By Michael A. Fritton, CPA
Principal, Somerset CPAs, P.C. – Agribusiness Team
Farmers and ranchers are typically strapped for cash so when one of them dies leaving an estate large enough to be exposed to the federal estate tax the family can expect to have to sell something to cover the tax. That does not have to be the case. The estate tax has been described as a “voluntary” tax. Voluntary, that is, if you are willing and able to take advantage of the planning opportunities that are in the law. If not, life insurance can be a very appealing alternative to having to sell the family farm.
There are several strategies that can be employed to ease or eliminate the federal estate tax burden. At the most basic level, a married farmer or rancher can postpone any estate tax until the death of their surviving spouse by utilizing the unlimited estate tax marital deduction. This is because since 1981 that deduction exempts from tax any property that the decedent leaves to their surviving spouse. Of course, any of that property which is still remaining in the surviving spouse’s hands at his or her death will be exposed to tax but at least the couple gets to postpone any tax until the second death.
Even though the marital deduction is a great estate planning opportunity it is also a trap for the unwary. That is because while a taxpayer can avoid any estate tax on their death by simply leaving all of their property to their spouse, such an approach may cause an unnecessary increase in estate tax at the surviving spouse’s death. The reason is that the first spouse to die would not be properly utilizing their applicable estate tax exclusion amount. To avoid this problem an individual’s Will is usually drafted to provide that property equal to their applicable estate tax exclusion be placed in what is called a “By-Pass” trust with the remainder of the estate given to the surviving spouse under the marital deduction. This approach still avoids any estate tax at the first death because the amount in the By-Pass Trust is shielded by the applicable estate tax exclusion while the balance is covered by the marital deduction.
The individual’s spouse should not be concerned about losing access to the amount in the By-Pass Trust. According to the Trust’s terms, all the income can go to the spouse and the trustee can have the discretion to pay the spouse as much of the principal as necessary. Further, the spouse can have the right to demand the greater of $5,000 or 5% of the Trust principal each year.
By taking the By-Pass Trust/Marital Deduction approach, the advantage becomes apparent when the surviving spouse dies. The value of the property in the By-Pass Trust will not be included in the spouse’s estate and will not be subject to estate tax. The is because the spouse will not be deemed to own the property in the Trust and only property that the spouse owns at death is subject to the estate tax. So, whatever is left in the By-Pass Trust, at the spouse’s death, can go to the couple’s children or other beneficiaries free of estate tax.
What will be taxed at the surviving spouse’s death will be the amount of property that the spouse has in excess of the spouse’s own estate tax applicable exclusion. This figure will be comprised of the spouse’s own separate property plus what remains of the property that the spouse received under the marital deduction.
The advantage of employing the By Pass Trust in combination with the marital deduction as opposed to giving all the property to the surviving spouse may be seen from the following example:
- Assume that the first spouse dies in 2011 with an estate of $15,120,000 when the estate tax applicable exclusion is $5,120,000.
- Assume further that the surviving spouse has no separate property and dies in 2012.
Unlimited Marital Deduction Marital Deduction/By-Pass Trust
First Death in 2011 First Death in 2011
$15,120,000 Gross estate $15,120,000 Gross Estate
$15,120,000 Marital Deduction $10,120,000 Marital Deduction/$5,000,000 By-Pass
$0 taxable Estate $0 Taxable Estate
Second Death in 2012 Second Death in 2012
$15,120,000 Gross Estate $10,120,000 Gross estate
$5,120,000 Exclusion $5,120,000 Exclusion
$10,000,000 Taxable Estate $5,000,000 Taxable Estate
$3,500,000 Tax $1,750,000 Tax
As the above example demonstrates, $1,750,000 of estate tax can be saved on the second death by dividing the estate between the marital deduction and the By-Pass Trust. It should be noted, that if the surviving spouse had actually died first their estate tax applicable exclusion would have been wasted. This is because that spouse would have had no separate property with which to set up a By-Pass Trust if they died first. To solve that problem the spouse with all the property should consider giving an amount of property equal to the estate tax applicable exclusion to the spouse with nothing. (For this purpose you should note that the gift tax marital deduction would prevent any gift tax from applying to such a transfer.) That would assure the same over all estate tax savings whichever spouse died first.
This is a new concept to the federal estate tax that was introduced by the 2010 tax act. Basically it allows the executor of a deceased person’s estate to transfer any of their unused estate tax exclusion to their surviving spouse. The problem is that the portability provision only applies to those dying in 2011 and 2012. Therefore if a person relies on portability and it is not in effect at their death after 2012, their estate tax exclusion is wasted. This means that those writing wills in 2011 and 2012 are not likely to use portability and risk wasting their estate tax exclusion.
