The Taxpayer Relief Act of 1997 represents Congress’s first tentative step toward accomplishing true estate tax reform. The Act will provide relief for some family businesses, potentially saving a married couple’s heirs up to $761,000 in estate taxes. But the complex requirements for the exclusion will prevent many businesses from qualifying. While many Congressional Republicans favored estate tax reform and even outright repeal in the debate over the budget bill, most Democrats were opposed to significant reductions. The resulting legislation is a clear example of the compromise spirit in the Congress, since neither side completely attained its goals.
There was only one surprise in the legislation—one that could, however, significantly reduce income taxes on the assets in an estate. The new law apparently allows heirs to use full fair-market value as the basis for payment of income taxes on the business interest included in an estate, even if they exclude part of the value of a family business for estate tax purposes. This is in contrast to the income tax treatment of real estate used in a family business, for heirs cannot claim full fair-market value as the basis for income tax if they have taken advantage of a “special-use” exclusion to reduce estate tax. It is not clear whether the omission of such a provision in the new tax law was intentional. But so far Congress has made no change that would reduce basis by the amount of the excluded value.
By the year 2006, when all the provisions of the new law are fully phased in, the net benefit of the family business exclusion will be relatively small—$330,000 for couples in the highest estate tax bracket. However, the increase in the unified gift and estate tax credit, available to everyone, will by that time add savings of $306,000.
Higher unified credit
The first tax change affecting estate planning is an increase in the exemption which is sometimes called a “unified credit equivalent.” Since 1986, individuals have been able to transfer up to $600,000 each to their heirs without having to pay tax. The exemption is provided as a credit against the tax. The credit, which applies to both lifetime gifts and transfers at death, reduces taxes at the lowest rates, leaving assets in excess of the exemption to be taxed at the higher rates applicable to the estate or to gifts. With a $600,000 exemption, the taxes are paid at rates from 37 percent on estates with assets just above $600,000 to 55 percent on estates of $3 million or more.
The Act increases the $600,000 unified credit equivalent gradually each year; by 2006 it will be $1 million per individual for people who die after 1997. Thus, if you are married, you and your spouse together will eventually be able to transfer $2 million free of estate and gift tax. As the first table below shows, most of the increase occurs in the last three years of this phase-in period. When fully phased in, the exemption will save your heirs $153,000 in federal estate and gift taxes. As before, the exemption will save taxes at the lowest rate, subjecting additional assets to rates of 41 to 55 percent.
The amount of assets exempt from estate taxes will increase annually. This translates into a rising unified credit against the estate tax, saving heirs more in taxes with each annual step up. Numbers are for estates in the highest tax bracket.
You should plan for the increased exemption by reviewing your will and other estate planning documents, particularly if you are married. You must structure your bequests to ensure that so much property does not pass to your spouse that the marital deduction does not reduce your estate below the exemption. Many wills contain a formula for computing the marital deduction that will accomplish the proper result without change. You should check whether your will is one of these or needs to be updated. Also, if you are married, you should review the ownership of your assets to ensure that both spouses own assets of at least the amount of the exemption.
The second change in the new law specifically benefits certain family owned businesses and farms. The Act allows an executor to elect to exclude part of the interest in a family business from the taxable estate. The business can be a corporation, partnership, or any other entity. The exclusion is equal to $1.3 million, less the unified credit equivalent. Therefore, in 1998, when the unified credit equivalent is $625,000, the family business exclusion is $675,000, for a total of $1.3 million. The exclusion will decline to $300,000 when the unified credit equivalent reaches $1 million.
The new exclusion exempts a portion of family business assets from estate taxes. The amount allowable is $1.3 million minus the unified credit exemption. The exclusion declines through 2006 because the unified credit increases.
As an “off-the-top” exclusion, the provision will save estate taxes at the highest marginal rate. This contrasts with the exemption, which saves taxes at the lowest rate. Thus, if the estate totals $2 million, the saving in 1998 from the $675,000 exclusion is $300,250. If the estate totals $3.675 million or more, the saving is $371,250.
Your spouse’s estate can also qualify, doubling the benefit. To qualify, shares in the business owned by a spouse must be included in his or her estate. If your spouse does not already have sufficient shares to qualify, you should gift or bequeath enough to him or her so they do. The transfers may involve changes in corporate or partnership agreements and policies if they prohibit ownership by spouses.
