The Family-Owned Business Deduction — Section 2057 (Portfolio 829)

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Tax Management Portfolio, The Family-Owned Business Deduction — Section 2057, No. 829-2nd, discusses in detail the federal estate tax family-owned business exclusion which was enacted by the Taxpayer Relief Act of 1997 and amended in 1998.

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Tax Management Portfolio, The Family-Owned Business Deduction — Section 2057, No. 829-2nd, discusses in detail the federal estate tax family-owned business exclusion which was enacted by the Taxpayer Relief Act of 1997 and amended in 1998. The provision was designed to provide federal estate tax relief to eligible farms and other small businesses which continue beyond the deaths of the owners. Many, but not all, of the provisions are drawn from §2032A, special use valuation. That section has provided, since 1977, two procedures for valuing land (used in a business) for federal estate tax purposes. The Portfolio discusses the significant modifications made by the 1998 IRS Reform Act, which most significantly converted the exclusion into a deduction for qualifying family-owned business interests under §2057 and better coordinated the benefit with the unified credit to take into account the increases in the applicable exclusion in later years. Finally, the Portfolio addresses the repeal of §2057 by the 2001 Tax Relief Act. Since repeal did not affect the recapture tax imposed for failure to meet the qualified use requirements in the post-death period, planning for qualified use during that period will continue to be important.
The Portfolio discusses in detail the pre-death qualification requirements for the family-owned business deduction with particular emphasis on the material participation and passive asset tests. The Portfolio also provides detailed coverage of the recapture rules for the 10-year period after death including the post-death material participation test, transfer of assets outside the family and the meaning of the statutory requirement for a “business” after death. Further, the Portfolio outlines the requirements for the family-owned business interest election, which is derived from the special use valuation rules. The Portfolio also explores several post-death planning considerations including the integration of the family-owned business provision with special use valuation of land and 15-year installment payment of federal estate tax. The Portfolio discusses the availability of discounts on asset values under the three provisions. The Portfolio contains planning guidelines as well as detailed Worksheets which provide guidance on using the family-owned business deduction.
For additional relevant materials, see T.M., Section 2032A — Special Use Valuation; and other Tax Management Portfolios listed in the “Estates, Gifts, and Trusts Portfolio Classification Guide” in the Tax Management Portfolio Index binder.
This Portfolio may be cited as Harl and McEowen, T.M., The Family-Owned Business Deduction — Section 2057.


Neil E. Harl, Esq.

Neil E. Harl, B.S. Iowa State University (1955); J.D. University of Iowa College of Law (1961); Ph.D. Iowa State University (1965); member, Iowa Bar; research and writing concentrates on tax aspects of estate and business planning; frequent author and lecturer on these and other subjects.

Roger A. McEowen, Esq.

Roger A. McEowen, B.S. Purdue University (1986); M.S. Iowa State University (1990); J.D. Drake University School of Law (1991); member, Kansas and Nebraska Bars; research and writing concentration on federal estate and gift taxation and other legal issues impacting farm and ranch operations; frequent author and lecturer on these subjects.