Special use valuation of farm or small business property.
The second basic estate tax saving technique that is available to farmers and ranchers pertains to the special use valuation of farm or ranch property. This is because in 1976 Congress enacted Internal Revenue Code Section 2032A finding it desirable to encourage the continued use of real estate for farming, ranching and other small business purposes. Prior to the passage of Section 2032A, real estate that was included in a decedent’s estate was valued at its fair market value. Consequently, where the realty was used for farming, ranching or other small business purposes, including it in the estate at fair market value often created a substantially higher estate tax liability than was warranted, considering the value of its use as a farm, ranch or small business operation.
Section 2032A permits real estate that qualifies to be valued in the estate on the basis of its actual use rather than its higher fair market value. This means that where the provision applies, it grants relief to the heirs of farmers, ranchers and small business owners who wish to carry on the family business and might otherwise find that fair market value produces such a large estate tax that they have to sell the property to pay the tax.
There is a $1,040,000 limit per decedent for 2011 on how much the real estate may be reduced from its fair market value to its actual use value. For example:
- Assume that the estate of a decedent contains qualifying farmland with a fair market value of $1,500,000 that is worth $400,000 as a farm.
- It will be included in the estate at a value of $460,000. This is because while the difference in value is $1,100,000 the maximum reduction is only $1,040,000 (as adjusted for inflation).
- Here it should be noted that between a husband and wife the total reduction in value after both deaths is two times $1,040,000 or $2,080,000.
The problem with Section 2032A (like other tax saving provisions) is that it requires certain conditions to be met. Even where those requirements can be complied with, the parties may consider them too onerous to be worth the tax benefit. Among the stipulations for 2032A to apply are the following:
- The decedent must be a resident or citizen of the United States.
- The property can only pass to certain members of the decedent’s family.
- The decedent or a member of the decedent’s family must have owned the property and materially participated in the operation of the farm or business for 5 of the 8 years before and after the decedent’s death.
- The value of the real and personal property used in the farm or business must comprise at least 50% of the value of the decedent’s gross estate.
- At least 25% of the value of the decedent’s gross estate must be represented by the value of the farm or small business real estate.
- If the decedent’s family disposes of the property or ceases to use it in the prescribed manner for the required period, the tax benefits are recaptured through the imposition of an additional tax.
While the theory of 2032A is not difficult to understand, it is extremely complicated to apply in practice. If you have a customer who is contemplating the use of 2032A to minimize estate taxes, have them seek the necessary expertise.
Installment payment of estate tax on farm, ranch or closely-held small business property.
If more than 35% of a decedent’s adjusted gross estate consists of an interest in a farm, ranch or other closely-held business, the executor may elect to defer payment of the estate tax attributable to the farm or business for 5 years (paying interest only), and thereafter pay the tax in equal installments over the next 10 years. In addition, pursuant to the 1997 tax act for decedents dying after 1997, interest is imposed at a 2% rate on the first $486,500 of tax (for 2012) The rate imposed on the balance of the deferred tax is reduced to 45% of the rate applied to underpayments of tax.
As previously stated, to qualify for this benefit under Internal Revenue Code Section 6166, more than 35% of the decedent’s estate must be comprised of the interest in the farm, ranch or other closely-held business. In applying this rule it does not matter whether the interest is held as a proprietorship, partnership or corporation. It must, however, be operated as an active trade or business since a passive rental of property does not count. In any case, the problem with Section 6166 is that like Section 2032A it puts limits on the family’s use and disposition of the property in question. Because of taxpayer noncompliance with payment obligations the IRS has imposed onerous requirements, such as a surety bond, that mean that Section 6166 is no longer a feasible strategy.
Estate tax saving through gifting.
Beyond the basics of the marital deduction, 2032A and 6166 the next level of estate planning begins with the understanding that individuals with estates in excess of the estate tax applicable exclusion (and married couples with twice that amount) face the possibility of federal estate tax liabilities upon their deaths. In that regard, the only way to avoid the tax is to dispose of the excess before death or to leave it to charity at death.
As to dispositions before death, for those who can afford it, a lifetime gifting program provides a means of estate tax savings while enjoying the personal satisfaction that comes from helping others. The problem, however, is that the donor is exposed to gift tax on the transfers. That may be mitigated however, through the use of the donor’s annual gift tax exclusion and gift tax applicable exclusion amount.
