The Family-Owned Business Deduction and Equity Interests

In 1997, the Congress created an allowance from federal estate tax for qualified family-owned business interests (QFOBIs). It applied to estates of decedents beginning for deaths in 1997. In 1998, the provision was changed to a deduction – the Family-Owned Business Deduction (FOBD) and placed in I.R.C. §2057. The idea was to provide additional federal estate tax relief for closely-held, family-operated businesses by addressing the liquidity concerns that tend to be a significant issue for these businesses. I.R.C. §2057 provided that a decedent’s estate could make an election so that the combined FOBD and the federal estate tax exemption would be $1.3 million. But, to utilize the deduction, the aggregate value of the decedent’s QFOBIs must exceed 50 percent of the adjusted gross estate (gross estate less allowable deductions), and that amount or more must pass to or be acquired by qualified heirs. A QFOBI includes an interest as a proprietor in a business carried on as a proprietorship or an interest in a closely-held entity carrying on a business if at least 50 percent of the entity is owned, directly or indirectly, by the decedent or a member of the decedent’s family.

When the federal estate tax exemption was increased to over $1.3 million, the QFOBI deduction became obsolete and was made inapplicable to decedents dying after 2003. But, there may be reasons to keep the FOBD in mind. For example, even though it is unlikely, a future Congress could lower the estate tax exemption and reinstate the deduction. On the other hand, the Congress might raise the deduction amount and reinstate the FOBD. Indeed, in late 2007 H.R. 4042 was introduced which would resurrect the FOBD at an $8 million level. If the Congress does nothing, the FOBD is set to be reinstated for estates of decedents dying after 2010.

As indicated above, the FOBD is allowed only on transfers to a qualified heir (or heirs) that continues to operate the family business. Not every qualified heir has to operate the business, but the business must remain family-owned and operated. If the heir sells the transferred QFOBIs, then the estate tax savings are recaptured on that subsequent transfer. The idea is that if an heir is willing to sell the business anyway, there is no need to provide relief. This restriction on transferring QFOBIs lasts for 10 years - a long time for many qualified heirs. So, when working with clients with closely-held family businesses where the FOBD election is in play, it is important to pay attention to the outstanding QFOBIs to avoid estate tax recapture.

Are Equity Interests QFOBIs?

Two recent Tax Court cases, one of which has now been affirmed on appeal, while not focusing on the FOBD’s recapture provision, shed light on what exactly constitutes a QFOBI. In the first case, the parents loaned money to their family-owned corporation (a business that operated retail automotive parts stores in Minnesota and the Dakotas) in return for unsecured promissory notes for 20 years before they died. The purpose of the loans was to help the family business expand (also, the loans probably made sense from an income planning standpoint if the business was a C corporation (the opinion doesn’t specify the type of business involved) because the owners could withdraw cash as deductible interest). When the parents died, their estates each held 50 percent of the outstanding shares of the corporation’s voting common stock, and the unsecured promissory notes. The estates treated both the stock and the promissory notes as QFOBIs, causing the adjusted value of the QFOBIs in both estates to meet the 50-percent test liquidity test (I.R.C. §2057(b)(1)(C)) in order to receive the FOBD. So, if the promissory notes counted as QFOBIs, then the estates would have been entitled to receive the QFOBI deduction. Unfortunately, the I.R.C. §2057(e)(1)(B) definition of an “interest in an entity,” the court held, is limited to equity ownership interests. Notes are not equity. Consequently, the estates failed to meet the 50-percent liquidity test and the FOBD was not available for either estate. On appeal, the U.S. Court of Appeals for the Eighth Circuit affirmed. The court noted that the statute clearly refers to an “interest in an entity.” That means an “ownership” interest, not merely an interest as a creditor. Judge Shepherd dissented. He didn’t belief that the statutory definition of “interest in an entity” expressly excluded an interest in the form of loan indebtedness owed by the family business to family shareholders. Instead, he believed that the Congress intended to include both debt and equity interests in the definition. Estate of Farnam v. Com’r, No. 08-3196, 2009 U.S. App. LEXIS 22161 (8th Cir. Oct. 8, 2009), aff’g,130 TC No. 2 (2008).

Also in 2008, the Tax Court reached the exact same conclusion in a second case – loans to an entity owned by a decedent and two of the decedent’s children were not treated as interests in that entity under I.R.C. §2057(b)(1)(C). Estate of Artall v. Com’r, T.C. Memo. 2008-67.

Note: Issuing debt in a family-business transaction is a common technique (and, as noted above, makes sense from an income tax standpoint in C corporations), and it probably wouldn’t be wise to advise such clients to avoid issuing debt solely on the chance that the FOBD might be reinstated. But, it still might be a good idea to keep the FOBD rules in mind…just in case.