Gifts i. Gifted business interests $40,000 ii. Gifts to spouse within 0 10 years of death iii. Non-business gifts over 0 40,000 $10,000 within 3 years of death Gross Estate for Qualified 1,740,000 Family-Owned Business Purposes Figure 42.3 CALCULATING ELIGIBILITY FOR THE DEDUCTION 50% Gross Estate (Gross Estate from Figure 42.2) $ 870,000 (if less than next line, estate is eligible) Adjusted Qualified Family-Owned Business 1,438,000 Interest (from Figure 42.1) Maximum Deduction 675,000 Actual Deduction 675,000 (lesser of Adjusted Qualified Family-Owned Business Interest, or Maximum Deduction amount)
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|Title Annotation:||Part 8: Intrafamily and Other Business Transfers Techniques|
|Publication:||Tools & Techniques of Estate Planning, 14th ed.|
|Date:||Jan 1, 2006|
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