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ESTATE PLANNING WITH AGRICULTURAL ASSETS: ACHIEVING
LIQUIDITY, LEGACY AND FLEXIBILITY
David J. Dietrich
Dietrich & Associates, P.C.
404 N. 31st Street, Suite 213
Billings, Montana 59103
E-mail: [email protected]
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David J. Dietrich Dietrich & Associates, P.C. 404 N. 31st Street, Suite 213
Billings, Montana 59103-7054 (406) 255-7150
Email: [email protected]
David J. Dietrich graduated Whitman College, BA degree with honors (1979) and served in the United States Peace Corp in Abidjan, Ivory Coast (1979-1980). He attended the University Of Montana College Of Law and graduated with a Juris Doctor (JD) in 1984. David is the incoming Vice Chair of the 26,000 member Real Property, Trust and Estate (RPTE) Section of the American Bar Association and has served as its Secretary of since 2010.. He is a past Co-Chair of the RPTE’s Property Preservation Task Force (2003-2011), which resulted in the Uniform Law Commission’s adoption Uniform Partition of Heirs Property Act. He is active on the Planning Committee for the RPTE Section, sits on the University of Montana Tax Institute Advisory Board, and on the Board of Directors of Saint Vincent’s Hospital and Health Care Center in Billings. He served for six years on the Board of Directors of the Montana Land Reliance, a private land trust in Montana, having in excess of 1,000,000 acres under protection. David is a fourth generation Montanan, with a ranching, real estate and estate planning background in South Central Montana, Billings, a regional service center for the Northern Great Plains. His firm, Dietrich & Associates, PC, has provided real estate, tax and estate planning service to the region for over 22 years involving conservation easements, business organization, formation, and dissolution; and tax and estate planning. David’s publications include the 2011 ABA Book Conservation Easements: Tax and Real Estate Planning for Landowners and Advisors; “Selected Post-Mortem Estate Tax Elections for the Small Business Owner”(2002), “Pleasing Mother Earth and the IRS: Using Conservation Easements to Save Open Space, Income and Estate Taxes” for the Heckerling Institute for Estate Planning for the University of Miami, (January 2003); and other tax and real estate related topics for the State Bar of Montana David and his family enjoy living in the Big Sky Country; he is a Canon SLR camera fan, an avid Kindle user, engages in outdoor activities in all seasons, and is his daughter’s horse barn worker.
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AGRICULTURAL ESTATE PLANNING IN 2013
I. INTRODUCTION
Agricultural estate planning often involves a combination of asset protection
planning, gift and estate tax minimization, and variable non-tax engagements, such as
consolidation of management through limited partnerships and limited liability companies for
land entities and Sub Chapter S corporations for operation entities. In addition, because of the
unique nature of many ranching properties, conservation easements may ensure continuity of
conservation purposes by preventing land fractionalization. As always, the agricultural real
estate lawyer must be not only familiar with valuation reduction and estate tax deferral methods
set forth in IRC § 2032A and 6166, but must also be aware of many incidents unique to
agricultural property such as mineral rights, water rights, access issues and, increasingly,
preserving the land for conservation values. The agricultural estate planner cannot be a casual
real estate lawyer.
It is particularly important in any agricultural operation to identify the clients’ “team of
advisers”. But first, identifying those members of the family who have been chosen or have
demonstrated through their own skills their abilities to continue the agricultural operation is
critical; it is equally important to determine what the senior generation desires to do for those
children who have not been favored with, or able to, remain on the operation and to provide
advice on wealth distribution to those children inasmuch as life insurance products and other
financial products can be used to provide for their well-being. In connection with all of this, it is
critical to establish the nature and extent of the engagement, and to confirm that information
given by the client to other advisors such as certified financial planners, certified public
accountants, life insurance agents and other “estate planning advisors” be also made available to
the attorney. Consideration should be given to providing for a continuing release of such
information as exhibits to the engagement letter. In addition, the engagement letter should
contain an express limitation on the scope of the engagement for information shared only with
other “estate planning advisors” which is not also shared with the attorney. Although it is a
worthy goal that a “team approach” can work with estate planning, it is necessary to have
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waivers and disclosures of information delivered to other advisors so that the estate planning
attorney can have the entire picture before him or her. Furthermore, the recommendation that the
client return on an annual or every other year basis to the estate planner should be made a part of
the engagement letter. Finally, limited waivers of conflicts of interest consistent with the rules of
professional conduct should be obtained in the event that the attorney would be representing both
husband and wife and an agricultural business organization consisting of members of the second
generation.
II. BEGINNING THE PROCESS: EXAMINING THE FAMILY’S OBJECTIVES: LIQUIDITY, FLEXIBILITY AND LEGACY It is critical at the outset of the estate planning process to examine the estate planning
objects, family dynamics, and personal and tax related financial information, in addition to
performing due diligence on the business organizations and real estate involved in the
agricultural estate. Probing the client for their estate planning objectives is often a challenging
engagement inasmuch as the most trusted advisors may not be present during the meeting. It is
important to identify the long term goals of the client individually and the family generally,
which likely includes a determination of whether a limited partnership, limited liability company,
or Sub Chapter S corporation is a feasible business entity, involving non-family members, and
whether existing business organizations have been properly formed and are capable of
transmitting wealth by gifting or post mortem transfers to family members with appropriate
discounts. Estates rarely come in neat packages. Often in a going concern operation, clients will
deliver a 25 year old corporate minute book of a C Corporation holding highly appreciated real
estate where the minutes have not been maintained, the bylaws are outdated, no stock restriction
agreement exists, and family members negotiated a “detente” with a defacto business division
that they have made of the operation (farming and ranching). This may be a treasure trove of
legal work.
It may be necessary to identify what the client’s goals are on the “liquidity” or “legacy”
spectrum. “Liquidity” is often a luxury in many agricultural estates because many successful
agricultural operations consider their most valuable liquid assets to be livestock, unencumbered
machinery, and land which may not be necessary for the operation. Many such clients do not
have an established 401k program or portfolio of non-qualified assets. The value of cattle and
land remain volatile while the value of machinery and equipment depreciates rapidly. On the
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other end of the spectrum, the client may be equally concerned with preserving the “legacy” of
the family ranch. Using conservation easements to restrain the development and
fractionalization of real estate is a valid but potentially radical solution to a concern about
piecemeal sales of the family ranch. A compromise position may be a limited liability company
with centralized management which can avoid partition but provide for limited distributions in
kind (at the expense of deep discounts for gifting or estate tax). Beware of tenancies in common
where the income is reported on a partnership tax return. RUPA may fold it into a partnership.
In addition, the planner must be aware of the asset protection and preservation motives of
the client. Does the client have multi-state assets? Can the client segregate his personal use
assets from the business assets, often a difficult task if the traditional family ranch has been
owned “all in” by a C corporation but likely necessary to avoid 2036 inclusion? (See discussions
of Turner, p. 18 below). Is state income tax planning an overriding consideration, as may be the
case in a no-tax state such as Wyoming; is the client also in a high risk profession such as
medicine, law or other professions; does the client have a large amount of high risk assets
engaged in trucking, shipping, cattle feeding, oil and gas or other high risk operations; are the
assets to be protected primarily real estate; to what extent may insurance be used to achieve asset
protection and to what extent should “firewalls” of other limited liability entities be created; are
the assets to be created primarily real estate and if so, are the real estate assets held in a limited
liability company, limited partnership or corporation which business interests themselves could
be successfully protected in a domestic asset protection trust under the laws of the local
jurisdiction or another jurisdiction?
Finally, serious consideration needs to be given to whether the family organization will
have non-family members. Make sure that appropriate waivers of conflict and independent
counsel relationships exist. Pay special attention to the drafting of the triggering event/buyout
provisions in stock purchase operating agreements or limited partnership agreements. What is
the net worth of the non-family members and can they dilute with capital all of the family’s
ownership? Is a private placement memorandum possible for a high net worth investor; are
securities being sold over state lines and is an exemption from the state security commissioner
necessary or advisable. Consider obtaining specialty counsel for securities compliance.
III. FUTURE CARE AND FEEDING OF THE PLAN
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An often overlooked aspect of estate planning is maintaining and defending the plan.
Traditionally, estate planners have considered the estate planning engagement, on a legal basis,
to be finite, although in the clients’s mind the engagement is continuing. The initial engagement
is the due diligence and formulation of the will or trust including a business entity, with
healthcare or financial powers of attorney. It is at this juncture that estate planners are
particularly vulnerable to changes in technology which are rapidly changing our profession in the
form of do-it-yourself (“DIY”) wills or DIY corporations and LLC’s. Enter a query on Google
for “do-it-yourself wills and trusts” and the first ten entries generate websites including
legalzoom.com, totallegal.com, uslegalforms.com, ca-trusts.com, Quicken Willmaker Plus and
Suzie Orman’s Will and Trust Kit. The Texas legislature amended its unauthorized practice of
law statutes in response to a court decision finding that Quicken Family Lawyer violated the
unauthorized practice of law requiring it to specify that such products are not a substitute for the
advice of an attorney. Legal scholars who have studied the subject recommend that any such
programs affirmatively disclose that the organization selling the product is not a law firm, that
the ethical duties lawyers have to clients may not apply to the transaction between the buyer and
the seller of the product, and that the organization selling such software should be required to file
with an appropriate agency wherever it authorizes its services or products the location of its
principal business and the names and addresses of its senior officers with the fact and the
location of this filing revealed on this organization’s website. Furthermore, if any lawyers have
participated in the creation of the program or its content, their names, business addresses and bar
number status must be posted on the website; or, if no lawyers participated in the content or
creation of the program, then that fact must also be stated. See Generally Stephen Gillers, A
Profession If You Can Keep It, How Information, Technology And The Fading Borders Are
Reshaping the Legal Marketplace and What We Should Do About It, p. 155 found at
http://ssrn.com/abstract=2026052.
Make no mistake about it, the planner must justify to the client, agricultural or otherwise,
that the value of their services are significantly better than anything they can obtain from DIY
internet websites. An initial meeting with the client identifying the clients’ objectives,
explaining the risks of DIY programs cited above, comparing the use of a will or a trust, with or
without entity planning, with or without more advanced estate planning topics such as
irrevocable life insurance trusts or advanced planning techniques, certainly will impress the
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client and possibly dissuade them from Quicken Willmaker Plus or Susie Orman’s Will and
Trust Kit.
In addition, the attorney must not only justify the nature and extent of his or her initial
engagement, but also provide a clear basis for the clients’ continuing use of the estate planning
attorney. In this connection, the client should be advised of when and under what circumstances
the estate plan should be reviewed, including death, divorce, inheritance of additional assets,
change in the family structure, or change in tax laws.
It is advisable that the attorney send annual letters advising the client to meet with the
attorney to update the estate plan, on an automatic basis. This can usually be done on the basis
that there is considerable continuing uncertainty with respect to the federal gift and estate tax and
clients need to know that they need to continually reassess their plan.
IV. PROBATE VERSUS REVOCABLE TRUSTS
Each state has different laws for probating wills, although many are “non-intervention”
Uniform Probate Code states. Probate can be extremely rapid and inexpensive (no court
involvement except upon opening an informal probate or the conversion of the proceeding to
formal or supervised administration). Heir contests, creditors’ claims, or disputes about the
distribution of assets by an unsupervised but irresponsible personal representative may also delay
administration. Inadvertent probates may be required where property has not been funded into a
revocable trust, mineral rights are discovered after probate, or property is not held in joint
tenancy with right of survivorship under a payable or transfer on death designation in the case of
a bank account or stock account.
In a non-intervention state such as Montana, the petitioner need only provide a petition
with an original will showing his or her statutory priority to serve as personal representative, a
proposed order to be appointed as personal representative, letters undertaking the duties to serve
as a personal representative and a notice to the heirs and devisees that such an administration has
begun. Thereafter, the personal representative is largely free to accumulate assets and pay debts
without necessity of further court involvement. Closing can be achieved by filing a sworn
statement that all assets have been administered and all debts paid after which the personal
representative’s authority expires within six months.
Notwithstanding the simplicity and low cost of probate, the prevalence of revocable trusts
since the early 1990’s has continued. The most basic reason for this is that the revocable trust
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allows and in fact requires the trustor to accumulate and inventory assets which may be
otherwise missed in the accumulation and inventory of assets when a simple or more tax
sensitive will is drafted and signed. As a consequence, it is critical in any estate plan to confirm
that all transfer on death and beneficiary designation assets have been properly accounted for and
that the beneficiary designation’s coordinate with either the will or the revocable trust. This is
particularly the case with complex assets involving an agricultural estate plan which may include
certificate of title vehicles, non-titled equipment, livestock bearing brands, real estate assets held
under joint tenancy with right of survivorship, and business organizations including Sub Chapter
C corporations, LLC’s and limited partnerships, the interests of which may, in fact, be held in
joint tenancy rather than outright by the decedents. The process of inventory and appraising all
assets of the decedent in the context of planning for a revocable trust often results in better asset
management than achieved with drafting the simple will. Moreover, a revocable trust may save
considerable filing fees.
