If Jim’s business qualifies, up to $675,000 of the value of his business can be deducted from his estate before estate taxes are calculated. When added to his 1998 applicable gift and estate tax exclusion amount of $625,000, the total nontaxable portion of his estate is $1.3 million. Jim is disappointed to learn, though, that the total amount will not increase above $1.3 million. That’s because when you qualify for the family-owned business interest deduction, you give up some of the increases in the applicable exclusion amount.

Is Jim Qualified?

Jim was born and raised in the U. S., so he meets the requirement that he be either a United States citizen or resident and also that the business not be a foreign business. Since Jim started the business in his garage in 1958, he easily meets the requirement that the business have been owned by him or a member of his family for five of the eight years immediately preceding the time he dies. Jim and his family meet the requirement that they own at least 50% of the business. If Jim wanted to accept an offer from a business associate to sell part of the business, he would need to retain at least 30% of the business after the sale to still qualify for the deduction.

The Heirs

Jim will leave the business primarily to his son and daughter, so he will meet the requirement that the business either pass to or be acquired by a qualified heir. Qualified heirs generally include spouse, ancestors and lineal descendants.

Jim is also considering different ways to include his right hand-man, Luke Johnson, in his plans. Luke has been an employee of the business since 1968. Jim is glad to know that he might be able to enter into a buy-sell agreement with Luke or that he could leave a portion of the business to Luke without jeopardizing his deduction, because the law allows an employee of 10 years or more to be considered a qualified heir.

Personal Holding Company Status

Jim’s company was never involved in offering marketable securities and has not received more than 35% of its income as personal holding company income. Although the business is doing well, Jim does not have much cash or many marketable securities in excess of his day-to-day working capital needs, which could disqualify his business.

Portion of the Estate

Most of Jim’s wealth is tied up in the business, so he should have no trouble meeting the requirement that his business represent at least 50% of his adjusted gross estate on his death. Just the same, Jim will have his advisors run a calculation that will use the complex statutory formula to account for his past gifts of part of the business to his children, his debts and other statutory factors.

Material Participation

Jim intends to continue working, and his children both work in the business full-time. They easily meet the requirement that he or a member of his family must have materially participated inthe business for five of the eight years immediately preceding his death. Jim is glad to know that there are special rules for retirement and disability (and surviving spouses) in case something should happen to him.

Jim’s children are not concerned about a recapture of tax excluded. They intend to continue working in the business and have no intention of selling or moving the business or themselves out of the country in the next 10 years.

Jim Qualifies, Do You?

Jim’s glad. His business meets all requirements for the family-owned business deduction, and his heirs will be spared a lot of tax on his estate. You, too, may be eligible for this significant new deduction.

As this article goes to press, there is a technical corrections bill pending. This article has outlined the changes to the family-owned business deduction as set forth in the bill. It is well worth the time to determine if your business would qualify. Please let us know ifyou have any questions about the family-owned business deduction or would like assistance in determining if you qualify. We would welcome the opportunity to help you minimize taxes on your estate.

What Are Recapture Events?

A portion of the family and business exclusion can be recaptured and taxes may be due if any of the following events occur:

• The qualified heir fails to materially participate in the business for at least five of the eight years during the 10-year period following the decedent’s death.
• The qualified heir disposes of all or part of the interest to someone other than a family member.
• The qualified heir becomes disqualified by losing U.S. citizenship, ceasing to be a lawful permanent U.S. resident or commencing residency in a foreign country that has a treaty with the United States.
• The business’s principal place of business ceases to be in the United States.

How are amounts previously excluded from the estate later recaptured? Eachqualified heir is potentially responsible for a portion of the tax equal to his or her percentage interest in the business. This recapture tax applies on an event-by-event basis. A recapture event occurring with respect to one heir will not necessarily mean that other heirs will owe recapture tax.