Very few electrical contractors want to think about what will happen to their business after their passing, let alone plan for it. Fortunately, Congress has taken pity on those contractors who fail to take the steps necessary to insure that the electrical contracting operation will pass to the desired beneficiaries with a minimum tax burden.
Until recently, the total amount given as gifts during the electrical contractor's lifetime was combined with the total amount left behind by the deceased contractor, in order to arrive at an estate value upon which estate taxes could be levied. The total could be staggering to pay, especially when the primary manager is dead.
Aside from the marital exclusion, a unique "unified credit" exists today that, in essence, allows an electrical contractor's estate to escape taxes on up to $675,000 of the estate's value (up from $650,000 in 1999).
Before the passage of the Taxpayer Relief Act of 1997 (TRA '97), there was no specific estate tax provision that excluded a portion of a qualified family-owned business from anyone's estate. TRA '97 contained a new, highly touted, exclusion for part of the value of a deceased electrical contractor's interest in one or more family businesses. Indeed, the most-talked-about change in the federal transfer tax law was that addition of a $675,000 federal estate tax exclusion for eligible estates composed of, or containing, family-owned business interests.
Naturally, in order to qualify for this unique exclusion, the family-owned business must meet a number of complex requirements laid down by our lawmakers. What's more, combining the amount of estate value offset by the "unified gift and estate tax credit" ($675,000) with the allowable portion of the family-owned business exclusion ($650,000) will always equal $1.3 million - regardless of how it is divided.
It is important to note that while the discussion about the law and all of the accompanying hoopla speak in terms of a total $1.3 million exclusion, that is not what the law actually provides. The new exclusion is, after all, an exclusion, not a credit.
Consequently, like other tax credits, the new exclusion comes off the top of the electrical contractor's taxable estate and can never exceed $675,000. The unified credit, on the other hand, comes off the bottom and is slated to increase to $1 million by the year 2006.
If we assume that the gross estate of an electrical contractor, Charlie, is valued at $1.4 million, we can see how this exclusion really works. If Charlie dies in 2000, when the applicable exclusion amount is $675,000, his estate includes $1.4 million of qualified family-owned business interests (QFOBIs), and his executor elects to take the maximum $675,000 deduction. Since the estate is electing to take the maximum QFOBI deduction, the applicable exclusion amount is only $625,000.
The law provides that the exclusion is from the gross estate. The net amount after this exclusion and all other deductions constitutes the "taxable estate." This becomes a starting point for other computations. Obviously, consideration should be given, if necessary, to reducing the nonbusiness assets in the gross estate during the electrical contractor's lifetime, in order to qualify for the family-owned business exclusion. This does require advance planning.
A qualified family-owned business interest is defined as either an interest in a trade or business carried on as a sole proprietorship, or an interest in an entity (corporation, partnership, or limited liability company [LLC] carrying on a trade or business.
There are two key requirements for qualification for the family-owned business exclusion. First, the interest must be in a business entity. Second, the decedent or a member of the decedent's family must have owned and materially participated in the business for five of the eight years prior to the date of the decedent's death. In addition, a qualified heir must continue to materially participate in the electrical contracting business for 10 years after the date of the decedent's death.
Material participation refers to full-time management. If the decedent was the owner, self-employment tax should have been paid. If an agent or employee operated the business, there should be proof of authority. Being a shareholder, partner, officer, or director does not prove the family provided material participation.
According to our lawmakers, "physical work and participation in management decisions" are the principal factors to be considered. An individual, for example, generally is considered to be materially participating in the business if he or she personally manages the business fully, regardless of the number of hours actually worked.
An additional estate tax will be imposed if the material participation requirements are not met for the required 10-year period following the decedent's death, or if the qualified heir disposes of any portion of the interest.
Every electrical contractor should keep in mind that transfers to the decedent's spouse will not be effective unless they are made more than 10 years before the electrical contractor's death. Transfers to others, except nontaxable transfers to members of the decedent's family, must occur more than three years before the decedent's death.
Each person with an interest in the property is required to agree to pay his or her fair share of any additional estate tax that becomes due if the property is sold or no longer qualifies during the recapture period. This agreement must bind all persons having an interest in the property, whether or not they are qualified heirs. However, the U.S. Tax Court has, in the past, ruled that regulations requiring signatures by persons who were tenants in common but not heirs are invalid.
As matters now stand, the impact of the exclusion was greatest in 1998 and will diminish significantly in 2006 and thereafter, as the unified gift and estate tax credit increases. The relationship between the two provisions will create difficulties for those electrical contractors who have, for example, one child in the business and one or more who are not.
In almost every situation, estate or succession planning might not be a bad idea after all.
BATTERSBY is a freelance financial writer, based in Ardmore, Pa. He can be reached by telephoning (610) 924-9157 or (610) 789-2480, or by e-mail at Mbattersby@MCIMail.com