V. AN OVERVIEW OF FUNDING CLAUSES
Since 2001, the Applicable Exclusion Amount or exemption amount (often the amount
funded into a bypass trust and otherwise known as an exemption trust or credit shelter trust) has
been a moving target. Exemption amounts have ranged from $1 million to $5 million dollars..
Since the current tax revision in early 2013, the Applicable Exclusion Amount is the sum of the
basic exclusion amount of $5.25 million dollars and, in the case of a surviving spouse, the
Deceased Spousal Unused Exclusion Amount. See IRC § 2010(c)(2). This statutory language
implements the term “portability” such that the unused amount of the deceased spouse
exemption is carried forward to the surviving spouse as limited by the term “the last deceased
spouse of such surviving spouse”. See IRC § 2010(c)(4). The executor of the estate of the
deceased spouse must file an estate tax return to make the election. IRC § 2010(c)(5)(A). See
also Notice 2011-82.
Consequently, it is not necessary to use a bypass trust to “capture” the entire applicable
exclusion amount available to both spouses. Nevertheless, due to the need for asset protection or
trust management, traditional planning techniques, split the estate on a first death into a (1) credit
shelter trust (the non-marital share) and (2) a marital trust (a QTIP general power of appointment
or QDOT trust) remain an extremely attractive estate planning strategy, particularly where the
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agricultural operation has been placed into a business organization such as a sub chapter S
corporation, limited liability company or limited partnership.
Tax funding clauses are the heart of what divides and allocates these trusts and the most
commonly used are the fractional tax funding clauses and the pecuniary tax funding clauses. See
Kelly, Donald, Estate Planning For Farmers and Ranchers, Chapters 4:21, 4:22.
Fractional Clause - A fractional formula expresses the amount which can pass free of
estate tax calculated on the basis of the value of the assets in the estate at the applicable valuation
date and entitles the surviving spouse or marital trust to that fraction of the reside. The simplest
form of the fractional formula is an in-kind distribution of the fractional interests in all assets. If
the executor has the power to “pick and choose assets” to be used in funding the marital legacy, a
fractional formula is considered by some to avoid disadvantages of both fractional and pecuniary
legacies. An example of such a clause is set forth as follows:
Devisees of real and personal property/spouse survives
If my spouse survives me, as such survival is herein defined, I hereby give and devise my property as follows: (1) all personal effects, household goods, and automobiles, of which I may die the owner, together with all policies of insurance relating thereto, to my spouse. (2) to my Trustee that fraction of my residuary estate of which the numerator shall be a sum equal to the largest amount, after taking into account all allowable credits and all property passing in a manner resulting in a reduction of the Federal Estate Tax Unified Credit available to my estate, that can pass free of Federal Estate Tax and the numerator of which shall be the total value of my residuary estate. (3) for the purpose of establishing such fraction, the value finally fixed in the Federal Estate Tax proceeding and my estate shall control. (4) the balance of the residue of my estate after the satisfaction of the above devise, I devise to my spouse provided that any property otherwise passing under this paragraph which shall be effectively disclaimed or renounced by my spouse under the provisions of the governing state law or the Internal Revenue Code shall pass under the provisions of paragraph ___ below. (The paragraph cross-referenced in paragraph 4 is a reference to
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the Credit Shelter Trust which would normally follow this paragraph.)
Using entities for the ownership of agricultural land automatically apportions chattels,
elected real property and unelected real property between the marital and credit legacies, which
confirms the need to form entities for both the agricultural operational entity and land holding
entity. Kelly, Donald H., Estate Planning for Farmers and Ranchers, Chapters 4:61, 4:64,
Supplement at p. 181, See also Cason, The “Just Enough” Funding Technique: An Innovative
New Strategy, 35 Estate Planning 27 (June 2008); See also Soled, Wolf and Arnell, Funding
Marital Trusts: Mistakes and Their Consequences, 31 Real Property Probate and Trust J. 89
(Spring 1996).
Pecuniary Clause - On the other hand, a pecuniary formula arrives at a specific dollar
amount generally tied to the complete use of the federal estate tax unified credit in order to
reduce the estate taxes on the first estate of the spouses and assure full use of the unified credit of
each spouse. Such formulas which result in a pecuniary amount passing to the surviving spouse
are based on a calculation which subtracts from an amount equal to the taxable estate the amount
of unified credit value equivalent and makes other adjustments. A pecuniary formula can first
fund the marital share and leave the residue as the credit shelter trust. See Kelly, Donald H.,
Estate Planning for Farmers and Ranchers, Chapters 4:21, 4:22
The pecuniary to the surviving spouse form of marital deduction formula may be
addressed either (1) by minimal reduced to zero (least tax language); or (2) by carving out
prescribed amounts from the maximum marital deduction that will reduce the spousal legacy.
An example of such a pecuniary clause is as follows:
An amount equal to the maximum marital deduction allowable to my estate is finally determined for federal estate tax purposes, less the value so determined of all other property interests passing to my surviving spouse, other than by this instrument, which are includable in my gross estate for Federal Estate Tax purposes and which qualify for such marital deduction; unless such further amount, if any, required to increase my taxable estate to the largest amount that will result in the least amount of Federal Estate Tax [and state death taxes computed by the credit allowable under § 2011 of the Code] payable in my estate; [provided that the state death tax credit shall be taken into account only to the extent that it does not result in an increase in state or federal death taxes otherwise payable.] after taking into account all allowable credits and all property passing in a manner resulting in a reduction of the Federal Estate Tax Unified Credit
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available to my estate. Kelly, Donald H., Estate Planning for Farmers and Ranchers Chapter 4:92.50. In the event of an estate consisting primarily of farmland for which a 2032 election may
be made, optimum sheltering of property from taxation in the second estate occurs if the will
contains a pecuniary formula legacy to the surviving spouse and the special value election is
made across the board as to all eligible land of the decedent, regardless of whether the specially
valued property is passed to the credit shelter or to the surviving spouse. See Kelly, Donald H.,
Estate Planning for Farmers and Ranchers, Chapter 4:61, Supplement, See also Rev. Proc. 64-
19. There are several other observations regarding the mathematics of the marital deduction
involving farm land, stated as follows:
(a) The reduction in gross estate value resulting from a farm special value election leaves the Unified Credit unchanged, but lowers the amount required to obtain the marital deduction which will reduce the taxable estate to zero. As a consequence, the result obtained by funding only the necessary amount of marital deduction legacy with property at fair market value, or funding the credit shelter with § 2032(a) property at § 2032(a) value, is to add the amount of the § 2032(a) value reduction to the property covered by the credit shelter. Kelly, Donald H., Estate Planning for Farmers and Ranchers Chapter 4:6, Supplement p. 179
VI. CLAYTON QTIP WILLS
Under the Clayton QTIP regulations, Treas. Reg. 20.2056(b)(7)(D) an executor may
control the marital deduction amount rather than relying on a disclaimer by the spouse. Such a
provision generally provides that the interests of the surviving spouse is contingent upon an
executor’s QTIP election in order to constitute a qualified terminable interest property under
Section 2056(b)(7) and that the non-elective portion will pass in the form that would not qualify
for the marital deduction, i.e. a credit shelter trust. An example of a Clayton QTIP funding
clause is as follows:
If I am survived by my wife, my personal representative shall, as directed, divide my estate assets into One (1) or Two (2) shares, hereinafter designated as the “QTIP Trust" and/or the “Family Credit Shelter Trust". The QTIP Trust shall be that fraction of my estate assets (undiminished by any estate, inheritance, succession, death, or similar taxes) determined as follows: the numerator of the fraction shall be the amount elected as Qualified Terminable Interest Property
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(“QTIP”) for federal estate tax purposes by my personal representative. The denominator of the fraction shall be the value of my estate assets as finally determined in my estate tax proceedings. The personal representative shall have the sole discretion to select the assets which shall constitute the QTIP Trust. In no event, however, shall there be included in the QTIP Trust any asset or the proceeds of any asset which will not qualify for the federal estate tax marital deduction, and the QTIP Trust shall be reduced to the extent that it cannot be created with such qualifying assets. The QTIP Trust shall be administered as hereinafter set forth. The Family Credit Shelter Trust shall be the balance of my estate assets (or the entire estate assets, if my personal representative does not make the election) after the assets have been selected for the QTIP Trust to fulfill the QTIP election.
An added benefit to a Clayton QTIP trust is that it allows the executor rather than the
surviving spouse to make the election and may do so up to fifteen (15) months after date of
death, assuming the 706 return is validly extended, rather than relying on the compliance with
state and federal disclaimer law deadlines which require a valid disclaimer to be made at the
earlier of prior to acceptance of benefits or nine (9) months. Treas. Reg. 20.2056b(7)(d)(3). It
may be advisable to have a special personal representative specifically named for making the
Clayton election. See Mulligan, Updated Planning for Marital Dispositions, Lifetime QTIPS
and QDOTS, 26 Estate Planning 395 (November 1999).
VII. DISCLAIMER TRUST WILLS.
Because of the complexity of the use of tax funding clause, as described above, clients
may desire a more simplistic approach: namely the use of a disclaimer trust will. This allows
the surviving spouse to make the election at the earlier of a time prior to the acceptance of
benefits or nine months after date of death. See Generally IRC § 2518 which defines a qualified
disclaimer:
A. To qualify the disclaimer must be an “irrevocable and unqualified refusal:
1. in writing, 2. such writing is received by the transferor or his legal representative or holder of legal title within nine months of the later of (A) the date the transfer created the interest is made; or (B) the date upon which the person disclaiming reaches age 21, 3. such person has not accepted any benefit; and 4. the interest passes without any direction on behalf of the disclaimer.
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See IRC § 2518(b). A disclaimer can be made with respect to an undivided portion of an interest
which otherwise qualifies under § 2518(b). See IRC § 2518(c). The regulations further make
clear that joint tenancy with rights of survivorship do meet the requirements of qualified
disclaimers. Treas. Reg. § 25.2518-2(c)(4)(i). Furthermore, the regulations set forth a number of
examples wherein the disclaimant may have in his will an appropriate designation of a fiduciary
limited by an ascertainable standard where the surviving spouse can be the trustee. See Treas.
Reg. § 25-2518-2(e)(5) examples 1-12. The following is an example of a disclaimer trust
residuary clause and the related Family Trust:
Residuary Gift to Surviving Spouse; Contingent Gift to Trustee of The FAMILY TRUST. I give all the rest, residue and remainder of my property of every kind and description (including lapsed legacies and devises) wherever situate and whether acquired before or after the execution of this Will, to my wife, , if she shall survive me. If she shall not survive me or if she shall survive me but disclaims all or a portion of this residuary gift, then I give all the property or the portion thereof which is disclaimed to the Trustee of The FAMILY TRUST, to be administered as hereinafter set forth in Item X.
ITEM X
The FAMILY TRUST Introductory Provision. The
FAMILY TRUST shall be held, administered and distributed as follows:
Payment to Wife of Net Income. If my wife shall survive me, then commencing with the date of my death, my Trustee shall pay to or apply for the benefit of my wife during her lifetime such sums of the net income from The FAMILY TRUST as my Trustee deems advisable, giving preference to the needs and desires of my wife, in convenient installments but no less frequently than once every four months for any calendar year. Any undistributed income shall be added to principal of The FAMILY TRUST. Discretionary Payments of Principal for Wife. If my wife shall survive me, my Trustee may pay to or apply for the benefit of my wife during her lifetime, such sums from the principal of The FAMILY TRUST as in its sole discretion shall be necessary or advisable from time to time for the medical care, education, support and maintenance of my wife, taking into consideration to the extent my Trustee deems advisable, any other income or resources of my wife known to my Trustee.
Division Into Shares for Children. Upon or after the death of the
survivor of my wife and me, my Trustee shall divide and distribute this
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Trust as then constituted into equal separate shares to CHILD ONE, CHILD TWO, CHILD THREE, and CHILD FOUR, by representation.
VIII. RISKS OF DISCLAIMER TRUST WILLS
Often the disclaimer trust will involves a choice between trusting the surviving spouse to
make the election or having a QTIP trust wherein there is a mandatory funding, a pecuniary
fractional or otherwise, creating control in either a spouse or third party fiduciary of the marital
share. Consideration should be given as to whether the surviving spouse will actually execute
the disclaimer. Further, consideration should be given to the risks that the surviving spouse will
accept benefits prior to the execution of a qualified disclaimer and its delivery to the trustee or
filing in probate court. Consideration should also be given to the fact that the surviving spouse
must not have the power to effect the ultimate disposition of the trust property through a limited
power of appointment. See Estate of Engelman v C.I.R., 121 T.C. Memo 54 (2003).
