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New asset exclusion not all it's cracked up to be

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Beginning in 1998, owners of small businesses and farms may be able to exclude some of those assets' value from their estates at death. Theoretically, this exclusion will reduce the frequency of heirs being forced to liquidate the family business in order to pay the tax bill.

But many estate planning experts say the new rules affecting this transfer are exceptionally complicated, difficult to meet and, over the long run, worth little.

Under the new exclusion, passed in the Taxpayer Relief Act of 1997, you can exclude $1.3 million of the value of your business or business interest minus the estate- and gift-tax exclusion.

The $600,000 estate- and gift-tax exclusion was indexed by the tax act, and in 1998 that exclusion rises to $625,000. In effect, if you were to die in 1998, you could exclude $675,000 of the value of your business, in addition to $625,000 in your estate. This would save $277,000 in federal taxes that could have been paid before the new law.

The estate- and gift-tax exclusion is scheduled to rise to $1 million during the next 10 years. However, the family business exclusion is not. That is, 10 years from now, the business exclusion will amount to only $300,000. Moreover, the complex rules make it difficult just to qualify for the exclusion. The major qualification rules include:

?Fifty percent of the business must be owned by the decedent and members of the decedent's family. Or, 70 percent must be owned by members of two families or 90 percent by three families.

?The business (or aggregate value of qualified business interests) must exceed 50 percent of the adjusted gross value of the estate passed on to the heirs.

?The principal place of business must be in the United States.

?Company stock or securities may not have been publicly traded within three years of the owner's death.

?Generally, no more than 35 percent of the gross business income may derive from income as a personal holding company.

?The deceased or a family member must have owned and materially participated in the business at least five of the eight years preceding death.

Even if all these requirements are met, the estate may face a "recapture" tax if post-death requirements aren't met. These include:

?A qualified heir or family member must materially participate in the business at least five years of any eight-year period within 10 years following death.

?The heirs cannot dispose of the business or a portion of it to anyone other than to a member of the heirs' family.

?The business cannot move out of the country, and the heir must not lose American citizenship.

Estate planners argue that the participation rules in particular may make it difficult for many family businesses to take advantage of the exclusion.

The 50 percent liquidity test also will require more careful transfer of nonbusiness assets. For example, the "adjusted gross estate" includes lifetime gifts to heirs and transfers to the decedent's spouse within 10 years of death (three years to other heirs).

The test could prove particularly difficult for owners wanting to treat multiple heirs fairly, some of whom aren't involved in the family business.

If the inherited business is sold because of difficult financial times, the recapture tax will be imposed on an already troubled business. Perhaps most frustrating is that the exclusion is not indexed, effectively diluting its value each year.

Business owners, their heirs and their financial advisers will have to pay careful attention to the rules. They also should explore other strategies for passing on the family business, such as employee stock ownership plans and family limited partnerships.

(The preceding article was provided by the Institute of Certified Financial Planners by William O. Woody, CLU, ChFC, CFP, of Stovall Woody Associates.)

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