Estate Tax Deduction for Qualified Family-Owned Business Interest Denied
In Farnam,1 the Tax Court held that for purposes of Section 2057 2 (relating to estate tax deductions for certain qualified family-owned business interests), loans by a decedent to a corporation are not treated as interests in the corporation.
Over the years, Mr. and Mrs. Farnam, other members of the Farnam family, and entities owned by the Farnam family loaned funds to a family-owned corporation. These loans were evidenced by promissory notes, and the funds were used in the business operations of the corporation. The parties stipulated that these promissory notes were legitimate debt obligations of the corporation.
Mr. Farnam died in 2001 and Mrs. Farnam died in 2003. At the time of their respective deaths, Mr. and Mrs. Farnam each owned 500 shares of the 1,000 outstanding shares of voting stock of the corporation. All of the 99,000 shares of nonvoting stock were owned by the Farnams' son. Upon Mr. Farnam's death, his voting stock was distributed to his son. On the federal estate tax returns of both Mr. and Mrs. Farnam, a deduction was claimed under Section 2057 for qualified family-owned business interests.
For decedents dying before January 1, 2004, in determining the amount of the decedent's taxable estate, Section 2057 allows a deduction, not to exceed $675,000, for the value of qualified family-owned business interests owned by the decedent. To qualify for the deduction, the decedent or a member of the decedent's family must have owned and materially participated in the trade or business for at least five of the eight years preceding the date of the decedent's death. In addition, the value of the qualified family-owned business interests included in the decedent's gross estate, plus the value of certain gifts of such interests by the decedent, must exceed 50% of the decedent's adjusted gross estate.
In determining whether the 50% test was satisfied, the personal representative of both Mr. and Mrs. Farnam's estates included not only the value of the stock in the corporation that they owned but also the value of the promissory notes to the corporation that Mr. and Mrs. Farnam owned directly as well as those they owned indirectly through their ownership interests in entities that made loans to the corporation. The IRS disallowed the Section 2057 deduction for the qualified family-owned business interests in both Mr. and Mrs. Farnam's estates, and issued statutory notices of deficiency.
The parties stipulated that if the promissory notes were treated as qualified family-owned business interests, then Mr. and Mrs. Farnam satisfied the 50% test. Similarly, the parties also stipulated that if the promissory notes were not treated as qualified family-owned business interests, then Mr. and Mrs. Farnam did not satisfy the 50% test.
The issue before the Tax Court was one of statutory interpretation, specifically the meaning of the term “qualified family-owned business interest” as that term is defined in Section 2057(e)(1)(B). The estates of Mr. and Mrs. Farnam contended that the word “interest” as used in that section included not only an equity interest but also included debt interests. The IRS, on the other hand, argued that the term “interest” did not include debt interests but included only equity interests.
The court found for the IRS and held that the term “interest” included only an equity interest and did not include a debt interest. The court noted that no Regulations under Section 2057 have been issued and stated that the legislative history of Section 2057 was not of particular help in resolving the issue.
Turning its analysis to the statute itself, the court noted that throughout Section 2057 words expressly denoting equity ownership are used. For example, Section 2057(e)(1)(A) provides that with respect to a sole proprietorship, the term “family-owned business interest” means “an interest as a proprietor in a trade or business.” In addition, Section 2057(e)(3) expressly uses the terms “stock” and partnership “capital” interest. Finally, Section 2057(e)(1)(B)(i) refers to certain ownership percentages of the entity in question. Having held that debt interests cannot be taken into account for purposes of Section 2057, Mr. and Mrs. Farnam did not satisfy the 50% test, and therefore they were not eligible to deduct the value of their ownership interest in the corporation for estate tax purposes.
Section 2057 is currently of limited applicability because it has been repealed. There are, however, undoubtedly a number of cases in the audit or appeal pipeline that may be affected by this case. If and until Section 2057 is reinstated, the decision on the manner in which to capitalize a business using a combination of debt and/or equity will not have an impact on the availability of Section 2057. Nevertheless, practitioners should be aware that H.R. 4042, introduced on November 1, 2007 in the House of Representatives, proposes to reinstate Section 2057 and increase the maximum allowable deduction to $8 million.
1 130 TC No. 2 (2/4/08).
2 The provision for qualified family-owned business interests was enacted in the Taxpayer Relief Act of 1997 as an exclusion from the gross estate under Section 2033A. In the Internal Revenue Service Restructuring and Reform Act of 1998, the provision was moved to Section 2057 and was converted from an exclusion to a deduction. Section 2057 is substantially the same as former Section 2033A. The Economic Growth and Tax Relief Reconciliation Act of 2001 repealed Section 2057 for estates of decedents dying after 12/31/03. In the absence of action by Congress, Section 2057 is scheduled to be reinstated for estates of decedents dying after 12/31/10.
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.