IX. ANNUAL EXCLUSION GIFTING
Provided that the estate planner has formed and funded a limited partnership or limited
liability company or other entity suitable for the clients’ needs, serious consideration needs to be
given to the gifting of business assets. Under the Tax Relief Unemployment Insurance
Reauthorization and Job Creation Act of 2010, the applicable credit for gift taxes increases from
$1 million dollars to $5 million dollars for 2011 and 2012 before returning to $1 million dollars
in 2013. Serious consideration needs to be given during the remainder of 2012 as to whether
sizeable gifts should be completed, utilizing discounts likely available for business interests in
limited liability company or limited partnership form. Under IRC 2035, with certain exceptions,
gifts from a donor to any donee aggregating less than $13,000.00 as adjusted for inflation in a
calendar year, are removed from the donor’s estate at the moment of the gift. The number of
permissible donees is without limit. The amount in excess of any $13,000.00 gift will be brought
into the estate tax calculation as adjusted taxable gifts.
A fundamental requirement of the gift is it must be a gift of a present interest, not a future
interest. A case of major importance in this regard is Hackel v Commissioner, 118 T.C. Memo
279, which held that gifts of entity units in a limited liability company were gifts of future
interests and not entitled to an annual exclusion. The court based its holding on a finding that the
operating agreement did not allow the donees to presently access any economic or financial
benefit from the gifted interests; had there been in Hackel current income distributed or available
Comment [JV1]: frag
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for distribution, the ability to sell the gifted interest or the right to put the gifted interest, the
result may have been different. See Kelly, Donald H., Estate Planning for Farmers and
Ranchers, Chapter 6:35 at 6-87; See also Price v CRR, T.C. Memo 2010-2. In Price, there was
no immediate enjoyment of the donated property itself because the donees had no ability to
withdraw their capital accounts and could not sell their interests without the written consent of
all other partners and there was no immediate enjoyment of income from the donated property in
the absence of a steady flow of income since distribution of profits was in the discretion of the
general partner and the partnership agreement provided that distributions would be secondary to
the partnership’s primary purpose of generating a long term reasonable rate of return. Kelly,
Donald, H., Estate Planning for Farmers and Ranchers, Chapter 6:25, Supplement Page 463.
From a compliance standpoint, it is necessary to start the statute of limitations running
under the “adequate disclosure” regulations. See Proposed Regulations Sections 20.2001-1,
25.2504-2, and 301.6501(c)-2(f). Thus, as a practical matter, upon the filing of a federal gift tax
return, Form 709, the grantor is required to (1) describe the gifted property and any consideration
received by the donor; (2) the identity of in relationship between the donor and the donee; (3) a
detailed description of the method used to determine the fair market value of the gifted property
including relevant financial data and a description of any valuation discounts taken such as
blockage, minority, fractional interests and lack of marketability. In the case of an entity such as
an FLP or LLC, a description of the discount taken and a statement of the fair market value of
100% of the entity value without discounts must be included; and a statement of the relative facts
affecting the gift tax treatment of the transfer sufficient to apprise the service of the nature of any
potential controversy concerning gift taxes, describing any legal issue presented by the facts and
disclose any position taken contrary to any temporary or final regulations.
X. ENTITY FORMATION: INITIAL DUE DILIGENCE
An identifiable category of any estate planning engagement is the formation of business
entities for the purpose of transmitting wealth. However, many estate plans come laden with
historic business organizations which may not meet the financial and estate planning goals of the
client. While fifty years ago the estate planner was limited to C Corporations, S Corporations,
and business trusts, as well as general partnerships and sole proprietorships, today the planner
has at his or her disposal domestic asset protection trusts, limited liability limited partnerships,
limited liability companies, and more traditional C Corporations, S Corporations and general
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partnerships. Since 1986 and the repeal of the General Utilities Doctrine, many C Corporations
remain high capital gains tax zombies with operational risks because of highly appreciated real
estate assets with a lurking 50% to 60% tax liability in the event of liquidation or sale. Often the
most valuable task that can be performed by the estate planner is a tax free division under IRC
§355, discussed below. In addition, the planner should review whether any buy sell agreements
exist, whether they are outdated, the integrity of the “financial health of existing life insurance
policies (i.e. get in force illustrations from the life insurance company or an independent analysis
by a non-commission based insurance analyst). In addition, the planner should review the stock
transfer legends of the corporation to confirm that such legends are up to date. The planner
should also review whether the corporation has a capital structure extending beyond a single
class of stock or the differentiation between voting and non-voting shares, i.e., are there
preferential voting rights or distribution rights upon liquidation. In this connection, the most
valuable work that a planner might possibly perform is encouraging all shareholders to elect
subchapter S treatment to enjoy greater net sales proceeds upon sale or liquidation date the
expiration of a ten (10) year period or of the ten year period required under rules governing
Subchapter S election.
XI. DIVISION OF CORPORATIONS
While the matriarch or patriarch of an agricultural operation is still alive, (although it is
not required under IRC §355 and related regulations), it is most feasible to achieve a tax free
division of a C Corporation or S Corporation, and avoid the prospect of a taxable liquidation or
shareholder oppression claims.
Examining the scope of the requirements under IRC §355 is beyond the scope of this
outline. The issue should be recognized, however, by the estate planner because often siblings
inheriting stock by gift or devise have different business objectives and latent or overt hostility;
some owners may be active and others may be passive. Although electing Subchapter S and
waiting the ten year period may soften the tax on liquidation, often business owners do not want
to liquidate the entire entity, or cannot afford the tax issue. As a consequence, a tax free division
under IRC §355 may provide a solution. One or more subsidiary corporations are formed by the
existing corporation transferring some or all of the assets to them. The subsidiary stock is then
transferred to the owners in exchange for the stock in the original corporation. To qualify for tax
free division, both the distributing and controlled corporation (original parent and new
Comment [JV2]: rework sentence
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subsidiary) must be engaged in the active conduct of a trade or business immediately after the
division. In a farming situation, a problem may arise if the operation has changed to a passive
rental, which may occur of the next generation has left the farm and the older generation has
retired using the farm property as a source of retirement income from the rents. See Kelly,
Donald H., Estate Planning for Farmers and Ranchers, Chapter 8:52, see also Brunell E.
Steinmayer, Jr., Burnell E., and Turner, Todd D., Second Generation Planning – The Corporate
Division Alternative, 20 Probate and Property 49, Volume 20, Number 6, (Nov/Dec 2006). The
active conduct of a trade or business requires the corporation itself (through its officers and
employees) to perform active and substantial management and operational functions. If the
corporation engages in substantial management and operational functions, an IRC § 355 division
may be available so that the next generation of owners can then work toward their independent
goals without incurring a substantial tax cost. See Generally Rev. Ruling 73-234, Rev. Ruling
86-126 and Rev. Ruling 2003-52. Importantly, in Rev. Ruling 2003-52, the National Office of
the Internal Revenue Service ruled that a disagreement between a brother and sister operating a
corporation with respect to future operations was significantly serious such that it would prevent
each of them from developing a business in which they would have a majority interest; a division
would eliminate the disagreement and allow each of them to operate separate businesses to
which they could devote their full time and energy. The senior generation, i.e., mother and
father, would each own 25% in both of the two surviving corporations and would continue to
participate in major management decisions related to the businesses of each corporation;
however, in other situations the senior generation could no longer be active as to their vote
concerning the stock. Kelly, Donald H., Estate Planning for Farmers and Ranchers, Chapter
8:54, Supplement at page 707.
XII. FAMILY LIMITED PARTNERSHIP AND LIMITED LIABIITY COMPANIES: CAPITAL STRUCTURE AND OPERATION TO AVOID 2036 INCLUSION The limited liability company and limited liability limited partnership are the entities of
choice to hold real estate using agricultural operations. With respect to limited liability
companies, the choice of the capital structure often ranges between a member managed
organization with straight up pro rata voting depending on ownership percentages and a manager
managed structure where notwithstanding the percentage of ownership of the managers, the
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managers control the operation, not unlike a corporation or limited partnership. A critical
determination here is the interplay between the capital structure of the limited liability company,
and the possible inclusion of the capital interests in the limited liability company under IRC §
2036(a)(2). See Generally Estate of Turner, TC Memo 2011-2009. See also Breed, Richard P.
and Hilario, Lessons From Turner to Protect Against IRS Challenge FLP, Estate Planning July
2012, Volume 39, Number 7, Page 13. The Turner case provides excellent instruction to the
estate planner forming a family limited partnership or LLC about its original capital structure and
eventual operation and how to avoid estate tax inclusion under IRC§ 2036(a)(2). Specifically,
the planner must achievethe threshold requirement that the formation and operation of the entity
meet the requirements of a “bona fide sale for adequate and full consideration” exception to IRC
§ 2036 inclusion in the estate. Specifically, to fit under the Turner requirements, and its bona
fide sale exception, the FLP or LLC must pass a two part test:
1. The facts and circumstances of the FLP or LLC transaction must present, as actual motivation for planning, a “legitimate and significant” non-tax reason to create the FLP or LLC; and 2. The Transferor must receive a proportionate partnership interest equal to the property transferred to the FLP or LLC. In the Turner case, the court considered the following factors: 1. Whether the assets by their nature required active management or special protection; 2. Whether in fact the business entity required active management and whether a special investment strategy was implemented; 3. Whether the use of the FLP structure provided greater efficiency of management; 4. Whether there was litigation or a threat of litigation among family members creating a real risk to the family estate so as to justify the creation or formation of an FLP; and 5. Whether there was an actual need to protect family assets.
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In reviewing the factors, the Turner court held that the estate’s purported non-tax business
reasons for forming the LLC were unsubstantiated. The court also found additional factors
evidenced in the lack of a bona fide sale, as follows:
1. There was no meaningful or real negotiation with the parties involved in the transaction; 2. There was a co-mingling of personal assets and partnership funds; 3. There was a short time between the formation of the business organization and the ultimate transfer (here 8 months); and 4. There was evidence of transfer tax motives for the formation of FLP because of an attorney’s letter discussing the need to have an appraisal for gift tax purposes.
In forming an LLC or FLP it is very critical to document the non-estate tax reasons, (i.e.
legitimate business reasons) for the formation of the LLC or FLP. In addition, with respect to
the capital structure of the LLC, or the FLP, care should be given to avoid the following:
1. The ability of the senior generation to unilaterally amend the partnership agreement without the consent of the limited partners or other limited liability company owners; 2. The decedent or majority owner’s sole and absolute discretion to make distributions of partnership and income and distributions in kind; and finally 3. Because the decedent owned in excess of a majority interest of the limited partnership, he could make any decision concerning the FLP or LLC that effectively allowed him to control the limited partnership (in other words there was no super majority voting carve outs in the agreement).
In consequence of the foregoing, the tax court held that § 2036(a)(2) applied because Mr. Turner,
in conjunction with his wife, could designate who could possess or enjoy the property transferred
to the FLP.
As difficult as it may be for the estate planner, it is critical that the patriarch and
matriarch, acting in conjunction, cannot simply control all aspects of the limited liability
company or family limited partnership; to do otherwise risks inclusion under IRC § 2036(a)(2),
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particularly if the bona fide sale exception cannot be made because of legitimate non-tax reason
that the formation of the entity cannot be demonstrated.
XIII. LIMITED LIABILITY COMPANY AND LIMITED PARTNERSHIPS: CAPITAL ACCOUNTS AND STATE LAW CONSIDERATIONS Limited partnerships and limited liability companies are often formed under the mistaken
impression that they are low maintenance. However, from the outset, it is critical that
appropriate records be maintained for the LLC particularly for book/tax purposes. It is important
to use deficit capital account restoration language, qualified income offset, and minimum gain
chargeback provisions. See Generally Baker, Jr., Donald H., What Does That Operating
Agreement Mean, a Primer on LLC Capital Accounting for the Non-Specialist,
http://www.michbar.org/business/BLJ/Summer/%202010/DBaker.pdf.
In addition, LLCs are vitally important for their flexibility because of the ability, from a
tax standpoint, to allocate depreciation to the initial investor of cash, provide preferred returns to
initial investors, and allocate tax credits. LLCs can also be used to provide for eventual
distribution in kind of certain assets but such provisions, if exercised, may violate disguised sale
or mixing bowl regulations and severely limit the discountability of LLC or FLP interests.
It is important to consider which state the LLC or FLP should be formed in, because not
all states have adopted the Limited Liability Limited Partnership Act and states have varying
rules regarding, for LLC’s, what the operating agreement must contain, how internal affairs are
handled among partners, the duties and liabilities of managers, rules governing charging orders,
rules governing recovery for improper distributions, and remedies for oppressive conduct. See
Generally 2006 Revised Uniform Limited Liability Company Act (re/ullca on the Uniform Law
Commission Website at www.ulc.org . With respect to limited partnerships also see the Uniform
Limited Partnership Act revised by NCCUSL (now ULI) in 2001 which enhances limited
partnerships for the following reasons:
1. A limited partnership can be perpetual rather than terminate after a given period of time; 2. A limited partnership can be clearly an entity; 3. A limited partnership no longer depends on general partnership rules not contained in the Uniform Limited Partnership Act;
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4. The new Uniform Limited Partnership Act provides a full status based shield against limited partner liability for entity obligations; and 5. Under the new Uniform Limited Partnership Act, limited partnerships may opt to become limited liability limited partnerships simply by so stating in the limited partnership agreement and in the publicly filed certificate. (The effect of this election is to limit the historic unlimited liability of the general partner of the limited partnership.)
