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What Is The Qualified Family-Owned Business Deduction?

Caution: The QFOB deduction is repealed for the estates of persons dying in 2004 and thereafter. However, the recapture rules will still apply until the 10-year recapture period expires.

A Federal Gift and Estate Tax Deduction

When you die, your estate may be subject to federal gift and estate tax. If you own a family business or farm, and your estate qualifies, the qualified family-owned business (QFOB) deduction allows your personal representative to deduct a portion of the value of the business from your gross taxable estate. This results in reducing your net taxable estate and may result in reducing any taxes that are owed. The IRS allows the QFOB deduction because it wants to encourage your heirs to continue the family business and not have to sell it just to pay the taxes.

Caution: Unlike some of the other federal gift and estate tax deductions, the QFOB deduction is not available for federal generation-skipping transfer tax (GSTT) purposes.

New, Complex, And Subject To Limitations and Requirements

The QFOB deduction is extremely complex and full of limitations and requirements. For instance, your ownership interest in the business must be large enough, and it must comprise a large-enough percentage of your whole estate, to qualify. Due to such complex limitations and requirements, it is likely that the deduction will be difficult to plan for, and unlikely that it will help save taxes if you are wealthy.

Technical Note: The statute enacted in 1997 dealing with the QFOB deduction was originally numbered Section 2033A and was treated as an exclusion. The Internal Revenue Service Restructuring and Reform Act of 1998 renumbered the statute to Section 2057 and changed the exclusion to a deduction.

May Be Taken In Addition to Special Use Valuation

The QFOB deduction is patterned after special use valuation, which is another IRS provision that is meant to help keep the family business or farm in the family. If your estate qualifies, special use valuation values real property (i.e., real estate) used for farming or in a closely held business based upon its actual use, rather than its highest and best use. In contrast, the QFOB deduction includes all business or farm property, rather than merely realty. The QFOB deduction election may be taken in addition to the special use valuation election.

May Be Taken In Addition to Section 6166

Section 6166 allows federal gift and estate taxes and/or the federal GSTT due on a qualifying closely held business owner's estate to be deferred for 5 years and then paid in annual installments over a period of up to 10 years. This allows more time to raise sufficient funds or obtain more favorable interest rates. The QFOB deduction election may be taken in addition to the Section 6166 election.

Interacts With the Applicable Exclusion Amount

The combined total of the QFOB deduction and the applicable exclusion amount may not exceed $1.3 million. See below for more information.

Elected Post-Mortem

The QFOB deduction is a powerful post-mortem estate planning tool that your personal representative may use if your estate qualifies and if a proper election is made. Election procedures are fairly simple, but they must be strictly followed.

It is uncertain at this time whether it is possible to make partial elections, although there are circumstances when this may be desirable. Of course, whether your personal representative can make the election and whether he or she should make the election are two different questions.

Subject To the Recapture Rule

The QFOB deduction can be lost under certain conditions. Under the recapture rule, the IRS will impose an additional tax in the event the family-owned business property is disposed of or ceases to be used for the originally qualifying use within 10 years after your death.

What Is The Deductible Amount?

The maximum deductible amount is the lesser of: (1) the adjusted value of your ownership interest in the family-owned business, or (2) the maximum deduction.

The Adjusted Value of Your Interest

The adjusted value of your interest in the family-owned business is its fair market value (FMV) on the date of your death or on the alternate valuation date, whichever applies, reduced by most debts of your estate. These debts include all estate debts, even those that are not specifically related to the business interest. The only debts that are not included are:

  • Home mortgage debt
  • Debt incurred to pay educational or medical expenses for you (the decedent) or for your spouse or dependents
  • Debts that do not exceed $10,000

Example(s): John owns an interest in a family-owned business that qualifies for the QFOB deduction in every way. John's interest is valued at $750,000. John's estate has debts, other than those in the categories listed, which total $300,000. The adjusted value of John's interest is $450,000 ($750,000 - $300,000). Under the QFOB deduction, $450,000 may be deducted from John's gross estate.

The Maximum Deduction

The maximum QFOB deduction is $675,000. If the maximum deduction of $675,000 is used in calculating the taxable estate, the applicable exclusion amount that your estate can claim is limited to $625,000. This is because the combined total of the QFOB deduction and the applicable exclusion amount cannot exceed $1.3 million. If the amount of the QFOB deduction is less than $675,000, the amount of the applicable exclusion amount that your estate can claim increases (but not more than the maximum applicable exclusion amount for the year).

