Estate Planning and Taxation – An Overview


Background

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 an especially complex endeavor.  The proper estate plan is unique to the facts and circumstances involved in each situation based on business goals, 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 provides unique circumstances that must be carefully assessed, such as assets in the form of highly appreciated land, the emotional investment of the family in the farming operations, 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.   As this Reading Room is intended to be an overview on 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.


Planning Considerations


Business Goals

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 becomes easier as the assets of the estate need only to be liquidated and the proceeds from the sales divided according to the wishes of the decedent.  If the operation is designed to continue, the planning may become complex in order, for example, to accommodate parental desires of fairness between heirs when some manage the continuing operation and others pursue different career opportunities.  Another issue may be the potential need for income for the retiring generation.

The operational structure must be based not only on estate planning options but more importantly on sound business reasoning, such as keeping the business viable in the long run, 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 because often times the bulk of the estate is tied up in the business or farming operation and it needs to remain relatively intact in order for the business to continue.


Familial Relationships

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 will receive.


Tax Issues

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.  One tax law that can be particularly important is the federal estate tax.  The federal estate tax is a tax upon the applicable portion of the decedent’s property at death.  Currently, only very large estates should be concerned with federal estate tax liability, but many states also have similar taxes either in the form of inheritance taxes or estate taxes.


Property Succession

Upon a person’s death his or her property is distributed to other surviving persons or entities.  This property is distributed through a will, in accordance with state law if no will exists, or through contractual agreements and trusts.  Every state has a statutory system for the distribution of property upon the death of persons that are without a valid will.  The property of an individual with a valid will passes according to the will’s valid provisions.  Excess property not disposed of in a will passes according to the intestate statutory system.


Intestate Succession

Intestate succession statutes are different in each state, although some states have adopted the Uniform Probate Code.  The division of the property is dependent upon the surviving relatives of the decedent.  Generally, if a surviving spouse exists, the spouse takes the first share of the estate. If no children or parents of the deceased survive, property passing under this system 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.


Testate Succession

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, wills in the testator’s handwriting, and oral wills under special circumstances, such as soldiers’ and sailors’ wills made during military service or oral wills 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; however, children may be disinherited. Certain states limit the amount of money that may be left to charity to prevent the disinheriting of heirs.  Portions of wills may not be unenforced if they are illegal or go against public policy such as instructions to destroy property, commit illegal or immoral acts, etc.


Non-probate Succession

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, and property held in joint tenancy all pass to heirs based on 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 specific 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 trustees, 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 at death, usually by 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.  Currently, the estate tax rate is decreasing and the Unified Credit is increasing until it is repealed in 2010, but a sunset provision in the repealing law returns the estate tax in 2011 to the level that existed on June 6, 2001.

Federal estate tax is based on the value of property in the taxable estate.  Property is usually valued as of the date of death, and the taxable estate consists of all the decedent’s owned property less allowed costs, losses, deductions, and exclusions.  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.

Typically, property is valued as of the date of death.  However, if the estate is large enough, then the property may be valued six months after death so 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 at the 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 special use value for the land is determined by one of two methods, rent capitalization or the five factor test. Rent capitalization uses a formula to determine the value.  The average cash rent for the previous five years for comparable real estate minus the average property tax divided by the five year average interest rate for Farm Credit Banks provides a special valuation amount per acre.  This method is available only for farm land.  The five factor method uses capitalization of income, capitalization of rent, assessed tax value, comparable sales without pressure from urban areas, and any other factor that will fairly value the property to provide the special valuation amount.

There are significant eligibility requirements that must be met in order to utilize special valuation.  The farm property must be a major portion of the estate and meet several tests and requirements including percent tests, equity interest tests, material participation tests, ownership requirements, and qualified heir requirements.  The eligibility criteria are designed to ensure that the benefits of the special valuation assist agricultural families and operations.  A recapture period also exists for ten years, and if an eligibility requirement is violated during that time the tax savings resulting from the special valuation must be repaid to the government.

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 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.

Another potential deduction in the recent past of some estates is the family-owned business deduction (FOBD). It allows the deduction of value equal to the value of assets used in a closely-held family-owned business up to its defined limit.  The FOBD also included eligibility requirements and a recapture period.  The deduction was repealed for deaths in 2003 and beyond, but the recapture provisions will continue for a number of years.  Also, as the state of the federal estate tax is being debated this provision may once again become important to the estate planner depending on the future estate tax system.

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 the deductions have been 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 system and estate system are tied together 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 because it is tied to both the estate tax system and the gift tax system, it is called the unified credit.


Federal Gift Tax

Federal gift tax applies to all gifts made during life based on their fair market value. However, an annual exclusion exists to allow small gifts to individuals each year (in excess of $12,000 per individual per year).  The amount changes from year to year depending on legislation, but gifts may be made to any number of individuals and so long as the amount given to each individual does not exceed the annual exclusion than 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 gift tax exclusion is exhausted completely.  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.  A life estate to a child followed by the remainder interest in the grandchild would result in the application of the generation skipping tax.  Without this tax the property would be taxed in the grandparent’s estate and the child’s estate, but not the parent’s estate which would allow for substantial tax savings in extremely large estates.  The GST tax is one of the harshest tax systems currently in place in the United States and the goal of many estate planners is to limit or avoid the payment of such taxes.  Like 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 due states.  Some states use an estate tax system that functions in a manner similar to 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 relatedness of the heir and the amount of property received.