If you are the owner of a family-run business, your heirs may be able to benefit from a special new estate tax break. However, be forewarned: these rules are complex with a capital "C."
Background: The new tax break for qualified family-owned businesses (QFOBs), which was first included in the Taxpayer Relief Act of 1997, has been revised by the IRS Restructuring and Reform Act of 1998. This provision is intended to avoid "fire sales" of business interests when a family is facing a huge estate tax bill.
Theoretically, the law change enables a married couple to pass up to $2.6 million from one generation to the next without incurring any federal estate tax. However, there's often a long way between theory and reality.
How it works: The tax break for QFOBs is used in conjunction with the federal estate tax exemption. This exemption (which could shelter up to $600,000 for decedents dying before 1998) is being gradually increased until the shelter amount reaches $1 million for 2006 and thereafter.
The new rules permit a maximum QFOB deduction of $675,000. If the maximum deduction is claimed, the otherwise available estate tax exemption is limited to $625,000 (no matter when the business owner dies). If the deduction for the business interest is less than $675,000, the exemption increases by the excess of $675,000 over the amount of the deduction.
Caveat: the estate tax exemption can never be more than what would be allowed if no deduction were claimed.
Net effect: A maximum of $1.3 million of family-owned business assets can be protected from estate tax.
Example (1): Tom dies in 1999, leaving a $1.4 million estate, composed of qualified family-business interests. The federal estate tax exemption for 1999 is $650,000.
Tom's estate is entitled to a deduction of $675,000 for the business interest, but can only claim an exemption of $625,000. Of the $1.4 million estate, $1.3 million is sheltered from federal estate tax.
Example (2): Mary dies in 2000 when the federal estate tax exemption is $675,000. Her estate is valued at $1.3 million, including a QFOB worth $500,000. The estate can claim a $500,000 deduction and an exemption of $675,000, which shelters a total of $1.175 million from estate tax.
However, Mary's estate is not entitled to an $800,000 exemption--$625,000 + ($675,000 - $500,000)--because the exemption cannot be more than the amount ($675,000) that would be allowed if no deduction were claimed.
The requirements for QFOBs are also complex. Here is a partial checklist:
- The principal place of business must be in the United States.
- 50% or more of the business must be owned by one family, 70% or more by two families, or 90% or more by three families. In all instances, the deceased owner and his or her family must own at least 30% of the business interest.
- The business must have been privately held (not traded on an established market) for at least three years prior to the owner's death.
- No more than 35% of the firm's income for the year of the owner's death can be "personal holding company income" (generally, interest and dividends). Note: there is an exception for banks and special rules for rental income.
- The deceased owner must have been a U.S. citizen or resident alien.
- The business interest must pass to "qualified heirs." A qualified heir is a family member or a person actively employed by the business for at least ten years preceding the owner's death.
- The "adjusted value" of the business interests must be more than 50% of the decedent's adjusted gross estate.
Last, but not least, there is the--
10-year rule: Each qualified heir or a member of the heir's family must materially participate in the business for five years out of any eight-year period during the ten years following the deceased owner's death. Otherwise, the proportionate estate tax that would have been due in the absence of the deduction is recaptured--with interest from the due date of the deceased owner's estate tax return.
Professional assistance is a must in this complex area.