Estate Planning and Taxation – An Overview
Estate planning is the development of a system to transfer the ownership of property to others in a manner that achieves the goals of the original property owner. These goals often include minimizing estate tax liability, succession of the family business or farm, equitable distribution of property among family members, donation to one or more charities, and ensuring the financial security of a surviving spouse. Agricultural estate planning can be especially complex. The proper estate plan is unique to the facts and circumstances involved in each situation based on business goals, personal values, familial relationships, and tax considerations. While individual state laws may impact the effectiveness or availability of certain planning devices, business entities, and rules governing succession of property, the Internal Revenue Code primarily governs the major tax issues associated with estate planning.
Agricultural estate planning often poses unique circumstances that must be carefully assessed. Examples of these unique circumstances include assets in the form of highly appreciated land, the family’s emotional investment in the farming operation, and potential conflicting desires of some heirs regarding the management or continuation of the operation. This overview focuses on broad concepts central to agricultural estate planning. However, the careful scrutiny of critical details in a myriad of subject areas (many of which are beyond the scope of this overview) is also necessary to develop a successful estate plan. Because this Reading Room is intended to be an overview of agricultural estate planning, there are links provided to other websites that provide more in-depth information on various topics ranging from succession planning to federal estate and gift taxation.
The future goals of the operation must be considered when planning the estate. The primary question is whether the operation will continue and be carried on by the next generation. If the operation will cease, the estate planning process becomes easier as the assets of the estate only need to be liquidated and the proceeds from the sales divided according to the decedent’s wishes. If the operation is designed to continue, the planning may entail greater complexities, such as accommodating desires for fairness between heirs where some heirs manage the continuing operation and others pursue different career opportunities, or the potential need of income for the retiring generation.
The operational structure must be based on estate planning options, but more importantly on sound business reasoning, such as ensuring long-term business viability, limiting potential liability, and capturing the maximum amount of farm program payments. There are numerous legal and practical problems facing the estate when passing an operation to the next generation. For example, the bulk of the estate is often tied up in the business or farming operation and it needs to remain relatively intact for the business to continue.
Relationships between family members are often complex, and a well-drafted estate plan must carefully consider the interplay between different personalities. It may be difficult for the retiring member of the farming operation to give up management responsibilities to the next generation, causing a strain on the relationship. Also, difficulties may arise if an operation continues to operate with both on and off-farm heirs who do not have a clear idea and consensus of what each person will receive and be responsible for.
The tax issues surrounding an agricultural estate plan can be significant. Tax laws can change frequently, and one must ensure that estate plans are updated to reflect tax law changes. The federal estate tax can be very important. The federal estate tax is a tax on the portion of the decedent’s property at death that is above the unified credit. Currently, only very large estates should be concerned with federal estate tax liability, but many states have similar taxes that are triggered by smaller estates.
Upon a person’s death, his or her property is distributed to other surviving persons or entities. The property is distributed according to the decedent’s wishes through a will, trust, or other estate planning tool if such a structure exists. If no formal estate plan exists, then property is dispersed according to state intestacy law. Every state has a statutory system for the distribution of property upon the death of persons that do not have a valid estate plan. This statutory system creates the default rules for the division of assets in the absence of a legally valid estate plan. The final option is one that very rarely occurs. However, if the decedent did not have a valid estate plan and they have no surviving family members or other individuals specified in the state intestacy plan, then their property could escheat to the state.
Intestate succession statutes differ in each state; although some states have adopted the Uniform Probate Code. The division of the property is dependent on the decedent’s surviving relatives. Generally, if there is a surviving spouse, the spouse takes the first share of the estate. If no children or parents of the deceased survive, the property is inherited completely by the surviving spouse. If parents or children survive, the spouse receives a portion of the estate, and the remainder passes to the issue —children and their descendants. If no issue survive, then the parents receive the remainder. If no parents survive, the estate systematically moves further away relationally, first to siblings, then to grandparents, and so forth. If there are no surviving heirs, then the property will escheat to the state.