XIV. LIMITED LIABILITY COMPANY AND LIMITED PARTNERSHIP MAINTENANCE Stephanie Loomis Price of Houston, Texas, an experienced practitioner in FLP/IRS
litigation gives very insightful tips regarding FLP maintenance and transfers as follows:
1. File required annual filings and memorialize all significant partnership decisions; 2. Comply with the terms of the partnership agreement; 3. Comply with any loan terms, if loans are made; 4. Make any distributions pro rata and pursuant to the terms of the partnership agreement; 5. Refrain from the personal use of partnership assets (at least unless fair rental is paid) or using assets for the partner’s personal obligation; 6. Refrain from having the partners individually pay partnership obligations; 7. Encourage partners to maintain current and accurate books and records; 8. Avoid the following as recurring transactions between the partners and the partnership: loans, redemptions, non-regular distributions and non-pro rata distributions; 9. Review the non-tax reasons for forming the partnership and follow them; and 10. Establish a protocol for administering the partnership in accordance with the requirements of the agreement.
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With respect to the transfers of FLP or LLC interests, Stephanie Loomis Price recommends as
follows:
1. Review books and records of the partnership prior to transfer; 2. Amend the Certificate of Limited Partnership (or LLC Articles of Organization) if necessary; 3. Execute appropriate transfer documents concurrent with transfers to the FLP or LLC; 4. Consider the effect of transfers if an IRC § 754 election is in effect; 5. Wait until after the partnership is fully funded and operational to begin gift planning; 6. Abide by transfer restrictions in the partnership agreement; 7. Carefully consider tax consequences of transfers; 8. Retain the services of an independent and qualified appraiser; 9. Encourage open communication with appraisers; 10. Do not conceal information from the appraiser; 11. Be specific about what interests need to be valued; 12. Be aware of IRS settlement guidelines; and 13. Carefully review the appraisal report and request revisions if it is not easy to understand.
XV. GIFT ON FORMATION PROBLEM
A problem encountered upon the formation of an FLP or LLC involves contribution of
property to a partnership creating an inadvertent gift upon entity formation. See Senda v C.I.R.,
T.C. Memo 2004-160, Judgment Aff’d 433(f)(3)(d) 1044 (8th Cir. 2006). See also, Gross v
C.I.R., T.C. Memo. 2008-221 (2008). Senda and Gross stand for the proposition that the step
transaction doctrine is alive and well for use by the IRS to attack initial contributions to a FLP or
LLC followed by an immediate transfer of a heavily discounted membership interest, if there is
no exposure to market risk. In Gross, a lapse of eleven days between the last contributions of
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securities and the date of the gift was deemed sufficient. Senda strongly suggests that structuring
the creation of a limited partnership so that any gifts made are clearly disconnected with the
formation of the partnership and the contribution of property to it. The IRS has issued appeals
settlement guidelines for family limited partnership and family limited corporations available on
the IRS website at http://www.irs.gov/pub/irs-utl/asg_penalties_fa
XVI. SELECTED POST- MORTEM ESTATE TAX ELECTIONS FOR THE AGRICULTURAL BUSINESS OWNER
The post-mortem elections discussed include the alternate use valuation under IRC §
2032, special use valuation under IRC § 2032A, a qualified family business interest deduction
under IRC § 2057, the election to pay federal estate taxes in installments under IRC § 6166, and
the qualified conservation easement under § 2031(c).
XVII. IRC § 2032: Alternate Valuation
Section 2032 provides an exception to the general rule that property comprising the
decedent’s gross estate is valued at its fair market value as of the date of death. IRC § 2031(a).
As an exception, Section 2032 allows the personal representative of the decedent’s estate to elect
valuation of the gross estate at a selected later date, rather than the date of death.
Basic Requirements. If the property comprising the gross estate is distributed, sold,
exchanged, or otherwise disposed of within six months after the decedent’s death, this property
can alternately be valued as of the date of distribution, sale, exchange, or other disposition. IRC
§ 2032(a)(1).
If the property comprising the decedent’s gross estate has not been distributed, sold,
exchanged or otherwise disposed of within six months after the decedent’s death, the personal
representative may elect to have the property valued on the date which is six months after the
decedent’s death. IRC § 2032(a)(2).
If the alternate valuation date is elected, special rules apply for the valuation of interests
that are affected merely by the lapse of time. Specifically, these interests are includable in the
gross estate at the value as of the decedent’s date of death, with an adjustment in value for any
decrease in value that is not attributable to the mere lapse of time. IRC § 2032(a)(3). Such
interests generally include patents, annuities, life estates por otra vie, or other interests that are
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dependent upon a specific time period or an individual’s life expectancy. Treas. Reg. § 20.2032-
1(f). Further, if the § 2032 election is made, the income tax basis under § 1014(a)(2) is the value
of the property on the applicable alternate valuation date.
Reduction in Value; “All or Nothing”. The alternate valuation date election may not be
made for decedents dying after July 18, 1984, unless it results in the deceased value of the
decedent’s gross estate and the reduction of any estate tax owing. IRC § 2032(c).
Additionally, the alternate valuation date election is essentially an “all or nothing”
proposition, inasmuch as the personal representative is not allowed to pick and choose as to
which properties will be valued as of the date of death and which will be valued as of the
alternate valuation date. The election must be made with respect to all properties comprising the
gross estate, or none at all.
In making such an election, the personal representative must consider the estate as a
whole and not focus on the drastic change in valuation of a single asset. Even though such a
change in value of a single asset may be substantial, the election may not be made unless the
overall value of the entire gross estate has decreased. As such, the personal representative may
elect alternate valuation even though some assets have increased in value, as long as the overall
value of the total gross estate has decreased between the date of death and the alternate valuation
date.
Property Distributed, Sold, Exchanged, or Otherwise Disposed of Within Six
Months After the Date of Death. As stated above, property that is distributed, sold,
exchanged, or otherwise disposed of within six months after the decedent’s date of death is
valued on the date of the distribution, sale, exchange, or other disposition. IRC § 2032(a)(1). As
such, the question then becomes what is the date of the actual distribution, sale, exchange, or
disposition.
The alternate valuation date to be used is generally the date when title passes as a result
of a sale, exchange, or other disposition, so that the property has ceased to form a part of the
gross estate, inasmuch as the economic benefit of the property has been transferred. Treas. Reg.
§ 20.2032-1(c)(1).
Distributed. Property is considered to have been “distributed” upon the occurrence of
the following events:
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(a) entry of order or decree directing the property’s distribution (if the order or decree subsequently becomes final); (b) the segregation or separation of the property from the estate or trust so that it becomes unqualifiedly subject to the demand or disposition of the distributee; or (c) the actual paying or delivery of the property to the distributee. Treas. Reg. § 20.2032-1(c)(2). Additionally, a trustee’s distribution of trust property, which is includable in the decedent’s
gross estate to a beneficiary of the trust, constitutes a “distribution” under IRC § 20.2032(a)(1).
Treas. Reg. § 20.2032-1(c )(2); Rev. Rul. 73-97, 1973-1 C.B. 404. On the other hand, when a
trustee divides the corpus of a revocable trust (which was includable in the decedent’s gross estate)
into two equal parts to facilitate payment of trust income to life beneficiaries, there is no
distribution, because the original trust still exists, regardless of this division.
Sale, Exchange, Other Disposition. Property may be sold, exchanged, or otherwise
disposed of by the following parties:
(a) the executor/personal representative; (b) trustee or donee to whom the decedent made a lifetime transfer of property, which is included in the gross estate under §§ 2035 – 2038 or § 2041; (c) an heir or devisee to whom title passed by operation of law; (d) a surviving joint tenant or tenant by the entirety; or (e) any other person. Treas. Reg. § 20.2032-1(c)(3).
Further, if property is sold, exchanged or otherwise disposed of under a contract, the
alternate valuation date is the effective date of the contract, which is generally the date the contract
is executed, unless the contract specifies a different effective date. The exception to this rule is
when a contract is not subsequently carried out in accordance with its terms and provisions. Id.
The service has found that even though a decedent’s will directs the personal
representative to sell specific property to a specific party at a set price, if the personal
representative elects the 2032 valuation date, the value to be included in the decedent’s gross
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estate is the value as of the alternate valuation date, not the price set forth in the decedent’s will.
Rev. Rul. 77-180, 1977-1 C.B. 270.
Property Not Distributed, Sold, Exchanged, or Disposed of. If the property has not been
sold, distributed, exchanged, or otherwise disposed of, then the alternate valuation date for purposes
of § 2032 election is the date six months after the decedent’s date of death. IRC § 2032(a)(2).
It is important to note that if there is no date in the sixth month following the decedent’s date
of death, which numerically corresponds to the date of death, the valuation date is the last day of the
month of the sixth month following the decedent’s death. For example, if the decedent died on
October 31st, the last day for alternate valuation would be April 30th, not May 1st. Handling Federal
Estate and Gift Taxes, 6th ed., § 4.1, p. 4-4 (2000) citing Rev. Rul. 74-260.
Change in Value Due to Lapse of Time. If the value of an interest or estate is affected
merely by the lapse of time, such interest or estate is included at its value as of the date of death,
with an adjustment for any difference in value that is attributable to factors other than the lapse
of time. (See Treas. Reg. § 20.2032-1(f) for examples of such interests or estates, and
calculations of this valuation.)
As such, the personal representative should attempt to link any decrease in property value
to other existing economic forces, and not the passage of time.
Included / Excluded Property. A decedent’s estate is comprised of his or her interest in
all property, real or personal, tangible or intangible, wherever situated, as of his date of death.
IRC § 2031. It is important to note that even if the personal representative elects the alternate
valuation date, the extent of the gross estate is still determined as of the date of death, regardless
of whether there is a subsequent § 2032 election for valuation purposes.
Generally, any interest the decedent held at his date of death, which is includable in the
gross estate under § 2033 or §§ 2035-2042 is valued at the alternate valuation date if the § 2032
election is made.
Property that comprises the decedent’s gross estate as of the date of death will remain
part of the gross estate if the § 2032 election is to be made, even if this property changes in form
during the alternate valuation period. Maass v. Higgins, 312 U.S. 443 (1941); Peoples-Pittsburg
Trust Company v. United States, 54 F.Supp. 742 (W.D.Pa. 1944).
A separate issue exists as to whether property, which was not part of the gross estate as of
the date of death, but was earned, received or accrued during the alternate valuation period is
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includable in the gross estate. This property often takes the form of accrued interest, rent,
dividends, or stock and is said to be excluded from the gross estate, because it could not have
been identified as property owned by the decedent as of his date of death. Treas. Reg. §
20.2032-1(d).
For example, an interest-bearing obligation, such as a bond or note, may be broken down
into two categories of property that are includable in the decedent’s gross estate at the time of
death. These two categories are:
(a) the principal of the obligation itself, and (b) the interest accrued up to and including the date of death.
Treas. Reg. § 20.2032-1(d)(1). One of these elements of includable property may be separately
valued if the alternate valuation date is elected. However, any interest accruing on this property
after the date of death and before the alternate valuation date is excluded from the decedent’s
gross estate and thus not subject to the alternate valuation method.
Further, if an advanced payment of principal or interest is made between the date of death
and the subsequent alternate valuation period, which has the effect of reducing the overall value
of the principal obligation at the alternate valuation date, such payment will be included in the
gross estate and valued as of the date of such payment. Treas. Reg. § 20.2032-1(d)(1). The
following examples illustrate the inclusion or exclusion of specific property under § 2032
valuation:
(a) Lease Property. Rents for real or personal property, which have accrued to the date of death, are includable in the decedent’s gross estate and may be separately valued on the alternate valuation date. Treas. Reg. § 20.2032-1(d)(2). Conversely, rents accruing after the date of death and during the subsequent valuation period are excluded from the decedent’s gross estate. Id. (b) Prepaid Rents. Prepaid rents in which the decedent had an interest are treated in a similar fashion as advance interest payments, and are deemed to be included in the decedent’s gross estate and may be valued under the alternate valuation method. Id. (c) Non-Interest Bearing Obligations. Non-interest bearing obligations sold at a discount, such as savings bonds, are includable in the decedent’s gross estate to the extent of the principal obligation and the discount amortized to the date of death. Treas. Reg. § 20.2032-1(d)(3). The obligation itself is valued at the
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subsequent alternate valuation date, without regard to any future increase in value due the amortized discount. Id. (d) Dividends / Stock. Stock held in a corporation, and dividends declared to stockholders of record on or before the decedent’s date of death, but not collected as of the date of death, are includable in the gross estate and may be valued under the alternate valuation method. Treas. Reg. § 20.2032-1(d)(4).
Conversely, dividends from earnings and profits declared to stockholders after the date of death
are excludable, and not to be valued under the alternate valuation method. Additionally,
dividends are excludable and not subject to the alternate valuation method, to the extent that they
are payable from post-date of death earnings of the corporation.