Example(s): You die in 2003, when the applicable exclusion amount is $1 million. If your business is valued at $2 million and otherwise qualifies, your estate can take a QFOB deduction of $675,000, and an applicable exclusion amount of $625,000. If your qualified family-owned business interest is valued at $300,000, you can take a QFOB deduction of $300,000 and the entire applicable exclusion amount of $1 million. If your business is valued at $200,000, you can take a QFOB deduction of $200,000 and the entire applicable exclusion amount of $1 million.

What Qualifies As A Family-Owned Business Interest For QFOB Deduction Purposes?

Ownership Requirements Must Be Met

For the purposes of the QFOB deduction, a qualified family-owned business interest is any interest in a trade or business or farm, regardless of form, the ownership of which is held: (1) at least 50 percent by one family, or (2) 70 percent by two families, or (3) 90 percent by three families. If held by more than one family, your family must own at least 30 percent of the business.

Example(s): The Smith family owns an interest in Sam's Restaurant. The ownership requirements are satisfied in all of the following examples:

1.

Family

Percentage of Ownership

Smith family

50%

misc. stockholders

50%

Example(s): The business is owned at least 50 percent by the Smith family.

2.

Family

Percentage of Ownership

Smith family

30%

Jones family

40%

misc. stockholders

30%

Example(s): The business is owned by more than one family, the Smith family owns at least 30 percent, and two families (Smith and Jones) own at least 70 percent.

3.

Family

Percentage of Ownership

Smith family

30%

Jones family

30%

Adams family

30%

misc. stockholders

10%

Example(s): The business is owned by more than one family, the Smith family owns at least 30 percent, and three families (Smith, Jones, and Adams) own 90 percent.

Example(s): However, the ownership requirements are not satisfied in the following examples:

1.

Family

Percentage of Ownership

Smith family

49%

misc. stockholders

51%

Example(s): One family does not own at least 50 percent of the business.

2.

Family

Percentage of Ownership

Smith family

25%

Jones family

25%

misc. stockholders

50%

Example(s): More than one family owns the business and the Smith family owns less than 30 percent.

3.

Family

Percentage of Ownership

Smith family

30%

Jones family

30%

Adams family

25%

misc. stockholders

15%

Example(s): More than one family owns the business. The Smith family owns at least 30 percent, but three families own less than 90 percent.

Technical Note: The term members of your family, for QFOB deduction purposes, means only your spouse, your ancestors, your lineal descendants, your spouse's lineal descendants, your parents' lineal descendants, and the spouses of any such lineal descendants.

Interests In Corporate or Partnership Form

If your family-owned business is a corporation, the ownership requirement is met if you and your family members own the required percentage of both the total combined voting power of all classes of voting stock and the total value of all shares of all classes of stock. To put it another way, the percentage test, as explained, must be met both in terms of percentage of voting power and in terms of percentage of value of stock. For partnerships, the partner must own the relevant percentage of the capital interest in the partnership.

Businesses That Own Other Businesses

Special look-through rules will apply in the case of a business that owns an interest in another business. Each business will be looked at separately by the IRS to determine whether each meets the ownership requirements as stated.

Request Guide TRG

What Doesn't Qualify As A Family-Owned Business Interest for QFOB Deduction Purposes?

Publicly Traded Corporate Stock

Your business will not qualify for the QFOB deduction if it is a corporation, and corporate stock was publicly traded at any time within three years of your death.

Personal Holding Company Income

Your business will not qualify for the QFOB deduction if more than 35 percent of the adjusted ordinary gross income (AOGI) from the business for the year in which you die was personal holding company income. This restriction does not apply to banks or domestic building and loan associations.

Tip: AOGI equals a corporation's gross income minus certain gains, expenses, and foreign and interest income. See Internal Revenue Code Section 543(b) for more details.

Does Your Estate Qualify For The QFOB Deduction?

To qualify for the QFOB deduction, all of the following requirements must be satisfied:

  • Your date of death must be after December 31, 1997 and before January 1, 2004
  • You must be a U.S. citizen or resident at the time of your death
  • The business interest must be included in your estate for estate tax purposes
  • The principal place of the family-owned business must be located in the United States
  • Your executor makes the proper election and files an agreement signed by persons with an interest in the business consenting to application of the recapture rule

You Must Give the Business to a Qualified Heir

The business interest must be passed to a qualified heir. A qualified heir is a member of your family, or any individual who was actively employed by the business for at least 10 years prior to the date of your death. A member of your family includes your spouse, your ancestors, your lineal descendants, your spouse's lineal descendants, your parents' lineal descendants, and the spouses of any such lineal descendants. Business interests may pass into a trust and still qualify if all the beneficiaries of the trust are qualified heirs.

