The impact of the family-owned business exclusion under the Taxpayer Relief Act of 1997.

Small Business Tax Solutions

Steven J. Crowell , CPA, JD, PhD, is a tax attorney with Blanco, Tackabery, Combs and Matamoros in Winston-Salem, North Carolina.

Q. What impact does the family-owned business exclusion—signed into law by President Clinton on August 5, 1997, as part of the Taxpayer Relief Act of 1997—have on succession planning for family businesses?

A. Family business start-ups began to surge following the end of World War II. Now, 50 years later, as the founders either retire or die, these businesses are being passed on to the next generation. This has created a crisis for businesses that had long been stable and has put Congress under pressure to ease the potentially devastating impact of estate taxes on the survival of these businesses. Congress provided family businesses with partial estate tax relief in TRA 1997 by enacting Internal Revenue Code section 2033A—the family-owned business exclusion.

Overview of the Provisions

The new exclusion may reduce the gross estate of business owners by the lesser of (1) the adjusted value of the decedent’s qualifying family-owned business interests otherwise includable in the estate or (2) the difference between $1.3 million and the applicable exclusion amount of the unified credit for the estate. For example, if the founder of company X dies in 1998 when the unified credit exempts $625,000 from tax and the adjusted value of her business interest is $1 million, the exclusion amount would be $675,000 ($1,300,000 — $625,000). If the adjusted value of her business interest is $500,000, the exclusion would be limited to $500,000.

It is important for practitioners to note that the family-owned business exclusion applies in addition to the IRC section 2032A special use valuation and section 6166 installment payment provision.

Qualifying business interests. A family-owned business interest qualifies for relief if it is a trade or business interest in either a proprietorship or an entity of which 50% is owned by the decedent and members of his or her family, 70% is owned by members of two families or 90% is owned by members of three families. For an interest to qualify under the 70% or 90% tests, at least 30% of the entity must be owned by the decedent and members of his or her family.

In the case of a corporation, the ownership test is based on the decedent’s family owning a requisite percentage of the total combined voting power of all classes of stock entitled to vote and the total value of all shares of all classes of stock. In the case of a partnership, the ownership test is based on the decedent’s family owning a requisite percentage of both the capital interests and the profit interests in the partnership.

Nonqualifying business interests. In addition to defining the business interests that qualify as family-owned business interests, the new code section defines business interests that specifically do not qualify, including

• Any interest in a trade or business with its principal place of business outside the United States.
• Any interest in an entity if its stock or securities were publicly traded at any time within three years of the decedent’s death.
• Any interest in a business other than a bank or domestic building and loan association if more than 35% of its gross income in the year of the decedent’s death would qualify as personal holding company income (dividends, interest, royalties and other investment-type income pursuant to IRC section 543(a)).
• The portion of an interest in a business that is attributable to cash or marketable securities in excess of the reasonably expected day-to-day working capital needs of the business.
• The portion of an interest in a business attributable to any other assets of the business that produce various types of passive income (dividends, interest, royalties and certain other types of passive income).

Qualifying estates. Since the purpose of the new exclusion is to prevent a forced sale or liquidation to pay estate taxes, the estate must meet two additional requirements:

1. A 50% liquidity test. The family-owned business interests transferred by the decedent must exceed 50% of the value of the estate.
2. A five-of-eight-year participation test. The decedent or a member of his or her family must have owned and materially participated in the business for at least five of the eight years preceding the date of the decedent’s death.

In addition to these two tests, an estate qualifies for the exclusion only if the decedent was a U.S. citizen or resident at the date of his or her death. The executor must elect the exclusion and must file an agreement in which each person with an interest in the business consents to the recapture rules described below.

Recapture rules. The estate tax benefits of the exclusion are subject to recapture, in the form of additional estate tax, if one of the following events occurs within 10 years after the decedent’s death and before the death of the qualified heir:

• The family members cease their material participation in the business for five years of any eight-year period.
• The qualified heir disposes of any portion of the qualified business interest other than by a disposition to a member of the qualified heir’s family or through a qualified conservation contribution.
• The qualified heir loses U.S. citizenship and does not comply with the security requirements that would avoid recapture.
• The principal place of business ceases to be located in the United States.

The amount of additional estate tax triggered by a recapture event is the applicable percentage of the adjusted tax difference attributable to the qualified family-owned business interest, plus interest on such amount at the IRC section 6621 underpayment rate. The applicable percentage of recapture tax is 100% for recapture events occurring in the first 6 years of material participation, 80% in year 7, 60% in year 8, 40% in year 9 and 20% in year 10.

A Small Step

Although certainly not a step toward simplification, section 2033A is a small step toward shielding the family farm or family business that will be continued by the next generation from the devastating impact of estate taxes. Along with certain technical amendments to section 2032A and section 6166, section 2033A is a welcome provision that should be widely used by family businesses until the increasing unified credit effectively eliminates the exclusion’s usefulness and until broader relief is available.

©1998 AICPA