The following examples illustrate the inclusion or exclusion of stock and dividends with
respect to the alternate valuation date:
(a) If a corporation makes a distribution to stockholders of record during the alternate valuation period in partial liquidation, which is not accompanied by surrender of a stock certificate for cancellation, the amount of the distribution received on stock included in the gross estate is itself “included property”, except to the extent that such a distribution was made out of earnings and profits since the decedent’s date of death. (b) If a corporation, in which the decedent owned a substantial interest, and possessed, at the date of the decedent’s death, accumulated earnings and profits equal to its paid-in capital subsequently makes a distribution of all of its accumulated earnings and profits as cash dividends to stockholders of record during the alternate valuation period, the amount of the dividends received on stock includable in the gross estate will be included property under the alternate valuation method. Likewise, a stock dividend distributed under these circumstances is also “included property.” Treas. Reg. § 20.2032-1(d)(4).
Effect on Other Deductions. With respect to other deductions, such as the charitable
deduction under § 2055 or the marital deduction under § 2056, when references are made to the
value of the property at the time of the decedent’s death, this reference is deemed to refer to the
value of the property used in determining the value of the gross estate. Specifically, if the
alternate valuation date is elected, the value “at the time of death” is either six months after the
decedent’s date of death or the date of the property’s distribution, sale, exchange or other
disposition. Treas. Reg. § 20.2032-1(g).
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Again, this adjustment in valuation may not take into account any difference in value that
is attributable to the mere lapse of time or the occurrence or non-occurrence of a contingency.
Id.
The following example illustrates the effect the § 2032 election has on other estate tax
deductions:
A decedent dies leaving to a qualified charitable organization, property worth $250,000 on the decedent’s date of death, but which increases in value to $300,000 as of six months later. The personal representative may elect the alternate valuation date, and may deduct $300,000 as a charitable deduction under § 2055, at which value he must also include the property in the decedent’s gross estate. Handling Federal Estate and Gift Taxes, 6th ed., § 4.4, p. 4-10 (2000).
Again, the above example illustrates the potential under § 2032 to achieve a higher
charitable deduction by using the increased value as of the alternate valuation date. However, the
overall value of the entire gross estate and any tax owing thereon must be decreased if the § 2032
election is to be effective.
The personal representative’s election of the § 2032 alternate valuation date, does not
affect a deduction for administration expenses under § 2053 (b) or the deduction for casualty
losses under § 2054, to the extent that the § 2032 election does not effectuate a “double dip” in
determining the taxable estate. The following example illustrates this prohibition on “double
dipping”:
M owned a farm. Approximately four (4) weeks after M’s death, a house and a barn on the farm were destroyed by fire. M’s estate incurred a $95,000 uninsured loss as a result of this fire. The executor of M’s estate elects to use the 2032 alternate valuation date. IRC § 2054 normally allows an estate tax deduction for uninsured losses incurred during the settlement of the estate. However, this provision does not apply if the loss is already reflected in the property’s value as reported on the alternate valuation date. Because the farm’s value on the alternate valuation date will reflect the $95,000 decrease in value caused by the fire, M’s estate is not entitled to a separate casualty loss under § 2054. PPC’s Guide To Practical Estate Planning, 8th ed., § 806. p. 806.15 (2001).
Method of Electing Alternate Valuation Date. The alternate valuation method is not
automatically implemented, but must be affirmatively elected by the decedent’s personal
representative. Further, once made, the alternate valuation election is irrevocable. IRC §
2032(d)(1).
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If the alternate valuation method is to be used, the election may be made only on the
Form 706 estate tax return, and only if this return is filed no later than one year after its due date
(including extensions). IRC § 2032(d)(2).
If the personal representative makes the alternate valuation date election, the Form 706
must set forth the following information:
(a) itemized description of all property comprising the estate as of the date of death;
(b) the value of each item as of the date of death;
(c) an itemized disclosure of any distribution, sale, exchange, or other
disposition of property, and the date of each, which occurred during the six month period after the date of death;
(d) supporting statements as to any distribution, sale, exchange or
other disposition; and (e) the value of each item of property as of the alternate valuation date
elected. Any interest accrued or rents accrued on the date of death and any dividends declared, but not collected, before the date of death must be separately stated. Treas. Reg. § 20.6018-3(3), (6); Treas. Reg. § 20.6018-4(3).
Time for Making Election. Essentially, a personal representative may delay electing
the alternate valuation date until twenty-seven (27) months after the decedent’s date of death.
This result can be accomplished by obtaining a six-month extension of time to file the 706 form,
pursuant to IRC § 6081. This extends the 706-filing deadline until fifteen (15) months after the
decedent’s date of death. Accordingly, the one-year deadline for making the 2032 election,
which is established under IRC § 2032(d)(2), does not begin to run until fifteen (15) months after
the date of death. As a result, the deadline for making a § 2032 election is twenty-seven months
after the decedent’s date of death (i.e., the fifteen (15) months for filing plus twelve (12) months
thereafter.) However, regardless of any extension of time in which to make the § 2032 election,
the date of the election still reverts back to the earlier of six months after the date of death, or the
date of the property’s distribution, sale, exchange, or distribution.
The service has recently granted extensions of time for making the § 2032 alternate
valuation date election when the personal representative of the decedent’s estate acted reasonably
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in reliance on a professional’s advice and the government’s interest was not prejudiced by the
granting of an extension. Rev. Rul. 2002-5; PLR 200227029; PLR 200203031.
The IRS has ruled that an estate may elect to value the decedent’s assets on the alternate
valuation date and also to elect to value the decedent’s qualified farm property under the rule set
forth in § 2032A. Rev. Rul. 83-31 (see also Rev. Rul 88-89).
XVIII. 2032A Special Use Valuation.
Special use valuation should be considered where the decedent or the decedent’s family
has been actively involved in a farming operation or other trade or business involving real estate,
and it is anticipated that this use will continue for a period of at least ten years after the
decedent’s death through qualified heirs of the decedent.1 In 2012, a qualified 2032A election
may reduce the value of the decedent’s estate by $1,040,000. The successors in interest to the
decedent must realize the risk of recapture during the ten-year recapture period and the practical
limitations on the sale of the property imposed by the risk of recapture. If multiple heirs will
inherit the property, the estate planner should take special caution due the complexities relating
to tax allocation and consent agreements required under IRC § 2032A.
Pre-mortem Qualified Use: Nature and Duration. The decedent must be a citizen or
resident of the United States. IRC § 2032A(a)(1)(A). The real property must be located in the
United States. Id.
The real property must have been used on the date of the decedent’s death for a “qualified
use.” IRC § 2032A(b)(1). A “qualified use” of real property is use as a farm for farming
purposes, or in a trade or business other than farming. IRC § 2032A(b)(2). The term “farm” is
broadly defined to include stock, dairy, poultry, fruit, fur bearing animal and truck farms,
plantations, ranches, nurseries, ranges, greenhouses or other similar structures used primarily for
the raising of agriculture or horticulture commodities, and orchards and woodlands. IRC §
2032A(e)(4).
1 The principal treatise to consult in referencing special use valuation is Estate Planning for Farmers and Ranchers, A Guide to Family Businesses With Agricultural Holdings, 3rd Ed., Donald A. Kelley, David A. Ludtke & B. Steinmeyer, Jr., West Publishing Co., 1999; a concise explanation of the election is also set out in Belcher, Dennis I, “Planning for The Rancher/Farmer”, Estate & Personal Financial Planning, Koren, West Publishing Group, 2001, § 4:13 through 4:31).
32
Qualified use refers to whether the owner’s income from the property depends on the
success of the operation and a cash lease does not qualify. Reg. § 20.2032A-3(a). This
provision, however, has been modified by statute in 1997 to provide that a surviving spouse or
lineal descendant of the decedent shall not be treated as failing to use the qualified real property
in a qualified use solely because such spouse or descendent rents such property to a member of
the family of such spouse or descendent on a net cash basis. A legally adopted child of an
individual is treated as a child of such individual by blood. IRC § 2032A(c)(7)(E).
There must be active farming or some other active business. T.A.M. 9428002. A
qualified use can be established by cash leasing or share crop leasing by the decedent or by the
specified members of the decedent’s family, but not by outsiders who pay a cash lease to the
decedent. See Heffley v. Comm., 884 F2d 279 (CA7 1989); see also Estate of Donahoe v. Comm.,
T.C. Memo 1988-453].
During the eight-year period ending on the decedent’s death, the property must have been
both owned and used for qualified use by the decedent or by a member of the decedent’s family
for periods aggregating at least five (5) years or more. IRC § 2032A(b)(1)(C).
A member of the decedent’s family means an ancestor or a lineal descendant, the spouse
or the spouse of any lineal descendant of the decedent; a legally adopted child of the decedent is
also treated as a child of the decedent. IRC § 2032A(e)(2).
Material Participation – Postdeath Requirements. During the decedent’s life, the
decedent or a member of the decedent’s family must have materially participated in the business
for five years out of the eight-year period ending on the date of the decedent’s death. “Material
participation” is defined under the provisions of the self-employment tax. IRC § 2032(e)(6),
referencing IRC § 1402(a)(1). These include physical work, participation and management
decisions; inspection of production activities; assuming financial responsibility for a substantial
portion of expenses; furnishing of a substantial portion of the machinery, implements and
livestock used in the production activities; and the maintenance of a principal residence on the
premises.
A net cash rental to a member of the decedent’s family during the decedent’s lifetime will
not disqualify the property from a special use valuation. IRC § 2032A(c)(7)(E). If material
participation is to be met by a crop sharing or other “management” arrangement, the owner must
33
assume economic risk, commit significant capital and have final decision-making authority. See
Revenue Ruling 8823017.
The arrangement should be in writing and income derived from the arrangement should
be reported by the owner’s self-employment income (see Belcher, Dennis I, Planning for The
Rancher/Farmer, Estate & Personal Financial Planning, Koren, Thompson Reuters/West, 2012,
§ 4:16).
Acquisition from Decedent. The real property must pass to or be acquired from the
decedent. IRC § 2032A(b)(1).
Acquisition by Qualified Heir. The real property must pass to or be acquired by a
qualified heir of the decedent. Again, the term “qualified heir” is a member of the decedent’s
family which means only: an ancestor, the spouse, a lineal descendant of the decedent, the
decedent’s spouse or of a parent of the decedent, or the spouse of any lineal descendent. Nieces
and nephews are, therefore, included, but cousins are not. Under IRC § 2032A(g), trust property
is considered to have “passed from” the decedent to a qualified heir to the extent that the
qualified heir receives a present interest in the property; an interest in a discretionary trust is
treated as a present interest if all of the beneficiaries are qualified heirs. IRC § 2032A(g). In
addition, an interest in a partnership or corporation that qualifies as a closely held business
interest is defined under IRC § 6166(b) qualifies as special use property.
Material Participation - Postdeath Qualified Use. To avoid recapture tax, the qualified
real property must continue to be used throughout the entire ten-year recapture period for the
qualified use for which it qualifies for special use evaluation. IRC § 2032A(c)(6)(a). In
addition, the qualified heir must materially participate for at least five out of an eight-year period
ending after the date of the decedent’s death during the recapture period. IRC § 2032A(c)(6).
Material participation can be performed by either the qualified heir or by specified members of
his family under IRC § 2032A(c)(6)(B)(ii).
25% and 50% Percentage Tests. Qualified real property under IRC § 2032A must
comprise at least 25% or more of the adjusted value of the gross estate. The term “adjusted
value” means the value of the gross estate reduced by any amounts of unpaid mortgages and any
indebtedness included in the gross estate. The value of the gross estate is determined using the
fair market value without regard to valuation reductions under IRC § 2032A.
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In the event a partial election is made, all real property should be included for the
purposes of the 25% test; not just the real property for which the parcel election is made. See
Reg. § 20.2032A-3(a), and Estate of Miller v. U.S., 680 F.Supp. 1269 (CD Ill 1988).
The 50% test requires that 50% of the “adjusted value of the gross estate” consists of real
and personal property used for a qualified use. The “adjusted value of the gross estate” or the
“adjusted value” of qualified real and personal property have the same meaning for the 50% test
as they do for the 25% test. IRC § 2032A(b)(3). Notwithstanding a partial election under
§ 2032A, all of the real property used in a qualified use is considered in meeting the 50% test.
IRC § 2032A(b)(3)(A).
Gifts made within three years of the decedent’s death are included in calculating whether
both percentage tests are met. IRC § 2035(c)(1)(b).
Election. To qualify the estate for special use valuation, the executor must make an
election on the first estate tax return filed for the estate. IRC § 2032A(d). The executor cannot
make the election by amending a state return in which a § 2032A election was not made. Reg.
§ 20.2032A-8(a)(3). An election is made by attaching to the estate tax return an agreement to
special use evaluation and a notice of the election. The agreement must provide that the
qualified heirs consent to personal liability in the event the estate tax savings are recaptured.