Caution: However, be aware that transfers to your spouse will not qualify for the deduction unless made more than 10 years before your death, and other transfers (except certain nontaxable transfers to your family members) will not qualify unless made more than 3 years before your death.

You, or a Member of Your Family, Must Have Materially Participated In the Business

You, or a member of your family, must have materially participated in the business for at least five out of the eight years preceding your death. Overlaps are not counted (e.g., if you and your spouse materially participate in the business during 1999, only one year is counted, not two). Brief interruptions (30 days) may be disregarded as long as the interruption is preceded by and followed by substantial periods (more than 120 days) of material participation.

Technical Note: "Material participation" is a legal term. Physical work and participation in management decisions are the principal factors considered in determining whether the material participation requirement is satisfied. At a minimum, actual employment must be substantially full time (35 hours a week), and those participating in management (day to day) decisions must participate in making a substantial number, if not all of these decisions.

Your Estate Must Pass A 50 Percent (Liquidity) Test

Simply stated, your family-owned business interest must comprise more than half of your total estate (this is known as the liquidity test). More specifically, the value of your family-owned business less certain debts and unpaid mortgages (the adjusted value of the qualified family-owned business) must exceed 50 percent of your gross taxable estate less debts and unpaid mortgages (the adjusted gross estate). Or, to put it algebraically:

Adjusted Value of Family-Owned Business Interest divided by The Adjusted Gross Estate The numerator is the adjusted value of the qualified family-owned business, which equals the value of the business reduced by: (1) unpaid mortgages on the business property, and (2) claims against the estate, except for: (a) home mortgage debt, (b) debts that do not exceed $10,000, and (3) debts incurred to pay educational or medical expenses, and increased by the amount of gifts of family-owned business interests made during your life. The denominator is the adjusted gross estate, which equals the value of the gross estate reduced by unpaid mortgages and indebtedness, and increased by: (1) the family-owned business interests you have already given as gifts during your life, (2) gifts you made to your spouse during the 10 years preceding your death, and (3) gifts you made to others during the 3 years preceding your death (except gifts to family members that were excluded by the annual gift tax exclusion).

Passive assets are not counted — in determining the 50 percent test, passive assets are not counted in valuing the family-owned business. Passive assets are those that are not actually used in the operations of the business. Passive assets generally include:

  1. Cash and marketable securities that are in excess of day-to-day capital needs
  2. Assets that produce dividends, interest, rents, royalties, annuities, and other types of passive income
  3. Assets that produce no income
  4. Interests in trusts or partnerships
  5. Real estate, except certain rental real estate
  6. Insurance on the life of the sole proprietor
  7. Rental business, unless the business involves more than the mere management of investments
  8. Generally, stock in another company

What Is The Recapture Rule?

The recapture rule is a law that requires the IRS to impose an additional tax in the event that: (1) your personal representative elects the QFOB deduction, and (2) the qualified property is disposed of, or ceases to be used in the qualifying way within the 10-year period that follows your death (the recapture period). The IRS may take back, or recapture, a portion or all of the tax savings enjoyed by your estate because of the election if the qualified heir disposes of the property, or ceases to use it for the qualified use, before the expiration of the recapture period.

Remember that the IRS allows this deduction so that the business can remain in the family. If the business leaves the family, the intent of the deduction is not fulfilled and the deduction is disallowed. Like-kind exchanges and involuntary conversions will not trigger the recapture rule to the extent that the property received would qualify for the QFOB deduction. In these cases, property received in exchange will be treated as the qualified family-owned business interest for the determination of subsequent recapture events.

Caution: The recapture rule still applies, even though the QFOB deduction is repealed, until the recapture period expires.

What Is A Qualified Use?

Qualified use means that for at least five years of any eight-year period within the recapture period, the qualified heir: (1) continuously uses the qualified property for family-owned business purposes, and (2) the qualified heir, or a family member, "actively manages" its operation. A qualified heir is regarded as using the qualified real property for its qualified use only if the qualified heir has an equity interest or a financial stake in the property. The financial stake requirement is satisfied if the property is leased to a family member on a net cash lease basis, or, in the case of a farm, is rented out to someone under a crop share lease.

Technical Note: "Active management" is a legal term. Active management is a slightly lower standard than material participation, which is required of you, or a family member, to qualify your estate for the QFOB deduction. An active management standard requires less involvement in the business operations. The active management requirement will be satisfied if the qualified heir rents the qualified property to a member of his or her family on a net cash basis, and that family member actively manages the business.

Tip: The qualified heir is given a two-year grace period to commence the qualified use of the qualified real property. The recapture period is extended by the amount of grace period used.

