The Pennsylvania Inheritance Tax Act was amended recently to exempt interests in a “qualified family-owned business” from the Inheritance Tax. The goal of this exemption is to preserve certain family-owned business enterprises in the event of the death of the owner. Although the exemption makes for a good sound bite, it will have limited application for business succession planning.

The exemption applies if (1) the transfer is to one or more “qualified transferees,” (2) the qualified transferee(s) continue to own the business for a seven-year period after the date of death, and (3) the transfer is reported on a timely filed Inheritance Tax return. A “qualified transferee” includes the decedent’s spouse, children and other descendants, siblings, the descendants of siblings (nieces and nephews), as well as the decedent’s ancestors and the siblings of ancestors (so a decedent’s parents and the siblings of parents are included).

Each qualified transferee must certify to the Department of Revenue each year for seven years, that the family business continues to be owned by one or more qualified transferees. The failure to make this certification will result in loss of the exemption. The consequence of the loss of the exemption is that the Inheritance Tax that was avoided is due plus interest on the amount due.

The definition of a qualified family-owned business interest (a “QFOBI”) depends on whether the QFOBI is a sole proprietorship or an entity such as a corporation, partnership, or LLC, although there are requirements common to both a sole proprietorship and an entity, all of which are evaluated as of the date of death. First, there must be fewer than 50 “full-time equivalent” employees. Second, the net book value of the business must be less than $5,000,000. Third, the business must have been in existence for five years.

If the QFOBI is an entity, there are two additional requirements. First, the entity must be wholly owned by the decedent and qualified transferees. Second, the entity must be engaged in a trade or business which is not the management of investments or income-producing assets.

There are a number of issues (and perhaps opportunities) with the QFOBI exemption. For example:

• The definition of “qualified transferee” does not include a trust that benefits one or more qualified transferees. Trusts are often an important part of a client’s estate plan, such as providing the surviving spouse with creditor protection or consolidated asset management, so this definitional limitation will restrict planning for certain clients.
• A QFOBI that is an entity must be wholly owned by the decedent and qualified transferees. Therefore, businesses that are owned in any part by an unrelated person are not QFOBIs. For example, a partnership or corporation owned by two unrelated persons does not satisfy the definition. Similarly, based on the definition of a qualified transferee, it appears that in-laws are not qualified transferees, so a business owned by two brothers-in-law would not qualify. Furthermore, the definition excludes businesses that have rewarded valuable, unrelated employees with minority ownership interests.
• There are no exceptions to the annual certification requirement. The penalty for failing to meet this requirement is harsh, and a reasonable cause exception would be fair accommodation.
• The definition of “entity” requires that the entity be in existence for five years. What if as of the decedent’s date of death the entity existed for three years and the entity’s creation was preceded by three years of a sole proprietorship? Logic would dictate that the QFOBI exemption would apply, but this is not clear from the definition.
• What is a “full-time equivalent employee”? This definition will be important for certain businesses that have part-time employees, such as restaurants and seasonal businesses.
• How will the Department of Revenue approach family limited partnerships? A family limited partnership generally will be owned exclusively by qualified transferees, but disputes may arise over whether the partnership was “engaged in a trade or business which is not the management of investments or income-producing assets.”
• The $5,000,000 book value requirement favors service oriented businesses (such as consulting) over capital intensive businesses (such as manufacturing or construction).
• There is no “common holding” limitation. Therefore, for certain businesses that do not meet the QFOBI definition, a spinoff of a division into a separate entity may be considered to divide employees and equity to ensure that both entities qualify as QFOBIs.

Although the QFOBI exemption will benefit some business owners, the exemption has limited application. In addition, many business succession plans involve the lifetime transfer of business interests, such as a sale to a third party or a transfer to one or more family members. This lifetime planning should not be affected by the exemption. Also, the growth and success of a family business should not be constrained by trying to maintain QFOBI status. Many planning techniques exist to mitigate or eliminate exposure to the Inheritance Tax (and the Federal Estate Tax), and these techniques can be employed to allow for the growth of a family business beyond the definitional limitations.