The gift tax annual exclusion and $5 million gift tax applicable exclusion.
The gift tax “annual exclusion” is simply a rule that allows a person to give to as many people as they want each year $13,000 gift tax free. Further, if they are married and their spouse consents in making the gift the couple can transfer $26,000 to as many individuals as they choose gift tax free. For example, a couple with three children could give each child $26,000 for a total of $78,000 gift tax free.
The gift tax “applicable exclusion” is a rule that permits individuals to give away $5.12 million gift tax free during 2012. This $5.12 million is in addition to what can be given away using the annual exclusion. For example, assume that a married couple gave each of their three children $54,000 for a total of $162,000. This would result in a gift to each child of $28,000 in excess of the amount that the parents can give tax free by utilizing their combined annual gift tax exclusions ($54,000 – $26,000). To avoid having to pay a gift tax on the $28,000 excess to each child, the parents would offset the excess against their $5.12 million gift tax applicable exclusion. Since each parent’s share of the excess would be $14,000 per child (1/2 of $28,000) and there are three children, the reduction in each parent’s gift tax applicable exclusion would be 3 x $14,000 or $42,000.
Further, for every year that the gifts are repeated, each parent’s gift tax applicable exclusion would drop by another $42,000. Consequently, if the gifts were continued for ten years, each parent’s gift tax applicable exclusion would be reduced by 10 x $42,000 or $420,000. Note that pending Congressional action the gift tax applicable exclusion is scheduled to drop to $1 million after 2012.
Gifting at a discount.
With the above gifting opportunities in mind it is apparent that a farmer or rancher can significantly reduce the size of their estate and consequent estate tax exposure through a gifting program to their heirs using the annual exclusion and $5.12 million applicable exclusion. Moreover, farmers and ranchers may also leverage the annual exclusion and $5.12 million applicable exclusion by repackaging the farm or ranch property that is to be given away in a business structure that allows discounts to be taken against the value of the gift for lack of marketability and lack of control. The idea behind leveraging with discounted gifts is to structure the transfer in a way that allows the value of the gift to be reduced before applying the gift tax annual exclusion and the $5.12 million gift tax applicable exclusion. This means that more farm or ranch property can be transferred for the same amount of annual exclusion and $5.12 million gift tax applicable exclusion.
To gain an understanding of how this concept operates, assume that a married couple owns among other assets a large farm worth $20,000,000 that they would like to pass on to their three children. If the parents were to form a family partnership in 2012 and transfer the farm to the partnership in return for partnership interests, they could make transfers of partnership interests to the children by gift.
Gifting to the children.
In making gifts to the children the parents can choose to make outright gifts of the partnership interests using their annual gift tax exclusions and $5.12 million gift tax applicable exclusions. Depending upon the facts of the case, the value of the interests transferred to the children may be substantially reduced for the lack of marketability and lack of control discounts. These marketability and control discounts relate to the fact that a stranger to the family would not pay full price to acquire an interest in a family partnership for which there is not a ready resale market and in which they would have a noncontrolling interest.
From a leveraging perspective, what this means is that the discounts allow the parents to magnify the amount of farm or ranch property that they transfer to the children gift tax free through utilization of their annual exclusions and gift tax applicable exclusions. For example, if upon establishing the family partnership described above, the parents were able to give the children partnership interests equal to the parent’s combined annual exclusions and $5.12 million gift tax applicable exclusions at a 35% discount, the children would receive $15,873,846 of undiscounted partnership interests. Without the discounts the parents could only have transferred $10,318,000 gift tax free ($10,240,000 of the parents’ combined $5.12 million gift tax applicable exclusions in 2012 plus $78,000 of their combined gift tax annual exclusions for the year = $10,318,000). Consequently, the discounts allow the parents to transfer an additional $5,555,846 of undiscounted value using the same amount of annual exclusions and $5.12 million gift tax applicable exclusions.
Further, in subsequent years the parents could continue to make tax free discounted gifts by utilizing their annual gift tax exclusions even though their $5.12 million gift tax applicable exclusions are used up. This would have a dramatic impact on the reduction of the parents’ potential estate tax liabilities without generating any gift tax.