Reg. § 20.2032A-8(c)(1). All persons having an interest in their real property must consent to
collection of any additional estate tax from the real property valued under § 2032A. In addition,
the agreement must designate an agent to deal with the IRS. Id. Although implementing
regulations require all persons, including spouses, of qualified heirs to sign the agreement, the
tax Court has held such a requirement invalid. See Estate of Pullin v. Comm., 84 T.C. 789
(1985). If the decedent died after 1985, the Service is directed to prescribe procedures that
permit the executors who have “substantially complied” with the regulations to perfect a §
2032A election under certain limited circumstances. IRC § 2032A(d)(3). The concept of
substantial compliance should not be relied upon inasmuch as it is a narrow exception to the
stringent requirements of the 2032A statute. The information required under the notice of
election should include the following:
(a) the decedent’s name and social security number;
(b) the relevant qualified use (for example, farming or woodlands);
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(c) the items of real property to be valued under special use;
(d) the fair market value of the real property and the special use value of such property;
(e) the adjusted value of the real property;
(f) the items of personal property used in a qualified use and the adjusted value of such property; (g) the adjusted value of the gross estate; (h) the method used in determining special use values; (i) copies of written appraisals as to fair market value; (j) a statement as to material participation;
(k) identification of the periods during the eight-year period preceding the
decedent’s death during which the real property was not owned or used by the decedent or a member of his family;
(l) the name, address, and social security number of each person taking an interest in the property and the value of the interest passing to the person;
(m) affidavits describing the material participation; and (n) a legal description of the real property specially valued.
Reg. 20.2032A-8(a)(3). (See sample agreement provided on 706 form)
The Agreement. The Agreement must be signed by all parties having an interest in
the property. Reg. 20.2032A-8(a)(3). The required Agreement is now part of Schedule A-1 of
Form 706. Once filed, it is irrevocable. It must be submitted as part of the initial return filed.
T.A.M. 8346009; T.A.M. 8249013.
All qualified heirs must sign the Agreement whether their interest is vested or contingent
and whether or not they are in possession of any portion of the property. Ltr. Rul. 8341004; Ltr.
Rul. 8416002.
Under the Agreement, the qualified heirs consent to personal liability in the event estate
tax savings are recaptured. Reg. 20.2032A-8(c) (1) . The Agreement must designate an agent to
deal with the IRS. Reg. 20.2032A-8(c )(1).
36
Valuation. The special use value of real property under the farm method allows the
executor to use the five-year average annual gross cash rental of comparable real property,
subtract out the annual five-year average real estate taxes, and capitalize the net cash rental by
the annual interest rate charged on Federal Land Bank loans. This can result in a substantial
reduction from fair market value.
Combined Use of 2032A and Valuation Discounts. The Tax Court ruled that a
taxpayer can combine special use valuation and minority discounting. See Hoover v. Comm., 69
F3d 1044, CA10 (1995)), reversing 102 T.C. 777 (1994). In that case, the decedent held a 26%
interest in a ranch which proportional interest had a fair market value of $2,007,030. This
amount was discounted by 30% for a minority interest to yield a discounted value of $1,009,011.
Under special use valuation, the proportional share of the ranch was valued at only $533,548
without any consideration for minority discount. Because the difference between these two
amounts was greater than $750,000 maximum reduction allowed, under § 2032A(2), the estate
reduced the $1.9 Million figure by $750,000 of the special use value on the return of $1,161,000.
The Service objected and the Tax Court supported it, holding that a taxpayer cannot employ a
minority discounting combination with a special use valuation election. According to the 10th
Circuit, however, the “fair market value,” that is the starting point for special use valuation can
be a value that is discounted for minority interests. Accordingly, it can be appropriate to stack
the two options to reduce estate valuation.
Limitation on Valuation Reduction. The amount capable of being reduced during the
year 2012 is $1,040,000. See IRC § 2032A(a)(3) and Rev. Proc. § 2011-52, § 3 2012 Adjusted
Items .30 Valuation of Qualified Real Property in Decedent’s Gross Estate..
Recapture. Recapture of the estate tax savings obtained through special use valuation
may occur up to ten years following decedent’s death. There are several events that cause a
recapture:
(a) cessation of the qualified use for the qualified heir, such as developing the property for residential purposes; (b) cessation of material participation for more than three years out of an eight year period by the qualified heir or member of his family (such as a cash rental of the real property to a non-family member); and (c) disposition of the property by the qualified heir to a non-family member of the decedent.
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In Williamson v. Comm., 974 F.2d 1525 (9th Cir. 1992), a cash rental negated special use
farm valuation. This provision has now been overruled by amended IRC § 2032A(c)(7)(e),
which provides the surviving spouse or lineal descendant of the decedent is not treated as failing
to use qualified real property in a qualified use solely because such spouse or descendant rents
such property to a member of the family on a net cash basis. A legally adopted child of an
individual is treated as a child of such individual by blood.
In addition, a qualified conservation easement by gift or otherwise is not deemed to be a
disposition, disqualifying the property and triggering recapture tax. IRC § 032A(c)(8).
An exchange of specially valued property between members of the decedent’s family
likewise will not trigger the recapture. Letter Ruling 8850032.
The IRS also ruled that an exchange of property that qualifies for tax–free treatment
under § 1031 will not produce a recapture tax. Letter Ruling 9604018.
The death of a qualified heir terminates the recapture period with respect to the qualified
heir’s interest [108228003 (1982)].
A partial recapture can occur with respect to a portion of the real property if there is more
than one qualified heir. IRC § 2032A(c)(2)(D).
If there is recapture, the amount of tax recaptured is the lesser of: (a) the amount realized on sale (or the fair market value of the real property if there is no sale at arms-length); less the special use value with respect to the interest disposed of; or (b) the adjusted tax difference attributable to the interest disposed of, which generally is that portion of the estate tax savings realized through special use valuation as the special use value property disposed of bears to the total special use property. IRC § 2032(A)(c)(2).
The recapture tax on a partial disposition by a qualified heir is based on the estate tax
saved with respect to all specially valued property a qualified heir received and not just the
property disposed of by the heir. T.A.M. 8308004 (1983).
There is a special lien on all real property valued under Special Use Valuation to secure
payment of the recapture tax. IRC § 6324. A recapture tax is not available for deferral under
IRC § 6166(a)(1).
XIX. IRC §2057: The Family-Owned Business Interest Deduction.
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IRC 2057 was repealed in by EGTRRA of 2001 for estates after December 2003, but it
has been frequently considered for “revival” as an additional means to achieve business
deductions for decedents who do not qualify for IRC 2032A; its contents are summarized in the
following footnote2.
2 General Requirements. Section 2057(a)(2) allows a deduction from the gross estate for decedents who are owners of the requisite percentage
of a “qualified family-owned business interest” (QFOBI) and who pass the other tests for eligibility in an amount equal to the lesser of the
adjusted value of the family-owned business interest of the decedent as defined in IRC §2057(d), or the total value of the qualified family owned
business interests defined at IRC §2057(a)(2) which cannot exceed $675,000. The §2057 deduction from the gross estate applies to estate taxes
only; it does not apply to gift taxes. The deduction reduces the available applicable exclusion amount. For example, in 2002 (when the
applicable exclusion amount is $1 Million), if the executor elects to deduct the full $675,000 per family business assets, the applicable exclusion
amount taken must then be reduced to reflect an applicable exclusion amount of $625,000.
The Election Agreement. The executor must affirmatively elect application of §2057(b)(1)(B). The format prescribed for the
election by Form 706 is set out on Schedule T, and is similar to that required for the §2032A election. The election must be made on the return of
tax imposed by §2001 under §2057(d)(1); thus the election may be made on a late-filed return, although the return must be the first return filed.
The Consent Agreement. The consent agreement is prescribed as part of Form 706 at Schedule T, Part 5. The agreement included in
Schedule T describes the persons executing the agreement as being all the qualified heirs, and being all other parties having interests in the
business(es) which are deducted under § 057. The consent agreement must: (1) approve the election made by the executor, (2) require the
qualified heirs to consent to personal liability for the recapture tax, (3) require parties who receive interests in qualified property to consent to the
collection of recapture tax, even though they are not themselves heirs, (4) consent to the recording of a lien under § 6324B on the described
property to secure payment of the recapture tax, and (5) appoint an agent for all dealings with the Service involving the qualified property. The
property subject to the recapture tax is limited to those items designated in the agreement, since the qualified heirs must consent to the application
of the recapture tax lien to authorize recording against a given property interest. Thus, if only equity interests in entities are listed as elected
QFOBIs, consent for imposition of the lien extends literally only to them, not to the inside assets of the entities (see Kelley, Donald H., Code
Sections 2057 and 2032A, Working in Tandem, A Work in Progress, 2000 Real Property, Probate and Trust Section Midyear, June 2, 2000).
Each individual QFOBI is “elected” as a deduction because the quantity of the property to be required to be included in the agreement
extends only to those interests actually elected.
Qualified Business. IRC §2057(e)(1) provides that a qualified business means: (1) an interest as a proprietorship in a trade or a
business carried on as a proprietorship; (2) an interest in an entity carrying on a trade or business, if at least (a) 50% of the entity is owned
directly or indirectly by the decedent and family members; (b) 70% of the entity is owned by members of two families (at least 30% by the
decedent or his family), or (c) 90% of the entity is owned by members of three families (again, 30% by the decedent and his family). These rules
are intended to preclude the use of the deduction for widely held businesses. IRC §2057(e)(1).
Qualified Recipient of QFOBI. The business must be acquired by, passed to, qualified heir from the decedent. The term, “qualified
heir” includes an ancestor, spouse, lineal decedent, lineal decedent of the decedent’s spouse, lineal decedent of decedent’s parent, or of the spouse
of any lineal decedent. A qualified heir also includes any active employee of the trade or business to which the qualified family-owned business
relates, if such employee has been employed by the trade or business for a period of at least ten (10) years before the date of the decedent’s death.
IRC §2057(e)(1).
Material Participation. To qualify for the deduction, the decedent (or member of the decedent’s family) must have owned and
materially participated in the trade or business for at least five of the eight years preceding the decedent’s date of death. IRC §2057(b)(1)(D).
Qualified family-owned business interests that are taken into account on behalf of the decedent must exceed 50% of the “adjusted gross estate”.
IRC §2057(b)(1)(C)). This percentage is computed by calculating a numerator that consists of the value of the qualified family-owned business
interests (adjusted to eliminate excess liquid market assets of the business/cash and marketable securities), plus gifts of such interest to such
family members, other than the spouse, since 1976, so long as those interests are still held by the family member. This total is unreduced by all
indebtedness of the estate except for “good debt,” which includes:
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XX. IRC § 6166: Extension of Time for Payment of Estate Tax Where an Estate Consists Largely of Interests in Closely-Held Business The underlying premise of § 6166 is to address the liquidity problems of estates holding farms
and closely-held businesses, to prevent the liquidation of such businesses in order to pay estate
taxes. To support this notion, the Legislature has extended the period for payment of estate
(a) home mortgage debt or home equity indebtedness that qualifies for the mortgage interest deduction;
(b) debt incurred to pay the educational and medical expenses of the decedent, his or her spouse or dependents; and
(c) any other indebtedness that does not exceed $10,000. The denominator is the gross estate, less claims and indebtedness, increased by any of the following transfers that are not already in
the gross estate:
(a) the same business interests gifts to the family members that were added to the numerator;
(b) non-diminimis transfers to the decedent’s spouse within ten (10) years of death; and
(c) all of the gifts from the decedent within three (3) years of death, except that annual exclusion gifts to members of the family are not taken into account.
If gifts are brought back into the gross estate, they are not double counted. The numerator has been divided by the denominator, and if the result
is greater than 50%, the estate will pass a liquidity test. See Belcher, Dennis I, “Planning for The Rancher/Farmer”, Estate & Personal Financial
Planning, Koren, Thompson Reuters/West, 2005, § 4.32).
Recapture. The benefit of the deduction is subject to recapture if, within ten (10) years of the decedent’s death and before the
qualified heirs’ death, one of the following recapture events occurs:
(a) The qualified heir ceases to meet the material participation requirement; (b) The qualified heir disposes of any portion of his or her interest in the family-owned business, other than by disposition to a member of the qualified heir’s family, or through a conservation contribution; (c) The qualified heir loses United States citizenship; or (d) The principal place of business ceases to be located in the United States (see IRC §2057(f)(1)(D)).
Trade or Business Requirement. Under §2057(e)(1), a QFOBI must be an interest in assets or an entity carrying on a “trade or
business” (mere passive or rental activity will not qualify for the 2032A qualified use, and presumably will not qualify for the active trade or
business requirement under 2057(e)(1), as well. (See Kelly, Donald H., Code Sections 2057 and 2032A, Working in Tandem, A Work in
Progress, 2000 Real Property, Probate and Trust Section Midyear, page 17-11.)
