Summary

Pennsylvania has enacted legislation that exempts certain family-owned business interests from its Inheritance Tax. Among the bills passed and signed by the governor during the annual budget process is one that permits families who inherit qualified businesses and continue to operate them for a period of years to pay no Inheritance Tax on those business assets. As is the rule with all tax legislation, it is important to examine carefully the definitions, requirements and limitations in the new law.

What is exempt?

The transfer of a qualified family-owned business interest is exempt from inheritance tax. In order to be “qualified,” a business must be operated as a proprietorship (one individual owner) or through a business entity such as a corporation, partnership or LLC. The business must have fewer than 50 employees and a net book value of less than $5 million. Note that the law refers to book value, which often has little relation to the fair market value of a business. To be considered a family business, the business must be owned by the decedent alone or by the decedent and members of the decedent’s family, and the business must have been in existence for five years prior to the decedent’s death. Entities like LLCs, partnerships or corporations whose principal purpose is to manage investments are not qualified. The exemption also does not apply to assets transferred into the business within a year of death, unless the transfer was for a legitimate business reason.

Are there limitations on who may inherit the qualified business interest?

In order to benefit from the exemption from inheritance tax, the decedent must transfer the qualified business interest to members of the decedent’s family – those family members are referred to as “qualified transferees.” Qualified transferees consist of the decedent’s spouse, lineal descendants (children, grandchildren, etc.), siblings, the lineal descendants of siblings, ancestors (parents, grandparents) and siblings of ancestors.

For a period of seven years from the decedent’s death, the business must remain owned by qualified transferees. If that does not occur, the inheritance tax, plus interest, will be imposed. The transferees must certify each year that they continue to own the interest. The transferees, however, do not have to operate the business, just own it. After the seven years have elapsed, the business can be sold to outsiders without incurring inheritance tax.

What planning benefits are available under the new law?

This new provision takes effect immediately. For qualified businesses, the law eliminates an inheritance tax liability that can range from 4.5 percent to 15 percent, and will benefit owners who want to keep the business in the family after the owner’s death. The law does not apply to, and is not needed for, interest transferred by the decedent more than one year before death, because Pennsylvania has no state gift tax, and only taxes assets given away within one year of death. The benefits of this new law can be combined with a business succession plan involving transfers of interests during the business owner’s lifetime to help ensure that the next generation of business owners is not crippled by transfer tax at the first owner’s death.