Family-Owned Business Exemption

April 13, 2006

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Once upon a time, before estate tax reform in 2001, one of the basic tenets of estate taxation was a special consideration for small businesses.

Prior to 2004, as a small business owner, you were eligible for an additional estate planning exemption. The exemption totaled $1.3 million. However, the small business owner had to subtract his regular exemption from this amount.

Thus, the difference really amounted to an additional exemption, beyond the regular exemption. For example, the regular exemption was $1 million in 2003. Thus, this exemption yielded an extra $300,000 ($1.3 million - $1 million).

However, in 2004, as a result of recent estate tax reform, the family-owned business exemption was eliminated. At the same time, though, the regular exemption was increased to $1.5 million, exceeding the previous family-owned business exemption amount.

This additional exemption was available only to small business owners who met all of the eligibility criteria. One requirement was that the business be family-owned. One family must normally own at least a 50 percent interest in the business. However, a family could own as little as a 30 percent interest if it aggregates its interest with a second or third family. In that case, the total ownership among all the families must be at least 70 percent if there are two families, and at least 90 percent if there are three families. This requirement was seldom a problem for a small, family-owned business.

A second requirement had posed a greater obstacle for the small business owner. The value of the business included in the owner's overall estate must exceed 50 percent of the total value of the estate. If the small business owner had been successful at running the business, presumably there would be significant wealth accumulated outside of the business, in the form of an investment portfolio, retirement benefits, life insurance, etc. In many cases, the business likely represented less than 50 percent of the value of the total estate. In short, this criterion sometimes excluded a large number of small business owners.

In response, the small business owner usually found it advantageous to transfer interests to the next generation and, possibly as a result, forego this additional exemption, when:

The value of the interests transferred could be expected to exceed $300,000 (the value of the additional exemption in 2003), at the time of the parent's death.
The owner expected to have an especially large taxable estate due to personal wealth accumulated outside of the business.

Additionally, the more successful business owner was able to take advantage of both planning opportunities. While alive, the parent could transfer interests representing a significant portion of the value of the business to the next generation, while other estate planning techniques could reduce the size of the taxable estate that results from other assets. In the end, the value of the business interest included in the parent's estate, while relatively modest, would still exceed 50 percent of the total value of the estate, which allowed the added exemption.

However, going forward in 2004, these strategies for using the family-owned business exemption are unnecessary because of recent changes to estate tax laws.