Under a new estate tax law in Minnesota, deceased owners of a qualified small business or a qualified family farm may deduct up to $4 million of the value of the business or farm from the Minnesota adjusted taxable estate for purposes of determining Minnesota estate tax. The law is effective for business or farm owners who pass away after June 30, 2011.
Details and Scope of the New Estate Tax Law
Minnesota imposes a tax on estate assets in excess of $1 million at a variable tax rate that depends on the size of the estate, averaging between 10% and 16%. For small business and farm owners, this can mean that a significant part of a family's wealth is subject to tax at the owner's death. Minnesota's new estate tax law, while narrow in scope, attempts to alleviate this tax burden in certain circumstances.
The new law applies to small businesses that are actively engaged in a trade or business, and that have gross annual sales that do not exceed $10 million for the tax year ending just before the decedent died; or, to family farms that the deceased owner (or the decedent's spouse) claimed as homestead property. The decedent (or the decedent's spouse) must have materially participated in operating the trade or business or farm, and must have owned the business or farm for at least three years before death.
The deceased owner's estate can exclude up to $4 million of the value of the business or farm from the owner's taxable estate. If the trade or business includes holdings of cash or cash equivalents, those assets are not included for purposes of calculating the deduction.
To obtain the exclusion, the small business or farm interest must pass directly to a "qualified family member." It is not sufficient that the family member receive the proceeds from the sale of the business interest or farm property. If the family member sells the inherited interest in the business or farm within three years of receipt, the family member or the estate must pay a recapture tax on the amount initially claimed under the exemption, at a rate of 16%. No recapture tax is triggered, however, if there is a sale or transfer of the interest to another qualified family member.
Important Terms Defined
A qualified heir must be a family member who acquired the property from the decedent and continuously uses the property in the operation of the trade or business for three years following the decedent's death.
A family member is defined under the Internal Revenue Code as the decedent's spouse, parent, grandparent, children, other lineal descendants, or lineal descendant of the decedent's spouse or parents, and the spouse of any lineal descendant.
In addition, the Internal Revenue Code specifically includes indirect ownership by a trust, corporation or partnership under the definition of a family member.
There are some nuances to consider under the new estate tax law:
- Transfers to trust. The new law needs to be reconciled with the current Minnesota corporate farming statutes, which place restrictions on owning, acquiring, or otherwise obtaining interests in agricultural land or engaging in farm activities, unless transferred to or owned by a qualifying family farm trust, charitable remainder trust, charitable lead trust, or other specific family-owned entity. Presumably, a transfer of a qualified family farm at death from the decedent to a qualified family member through a family farm trust to sustain family property ownership would qualify for the exemption; however, transfers of the family farm or agricultural land raise issues that require further analysis and careful planning. Your attorney can help you navigate the intricacies of these laws.
- Licensed business activities. Companies that provide a professional trade or business which require the owner to be licensed to carry out the trade or business may utilize the exemption only if the qualified family member is also appropriately licensed to carry on the trade or business.
- Partial transfers. Transfer of the entire business or farm to a qualified family member is not required; a deduction is available for the portion of the interest being transferred.
- How to claim exemption. To claim this new exemption, Schedule M706Q must be submitted with the Minnesota estate tax return. This form is not yet available from the Minnesota Department of Revenue.
- Difference from federal election. Making the new election under Minnesota law differs from the § 2032A federal election for special land use valuation. For example, special land use valuation for farm property under the federal election, among additional considerations, requires that the farm assets make up at least 50% of the gross estate, the property must be owned by the decedent (or a family member) for five of the past eight years, and the qualified heir receiving the property at the decedent's death must maintain the qualified use of the property for ten years following the decedent's death to avoid a recapture tax. The federal election requires a timely filed estate tax return, an agreement of the parties regarding use and personal liability, and notice of election. Therefore, the Minnesota exemption may be more flexible and appealing for filers.
Suppose for the past ten years you have solely owned a small Minnesota corporation that manufactures boats, with gross annual sales of $3 million for the year 2010 and an appraised discounted value of $4 million for 100% ownership of the shares, excluding any cash and cash equivalents. Your Shareholder's Agreement/Buy-Sell allows for the designation of a successor owner for the shares. You pass away on December 1, 2011, and your revocable trust names your child as the recipient of your shares. Your estate and your child file Form M706Q with the Minnesota estate tax return, claiming an exemption under the new law of $4 million and therefore owe no estate tax on this asset. Your child continues to run the boat manufacturing business for the next three years, which does not trigger any recapture tax.
If your child sold the business or ceased to continue operating the business within three years of your death, your child would owe $640,000 of recapture tax on the $4 million claimed on form M706Q. Suppose, also, the situation in which the new estate tax exemption had not been claimed, or could not be claimed. The Minnesota estate tax on your full estate, valued at $5 million, taxed at a rate of 7.83%, would be $391,600 due at your death.
A fact sheet publication by the Minnesota Department of Revenue can be found here.