Table of Contents

Detailed Analysis

I. Introduction

Introductory Material

A. General

B. Amount of the Qualified Family-Owned Business Deduction

II. Pre-Death Requirements For Eligibility

Introductory Material

A. Decedent a Resident or Citizen of U.S. and Ownership Test

B. Qualified Family-Owned Business Interests More Than 50% of Adjusted Gross Estate: “The 50 Percent Test”

1. Qualified Family-Owned Business Interest

2. Excess Cash in the Business

3. Calculation of 50% Test

C. “Passing From” Requirement

1. “Passing to” Qualified Heir

a. The “Acquired from” or “Passing from” Requirement

b. Passing by Disclaimer

c. Passing by Corporate Stock Redemption

d. Income Tax Basis of 2057 Assets

2. Member of Family

3. Qualified Heir

D. Qualified Use Test

E. Requirement of a “Trade or Business”

1. “Passive Asset” Test

2. When Test Must Be Met

3. No “Qualified Use” Test

4. Implications for Structuring Farms and Small Businesses

F. “Material Participation” Test

1. Nature of Requirement

2. Bar to Material Participation by Agent

3. Failure to Pay Self-Employment Tax

4. Judicial Interpretation of “Material Participation”

5. Lease Provisions Supporting Material Participation

6. Active Management Substituting for Material Participation

7. Section 2057 Committee Report Statements

G. Present Interest Test

1. Absence of Income Interest

2. Successive Interests

H. Other Pre-Death Eligibility Considerations

1. Eligibility of Residence

2. Tax-Free Exchanges and Involuntary Conversions

3. Community Property

III. Election

A. When Election Timely

B. Perfecting Defective Elections

C. Agreement of Personal Liability

D. Protective Elections

E. Partial Elections

IV. Post-Death Requirements to Avoid Recapture

Introductory Material

A. Absence of Material Participation

1. Meaning of “Material Participation”

2. “Active Management” as a Substitute for Material Participation

3. Role of Agent

4. Committee Report Language

B. Principal Place of Business Outside U.S.

C. Qualified Heir Loses U.S. Citizenship

D. Post-Death “Passive Asset” Test

E. Disposal of Interest

1. Transfers Affected

a. Disposition for Construction of Residence

b. Oil and Gas Leases and Exploration

c. Transfer to Non-Family Members

d. Corporate Stock Transactions

e. Easements

f. Transfer to Trust

g. Severance of Timber

h. Partitioning Property

i. Sale and Leaseback

j. Tax-Free Exchanges

k. Involuntary Conversions

l. Mortgaging Property

m. Bankruptcy

n. Foreclosure

o. Merger of Trusts

p. Death of Qualified Heir

q. Areas of Disposition or Transfer Without Specific Guidance

r. Provisions Adopted From Installment Payment of Federal Estate Tax

(1) Section 303 Stock Redemption

(2) Corporate Reorganizations

(3) Transfer at Death to Member of Family

2. Amount of the 2057 Deduction Benefit Recaptured

a. Interest Imposed

b. Amount of Recapture Tax

c. Partial Dispositions

d. Conveyance to New Entity

e. Phase-Out of Recapture

f. Only One Additional Tax Imposed

g. Period for Assessment

h. Recapture Form Filed

i. Agreement of Personal Liability

j. Lien Imposed

k. Personal Liability and Furnishing of Bond

l. Noncitizen Qualified Heirs

V. Other Post-Death Planning Considerations

Introductory Material

A. Special Use Valuation

B. Discounts

1. Discounts Under Special Use Valuation

2. Discounts for Fractional Interests

3. Discounts Under the Family-Owned Business Deduction

C. Installment Payment of Federal Estate Tax and Corporate Stock Redemption

VI. Planning Guidelines

A. Overview

B. Marital Deduction Planning

1. Types of Formula Clauses

a. General Observations

b. Pecuniary Formula Clauses-Post-Death Planning Concerns

(1) Drafting Language and Associated Concerns

(2) Distribution Values and Rev. Proc. 64-19

c. Fractional Share Clauses

d. Estate Balancing Clauses and the Terminable Interest Issue

2. Funding the Marital Deduction

a. Gain in Satisfying Marital Deduction Bequest

b. Effect of Special Use Value

(1) Funding With Fair Market Value

(2) Other Funding Possibilities

c. Effect of “Pre-Death” Gain

d. Potential Gift

e. The Potential “Double Deduction” Problem

3. Possible Approaches

4. Funding Marital and Nonmarital Deduction Portions: The Possibility of a Discount

C. Planning for Utilization of the FOBD and the GST Tax

1. General Planning Implications

2. Formula Clauses

VII. Other Considerations

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Checklist: Items to Be Included in 2057 Election

Worksheet 2 Affidavit Regarding Material Participation

Worksheet 3 Members of Family (and Qualified Heirs) - Pre–Death Eligibility

Worksheet 4 Members of Family of Qualified Heir - Post–Death Recapture

Worksheet 5 Material Participation Share Lease

Worksheet 6 Letter to Qualified Heirs on Aspects of the Family–Owned Business Exclusion

Worksheet 7 Tax Power Included in Financial Power of Attorney

Worksheet 8 Fiduciary Power

Worksheet 9 Planning Strategy

Worksheet 10 Transferee Agreement Consenting to Personal Liability Under 2057(b)(1)(B) - Individual

Worksheet 11 Section 2057 Worksheet for Determination of Eligibility

Worksheet 12 Section 2057 Checklist

Worksheet 13 Worksheet to Estimate Working Capital Needs by Operating Cycle Method

Worksheet 14 Will Provisions Concerning 2057 Election

Worksheet 15 IRS Questionnaire Directed to Agent

Worksheet 16 Form 706, Schedule T - Qualified Family-Owned Business Deduction

Worksheet 17 Form 706-D, United States Additional Estate Tax Return Under Code Section 2057

Worksheet 18 Excerpt from S. Rep. No. 33, 105th Cong., 1st Sess. (1997) (Taxpayer Relief Act of 1997)

Worksheet 19 Excerpt from H.R. Conf. Rep. No. 220 (Statement of Managers), 105th Cong., 1st Sess. (1997) (Taxpayer Relief Act of 1997)

Worksheet 20 Letter from Joint Committee on Taxation Interpreting Portions of Statute

Worksheet 21 Excerpts from H.R. Rep. No. 356, 105th Cong., 1st Sess. (1997) (Technical Corrections Act of 1997)

Worksheet 22 Excerpts from S. Rep. No. 174, 105th Cong., 2d. Sess. (1998) (Internal Revenue Service Restructuring and Reform Act of 1998)

Worksheet 23 Excerpts from H.R. Conf. Rep. No. 599, 105th Cong., 2d Sess. (1998) (Internal Revenue Restructuring and Reform Act of 1998)

Worksheet 24 Excerpts from Conference Report to Accompany H.R. 1836, the Economic Growth and Tax Relief Reconciliation Act of 2001, 107th Cong., 1st Sess., (May 30, 2001)





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