Grantor Retained Annuity Trust (“GRAT”)
Beside making direct gifts to the children of interests in the family partnership the farmer or rancher can transfer the partnership interests to a trust and retain a right to income from the trust for a period of time. After the expiration of the farmer’s or rancher’s income period the remainder interest in the trust assets (partnership shares) passes to the family member(s). The value of the remainder interest is a gift to the family member(s). This is a useful approach where the farmer or rancher wants to give the property to the family member(s) but would like to retain a right to income for a period of time. For example, assume that in 2012 Bill at age 65 transferred $1 million of family partnership interests to a GRAT retaining the right to receive 4% or $40,000 per year for 10 years.
- Assume further that the present value of Bill’s right to income is worth approximately $350,000
- The gift of the remainder to family members is worth approximately $650,000 and may be offset against his $5.12 million lifetime gift tax exclusion
- If the trust assets earn 7% per year the family will receive approximately $1,400,000 at the end of 10 years
It should be noted that if the farmer or rancher dies during the income period the property will be brought back into their gross estate. To offset any possible estate tax that might result the farmer or rancher can buy a tem insurance policy for the duration or the income period in an amount sufficient to cover any possible estate tax.
Sale of the farm or ranch to the family member(s).
Alternatively, the actual property or partnership shares may be sold to the family member(s) using an installment sale, self canceling installment note, sale to a defective grantor trust or a life insurance funded buy & sell agreement.
Under this approach the farmer or rancher sells the property or partnership shares to the family member(s) for a series of installment notes. It is appropriate where the farmer or rancher has used up their gift tax exclusions or they want to receive income payments during retirement. The farmer or rancher may purchase life insurance on the family member(s) to cover the possibility that the purchaser(s) will die before all the installments are made.
Self-canceling installment note.
This is also an installment sale situation. What is different is that the family member(s) pays a premium for the right to have any unpaid installments canceled at the farmer’s or rancher’s death. This would keep any unpaid installments out of the farmer’s or rancher’s estate for federal estate tax purposes. Again, the farmer or rancher should insure the life of the purchaser(s) to cover the possibility that the purchaser(s) will die before all the installments are paid.
Installment sale to a defective grantor trust.
This approach involves the farmer or rancher setting up a trust that has certain provisions that cause the trust’s income tax consequences to be reported to the farmer or rancher. The trust is for the benefit of the family member(s) who is to receive the property or partnership shares. The farmer or rancher generally seeds the trust with a gift of income producing assets that is offset by their $5.12 million gift tax exclusion. The farmer or rancher then enters into an installment sale with the trust. (The rule of thumb is that for every dollar gifted to the trust the trust may purchase ten dollars of property or partnership interests from the farmer.) The trust then pays off the installment notes with the income from the gifted and purchased assets. The result is that since the farmer or rancher is treated as the owner of the trust for income tax purposes, it is as though the farmer or rancher sold the property or partnership shares to themselves and consequently he or she should recognize no taxable gain on the sale.
Buy & sell agreement.
The farmer or rancher and the family member(s) enter into a life insurance funded buy and sell agreement. If the sale takes place during the farmer’s or rancher’s business life the cash value of the policy can serve as a down payment with the rest of the sales price made up of installments. If it is a sale at death the death proceeds cover the purchase price. Note that due to the flexibility of buy & sell agreements as an exit strategy tool they may also be used with co-owners and outsiders as well as family members.
Life Insurance – the Palatable Alternative
Finally, let’s talk about the effects of the farmer’s and rancher’s increasing age on attitudes toward estate tax planning. The issue is that going forward fewer and fewer farmer’s and rancher’s are likely to be interested in rearranging their affairs to save taxes on their children’s inheritances. This is because as the baby boomers age they will not like change and estate tax reduction techniques typically involve creating changes in how property is owned and managed as well as making large gifts to the next generation.
The result is that not liking change and the making of large gifts necessitates that professional advisors find a palatable alternative for these farmers and ranchers with taxable estates. In that regard, an alternative is to purchase life insurance through an ILIT. That is because:
- It does not require changing the farmer’s or rancher’s life.
- Premiums are an affordable alternative to large estate reducing gifts.
In closing, it must be understood that objective of estate planning is not to just focus on saving taxes. Rather, the goal should be for the farmer or rancher to do what they should to take care of themselves and their families and then with proper planning to do that at the lowest tax possible. It must be recognized, however, that not everyone has the inclination to engage in estate tax saving techniques that require changing their lives and making large gifts. Fortunately, for those who are not predisposed to complicated tax planning, life insurance provides a palatable alternative. This is because it does not require that they upset their lives and is cost efficient while providing the necessary funds to pay estate taxes when they are needed upon the person’s death.