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Discover How to Pass Your Family-Owned Business Free of Inheritance Tax

You’ve put your heart and soul into your family business, which took decades to build. Your plan is to transition it to the next generation, and you’ll want to apply that same careful planning to develop a sound family business succession plan. One part of a good succession plan is to reduce inheritance taxes imposed on the transfer of your family-owned business. Here’s some good news – Pennsylvania offers an exemption for certain family-owned businesses.

A Word about Inheritance Tax

Pennsylvania inheritance taxes can be substantial, particularly if the beneficiary is not a spouse, child or lineal descendent of the decedent. The tax rate is based on the relationship of the beneficiary to the decedent: 0% for spouses, 4.5% for children and grandchildren, 12% for siblings and 15% for all other beneficiaries. For a business valued at $5 million, the tax could be anywhere from $225,000 for children, to $600,000 for siblings, to $750,000 for other beneficiaries. The concern is that small, family-owned businesses are often illiquid assets of an estate, most businesses do not have that kind of cash on hand and a tax of this size could force the family to sell the business in order to pay the tax. The bill comes due fairly quickly - inheritance tax is payable within nine months from the date of death.

Qualified Family-Owned Business

In Pennsylvania certain “qualified” family-owned business interests to “qualified transferees” is not subject to Pennsylvania inheritance tax. Thus there are two qualifiers – the business must qualify and the persons to whom the business is transitioned must qualify.

A qualified business is defined as a sole proprietorship or an interest in a business entity (such as a limited liability company, corporation or partnership) that meets the following criteria:

  • Has fewer than 50 full-time employees;

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

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

  • Is wholly owned by the decedent or in conjunction with members of the decedent’s family; and

  • Is engaged in a trade or business that is not simply managing investments.

A qualified transferee is defined as:

  • A spouse;

  • Lineal descendants of the decedent (e.g. children, grandchildren);

  • Siblings of the decedent and their lineal descendants.

The Tax Exemption Can be Lost

The tax exemption that qualified transferees enjoy can be lost. Qualifying for the exemption is not a snapshot at the death of the decedent. In order for the business to qualify for the tax exemption, the business must continue to be owned by a qualified transferee for seven years after the decedent’s death. Transferees are obliged to report any changes to the business that would cause it to no longer qualify for the exemption, such as a sale of all or substantially of the business or its assets to a non-qualified transferee. A certification must be filed annually by each qualified transferee for the seven-year period. Failure to file the certification will result in loss of the exemption and inheritance tax will be due with accrued interest dating back to nine months after the date of the original decedent’s death.

Planning To-Do List

Business owners should take action to ensure their family can benefit from the tax exemption.

1. Prepare a Will or Trust. The most basic first step is to ensure that you have your estate planning documents prepared and in order. Wills and Trusts are excellent ways to accomplish this, and it should not be overlooked. Over half of Americans do not have a Will. This is an easily avoidable mistake. If you do not have a Will or Trust, you’ll be relying on the government’s Will to take care of your family – the law of intestate succession. The government’s Will may not transfer your business to qualified transferees. We’ll state the obvious – do not rely on the government’s Will to take care of your family.

2. Understand Book Value. The tax exemption applies to businesses with a book value of $5 million. This provision relates to the value of the business as a whole, not the decedent’s ownership interest in the business. The exemption is not for $5 million of value from the decedent’s estate; it is for the value of the decedent’s interest in a business that has a book value of $5 million or less. For example, if the decedent owns 50% of a business that has a book value of $10 million, the decedent’s interest is not exempt. “Book value” does not mean the fair market value of the business. Book value is an accounting concept based on the historical cost of assets owned by the business less accumulated depreciation on those assets and less liabilities. It is entirely possible for a business that owns an apartment complex with a fair market value of $10 million to have a book value of less than $5 million if the asset has been depreciated for many years.

3. Consider Restructuring Your Business. The exemption is not limited to a single business. Business owners can pass multiple businesses tax free provided each of them meets the qualifications. This means that if you have a single business that exceeds $5 million in book value, it may be possible for you to restructure your business to separate it into multiple entities that are below the book value threshold. Understanding this threshold may also inform real estate investors and developers about structuring businesses as they’re being built to keep them under the book value threshold.

4. Include Control Provisions in Governance or Estate Planning Documents. Qualifying for and keeping the exemption require that your family hold the business for seven years. You can include provisions in your business and estate planning documents that will prevent your family from selling or doing something else that would cause the exemption to be lost. You will definitely want to give your business or family the ability to avoid having non-qualified transferees become owners, such as in the event of death or divorce. Prudent planning and avoid these types of real-life issues from upending your tax savings plan.

We Can Help with Succession Planning

Substantial business value can pass to family members free of Pennsylvania inheritance tax. With careful planning, family-owned businesses in Pennsylvania can save hundreds of thousands of dollars. Plan your business succession strategy with help from the experienced business and estate planning attorneys at Fiffik Law Group. Contact us today.


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