Updated: Oct 27, 2022
The greatest part of America's wealth lies with family-owned businesses. According to the US Census Bureau, family firms comprise 90 percent of all business enterprises in North America. More than 30% of all family-owned businesses make the transition into the second generation. Without tax-efficient planning, the inheritance tax bill that comes due on the transfer from one generation to the other can be crippling for a small business. There’s a way to avoid that.
Inheritance Tax on Family-Owned Business
Certain family-owned businesses can be passed to the next generation and earn an exemption from inheritance tax. Pennsylvania has an inheritance tax that applies in general to transfers resulting from a person’s death. The tax rate depends on the relationship of the recipient to the decedent (i.e., 0% for a spouse; 4.5% for a lineal descendant (child or grandchild). The tax bill can be difficult to pay for a business that is not flush with cash. For example, a family plumbing business valued at 1 million dollars will have a tax bill of $45,000. That can eat up a large piece of the net operating margin for a business.
Qualified Family-Owned Business Tax Exemption
Businesses meeting certain criteria (known as “qualified” businesses) transferred to certain transferees can avoid inheritance tax. A “qualified family-owned business” is defined as a sole proprietorship or business entity (like an LLC or corporation) that was in business for five years prior to the decedent’s death and at the time of the decedent’s death has (i) fewer than fifty full-time equivalent employees and (ii) assets with a net book value less than $5,000,000. Further, the business qualifies only if it was wholly owned by the decedent or by the decedent and eligible family members (i.e., spouse, lineal descendants, siblings, sibling’s lineal descendants, ancestors and ancestor’s siblings). Plus the entity must have a trade or business with a principal purpose other than the management of the entity’s investments or income-producing assets.
Eligible Transferees of Business
The exemption applies only if the decedent’s interest in a qualified family-owned business is transferred to one or more eligible family members (i.e., spouse, lineal descendants, siblings, sibling’s lineal descendants, ancestors and ancestor’s siblings.) Thus, the class of eligible transferees is the same as the class of family members who can have an ownership in a qualified family-owned business entity at the time of the decedent’s death.
The Family Must Continue Operating for Seven Years
The exemption applies so long as a qualified transferees continue to own the and operate the business for at least seven years after the decedent’s death. If the exemption is lost, the business interest will be subject to tax as though the exemption never applied, with interest accruing from the original due date that otherwise would have been in effect. The owner at the time of the disqualification will have the personal obligation to pay the resulting tax and interest. During the seven-year period, each owner must certify to the Department of Revenue on an annual basis that the interest continues to be owned by an eligible transferee. Any transaction or occurrence that causes the qualified family-owned business interest to fail to qualify for the exemption must be reported to the Department of Revenue.
Penalty for Last Minute Planning
To prevent people from making transfers in contemplation of death merely to avoid tax, the law provides that if the decedent added property to the qualified family-owned business within one year of death, such property will not be exempt unless it was added for a legitimate business purpose. It pays to plan well in advance.
Other Benefits of Advanced Planning
There are benefits to planning in advance beyond the tax benefits. Family-owned businesses that struggle with the transition often have one or more of these problems:
Nextgen leader not defined. Every business needs an undisputed leader. A successful succession plan for a businesses with multiple family members involved includes defining who that next leader will be. You do not want to leave a power struggle as your legacy for the family or business.
Undefined roles. When the founder of the business is involved, defining the roles of family members is less of an issue. However, when that founder passes away or retires, family members who had overlapping and potentially unclear roles can be a source of conflict. Existing family dynamics and communication styles that are inappropriate in a work environment may worsen business conflicts. Planning in advance allows the founder to clearly define roles once they exit the business.
Fairness to family not involved in the business. This is one of the most difficult problems to solve. Usually the business is a large portion of the owner’s wealth. How do you pass the business to one child but be fair to the others who are not involved? There are a wide variety of options for solving this problem but they all require advanced planning.
Uncertainty for customers and employees. Your employees and customers all need to have confidence that they can rely on your business continuing once you are gone. Lack of continuity creates chaos, service disruptions, late bill paying, and other problems. The business that has an ill-defined or non-existent succession plan creates uncertainty that can cause employees to seek other jobs and customers other providers for products and services.
Read More: Business Continuity Planning
Our Experienced Estate Planning and Business Attorneys Can Help
Do you need help navigating the issues of succession planning for a family business? Our attorneys are ideally suited for this need as we complete thousands of estate plans annually while also representing hundreds of small businesses all over Pennsylvania, many owned by families such as yours. Contact our office to schedule an in-person, video or phone appointment.