An estate planning expert gives some tips to take full advantage of the Family-Owned Business Exemption.

Last month, we asked readers to send us questions about their estate transfer problems and we'd try to get answers. Here's how estate planner Kathy Boyd from Limon, CO, addresses one of our reader's questions about the "50% test."

Question: Is it true that 50% of a farmer or rancher's income must be from the farm/ranch operation in order for that individual to qualify for the new Family-Owned Business Exemption?

Answer: This is a great question and gives us a chance to clear up a misunderstanding. In the March issue of BEEF, "Developers Can't Have It," page 30, the first paragraph states that: "In addition, since the Mays are actively ranching, they're eligible for a personal business exemption ... as long as the ranch provides more than 50% of their income ..."

Actually, the new Family-Owned Business Exemption (FOBE) established in the Taxpayer Relief Act of 1997 (TRA97) can provide estate tax relief for owners of small businesses, farms or ranches based on how much of their total estate is made up of the business interest. The value of the qualified business interest that will pass to qualified heirs must exceed 50% of the value of the adjusted gross estate. Availability of the FOBE does not depend on income at all.

Since a number of family farm and ranch owners meet this "50% test," some other pertinent information about the FOBE will most likely be helpful.

1. The FOBE was designed to coordinate with the Personal Exemption Against Federal Estate Tax (which every taxpayer is entitled to). In 1998, the personal exemption is $625,000. In 1998, the FOBE is $675,000 - for a total exemption available to a qualifying business owner of $1.3 million.

In 1999, when the personal exemption increases to $650,000, the FOBE is set at $650,000 - again for a total of $1.3 million.

In 2000 and 2001, the personal exemption increases to $675,000, so the FOBE will be $625,000. There is once more a total exemption of $1.3 million.

In 2006, when the personal exemption levels off at $1 million, the FOBE also evens out - at $300,000 - adding up to $1.3 million.

It's important to note that there is no plan to expand either exemption past 2006, so business owners will have a maximum reduction of $1.3 million.

2. The FOBE is available if the entire value of the business (including land, buildings, machinery, equipment, livestock, crops growing, crops in storage, water rights, sheds and grain bins, etc.) is more than 50% of the total adjusted gross estate.

3. If the business interest has a significant amount of debt against it, then the owner may not be able to qualify for the FOBE. The net value of a heavily indebted business interest may not be at least 50% of the total adjusted gross estate.

A $1 million farm with $500,000 of debt only has a net value of $500,000. If the farmer also has money in investments, for example a home in town, several rentals, and a collection of antique tractors (not a qualifying business asset), then the net value of the business interest is not more than 50% of the estate.

4. The family-owned business interest must pass to a qualified heir (ancestor, spouse, lineal descendant, etc.) or can pass to an employee who was actively employed by the business for at least 10 years prior to the business owner's death.

5. During at least five out of the eight years prior to the business owner's death, that owner (or member of his/her family) must have owned and "materially participated" in the operation of the business.

6. "Material participation" is defined as either actively working in or at least helping with the management decisions of the farm or ranch. (This exemption is meant to help those actually involved in a family operation, not those who are merely passive investors.)

7. The deceased business owner must have:

* Owned the business as a sole proprietor, or

* The owner and the family owned at least 50% of the business, or

* The business was at least 70% owned by two families, and the decedent and family owned at least 30%, or

* The business was at least 90% owned by three families, and the decedent and family owned at least 30%.

8. The business owner must be a citizen or resident of the U.S. on the date of death.

9. The principal place of business must be the U.S.

10. The stock (or debt) of the business must not have been publicly traded within three years of the business owner's death.

11. The estate executor must specifically elect the Family-Owned Business Exemption exclusion at the business owner's death.

12. The qualified heir cannot dispose of the business (other than to another member of the qualified heir's family) or cease to materially participate in the operation of the business within 10 years of the business owner's death. This is known as the recapture period. If the qualified heir does not adhere to the recapture rules, the estate taxes originally saved by the exemption must be repaid with interest on a pro-rata basis.

If farmers and ranchers want their families to take advantage of the Family-Owned Business Exemption, they have to plan ahead. They will need to carefully consult with advisors before considering dispositions of business interests during their lifetimes, since the "50%" test must be met. (The days of merely "giving the land to kids" prior to death are long gone.)

Qualifying for the FOBE, however, can significantly benefit the succeeding family members. The FOBE is subtracted directly from the gross estate.

The example on page 46 illustrates the substantial savings resulting from the use of the Family-Owned Business Exemption.

For many family farm and ranch heirs, an estate tax savings of $300,250 could make the difference between keeping an operation viable - or having to sell the entire business to pay the tax bill.

If you have other estate planning questions, please send them to Greg Lamp, BEEF, 7900 International Drive, Ste. 300, Minneapolis, MN 55425.

John Rancher's Gross Estate -- $2,000,000

Less: Family-Owned Business Exclusion (FOBE) -- (675,000)

John Rancher's Adjusted Taxable Estate -- 1,325,000

Estate Tax (from IRS tax table - approximately 43% bracket) -- 480,550

Less: Unified Credit (tax equivalent on first $625,000 of assets) -- (202,050)

Takes advantage of the "$625,000 Personal Exemption"

Net Estate Tax -- $ 278,500

John Rancher's Gross Estate -- $2,000,000

No Family-Owned Business exclusion Deducted -- 0 -

John Rancher's Adjusted Taxable Estate -- 2,000,000

Estate Tax (from IRS tax table - approximately 49% bracket) -- 780,800

Less: Unified Credit (tax equivalent on first $625,000 of assets) -- (202,050)

Takes advantage of the "$625.000 Personal Exemption"

Net Estate Tax -- $ 578,750