Detailed Examination of the New Family Owned Business Interest Exemption from Pennsylvania Inheritance Tax

This article is intended to review some of the more detailed and technical requirements for this exemption. See the separate article on this website for a more general overview of the exemption and also see another separate article about Pennsylvania Inheritance Tax generally.

Pennsylvania law now provides that transfers of qualified family owned business interests to qualified transferees are exempt. It is crucial to determine if an ownership interest in a business is a “qualified family owned business interest” and if every person inheriting interests in that business is a “qualified transferee.”

What is a “qualified family-owned business interest”? It is an interest in a business that meets all of the following requirements on the date of the owner’s death:

• It is an interest in a business that is operated as a sole proprietorship or an interest in an entity carrying on a trade or business (for example, partnership, corporation or limited liability company)
• The business must have fewer than 50 full time employees
• The net book value of the business must be less than $5,000,000 – this is book value – historical cost less depreciation and less debt - not actual fair market value of the business
• The business must have been in existence for 5 years before the date of death – although the deceased owner did not have to own it for 5 years
• The business must be “wholly owned” by the deceased owner or by the deceased owner and “qualified transferees”
• The business must be engaged in a trade or business – its principal purpose cannot be the management of investments or income producing assets – someone cannot place a bundle of marketable securities in an entity and qualify the securities for this tax exemption

How does a business meet the $5,000,000 requirement? This requirement relates to the book value of the entire business – not just the deceased owner’s interest. For example, if the business has a book value of $10,000,000 and the interest of the deceased owner had a book value of $1,000,000 – the interest does not qualify for the exemption. Only the book value is relevant – not the actual market value. This accounting concept of book value is an entirely new approach to Pennsylvania Inheritance Tax valuation. “Book value” is the historical cost of the assets, reduced by proper depreciation and then reduced by business debt. It may have little, if any, relationship to fair market value. Many businesses have high value but low basis assets – that is, low book value assets. This is particularly relevant to real estate owning businesses that have held the real estate for many years and that are carrying the real estate on the books as substantially depreciated. This is also relevant to businesses that have high market value due to good will but low book value.

Who is a “qualified transferee”? If you own a business, a “qualified transferee” is:

• Your spouse
• Your lineal descendants – your children, grandchildren, great grandchildren, etc. down your family line – but not their spouses
• Your siblings and their lineal descendants – your sisters, brothers, nieces, nephews, great nieces, great nephews, etc. down your siblings’ family lines – but not their spouses
• Your ancestors – your parents, grandparents, great grandparents, etc. up your family lines
• Your ancestors’ siblings - your aunts, uncles, great aunts, great uncles, etc. up your family lines but not their spouses

Who is not a “qualified transferee”?

• Not people who are unrelated to you
• Not family members who do not fall in one of the categories set forth above – for example, not cousins or cousins’ children
• Not your child’s spouse – not daughters-in-law or sons-in-law
• Not your sibling’s spouse or your spouse’s sibling – not brothers-in-law or sisters-in law
• Not your spouse’s parents – not fathers-in-law or mothers-in-law
• Not other entities – if one of the business owners is another entity – the business does not qualify – for example, a partnership with a corporate partner will not qualify even if all the other partners are family members
• Not trusts – if one of the owners of the business is a trust or if the deceased owner leaves his or her interest to a trust – the business does not qualify

How is the “wholly owned” requirement met? Before the business owner’s death, the business must be owned only by (i) the deceased owner or (ii) the deceased owner and his or her qualified family members. If any owner of the business – shareholder of a corporate business, partner of a partnership, member of an LLC – is not a qualified family member, the business is disqualified. For example, a business owned by two brothers-in-law does not qualify. Similarly, a business where any owner is another entity does not qualify. For example, if a business is operated as a limited partnership and one of the partners is a corporation or limited liability company, the business does not qualify. A business in which any interest is owned by a trust does not qualify. For example, if the business owner is holding title to his business through a living trust, the business does not qualify. If the business owner leaves her business to a trust in her will, the business does not qualify even if the trust is for the benefit of qualified transferees such as a spouse or children. Many pre-2011 estate plans that employed trusts to avoid Federal Estate Tax would disqualify the business from this Pennsylvania Inheritance Tax exemption. The estate plan may no longer even be necessary because of the new high Federal Estate Tax threshold - $5,340,000 per person in 2014 - but as long as the old will or trust is in place, the business will not qualify for the exemption.

Timing Limitation - Property transferred to the qualified family owned business interest within one year before the owner’s death is not eligible for the exemption. This prevents an owner from making a transfer to his or her business in contemplation of death solely to obtain the exemption. For example, if the owner of a retail carpet store transferred $1,000,000 of marketable securities to the business a month before death – for no legitimate business reason, the marketable securities would not be eligible for the exemption. A transfer for a legitimate business purpose would be exempt.

What are the post death requirements?

• The business interest must continue to be owned by the qualified transferee for seven years after the date of the former owner’s death
• The business must be reported on timely-filed Pennsylvania Inheritance Tax Return upon the deceased owner’s death
• Each qualified transferee must file an annual certification for seven years after the former owner’s death

What happens if the new owner – the qualified transferee - fails to meet these requirements for the full seven years? If the qualification is lost there is a recapture tax – what the original tax would have been plus interest. It does not matter at what point in the seven year period the disqualification occurs – the tax is recaptured in full. It is not pro-rated based upon the time period of qualification. Because of the way the law is written, it is possible that the party who becomes responsible for the recapture tax is different than the party who would have been responsible under the will if the exemption had never been claimed.

What happens if the qualified new owner sells some or all of the exempt business interest in less than seven years? If the exempt business interest is transferred from one qualified transferee to another qualified transferee, there are no negative consequences. For example, if a business owner leaves his qualifying business to his two daughters and the exemption is claimed and a year later, one daughter sells her interest to the other daughter or to a third daughter, there is no loss of the exemption because both remaining daughters were qualified transferees. If the interest is sold or transferred to a non-qualified transferee during the seven-year period, the result may be different. If the business was a sole proprietorship, the exemption would be lost and the recapture tax would become due. If the business was an entity – like a corporation or LLC – the result might be different. The sale of the ownership interest in the business – for example, a sale of corporate stock – would result in a lost exemption and recapture tax. Perhaps assets of the business could be sold while the business itself – the corporate stock or LLC membership interest – is retained by the original qualified transferee. Arguably there would be no disqualification. It is too soon to know how the Department of Revenue and the Pennsylvania courts might interpret that transaction.

It should be noted that a transfer to a non-qualified transferee within the seven-year period only disqualifies the interest of the qualified transferee who made the transfer – not the entire business. If there was a non-qualified transferee owner at the time of the death, the business could never have qualified for the exemption. However, if the business was owned only by qualified transferees on the date of death and transferred upon death only to qualified transferees, a later non-qualifying transfer within the seven year period only disqualifies the transferred interest. For example, a business owner of a qualifying business leaves her business to her son and daughter and the exemption is claimed. Two years later, the son sells his interest to a person who is not a family member – a non-qualified transferee. The son’s interest becomes disqualified and is subject to the recapture tax but the daughter’s interest remains qualified and no recapture tax is due on her interest.

Summary - This new law provides many opportunities to avoid or reduce Pennsylvania Inheritance Tax on family owned businesses. There are strict requirements to qualify. Each situation should be reviewed independently to determine how to qualify without harming other aspects of the estate or business plan of the business owner or owners.

This article is for information purposes only and is not intended to be legal advice. You should consult a lawyer about this exemption and how it affects you.

Copyright 2014 Marc H. Jaffe