Drafting Administrative Provisions. If elected QFOBIs are not exonerated from death taxes, the taxes charged to elected QFOBIs
reduce the deductible amount, and such reduction must be replaced by the election of additional QFOBI values, that are themselves, in turn,
subject to such taxes. It would be desirable administratively to eliminate the circular calculation. An illustrative clause exonerating elected
QFOBIs from the burden of death taxes might be constructed as follows:
No portion of any Federal or State Estate, Inheritance or Generation Skipping tax or taxes arising by reason of my demise shall be chargeable to or collectible from any property as to which an election for such property to be deducted from my taxable estate under the provisions of §2057(a) is made by my Personal Representative, whether such property passes under the terms of my Last Will and Testament, or by reason of the nature of the ownership thereof; which property would otherwise by subject to any such taxes. (See Kelly, Donald H., Code Sections 2057 and 2032A, Working in Tandem, A Work in Progress, 2000 Real Property, Probate and Trust Section Midyear, page 17-18.)
40
taxes. H.R.Rep. 148, 105th Cong., 1st Sess. 83 (1997); S.R.Rep. 33, 105th Cong., 1st Sess. 48
(1997).
2001 Amendments. The 2001 tax relief act amended § 6166, broadening its coverage to
allow stock in lending and finance businesses to be considered as active business stock. In
considering this extended treatment of § 6166, the Senate Finance Committee stated:
“The Committee finds that the present-law installment payment of estate tax provisions is restrictive, and keeps estates of decedents who otherwise held an interest in a closely-held business at death from claiming the benefits of installment payment of estate tax. Thus, the Committee wishes to expand and modify availability of the provision to enable more estates of decedents with an interest in a closely-held business to claim the benefits of installment payment of estate tax.” S.Prt.107-30 at 83-84 (2001).
IRC § 6166 provides a taxpayer with an extension of time for payment of estate tax due,
where the estate consists largely of interests in a closely-held business. A proper and timely
election of § 6166 treatment can essentially defer payment of any qualifying estate taxes for up
to five years after the original due date of the estate tax return. Generally, the maximum five
year period is selected for deferral, although the taxpayer can elect a shorter deferral period.
Additionally, a § 6166 election allows an executor to pay qualifying estate taxes in up to
ten equal annual installments, the first of which must be made after the above-referenced deferral
period. It is important to note that if a shorter deferral period and installment plan have been
selected, the executor cannot later change his mind and select a longer deferral period or
installment plan. On the other hand, the executor can elect to prepay all installment payments,
without penalty. As such, the maximum deferral period and number of installments should be
selected.
Although § 6166 allows the taxpayer to defer the payment of any qualifying estate tax
due, the taxpayer must pay interest annually throughout the five years of the deferral period, or
the shorter period which was selected for deferral. IRC § 6166(f)(2), (4). The interest payment
must be made annually, at the time of, and as a part of the annual installment payment of tax.
The interest payable in the deferral period is calculated at a rate of 2% for the “2-Percent
Portion.” The “2-Percent Portion” is essentially that part of a taxable estate which is
$1,000,000.00 more than the exclusion amount. (i.e., $441,000.00 of tax in the year 2001, and
$480,000.00 of tax in the year 2002.) IRC § 6601(j)(2); see Belcher, Dennis I., Estate Planning,
Drafting, and Administration After the Economic Growth and Tax Relief Reconciliation Act of
41
2001, 2002 ABA Spring Section Materials, pp. 11-12 (2002). The $1,000,000.00 amount will be
increased for inflation in the years to come. IRC § 6601(j)(3).
For payments attributable to that portion of the taxable estate in excess of the above-
referenced “2-Percent Portion,” interest is payable at a rate which is 45% of the annual rate for
underpayments, established by IRC § 6601(a). IRC § 6601(j)(1)(B).
Basic Requirements. A personal representative of a qualifying estate may elect to pay
part or all of the estate tax due and owing in two or more equal installments, but no more than
ten installments. IRC §6166(a)(1). An estate qualifies for installment payments under § 6166 if
more than 35% of the adjusted gross estate is comprised of an interest in a closely-held business.
Id. The maximum amount of tax payable in installments under § 6166 is that amount which
bears the same ratio to the estate tax imposed (which is reduced by credits against such tax) as
the closely-held business amount bears to the amount of the adjusted gross estate.
Maximum Amount = Value of CH Business x Tax Due under § 2001
Under § 6166 Adjusted Gross Estate (less credits)
For purposes of qualification for the § 6166 election, the adjusted gross estate is defined as the
value of the gross estate, reduced by the sum of the allowable deductions under §§ 2053 and
2054. IRC § 6166(b)(6). The sum shall be determined on the basis of the facts and
circumstances in existence on the date for the filing of the estate tax return, including extensions.
Id.
Active Business Assets. The § 6166 extension may be elected if the value of the active
business assets in a closely-held business, which is includable in the decedent’s gross estate,
exceeds 35% of the value of the adjusted gross estate. IRC § 6166(a)(1). The § 6166 election is
not available for “passive assets,” which are, essentially, any asset other than an asset used in
carrying on a trade or business. IRC § 6166(b)(9)(B)(i). Stock is generally treated as a
“passive asset,” unless the stock is treated as held by the decedent as stock in a holding company
[which, for decedents dying after December 31, 2001, is treated as business company stock
under § 6166(b)(8)] and the quantum of stock held passes the 35% test set forth in § 6166(a)(1).
IRC § 6166(b)(9)(B)(ii). Additionally, for decedents dying after December 31, 2001, stock may
be considered as an “active asset” if:
(a) a corporation either owns at least 20% of the value of the voting stock of another corporation; or
42
(b) the other corporation has fewer than 45 shareholders; and (c) at least 80% of the assets of each corporation is attributable to assets used in carrying on the trade or business.
IRC § 6166(b)(9)(B)(iii). If both subsections are satisfied, then the corporations shall be treated
as one corporation for purposes of determining whether stock is a passive asset.
Revenue Ruling 2006-34 offers guidance as to what constitutes an active business for
purposes of I.R.C. § 6166 and revokes certain 1975 rulings. In its analysis of five hypothetical
situations involving a decedent’s interest in real property, the ruling states:
To determine whether a decedent’s interest in real property is an interest in an asset used in an active trade or business, the Service will consider all the facts and circumstances, including the activities of agents and employees, the activities of management companies or other third parties, and the decedent’s ownership interest in any management company or other third party. The Service will consider the following nonexclusive list of factors:
• The amount of time the decedent (or agents and employees of the decedent,
partnership, LLC, or corporation) devoted to the trade or business; • Whether an office was maintained from which the activities of the decedent,
partnership, LLC, or corporation were conducted or coordinated, and whether the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) maintained regular business hours for that purpose;
• The extent to which the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) was actively involved in finding new tenants and negotiating and executing new leases;
• The extent to which the decedent ( or agents and employees of the decedent, partnership, LLC, or corporation) provided landscaping, grounds care, or other services beyond the mere furnishing of leased premises;
• The extent to which the decedent (or agents or employees of the decedent, partnership, LLC, or corporation) personally made, arranged for, performed or supervised repairs and maintenance to the property (whether or not performed by independent contractors), including without limitation painting, carpentry, and plumping; and
• The extent to which the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) handled tenant repair requests and complaints. No single factor is dispositive of whether a decedents activities with respect to
the real property (or the activities of a partnership, LLC, or corporation through which decedent owns the real property) constitute an interest in a closely held business for purposes of section 6166. Rev. Rul. 2006-34.
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Significantly, Revenue Ruling 2006-34 revoked Revenue Ruling 75-365, 1975-2 C.B.
471. This impacts many farmers and ranchers as that ruling held that where the decedent
individually maintained a fully equipped business office to collect rental payments on
commercial and farm rental properties, and to receive payments, negotiate leases, make loans
and direct the maintenance of properties, the decedent was merely an owner managing
investment assets to collect the income ordinarily expected from the properties and was not
conducting a trade or business.
Interest in a Closely-held Business. In determining an estate’s qualification for § 6166
election, the Service will scrutinize whether the decedent’s interest is a qualifying interest that
satisfies the above-stated “35% test.” For purposes of determining qualification under § 6166,
the ownership tests are determined as of the time immediately preceding the decedent’s death.
IRC § 6166(b)(2)(A). The decedent’s interest as a proprietor in a solo proprietorship satisfies the
35% test. IRC § 6166(b)(1)(A). Likewise, if the decedent was a partner in a partnership
carrying on a trade or business, the decedent’s partnership interest will qualify under § 6166, if at
least 20% of the total capital interest in the partnership is included in the decedent’s gross estate,
or if there are 45 or fewer partners. IRC § 6166(b)(1)(B). Additionally, the decedent’s
ownership of stock in a corporation qualifies for § 6166 treatment if at least 20% of the voting
stock in the corporation is included in the decedent’s gross estate, or if the corporation has no
more than 45 shareholders. IRC § 6166(b)(1)(C).
Special Rules – Family & Entity Attribution. Special rules of attribution govern the
application of the ownership and membership tests for § 6166 qualification. First, the “Family
Attribution Rule” comes into play in determining qualification. Essentially, in determining the
number of partners or shareholders in an entity, any stock or partnership interest owned by a
decedent’s family member will be treated as if it is owned by the decedent as a single person.
IRC § 6166(b)(2)(D). Consequently, if all partners or shareholders are family members, the
partnership or corporation will undoubtedly satisfy the “less than 45” or “20%” elements. For
purposes of family attribution under this section, a family member includes any person within
the meaning of IRC § 267(c)(4). Additionally, a partnership interest or stock in a corporation is
treated as it is owned by one person if the interest is:
(a) Community property of a husband and wife, or the income therefrom; or
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(b) The property is held by a husband and wife as joint tenants, tenants by the entirety or tenants in common.
IRC § 6166(b)(2)(B). Further, a decedent’s interest in two or more closely-held businesses may
be combined and treated as one aggregate interest in a single business to satisfy the 35% test, if
the decedent’s gross estate included at least 20% of the total value of each of the separate
businesses. IRC § 6166(c). An interest held by a spouse as community property, or as a joint
ownership, with or without survivorship rights, will also be treated as includable in the
decedent’s gross estate, solely for purposes of determining whether the 20% stock ownership
aggregate requirement has been met. IRC § 6166(c).
Non-Readily Tradable Stock. With respect to partnership interest and stock, which are
non-readily tradable, separate rules of attribution apply. IRC § 6166(b)(7). Non-readily tradable
shares are shares of stock for which there is no market on a stock exchange, or in an over-the-
counter market at the time of the decedent’s death. IRC § 6166(b)(7)(B). Under this section, the
personal representative is allowed to attribute business interests to the decedent for purposes of
determining the 20% ownership requirement, as well as the 35% total gross estate value.
Acceleration of Deferred Payments. The extension of payments under the deferral
period will be cut short and all payments accelerated upon the occurrence of numerous events,
including the following:
(a) The disposition or withdrawal of 50%, in aggregate, of the closely held business’ value;
(b) The distribution, sale, exchange, or disposition of decedent’s qualifying § 6166 interest;
(c) The failure to distribute undistributed net income from the estate; or
(d) The taxpayer’s failure to make installment payments on the due date, including extensions, or within six months of the due date, including extensions. IRC § 6166(g).
The Service will send a notice of acceleration and a demand for payment upon the occurrence of
the events described in IRC § 6166(g). Acceleration under § 6166 is often a trap for the unwary,
and as such, it merits some discussion. For example, payments will be accelerated if the estate
withdraws a smaller percentage of the decedent’s qualifying § 6166 interest in the closely held
business, and separately disposes of the remaining qualifying interest. Specifically, if the estate
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withdraws 5% of the value of the qualifying closely held business, and separately disposes of
45% of the remaining interest, § 6166 payments will be accelerated. H. Rept. No. 97-201 (P.L.
97-34) p. 182.
Further, there is no “disposition” within the meaning of § 6166 if there is a transfer of
specific property to a devisee under the decedent’s will, or a transfer based on the state laws of
succession or a trust created by the decedent. § 6166(g)(1)(D). Likewise, there is no
“disposition” by reason of a subsequent transfer by reason of death, if the transfer is to a family
member, as defined in § 267(c)(4). Id.
With respect to late installments not paid within six months of the due date, these
payments do not qualify for the special interest rate established by § 6601. § 6166(g)(3)(B)(ii).
Additionally, any late payments are subject to a penalty, which is the sum of 5% of the late
payment and the number of months (or a fraction thereof) after the due date and before the
payment is actually made. § 6166(g)(3)(B)(iii).
How and When to Make the § 6166 Election. If an estate qualifies for § 6166
treatment, the executor should make the election at the time of filing the 706 Form. Treas. Reg.
20.6166-1(b). The time for making the election is the time prescribed by § 6075 for the filing of
the 706 Form, including extensions. The personal representative or executor of a decedent’s
estate must affirmatively elect to pay estate taxes in installments by attaching to a timely filed
estate tax return a notice of election, which contains the following information:
(a) The decedent’s name and taxpayer identification number as they appear on the estate tax return; (b) The amount of tax, which is to be paid in installments; (c) The date selected for payment of the first installment; (d) The number of annual installments, including the first installment, to be paid; (e) The property set forth on the estate tax return, which constitutes the closely-held business interest (to be identified by reference to schedule and item number); and (f) The facts supporting the qualification for payment of the estate tax in installments. Treas. Reg. 20.6166-1(b).
