Own a business that you want to remain in the family? Uncle Sam may be your foremost obstacle. Although the 2001 Tax Act phases out the estate tax over a period of years, the tax will not go away tomorrow. Judging by recent political commentary, relief may be short-lived. Without planning, the taxes may force a sale of part or all of the business, and the estate might not be in a very good bargaining position to get the maximum cash value. The government may also claim that the business is more valuable than it really is. Valuing a closely-held business is difficult because there is no ready market. This gives the government the opportunity to value high, requires the estate to value low, and leaves years of expensive negotiation and litigation.

There are a number of estate-planning tactics such as gifting with minority and marketability discounts, family limited partnerships and LLCs, stock purchase agreements, ESOPs, special-use valuations, insurance, and others. Our government is sensitive to the damage our economy would suffer if businesses were commonly sold or liquidated to pay death taxes. This was one of the motivations behind passage of the 2001 Act. Yet, what happens if the business owner dies before the Act phases in sufficiently?

Under § 2057 of the Internal Revenue Code, if the estate contains a family-owned business interest whose adjusted value is at least 50% of the adjusted value of the gross assets of the estate, the potential tax savings may be substantial. The value of the interest is deductible up to a maximum of $750,000. When combined with the unified credit, the deduction increases to a maximum of $1,300,000. Also, the unified credit (a deduction equivalent of $675,000 in 2001, increasing to $1,500,000 by 2005 and $3,500,000 by 2009) is available to all estates under § 2010. This translates to a cash savings of about $430,000 for a decedent who dies in 2001. In addition, the business may qualify for the special-use valuation under § 2032A, which can provide an additional deduction of up to $750,000 and result in total deductions of $2,050,000. If both spouses´ estates qualify at the time of their respective deaths, the savings can be enormous.

To take advantage of § 2057, the decedent must have been a citizen of the United States. Also, during the eight-year period prior to the decedent’s death, there must have been at least five years during which the business was owned by the decedent or members of his or her family. Further, the decedent or a family member must have materially participated in the operation of the business.

And there are still more conditions to § 2057’s application. The family-owned business must be acquired by or passed to one or more qualified heirs. Qualified heirs generally include the spouse and lineal ancestors or descendants. Moreover, the business must be “closely-held.” This means that at least fifty percent must be owned by the decedent or his family. However, the decedent´s family can own as little as 30% if 70% is owned by two families or 90% is owned by three families.

A business whose principal office is outside the U.S. does not qualify, nor does one whose equity or debt was traded on an established market or exchange within three years prior to death. If more than 35% of adjusted ordinary gross income in the year of death would qualify for a personal holding company (assuming that the entity was a corporation), it does not qualify. There are other exceptions, the common thread being equity or income derived from assets with a ready market.

Avoiding the exceptions, meeting the 50% liquidity test, and using the adjustments to the estate’s advantage might require advanced balance sheet planning because the values of both the gross estate and the qualified family-owned business interests are adjusted for the purposes of calculating the 50% test and the deductions. Anticipating unfavorable adjustments may justify balance-sheet strategies such as buying more stock in the business, paying off certain personal debts, transferring cash to a spouse, or converting the businesses cash and marketable securities into operating assets such as equipment and inventory.

Pursuing § 2057 benefits is not for the faint hearted. For instance, the family must materially participate in the operation of the business for ten years after the decedent’s death unless the qualified heir dies earlier. The heir cannot sell a portion of the business to a non-family member during the ten years. The head office cannot move outside of the United States and the qualified heir cannot lose his status as a qualified heir. If one of these unfortunate events occurs, the estate must repay the taxes saved, plus interest. The repayment percentage diminishes if the event occurs after the sixth year. Furthermore, restrictions that come with qualification may be inconsistent with the estate plan. For instance, there are certain limitations on the creative use of trusts.

In short, § 2057 can be very valuable in the right circumstances. Its potential value diminishes if and when the estate tax burden diminishes under the estate tax revisions of the 2001 Tax Act. Under that Act, the positive impact is effectively neutralized in 2004. Tax laws change with the political wind, and the recently-gained estate tax relief is an easy target in the light of budget shortfalls.