Your estate and business must meet numerous requirements to qualify for the exclusion. First, you must be a U.S. citizen or resident, and the business must operate principally in the United States. The business interest included in your estate must comprise more than 50 percent of the total. For example, if your estate is worth $2 million at your death, the value of your interest in the business must be more than $1 million.
What may seem a simple calculation can get complicated. In calculating the 50 percent, you can include in the numerator ownership that you gave to family members, provided they still own it. This is good news, since you can still make lifetime gifts part of your estate plan. The bad news is that all gifts of property other than business ownership that you make to your spouse during the 10 years prior to your death are added back in the denominator of the fraction. Also added back are gifts to all other persons within three years before your death. Thus, it will be difficult to manipulate the calculation by reducing your estate shortly before death. This means proper planning will be critical.
The business must be “family owned” to qualify for the exclusion. If you and your family own 50 percent or more, it will satisfy this test regardless of who owns the rest. Even if you do not meet this requirement, moreover, your estate can still qualify if two families together control 70 percent of the ownership and your family owns at least 30 percent at your death. Similarly, if three families own the business, they must together control 90 percent of the stock and your family must own 30 percent. This rule is another reason to re-examine plans to transfer ownership to nonfamily members, such as key executives. Too much outside ownership can make it impossible for your heirs to qualify.
Another restriction is the business cannot have been publicly traded during the three years prior to your death. Additionally, no more than 35 percent of the income of the business for the year of your death can come from passive sources, such as interest, rent, or dividends. Only active business assets are eligible for the exclusion. Marketable securities in your portfolio and cash in excess of the reasonably expected day-to-day needs of the business do not count, nor do other assets that produce passive income.
Finally, you or your family must have owned and materially participated in the business for at least five of the eight years prior to your death. And if your estate elects the exclusion, your family will have to satisfy the five-out-of-eight-year participation test for another 10 years. If they don’t, under an agreement your heirs must sign, the IRS will recapture part or all of the benefit of the exclusion depending on how many of the 10 years the heirs have satisfied the requirement. If they satisfy six years or less of the requirement, the IRS recaptures 100 percent; seven years, 80 percent; 8 years, 60 percent; nine years, 40 percent; and 10 years, 20 percent.
The IRS will determine “material participation” under rules similar to those that apply to special-use valuation of real estate. For tax purposes, real estate must be given a market value for its “best use”—that is, the most economically advantageous use. The tax code permits an exclusion from estate tax of up to $750,000 for special uses such as farming, which may not be the “best use” of the property. As mentioned, however, that amount must be subtracted from the value of the assets when determining the basis for income tax.
Whether material participation exists in a family business is a factual determination that will vary with the type of entity and the business that it conducts. Any one family member can satisfy this test, even though more than one family member owns the business. A similar requirement in the special-use regulations defines material participation as full-time employment of 35 hours a week (less if the business can be fully managed in fewer hours). If the family member doesn’t meet that test, no other single factor will enable the business to qualify, but physical work and participation in management decisions will be among the key considerations. Most accountants expect the IRS will issue regulations covering the exclusion that will closely parallel the existing special-use rules.
All told, the changes made by the Act do offer some estate tax relief, hopefully allowing heirs to avoid having to sell the business in order to pay taxes. However, you need to plan carefully to ensure that your heirs will be in a position to reap the maximum benefit.
If you think the exclusion will benefit your estate, you should review the ownership of the business to be sure it will qualify. Consider the implications of any plans you may have to transfer ownership to a nonfamily member. If you think the business will be sold after your death, you might think again: Perhaps one of your heirs could continue to run it instead, in order to meet the participation requirement and avoid a huge tax burden for the family. If you are married, make sure that the current ownership of the business and your will leave your spouse a large enough interest in the business to qualify for an additional $1.3 million when he or she dies. You should make sure your wills, trusts, and other documents conform to the requirements of the exclusion and will yield the best possible tax results.
Harvey J. Berger is an associate partner in the Washington, D.C., office of the Grant Thornton accounting and consulting firm. He specializes in estate planning and exempt-organization matters.