May 21st 2025.
In the state of Washington, both high-net-worth residents and nonresidents who own property in the state are subject to estate taxes. The tax rates can range from 10 to 35 percent, resulting in significant amounts being owed in estate taxes.
Fortunately, the state offers some deductions that can protect most taxpayers' estates. One of these is a standard deduction of $3,000,000, which is available to everyone. This means that for many people, their estate will not be subject to state estate tax.
Another deduction that can be claimed is the qualified family-owned business interest deduction, which can potentially shelter an additional $3,000,000 starting in July 2025. This is great news for small business owners, as it means that their families and heirs may be able to avoid paying state estate taxes on up to $6,000,000 of their estate by the end of 2025.
For example, if someone with a $10,000,000 estate passes away in the latter half of 2025, they may be able to shield $6,000,000 from estate taxes and only pay taxes on the remaining $4,000,000. However, the rules surrounding these deductions can be complex, so it's important to understand the details.
In order to qualify for the qualified family-owned business interest deduction, or QFOBI deduction, there are several requirements that must be met. First, the business must be an active trade or business, meaning it cannot be a passive investment such as real estate. Additionally, the business must make up more than half of the estate and be valued at $6,000,000 or less.
Furthermore, either the deceased or a family member must have been materially involved in the business for at least five of the eight years before their death, either by working 35 hours per week or in a hands-on managerial role. It's worth noting that the QFOBI deduction does not use the popular Section 469 material participation rules, but rather older estate-related rules from Section 2032A, which consider working 35 hours per week as a safe harbor, but also allow for a well-documented managerial role to qualify.
Lastly, at least one family member or a key employee with ten years of employment must work full-time for the three years following the date of death. If these requirements are met, the estate may be able to exclude a significant portion of their estate from being subject to taxes, potentially saving hundreds of thousands of dollars.
To better understand how the QFOBI deduction works, let's look at a couple of examples. Let's say Martha has a business worth $5,000,000 and the rest of her estate is valued at $4,000,000. Her son has been involved in the business for five years and will continue to run it for the next three years. In this scenario, Martha's estate may be able to deduct $3,000,000 from the value of the business and also claim the standard $3,000,000 deduction, leaving only $3,000,000 of taxable estate. This could result in approximately $400,000 in estate taxes in the latter half of 2025.
On the other hand, if John has a business worth $6,000,000 and the rest of his estate is valued at $5,999,999, his estate may be able to exclude $3,000,000 from the business and also claim the standard deduction of $3,000,000. This would leave $5,999,999 of taxable estate, resulting in approximately $1,100,000 in estate taxes.
It's important to be aware of potential pitfalls that could prevent the QFOBI deduction from being used. For example, if there is no family member or key employee already working for the business at the time of death, it may be difficult to meet the three-year requirement. Therefore, it's important to plan ahead and avoid any last-minute scrambling.
Additionally, if the deceased did not pay self-employment tax, the Washington Department of Revenue may question their material participation in the business. Lastly, while the QFOBI deduction cap will increase with inflation starting in 2026, the business worth cap of $6,000,000 will remain frozen. This means that fewer businesses may qualify for the deduction in the future.
Despite these potential hurdles, it's worth considering the QFOBI deduction if you or your clients operate a small business that makes up a significant portion of their wealth. It could save hundreds of thousands or even millions of dollars in estate taxes.
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