Until 1997, no special estate tax rules existed for family-owned businesses. Limited relief was available under §2010, (unified credit), the special use valuation of qualified real estate under IRC §2032A, and the deferral of estate taxes under §6166. In 1997, Congress granted further relief by enacting §2057, which provides for a “qualified family-owned business deduction” (QFOB). Requiring an election by the estate, the deduction augments benefits provided by §§ 2010, 2032A and 6166.
§2057 establishes a maximum QFOB deduction of $675,000. The statute is also closely coordinated with the unified credit (now applicable exclusion amount or AEA): The combined QFOB deduction and AEA limit is $1.3 million. Therefore, if a decedent dies in the year 2006 with a gross estate worth $2 million entirely comprised of a family-owned business, the QFOB deduction would be $675,000. However, since the maximum QFOB and AEA is $1.3 million, the AEA would be limited to $625,000 (despite an AEA of $1 million in 2006).
If a family-owned business is worth less than $675,000, then the QFOB deduction is that amount. However, a preadjusted AEA of $625,000 is adjusted upward by the difference between $675,000 and the value of the family owned business, with one proviso: The “adjusted” AEA cannot exceed the AEA as provided by §2010 for the year of the decedent’s death. To illustrate, assume the decedent dies in 2006 with a family-owned business worth $500,000. The QFOB deduction would in that case be $500,000. The difference between $675,000 and $500,000 is $175,000. The “adjusted” AEA would be $625,000 plus $175,000, which is $800,000. Since $800,000 does not exceed $1,000,000, i.e., the AEA for 2006, the full adjustment is taken. However, if the same decedent died in the year 2000, then the “adjusted” AEA, still $800,000, would exceed the AEA for the year 2000, which is $675,000. This is where the proviso applies: The “adjusted” AEA would be limited to $675,000.
To qualify under §2057, each of the following three requirements must be met: (a) the “50% Liquidity Test”; (b) the “Material Participation Test” and (c) the “Business Control Test”:
¶ First, the adjusted value of the decedent’s (a U.S. citizen or resident) QFOB interests must equal at least 50% of the decedent’s adjusted gross estate. In calculating this fraction, the numerator is determined by aggregating (i) the adjusted value of all family-owned business interests passing to qualified heirs and (ii) the total adjusted taxable gifts of QFOB interests made by the decedent to family members; and then by subtracting (i) all indebtedness of the decedent’s estate, except qualified personal residence indebtedness or indebtedness incurred for medical or educational expenses.
The denominator of the fraction is the decedent’s gross estate, decreased by (i) §2053(a)(3) claims against the estate and §2053(a)(4) indebtedness of the estate; and increased by: (i) lifetime transfers to family members of continuously held QFOB interests; (ii) transfers by the decedent to his spouse within 10 years of death; and (iii) any other transfers by decedent within 3 years of his death (except annual exclusion transfers to family members).
Maximizing the value of the fraction entails (i) increasing the size of the active QFOB; (ii) eliminating QFOB gifts to nonfamily members and to the spouse; (iii) ensuring that QFOB gifts to children are retained; (iv) eliminating taxable gifts (other than §2503(b) gifts) within 3 years of death; (v) decreasing value of gifts to the spouse within 10 years of death; (vi) decreasing the value of the estate’s non-QFOB assets, cash, marketable securities, passive assets; and (vii) reducing general indebtedness but increasing indebtedness for a qualified residence, for medical or educational expenses, or to acquire a business.
¶ Second, during 8-year period ending on the decedent’s death, there must have been periods aggregating 5 years or more during which the decedent (or family members) owned and materially participated in the QFOB. Material participation is defined by reference to §1402(a), i.e., net earnings from self-employment. Since the decedent or family member who materially participates must pay self-employment taxes, this may occasion the relinquishment of social security benefits.
§2057 imposes a recapture penalty in the form of an additional estate tax (equal to the 100% of estate tax saved) if a “recapture event” occurs within 10 years following the decedent’s death. The proscribed events include (i) lack of material participation by a family member of the decedent and (ii) disposal of the QFOB by a family member to a person other than a family member. The recapture percentage is 100% in years 1 through 6, 80% in year seven, 60% in year eight, etc. Thus, the QFOB election is only sensible where it is probable that the decedent’s family will actively manage and own the family business for at least 10 years after the decedent’s death. Note further that the qualified heir is personally liable for the payment of recapture tax unless a bond has been furnished, and §6324B imposes a special lien for estate taxes on the QFOB.
Under the regulations, material participation must occur pursuant to a formal arrangement, although it need not be memorialized. The owner or family member must regularly participate in a substantial number of management decisions and must have a financial interest in the business (whether ownership is direct or indirect through an entity). The business owner should also (i) pay self-employment taxes on income; (ii) hold an office commensurate with material involvement; (iii) be at risk with respect to the investment; and (iv) execute an agreement requiring the decedent or family member to materially participate.
[Note: In addition to the material participation requirement imposed upon family members during the decedent’s life, the qualified heir must materially participate in the family-owned business for 3 out of 8 years after the decedent’s death in order to avoid the recapture tax. However, minor heirs as well as the surviving spouse need only “actively” participate in order to satisfy the recapture tax participation requirement. This requires managerial decisionmaking, but not daily involvement in operations.]
Third, the business must be owned predominantly by three or fewer families, and must pass to members of the decedent’s family or long-term employees. §2057(e) defines the term “qualified family-owned business” as (i) an interest as a proprietor in a trade or business; or (ii) an interest in an entity carrying on a trade or business if (a) at least 50% of the business is owned by the decedent’s family; (b) at least 70% is owned by two families; or (c) at least 90% is owned by three families. The term QFOB excludes businesses (i) whose principal place of business is not in the U.S.; (ii) whose stock or debt was readily tradeable within 3 years of the decedent’s death; or (iii) more than 35% of whose AGI in the year of the decedent’s death constituted personal holding company income. (Nor does the QFOB include that portion of the trade or business attributable to cash or marketable securities in excess of the amounts reasonably required by the QFOB, or assets which produce personal holding company income.)
To maximize the likelihood of satisfying the Business Control test, the that a family business will be a QFOB, the owner should (1) avoid ownership with unrelated parties; (2) ensure that the business is active; and (3) distribute excess cash from the entity to avoid the excess cash rule.
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The QFOB deduction may have a significant impact on marital deduction planning, and on particular formulas. For example, assume the decedent dies in 2000 with an estate valued at $2 million, all of which qualifies for the QFOB. If the applicable exclusion amount of $675,000, as well as the QFOB deduction of $625,000 are both claimed, the taxable estate will be reduced to $700,000. If the Will called for the marital trust to be allocated the minimum amount necessary required to eliminate the estate tax, then the marital trust would be allocated $700,000.
If, on the other hand, the Will called for the credit shelter trust to be funded with the largest pecuniary amount necessary which would result in no federal estate tax, then only $675,000 might be required to fund the credit shelter trust, leaving $1,325,000 to fund the marital deduction trust, a result which might not be intended or desirable. Therefore, if the QFOB deduction is likely to be elected by the Executor, all estate planning documents, especially trust provisions in the Will, must be reviewed and revised. [§2057 property will be subject to the GST, and allocation of GST exemption to QFOB property is necessary.]
After death, QFOB interests receive a basis step-up to FMV, despite the fact that QFOB property is excluded from the gross estate. Another odd twist in post-mortem planning: In order to pass the 50% liquidity test, the estate may claim less of a valuation discount for the QFOB than does the IRS.