Property succession based on intestacy can be burdensome in an agricultural context. There is no ability to plan ahead, and the system is statutorily defined with little opportunity to modify the inheritance. It may create a problem for an ongoing farm or ranch because the assets are divided among all of the issue and only a few may be interested in continuing the operation.
A person that dies with a validly executed will, a testator, is deemed to have a testate estate. Each state has particular requirements for a valid will. Generally, a testator must be of sound mind, know his property, know his relatives, and know who receives property under the will. In addition, a will must usually be in writing, signed by the testator at the end, and witnessed by two competent disinterested parties. However, some states permit holographic wills, which are wills in the testator’s handwriting, and oral wills under special circumstances, such as soldiers’ and sailors’ wills made during military service or an oral will made during a testator’s last illness.
Wills may dispose of property in any manner desired by the testator with only a few exceptions. A spouse may not normally be disinherited completely. A spouse that does not take any property under the will may be entitled to a statutory share of the estate, but children may be disinherited. Certain states limit the amount of money that may be left to charity to prevent the testator from disinheriting the heirs. Portions of wills may not be enforced if they are illegal or go against public policy, such as if the will includes instructions to destroy property, commit illegal or immoral acts, etc.
Intestate and testate succession only disposes of probate property, property under the jurisdiction of the probate court. Many types of property fall outside of this category, and the succession of this property is often of a contractual nature. Life insurance, death benefits from pensions, payable on death accounts, beneficiary deeds, transfer on death deeds, and property held in joint tenancy all pass to heirs based on a contractual or legal arrangement outside of the will or intestate statute.
Trusts also provide for the distribution of property outside of the probate court’s jurisdiction. When a trust is created, legal title and management of trust property is given to the trustee for the benefit of designated beneficiaries. Because legal title is held by the trustee, the trust property does not fall under the jurisdiction of the probate court. However, it still may be subject to estate taxes associated with the creator of the trust.
The creator of the trust, the settlor, funds the trust with property, names the beneficiaries and trustee(s), and executes the trust agreement. Beneficiaries may receive income, principal, or both during the life of the trust or at dissolution. Trusts are flexible tools that enable efficient management of property with numerous options available to customize the trust to the settlor’s needs.
Testamentary trusts are created to distribute a person’s property upon the person’s death and are usually established in accordance with a will. Often this type of trust is used to protect minor children and disabled heirs or to take advantage of marital deductions for estate tax purposes. The trust provides more flexibility than a conservatorship and may be more economical.
Revocable living trusts are created during the settlor’s lifetime, and the settlor retains the power to revoke or amend the trust. The settlor often is the first trustee and an income beneficiary for life. These types of trusts may last for the lifetime of the surviving spouse and distribute assets upon his or her death. Often a pour-over provision in a will exists to put assets into the trust that were not trust property at death.
Irrevocable living trusts are created during the settlor’s lifetime, and the settlor gives up all power over the trust and trust property. Often the settlor is not a beneficiary of the trust, and the creation of the trust constitutes a completed gift. The lack of control over the trust and its income normally creates a situation that excludes the property from federal estate tax.
Federal Estate Taxation
The federal estate tax is a tax upon the transfer of property at death. Federal estate tax law is often complicated and changes frequently, often annually. Depending on the estate’s taxable amount, as of 2022, a certain tax rate ranging from 18% to 40% will be applied, and usually a set amount of taxes will be owed. Both the tax rate and the set amount owed vary upward as the estate’s taxable amount increases.
The federal estate tax is based on the value of property in the taxable estate. Property is usually valued at the date of death, and the taxable estate consists of all the decedent’s owned property less allowed costs, losses, deductions, and exclusions. Not all estates require the filing of an estate tax return. This depends on whether the estate’s combined gross assets and prior taxable gifts exceeded a certain amount in a given year. For 2022, the estate tax is imposed if a person’s assets exceed $12.06 million in value. Estate tax planning attempts to reduce potential estate tax liability by utilizing planning techniques to reduce either the amount of property in the taxable estate or to minimize the valuation of the property in the taxable estate.
