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Estate planning vs. income tax planning in the auto-parts business

October 09, 2009

When you go to the bank for a loan for your business, the banker will usually consider loans that you make to your business to be about the same as equity.

The estate tax rules don't look at it that way.

There is a special estate tax deduction for a "qualified family-owned business interest." Section 2057 lets you reduce your taxable estate by as much as $675,000 if more than half of the taxable estate consists of such "qualified" interests.

Duane and Lois Farnam died owning Farnam's Genuine Auto Parts, which has stores in Minnesota, North Dakota and South Dakota. Their estates claimed the Section 2057 deduction. Unfortunately, much of their investment in the business was in the form of loans. The Eighth Circuit yesterday said that the loans don't count as an interest in a family-owned business:

Even without the context of the statute as a whole, the plain and ordinary meaning of the words "interest in an entity," is that the person who holds that interest has an ownership interest in it. In contrast, it strains common understanding to say that a person holds an interest in an entity merely because he or she is a creditor of that entity

One of the judges on the panel disagreed:

No one questions that prior to the deaths of Lois and Duane Farnam, they, along with their son, were vested with full ownership of their family auto parts supply business. Part of that ownership interest was in the form of indebtedness owing to the Farnams, not as mere creditors of the family corporation, but by virtue of family shareholder loans made by the Farnams as part of the family's plan for the structure and ownership of this family business. To determine, as has the majority, that such debt interest does not constitute a "qualified family-owned business interest" ignores the real life practicalities of family business planning and is directly opposed to the congressional intent reflected in section 2057.

A sensible dissent, but it didn't carry the day.

This is a case where income tax planning conflicts with estate planning. If the business was a C corporation, standard income tax planning would favor using lots of debt to capitalize the business so the owners can take cash out as deductible interest, rather than non-deductible dividends. This case shows that such income tax planning can be expensive when you file the estate tax return.

The Moral: The estate tax is hard. Qualifying for special breaks for small businesses requires careful work with an estate tax specialist.

Cite: Farnam, CA-8, No. 08-3196.

Tags: Estate planning.estate tax.