How Does Qualified Property Cease to Be Used For a Qualified Use?

The property may cease to be used for a qualified use if:

  • It is no longer used for family-owned business purposes
  • The qualified heir ceases to meet the active management requirements
  • The principal place of business ceases to be located in the United States
  • The qualified heir loses U.S. citizenship

Tip: If the qualified heir loses U.S. citizenship, the additional tax may be avoided by transferring the business assets into a qualified domestic trust (QDOT).

What Is Subject to Recapture?

The amount subject to recapture is based upon when the recapture event occurs in relation to your death. If the recapture event occurs within the first six years of material participation, 100 percent of the reduction in estate taxes attributable to the qualified heir's interest is recaptured. Thereafter, the applicable percentage is 80 percent in the seventh year, 60 percent in the eighth year, 40 percent in the ninth year, and 20 percent in the tenth year.

Caution: The additional estate taxes are due six months after the date on which the triggering event occurs. Interest will be imposed on the additional taxes. Interest will accrue from the due date of the original tax liability (i.e., nine months after your death). Interest will be imposed at the federal short-term rate, plus 3 percent, compounded daily.

A special lien attaches to the family-owned business if your executor elects the QFOB deduction. The amount of the lien equals the estate tax savings enjoyed because of the election. The lien is discharged when: (1) the liability for additional tax has been satisfied, (2) the liability has become unenforceable due to the lapse of time, (3) it is established that no further liability will arise, or (4) your heirs provide a bond or other security in place of the lien.

Who Is Liable For The Additional Tax?

Your qualified heir is personally liable for any additional taxes imposed on the portion of the business interest he or she received. However, if the qualified heir wishes to be released from personal liability, the qualified heir can write to the IRS requesting the maximum amount for which he or she would be responsible in the event of recapture. The IRS will respond within one year. If the qualified heir posts a bond in that maximum amount, the IRS will acknowledge the discharge from personal liability.

How Does Your Personal Representative Make The Election?

Complete Federal Form 706 and Schedule T

  • Check the appropriate box on the estate tax return (Federal Form 706). The election for the QFOB deduction is made by checking the appropriate box on the estate tax return (Form 706). Once made, the election is irrevocable.
  • Complete Schedule T and attachments. Your personal representative must also complete Schedule T and required statements. Schedule T and attachments must be filed with Form 706 for the election to be valid.

Attach a Signed Recapture Agreement

Because the tax saved by using the QFOB deduction is subject to recapture under certain conditions, a recapture agreement must be attached to the estate tax return (Form 706). The recapture agreement must: (1) list the names of each qualified heir, his or her address, identification number, relationship to you (the decedent), and the value of the family-owned business before the election and after the election, and (2) be signed by each heir who receives an interest in the property.

Tip: You may be able to satisfy this requirement by completing Schedule A-1. However, if there is not enough room for all the information, a separate agreement must be attached.

Timely File the Estate Tax Return

Your estate tax return (Form 706) and attachments must be filed in a timely manner (i.e., nine months after your death unless an extension has been granted). An untimely filing may result in the IRS rejecting the election.

Can Your Personal Representative Make A Partial Election?

Uncertain

It is uncertain whether the IRS will allow partial elections. However, your personal representative may be tempted to consider a partial election in the following circumstances:

When the Business Far Surpasses The 50 Percent Test

If the value of the business far surpasses the 50 percent test, your personal representative may want to:

  • Treat only enough business assets as the business interest to satisfy the test and take the deduction. This way, your heirs may dispose of the other business assets without triggering the recapture rule.
  • Treat only certain shares of stock as the business interest to satisfy the test and take the deduction. This way, you can pass those shares to qualified heirs who intend to keep the business and the rest to other heirs who do not intend to keep them during the entire recapture period.

When You Have Interests in Multiple Businesses

You may own interests in more than one qualifying business entity. The value of one or some of those interests alone may be sufficient to pass the test. In this case, your personal representative may want to elect the deduction for those entities only, leaving the other entities available for disposition within the recapture period.

Should Your Personal Representative Make The Election?

After your personal representative has determined that an election can be made, he or she must then decide whether the election should be made. Because of the recapture rule, the QFOB deduction should be elected only if your heirs intend to continue the family-owned business. If your heirs intend to sell the business or otherwise dispose of it before the 10-year recapture period has expired, the tax savings will be lost and interest charges will have to be paid.

What Basis Does a Qualified Family-Owned Business Interest Receive?

The qualified family-owned business interest receives a step-up in basis. That is, it is the FMV of the interest on the date of your death or alternate valuation date, whichever applies.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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