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By Marc A. Aaronson, CPA, JD, LL.M., Richard A. Eisner & Co., LLP

The Taxpayer Relief Act of 1997 (TRA '97) adds a new estate tax exclusion for interests in qualified family-owned businesses, effective for decedents dying after December 31, 1997. However, since the exclusion is limited to $1,300,000 reduced by the unified credit exemption equivalent, the exclusion may be of limited value in substantial estates. This is due to the fact that the maximum exclusion will be decreasing from $675,000 ($1,300,000­$625,000) in 1998 to $300,000 ($1,300,000­$1,000,000) in 2006 while the unified credit exemption equivalent is increasing from $625,000 to $1,000,000 during the same period.

Although the new exclusion applies to any interest in a trade or business (regardless of the form in which it is held), all of the following requirements must be met in order to qualify:

1) The decedent was a U.S. citizen or resident at the date of death.

2) The principal place of the business is located in the United States.

3) If not carried on as a proprietorship, at least--a) 50% of the business is owned by the decedent and members of the decedent's family; or b) 30% of the business is owned by the decedent and members of the decedent's family and at least i) 70% is owned by two families; or ii) 90% is owned by three families. In applying the ownership tests in the case of a corporation, the decedent and the decedent's family members must own the applicable minimum percentages of total combined voting power of all classes of stock entitled to vote and the total value of all classes of stock of the corporation. For a partnership, the tests are applied by using the appropriate percentage of the capital interest (and the profits interest, according to the Senate Committee reports) in the partnership.

4) None of the stock or securities of the business (or a controlled group of which such business was a member) was publicly traded at any time within three years of the decedent's death.

5) The business interests subject to the exclusion were owned by the decedent or a member of the decedent's family for at least five years during the eight-year period prior to the decedent's death and the decedent or a family member materially participated in business operations during such period(s); "material participation" is defined by reference to IRC section 2032A (special use valuation of closely held farm/business real property); Treasury Regulations under that section state that, while no one factor is determinative, physical work and participation in management decisions are the principal factors to be considered.

6) The executor makes an election on the estate tax return and all individuals whose interests in the business qualify for the exclusion sign an agreement consenting to the assessment of an additional estate tax upon the occurrence of a "recapture event" (see below).

7) Except for banks and domestic building and loan associations, no more than 35% of the adjusted ordinary gross income of the business for the year of the decedent's death was personal holding company income (generally defined as dividends, interest, royalties, annuities, and rents).

8) The total value of the qualified family-owned business interests passing from the decedent to qualified heirs (individuals who have been actively employed in the business for at least 10 years prior to the decedent's death and members of the decedent's family) is more than 50% of the decedent's adjusted gross estate ("50% test").

For purposes of the 50% test,
the numerator is computed as follows:

1) The value of the family-owned business which passes from the decedent to qualified heirs and which would otherwise be included in the gross estate; plus

2) Gifts of such interests made by the decedent to the decedent's family other than the decedent's spouse (whether taxable or nontaxable due to the use of the annual gift tax exclusion), but only to the extent they have been continuously owned by the decedent's family and not otherwise included in the gross estate, and reduced by--

3) all indebtedness of the estate, except for a) indebtedness on a qualified residence of the decedent for which mortgage interest is deductible for income tax purposes, b) indebtedness incurred to pay educational or medical expenses of the decedent, and c) other indebtedness up to $10,000.

The denominator (adjusted gross estate) is the decedent's gross estate, reduced by all indebtedness of the estate, and increased by the following transfers to the extent they are not already included in the gross estate:

1) All gifts of such interests made by the decedent to family members (other than the decedent's spouse), provided such interests have been continuously held by the family members;

2) Any other transfers by the decedent to the spouse made within 10 years of the decedent's death; and

3) Any other transfers made by the
decedent within three years of death, except nontaxable transfers made to
family members.

The Treasury is authorized to issue regulations providing that de minimis gifts to nonfamily members may be disregarded. The gift-splitting election will be applicable for this purpose as well.

The definition of the members of an individual's family is the same as for IRC section 2032A and includes the following:

1) The individual's spouse;

2) The individual's ancestors;

3) The lineal descendants of the individual, the individual's spouse, or the individual's parents; and

4) The spouses of any such lineal descendants.

Special look-through rules apply in the case of tiered entities. Each trade or business owned (directly or indirectly) by the decedent and members of the decedent's family is tested separately in determining whether that trade or business meets the requirements of a qualified family-owned business interest. In applying these tests, any interest that a trade or business owns in another trade or business is disregarded in determining whether the first trade or business is a qualified family-owned business interest. Any interest held by an entity is treated as held proportionately by or for the entity's shareholders, partners, or beneficiaries.

The value of the family-owned business interest otherwise qualifying for the exclusion is reduced by the portion attributable to the following assets:

1) Cash and marketable securities in excess of the reasonable expected daily working capital needs of the business; and

2) Other passive assets that--

a) produce certain passive income such as dividends, interest, royalties, annuities, and rents [as defined in IRC section 543(a)];

b) are an interest in a trust, partnership, or REMIC and produce no income [as defined in IRC section 954(c)(1)(B)];

c) generate income from commodities transactions or foreign currency gains [as defined in IRC section 954(c)(1)(C) and (D)];

d) produce income equivalent to interest [as defined in IRC section 954(c)(1)(E)]; or

e) produce income from notional principal contracts or payments in lieu of dividends [as defined in IRC sections 954(c)(1)(F) and (G)].

The reduction in estate taxes attributable to the exclusion is subject to recapture if any of the following events occurs during the 10-year period after the decedent's death and before the qualified heir's death:

1) A qualified heir (or a member of the qualified heir's family) does not materially participate in the business for at least five years during any eight-year period;

2) A qualified heir disposes of any portion of the qualified business interest (other than by disposition to a family member or through a qualified conservation contribution);

3) A qualified heir loses U.S. citizenship or ceases to be a U.S. resident and does not a) put the business interest into a trust which is subject to U.S. or state law and requires at least one U.S. trustee pursuant to the governing instrument (i.e., a qualified domestic trust), or b) make some other security arrangement such as furnishing a bond; or

4) The principal place of the business ceases to be located in the United States.

The percent of the amount of the estate tax recapture depends on the year the disqualifying event occurs, as follows:

Year After Recapture

Decedent's Death Percentage

1 through 6 100%

7 80

8 60

9 40

10 20

There is no recapture if the disqualifying event occurs more than 10 years after the decedent's death. Qualified heirs are liable for the portion of the recapture tax attributable to their interests in the qualified family-owned business and the recaptured amount is subject to interest at the underpayment rate.

Since many of the requirements to qualify for the family-owned business exclusion are similar to those for special use valuation of closely held farm/business real property [IRC section 2032A], it may not be too difficult to arrange for an estate to qualify for both estate tax benefits. The exclusion of even only $300,000 (effective in 2006), together with the reduction for up to $750,000 in value of a closely held farm/business real property and the installment payment of estate taxes attributable to a closely held business [IRC section 6166] can result in considerable estate tax savings. *

Eric M. Kramer, JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.

Laurence I. Foster, CPA/PFS
KPMG Peat Marwick LLP

Contributing Editors:
Richard H. Sonet, JD, CPA
Marks Shron & Company LLP

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

James B. McEvoy, CPA
The Chase Manhatten Bank

Nathan H. Szerlip, CPA
Edward Isaacs & Company LLP

Lenore J. Jones, CPA
Jacobs Evall & Blumenfeld LLP

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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