If qualified family-owned business interests (QFOBIs) make up more than 50 percent of your taxable estate, you may benefit from a special provision that can increase your total effective exemption from estate tax to $1.3 million.
If an estate is eligible and elects to take the qualified family-owned business (QFOB) deduction, up to $675,000 of the adjusted value of QFOBIs may be deducted from the value of the estate. From the $675,000 maximum, you must subtract some of the amount that is effectively exempt from estate tax under the general provisions of the law.
In combination with the applicable unified credit exclusion amount, up to $1.3 million of qualified family-owned business interests may be shielded from estate tax in 2003. Since the general exemption amount is $1 million in 2003, the "extra" exemption benefit for a small business is only $300,000 in 2003.
The QFOB deduction has been criticized as being overly complicated and not very helpful to the estates of small family business owners. Starting in 2004, this controversial deduction is scheduled to be eliminated. The elimination of this deduction, however, is more than made up by the increased estate tax exclusion amounts which rise to $1.5 million in 2004-2005, $2 million in 2006-2008, and $3.5 million in 2009.
To qualify for the family business exemption, your business and your heirs must meet certain criteria.
- The business interest must comprise more than 50 percent of your estate, which may mean that you need to give away some non-business assets before you die.
- The principal place of business must be in the United States.
- The business must be owned at least 50 percent by one family, 70 percent by two families, or 90 percent by three families. Members of "one family" include your spouse; your ancestors; descendants of yourself, spouse, or ancestors; and the spouses of such descendants.
- The business's stock or securities must not have been publicly traded at any time within three years of your death.
- There are restrictions on the amount of passive assets, excess cash, marketable securities, or holding company income the business may have.
- The value of the business that passes to qualified heirs must exceed 50 percent of the estate's value. "Qualified heirs" include people who have been employed by the business for at least 10 years, and members of your family. Certain lifetime gifts to qualified heirs are also counted in this computation.
- You must have owned and materially participated in the business for at least five of the eight years preceding your death.
- Each qualified heir, or a member of the heir's family, must materially participate in the trade or business for five out of any eight years in the 10 year period following your death. Exactly what "material participation" means can vary depending on the industry, but physical work and participation in management decisions are the main factors to be considered.
- If any qualified heir disposes of his business interest within 10 years of your death, other than by a disposition to a member of his family or a conservation contribution, a portion of the estate tax reduction may be "recaptured;" that is, it may have to be repaid to the IRS.
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You leave your business to your two children. Your daughter materially participates in the business, but your son does not. Both heirs meet the material participation rule, since your daughter is a member of the son's family.
However, if the daughter stopped participating in the business within 10 years of your death, neither heir would meet the rule.
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These are the major requirements you need to meet, but the law has a number of complicated twists and turns, and if you want to take full advantage of it, you'll definitely need to consult an estate planning professional.