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 (regard less 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. …