Special Exemption for Family-Owned Businesses

A special provision benefiting qualified family-owned business interests (QFOBIs) has been eliminated beginning 2004. Because of the timeframe, however, you may need to know how the provision affects your total exemption from estate tax through the end of 2003.

Taking the qualified family-owned business (QFOB) deduction allows a total effective estate tax exemption of $1.3 million. For 2001, that meant that up to $675,000 of the adjusted value of QFOBIs could be deducted from the value of the estate. From the $675,000 maximum, you would subtract some of the amount that is effectively exempt from estate tax under the general provisions of the law. More specifically, you must subtract the portion of the general exemption amount that exceeds $625,000.

The general exemption amount rose to $1 million in 2002 and 2003. So, the "extra" exemption benefit for a small business shrank from $625,000 in 2001 to $300,000 in 2002-2003.

The QFOB deduction was criticized as being overly complicated and not very helpful to the estates of small family business owners. This would account for its demise starting in 2004.

The elimination of the QFOB deduction, however, is more than made up by the increased estate tax exclusion amounts. These amounts rise to $1.5 million in 2004-2005, $2 million in 2006-2008, and $3.5 million in 2009.

For those that may still qualify for the family business exemption, your business and your heirs must meet the following criteria:

• The business interest must comprise more than 50 percent of your estate, which may mean that you need to give away some non-business assets before you die.
• The principal place of business must be in the United States.
• The business must be owned at least 50 percent by one family, 70 percent by two families, or 90 percent by three families. Members of "one family" include your spouse; your ancestors; descendants of yourself, spouse, or ancestors; and the spouses of such descendants.
• The business's stock or securities must not have been publicly traded at any time within three years of your death.
• There are restrictions on the amount of passive assets, excess cash, marketable securities, or holding company income the business may have.
• The value of the business that passes to qualified heirs must exceed 50 percent of the estate's value. "Qualified heirs" include people who have been employed by the business for at least 10 years, and members of your family. Certain lifetime gifts to qualified heirs are also counted in this computation.
• You must have owned and materially participated in the business for at least five of the eight years preceding your death.
• Each qualified heir, or a member of the heir's family, must materially participate in the trade or business for five out of any eight years in the 10 year period following your death. Exactly what "material participation" means can vary depending on the industry, but physical work and participation in management decisions are the main factors to be considered.
• If any qualified heir disposes of his business interest within 10 years of your death, other than by a disposition to a member of his family or a conservation contribution, a portion of the estate tax reduction may be "recaptured;" that is, it may have to be repaid to the IRS.

Example You leave your business to your two children. Your daughter materially participates in the business, but your son does not. Both heirs meet the material participation rule, since your daughter is a member of the son's family. However, if the daughter stopped participating in the business within 10 years of your death, neither heir would meet the rule.

These are the major requirements you need to meet, but the law has a number of complicated twists and turns. If you want to take full advantage of this law, you'll definitely need to consult an estate planning professional.