When an estate is large enough, then the property may be valued six months after the decedent’s death as long as the estate is worth less at this later date. This alternate valuation technique can become complicated in an agricultural context that may involve growing crops or bred livestock. Property that exists at death is valued at either the six-month mark or the date of sale, whichever is earlier. Property that did not exist at death is not part of the alternate valuation.
Usually, property is valued by its fair market value; the price a willing buyer knowledgeable of all the facts would pay to a willing seller when neither is under a compulsion to buy or sell. Land in a farming or ranching operation is subject to a special use valuation. This special use valuation enables the land to be valued based on its agricultural value rather than the fair market value, but the amount of value reduction is limited.
The next planning technique used to reduce estate tax liability is the removal of certain property from the estate. The gross estate generally consists of property owned by the decedent, controlled by the decedent, and portions of joint tenancy property.
Deductions reduce the size of the gross estate. Administrative expenses that are ordinary and necessary may be deducted from the estate. The marital deduction is the largest available deduction and is 100% for qualifying property. Qualifying property is property that does not terminate with the spouse’s death. A life estate would not qualify unless the spouse was able to designate the recipient of the remainder. However, a qualifying terminable interest property (QTIP) election allows life estates that are left to a spouse with no control over the final beneficiary to be treated as qualifying for the marital deduction. This tool is helpful if divorce and remarriage are a concern.
A deduction of an unlimited amount is available for contributions to qualifying charities. Many charities must have a letter from the IRS approving their exemption status, but churches and political subdivisions are automatically eligible.
The taxable estate is reached after applicable deductions are removed from the gross estate and it has been adjusted for gifts and gift taxes. Taxable gifts are added back to the value of the estate because the gift tax and federal estate tax systems are interwoven with the exclusion. After the taxable estate is determined, the estate tax is calculated based on the applicable rate. An exclusion is then applied in the form of a tax credit to exempt estates below a certain size. The credit amount changes from year to year and is based on legislation enacted by Congress. The amount is based on the year of death, and it is called the unified credit because it is tied to both the estate tax and gift tax systems.
Federal Gift Tax
The federal gift tax applies to all gifts of property made during the decedent’s life based on the gifts’ fair market value. An annual exclusion exists to allow small gifts to individuals each year. As of 2022, if a gift does not exceed an appraised value of $16,000, then it may qualify for the exclusion, but this amount frequently changes. Gifts may be made to any number of individuals each year, and so long as the amount given to each individual does not exceed the annual exclusion, then no gift taxes are owed by the individual making the gift.
If a taxable gift is made, then a gift tax return is filed, but usually no tax is paid unless the total lifetime exemption amount for the gift tax exclusion is exhausted (as of 2022, this lifetime exemption amount is $12.06 million, but this number is also subject to frequent changes). A program of annual gifting can be used to reduce the size of an estate to a level below taxation, but the giver will lose complete control of the gifted property. Through the use of Crummey powers, the giver can still maintain substantial control over the gifts so long as a successful strategy can be implemented by the estate planner.
Generation Skipping Transfer Tax
A federal tax also applies to transactions that skip a generation. If a decedent were to establish a life estate in a child that is followed by the remainder interest in the grandchild or beneficiary who is at least 37 1/2 years younger than the decedent, this would result in the application of the generation-skipping tax. This additional tax is imposed on the property gifted to the grandchild or beneficiary to make up for taxes that were avoided by the generation skip. The generation-skipping transfer tax can be a major concern for estate planners. There are ways to avoid its imposition, and many estate planners aim to limit or avoid the payment of these taxes through careful planning. As with estate taxes, there is a credit that is applied to property that skips a generation and allows the decedent to pass a sum tax free to different generations.
State Death Tax
Estate or inheritance taxes may also be owed to individual states. Some states use an estate tax system that functions like the federal system, but other states use an inheritance tax system. The estate tax system taxes the right to distribute property, and the tax is paid from the decedent’s property. An inheritance tax is a tax on the right to receive property and is paid by the heir. Often there are rate reductions and exemptions based on the relationship of the heir and decedent and the amount of property the heir receives.