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If the executor fails to provide a complete statement of this information, the Service will
presume that the personal representative has elected to pay the maximum amount eligible for §
6166 treatment in ten equal installments, the first of which is to begin five years after the original
date established for the payment of estate tax under § 6151(a).
XXI. The Conservation Easement Exclusion under IRC § 2031(c)
The executor of an estate may make a postmortem conservation easement election under IRC
2031 (c) and achieve up to $500,000 of exclusion from the gross estate; it is important to note
that such a conservation easement must, in any event, comply with the requirements of a
charitable contribution conservation easement under IRC 170 (h) in addition to the requirements
of IRC 2031 (c). For an in depth discussion of the charitable income tax requirements under IRC
170 (h), see McLaughlin, Nancy L; Dietrich, David J., and Rothschild Jr., Alan F. “Conservation
Easements: Drafting, Amending and Defending” Spring Section Meeting, 2012, ABA Section
of Real Property, Probate and Trust Law; See also Conservation Easement Audit Techniques
Guide at http://www.irs.gov/businesses/small/article/0,,id=249135,00.html.
General Estate and Gift Tax Deductions for Conservation Easements. The federal
gift and estate transfer tax scheme provides charitable deductions for conservation easement
donations. Such deductions assume that testamentary or trust instrument has been established
before death by the decedent.
Estate Tax Deduction. IRC § 2055 (a), the estate tax deduction statute, allows a
deduction for bequests to various entities and includes:
(a) Bequests to the United States, state or any local subdivision if the bequest is exclusively for public purposes; and (b) Bequests non-profit organizations operated for charitable, scientific or educational purposes.
Additionally, IRC § 2055(f) provides that a deduction will be allowed for the value of a
"qualified real property interest" as defined in IRC § 170(h)(2)(c). Indeed, § 2055(f) literally
allows a deduction for a bequest of a perpetual use restriction for a purpose unrelated to
conservation, because the express language of the statute does not require that the "qualified real
property interest" be for a conservation purpose. The Regulations adopted to implement § 2055
incorporate Reg. § 1.170A-14 and seem to incorporate the requirement that the contribution be
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used exclusively for conservation purposes and that the conservation purpose be protected in
perpetuity, but do not expressly disallow an otherwise qualifying contribution merely because
the conservation purpose might ultimately be defeated as a result of events that appear highly
unlikely at the time of the contribution. The value of a deduction for a bequest of a qualified
conservation easement is the fair market value of the contributed property interest as of the
applicable date, generally the date of the decedent's death. Reg. 20.2055-2.
Gift Tax Deduction. IRC § 2522 (d) provides a deduction for federal gift tax purposes
for charitable donations and qualified conservation interests. The provision is identical to IRC §
2055(f), and is set out in Reg. § 25.2522 (c)-3(c)(2)(iv), which allows a deduction for a
charitable gift of a qualified conservation contribution. The qualifications are the same as for
estate tax purposes. XXII. POST MORTEM DEDUCTION UNDER IRC 2031(C) The Taxpayer Relief Act of 1997 provided a significant estate tax benefit by removing
from the definition of the gross estate certain land subject to a qualified conservation easement.
See IRC § 2031(c). In general, this new section provides, as to certain properties and at the
election of the estate, an exclusion of value equal to as much as forty (40%) percent of the value
of the property.
As of 2002, the exclusion was $500,000. Electing the exclusion effectively reduces the
gross estate and, as a result, the federal estate tax owed. The trade-off is that – to the extent of
the exclusion – the land takes a carry-over basis rather than a stepped-up basis for federal income
tax purposes. IRC § 1014 (a) (4).
In order to qualify for the benefit the statute merely requires that the property be located
within the United States or its protectorates, thus removing the cumbersome geographical
limitations placed in the original version of the legislation in 1997.3
The property must have been owned by the decedent or a member of the decedent's
property at all times during the three year period ending on the date of the decedent's death. For
this purpose, "family" is defined with reference to § 2032A(e)(2), namely ancestors, spouse,
3 Prior to the 2001 Tax Act, The subject property was required to have been located: a. In or within 25 miles of a metropolitan area (as defined by the Office of Management and Budget); b. In or within 25 miles of a National Park or Wilderness Area designated as part of the National Wilderness Preservation System (unless the IRS should determine that no significant development pressure exists).
c. In or within 10 miles of an area which is an Urban National Forest (as designated by the Forest Service)
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lineal descendants of the decedent, or the decedent's spouse, and the spouse of any lineal
descendent. A "qualified conservation easement" must have been conveyed by the decedent, a
member of the decedent's family (as defined above), the executor of the decedent's estate, or the
trustee of the trust, the corpus of which includes the land subject to the conservation easement.
The exclusion also applies to an interest in a "partnership, corporation, or trust if at least Thirty
(30%) percent of the entity is owned directly or indirectly by the decedent. IRC 2031(c)(2).
The exclusion available is based upon an "applicable percentage" of the value of the
easement protected property. The amount is forty (40%) percent of the easement protected
property's value, reduced by two percentage points for each percentage point (or fraction there
of) by which the value of the qualified conservation easement is less than thirty (30%) percent of
the value of the land determined without regard to the easement. This rule is intended to
discourage "marginal" easements that reduce the value of land only marginally. The Senate
Committee Report indicates that the exclusion amount is calculated based on the value of the
property after the conservation easement has been placed on the property. 143 Cong. Rec.
H6409-01, H6511. For example, land is valued at $1,000,000 and an easement is donated which
reduces the value to $700,000, the donor is entitled to a $300,000 income tax deduction under
IRC 170(h). In addition, his estate can reduce the reportable value of the land on the Federal
Estate Tax return subject to estate tax from $1,000,000 to $700,000. Finally, the executor can
elect to exclude an additional $280,000 of the remaining value under §2031c, calculated as
follows:
(a) 40 minus [2 times (.30 minus THE VALUE OF THE EASEMENT (300,000 here) / (THE VALUE OF THE LAND WITHOUT THE EASEMENT (1,000,000 here) less any "retained development rights. (none here)") (b) If the election occurs after year 2000, the full 280,000 exclusion can be taken on the estate tax return.
Another example, if land worth $1,000,000 before an easement is worth $900,000 after the
easement (a ten percent reduction), exclusion available would be zero because the easement was
zero percentage points lower than the thirty percent threshold.
(a) 40 minus [2 times (.30 minus THE VALUE OF THE EASEMENT (100,000 here) / (THE VALUE OF THE LAND WITHOUT THE
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EASEMENT (1,000,000 here) less any "retained development rights" (none here))]
Any "retained development rights" retained in the easement agreement will be subject to
estate tax. IRC § 2031 (c) (5) (A). The law, however, gives the heirs nine months after the
decedent's death to agree to terminate some or such retained rights and thereby avoid the tax on
those rights. The heirs have two years after the decedent's death to put this agreement into effect.
IRC § 2031 (c) (5) (C). "Retained Development rights" are defined as any right "to use the land
for a commercial purpose not directly related to and supportive of the use of the land as a farm
for farming purposes." IRC § 2031 (5) (D). Rights to maintain a residence for the owner's use,
as well as normal farming, ranching and forestry practices would not be considered retained
development rights. The retained right to subdivide land for development, and to carry on
commercial recreational activities are retained development rights and should be terminated
within the due date required under IRC § 2001 and related Regulations. PLR 2000 1403.
The "Permitted Uses" provision of a conservation easement should be analyzed post-
mortem to eliminate retained development rights, to ensure qualification under IRC § 2031 (c).
The amount of any outstanding debt incurred to acquire land must be subtracted from the
land's value before calculating the: exclusion. For example, if land has a value of $700,000 after
subtracting the value of an easement, and it is subject to a $300,000 mortgage, the exclusion can
be applied to $400,000 ($700,000 minus $300,000). The exclusion amount in this case is
$160,000.
The law makes the exclusion available for an easement donated by a decedent's executor
or trustee even though the decedent failed to donate the easement before his death. This "post
mortem election" is an extremely valuable estate planning tool, provided state law empowers the
personal representative to make this election.
The exclusion for land subject to a conservation easement may be elected in addition to
the IRC § 2032A special use valuation and the IRC § 2057 qualified family owned business
deduction. 143 Cong. Rec. H6409-01, H6511.
As a consequence, every estate planner advising their client on conservation easements
must take into account provisions of the Act. Easements that have been recorded should be
reviewed because of these new provisions, and the new law makes planning immediately after
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death necessary because a post-death election under the Act is required. The 2031(c) election is
made on “Schedule U” of the 706 form.
In general, the executor’s election to exclude a portion of the value of land subject to a
qualified conservation easement from the decedent’s gross estate under § 2031(c) does not
prevent an election to value the property under § 2032A. S. Rep. No. 105-33, 105th Cong., 1st
Sess 47 (1997), reprinted in 1997-4 CB (Vol. 2) 1067, 1127. Moreover, the donation of a
qualified conservation contribution is not a “disposition” subjecting the estate to additional tax
under § 2032A(c)(1)(A). IRC § 2032A(c)(8). Beyond these provisions, however, the
relationship becomes uncertain. As Stephens, et al. explain:
[The] problems between the two sections involve the issue of the extent to which one section is taken into consideration in satisfying the qualification requirements under the other section. A chicken and egg type Section 2031(c) – Section 2032A interrelationship problem occurs when real property that is potentially eligible for a Section 2032A reduction in value is also potentially eligible for a Section 2031(c) exclusion and an executor elects the application of both sections. It is unclear which section is applied first. Stephens, et al., supra note 288, at 4-68-69.
Because neither section addresses the impact of the other, “[t]he question is best resolved
by assuming that the other section is applicable in determining qualification under each section,
i.e., measuring the amount of the Section 2031(c) exclusion by using Section 2032A valuation
and testing Section 2032A qualification by applying the Section 2031(c) exclusion.” Id. at 4-69.
If the executor values the easement-encumbered property under § 2032A, they should use this
valuation in determining the amount of the exclusion under § 2031(c). Conversely, if the
executor elects the exclusion under § 2031(c), the executor must account for this election in
determining the property’s qualification for valuation under § 2032A.
Property acquired from the decedent by a qualified heir which, on the date of the decedent's
death, was used for a qualified use must satisfy two tests to qualify for valuation under § 2032A.
IRC § 2032A(b)(2) (defining “qualified use” as “the devotion of the property to . . . use as a farm
for farming purposes or use in a trade of business other than the trade or business of farming.”;
IRC § 2032A(b)(1). First, 50 percent or more of the adjusted value of the gross estate must
consist of the adjusted value of real or personal property which (i) on the date of the decedent's
death was being used for a qualified use by the decedent or a member of the decedent's family,
and (ii) was acquired from or passed from the decedent to a qualified heir of the decedent. IRC §
2032A(b)(1)(A). Second, 25 percent or more of the adjusted value of the gross estate must
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consist of the adjusted value of real property (i) acquired from or passed from the decedent to a
qualified heir of the decedent which (ii) for periods aggregating 5 years or more during the 8-
year period ending on the date of the decedent’s death was owned by the decedent or a member
of the decedent's family and used for a qualified use by the decedent or a member of the
decedent's family in which the decedent or a member of the decedent’s family materially
participated. IRC § 2032A(b)(1)(B).
Under both tests, the adjusted value of the gross estate (i.e., the denominator of the
fraction) is determined without regard to § 2032A. IRC § 2032A(b)(3)(A). Accordingly, the
executor’s election to exclude a portion of the value of land subject to a qualified conservation
easement from the decedent’s gross estate under § 2031(c) should reduce the denominator of
both fractions. The adjusted value of any real or personal property (i.e., the numerator of the
fraction) is likewise determined without regard to § 2032A. IRC § 2032A(b)(3)(B). However,
the effect on qualification for § 2032A valuation is less clear. As Stephens, et al. explain:
If the land subject to the easement is not a part of the special valuation property, Section 2031(c) has no effect on the numerators. If the land is a part of the special valuation property, then the nature of the Section 2031(c) exclusion becomes relevant. If, as is likely, the nature of the Section 2031(c) is effectively a reduction for estate tax purposes in the value of specific land, the n the exclusion would reduce the numerators of both of the fractions. In the alternative, if the nature of the Section 2031(c) exclusion is related to a dollar amount and not a specific asset, then the numerators of neither fraction would be reduced by the Section 2031(c) exclusion. Stephens, et al., supra note 288, at 4-70; see also Stephens, et al., supra note 288, at 4-67-68 and accompanying notes.
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XXIII. CONCLUSION
Modern agricultural estate planning often involves illiquid real estate planning of sizeable
wealth with discerning clients who often highly value the legacy of their land and its natural
habitat. The planner faces the biblical admonition that “it is easier for a rich man to pass
through the eye of a needle than to go to [tax] heaven.” Nevertheless, carefully crafted entity
formation and coordination among the taxpayer’s tax, real estate and business planner can yield
huge benefits in the form of valuation discount planning with gifting, the effective non tax uses
of limited liability companies and limited partnerships, and the use of post mortem planning
tools such as alternate use valuation, tax deferral, and conservation easements.
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