MARCH 2014 NEWSLETTER

Pennsylvania Inheritance Tax Exemption for Qualified Family Owned Businesses

Beginning July 1, 2013, the transfer at death of certain family owned business interests will be protected from the Pennsylvania inheritance tax. While the Pennsylvania inheritance tax is not nearly as burdensome as the federal estate tax, the tax may still be substantial and its payment may cause certain family business interests to otherwise be sold off to make payment of the tax.

The rate of the Pennsylvania inheritance tax is based off of the relationship between the beneficiary, or heir, and the decedent with rates ranging from 0% to 15%. For example, transfers to a surviving spouse are entirely exempted from Pennsylvania Inheritance Tax. However, a rate of 4.5% applies to interests transferred to lineal descendants and ascendants, such as children or grandchildren, parents or grandparents. A rate of 12% applies to transfers to siblings and a rate of 15% applies to transfers to all other beneficiaries. If the main family asset is the family business, then its transfer at death of the business owner can create liquidity problems for paying the tax.

Accordingly, in an effort to help protect certain Pennsylvania family owned businesses, the Pennsylvania legislature created a new exemption from the inheritance tax for the transfer of qualifying family owned business interests. The potential tax savings may be significant.

I. Statutory Requirements

In order for a death time transfer of a qualified family owned business interest to be 3 exempt from the inheritance tax, certain requirements must be met. There are two main requirements, which are: (1) the interest being transferred at death must be a qualified family owned business interest; and, (2) the person receiving the interest must be a qualified transferee. Other requirements apply as well.

A. Qualified Family Owned Business Interest

In order to be a qualified family owned business interest, the business must either be a qualifying sole proprietorship where the decedent was the owner and manager, or the interest transferred is a qualifying interest. To qualify, the business or business interest must be in an entity carrying on a trade or business that:

1. Has fewer than 50 employees;

2. Has a net book value of less than $5 million;

3. Has been in existence for five years prior to the decedent’s death;

4. Is wholly owned by the decedent or the decedent and members of the decedents family that are qualified transferees; and

5. Is engaged in a trade or business, the principal purpose of which is not the management of investments or income producing assets.

All of the above requirements must be in existence as of the date of death. While some of the requirements are straightforward, such as the 50 employee limitation, others are not. For example, $5 million book value requirement applies to the business as a whole, and not just the decedent’s interest. Furthermore, the statutory requirement requires the value be measured as book value and not fair market value. The difference is important in that, for example, the book value of a business may be significantly less than its fair market value because business assets have depreciated over time. Thus, as long as the business’ book value is less than $5 million, even if the fair market value is significantly greater than $5 million, the transfer of the business may still qualify for the exemption.

Meanwhile, the business must be wholly owned by the decedent and qualified transferees. If the decedent had transferred even nominal interest to someone who is not a qualified transferee, the transfer of the business at the decedent’s death may not qualify for the exemption. For example, if a son- or daughter-in-law was an owner, the death time transfer would not qualify because spouses of descendants are not qualified transferees. It is also important to remember that a trust is not a qualified transferee. Thus, if a parent placed the business in trust for the children, the transfer would be outside the scope of the exemption and not qualify.

B. Qualified Transferee

A qualified transferee generally is any member of the decedent’s family. Specifically, the definition includes husband and wife, lineal descendants, siblings and siblings’ lineal descendants, and ancestors and ancestors’ siblings.

C. Other Requirements

There are several other qualifications that apply in order for the transfer to be exempt 4 from the inheritance tax. They include:

1. The interest must be reported on the Pennsylvania inheritance tax return;

2. The business, or interest, must continue to be owned by the qualified transferee for seven years after the decedent’s death;

3. A certification must filed annually by the qualified transferee for the seven year period; and

4. Any property transferred to the qualified family owned business within one year of the decedent’s death is not eligible for the exemption unless it was transferred for a legitimate business purpose.

If the certification is not filed, the exemption will be lost and inheritance tax will be due. If a qualified transferee no longer owns the qualified family owned business interest during the seven year period, the inheritance tax will be due, plus interest. It is not necessary, however, that the same qualified transferee holds the interest during the entire seven year period.

In the event that loss of the exemption is triggered, the Pennsylvania Department of Revenue may place a lien on the business in the amount of taxed owed if necessary.

II. Planning Opportunities

The new exemption will benefit business owners who want to keep the business within the family after death. Planning opportunities exist. For example, if the decedent has a low basis in the business, there are opportunities to transfer the business tax free based on the low book value as compared to the fair market value. However, placing the business interests in trust is not an option. Thus, the business owner must feel comfortable transferring the business to one of the qualified transferees so that this new exemption may be incorporated into the owner’s business succession planning.

Ultimately, there are opportunities here and it is best to contact your estate and business succession planning attorney or professional to determine whether and how you should take advantage of this new law.