By Dr. Robert Tufts, Auburn University Professor, Agriculture, Forestry & Natural Resources
Transferring the family farm to the next generation requires planning. This content discusses three issues that affect the future of the family farm: estate (death) taxes, joint management, and built-in capital gains tax. Each of these issues can be managed to reduce the effect.
One of the major threats to the family farm in years past was the payment of estate taxes at rates as high at 55 percent on the value over $600,000. Some estates were forced to sell portions of the family farm to pay the estate tax assessment. Temporary relief was granted with the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, but it was to sunset after 2010.
The American Taxpayer Relief Act of 2012, signed into law January 2, 2013, finally made permanent the estate tax statutes permanent, meaning until Congress passes new legislation. The Tax Cuts and Jobs Act (not the official title for Public Law 115-97) was signed December 22, 2017 and provided even more favorable treatment for estates.
The applicable exclusion amount (AEA), the amount an individual can transfer tax free, is currently $11.4 million and it is indexed for inflation. The AEA started at $5 million in 2010 and was doubled by the Tax Cuts and Jobs Act. Therefore, a married couple in 2019 can transfer $22.8 million dollars of estate value to children tax free. Any amount over the AEA will be taxed at 40 percent.
Estate Tax Planning
Estate tax planning is essentially a gifting program. Estates valued over $11.4 can be reduced with planning and time. The first option is to make tax-free payments for medical and tuition expenses for children and grandchildren which does not reduce the AEA.
The next option is to use the annual exclusion which is another tax-free transfer that does not use any of the AEA. The annual exclusion is also indexed for inflation and the amount for 2019 is $15,000. This may not sound like much but consider a husband and wife with four married children and eight grandchildren. The husband could transfer $240,000 in 2019 [(4 children + 4 spouses + 8 grandchildren) multiplied by $15,000] and the wife, either with her own money or using gift-splitting, could also transfer $240,000 equaling almost half a million dollars per year. Remember, we are not talking about making the parents poor, we are talking about gifting the amount in excess of $11.4 million.
The third technique would be to make maximum use of the AEA by making split-interest gifts. A qualified personal residence trust (QPRT) is an example of a split-interest gift. The parents retain the right to use the house for some number of years less than their life expectancy (e.g. 15 years), after which the children own the house. Because the children’s interest does not mature for 15 years, the value of the gift is discounted to a present value. After the 15 years, the parents still live in the house but pay rent which further reduces the value of their estate.
Charitable transfers also reduce the value of the estate with no cost to the donor. If you are considering a charitable transfer you should talk to a tax planner about making the gift during life but retaining the use of the property because you will receive an income tax deduction as well as an estate tax deduction.
The most common will leaves all the assets to the spouse, if they survive, otherwise, the assets go to the children in equal shares. This creates an undivided ownership in the property. For example, if the property is 300 acres and there are three children, then each child has the right to use the entire 300 acres. The only way for a child to own individual property is for the will to provide a legal description for the property transferred to each child.
Joint ownership can often create problems. For example, let’s say parents left recreational property to their three children in equal shares. In this case, each has the right to use the entire property. If one child leased their right to the land to a hunting club, that would interfere with the other two children’s opportunity to use the property. If the children who are joint owners cannot agree on the management of the land, the only remedy is partition or the division into equal shares.
If the children cannot agree on a division among themselves, the court will oversee the division or sale for division. In any case, the tract of land that had been the family farm will be subdivided at best and sold at worst. In many instances, the family has been accumulating land over the years and the last thing the parents want is the division of the farm into smaller and smaller tracts that can no longer be operated as a farm and the sale of some of those tracts to individuals outside the family.
Using a Business Entity to Hold the Land
One way to prevent the partition of the land is forming a business entity and contributing the property to the entity. The entity can be managed by the individuals that have an interest in farming. The remaining children can be owners or beneficiaries so they can have an equal benefit. (e.g. the manager/farmer leases the land from the entity and the payments are divided among all the children.)
State law will determine the benefits and liabilities of the owners or beneficiaries of the entity. The business may be organized as a limited liability company, a limited liability limited partnership or a corporation. Sometimes the business will be a general partnership to qualify for federal benefits, but a general partnership does not provide liability protection to the owners.
All the children would be owners of the business and have an income interest but they would probably not all be managers. The business is typically organized to limit individual liability. The farm belongs to the business and the children own the business so, the children do not have a right to use or partition the property. The children/owners may have limited withdrawal rights and transfer rights to prevent harm to the farming operation. The business would also be protected against the creditors of the children. The one disadvantage of the business is that after the parents are gone, the children own the business and can dissolve it and sell the farm.
Using a Trust to Hold Land
A trust is an alternative to a business entity. A trustee (parents initially) holds legal title to the property for the benefit of the beneficiaries (parents, then children) who hold equitable title. The grantor (parents) writes the trust and specifies how the children benefit from the trust. For example, the trustee may lease the land to a beneficiary or transfer an acre to a child for a home site. The trust may also buy and sell equipment or animals or operate the farm. Children may be entitled to income or have to meet a requirement to earn the income (e.g. graduate from college, get married, work on the farm, or earn matching income). What the trust requires depends on the creativity of the grantors who specify how the trust is to operate.
The trust provides liability protection, even against a divorce. The children have no right to receive anything from the trust except as the parents specify. The children cannot partition, withdraw, assign their interest, or exert management rights. The disadvantage of the trust is that it will eventually end based on the State’s Rule Against Perpetuities. The general rule is the trust may last for a life in being plus 21 years. In other words, the trust must terminate 21 years after the death of all the children and grandchildren in being at the time the trust is created or about 100 years. If an Alabama trust holds land and is created properly, the trust can last for 360 year.
For families with some children interested in farming and others who are not, a business entity or trust may provide a better vehicle to hold the farm. Children can be treated equally while preventing the division or sale of the land.
Built-In Capital Gains Tax
Another issue that may arise is the children’s basis in the property left to them, and the property may be an ownership interest in a business. Basis is normally the investment in an asset. Basis is important because an owner does not pay tax on the return of basis when an asset is sold.
For example, if you buy stock for $60 and sell it for $100, your basis is $60 and your taxable gain is $40. If you purchase property, your basis is the price you paid to put the property in service. However, your parents may gift you the property or leave it to you in their will. The difference is important.
The donee of a gift (transfer during life for no consideration) takes the donor’s basis (technically, the donor’s basis plus the tax paid on the appreciation, but few people make taxable gifts). If the parents purchased the land in 1960 for $200 per acre and give it to the children in 2019 when the property is worth $3,000 per acre, the children’s basis is $200 per acre. If the children sell the property, they will have a taxable gain of $2,800 per acre. However, if the surviving parent died in 2019 and the children received the property from the decedent’s estate, their basis is the fair market value on the date of death. In this example the basis would be $3,000 per acre. If the children sold the property soon after death, they would not have a taxable gain on the sale.
Parents who are retiring from farming need to consider basis when deciding whether to give the farm to the children when they retire. The general rule is to leave low-basis assets in a will, revocable trust, or life estate so it will receive a basis adjustment. If the donee does not expect to sell the asset, land or machinery, then basis is not an issue.
If one or more children are buying the farm from the parents, then the children’s basis is not an issue, but the parent’s basis is. The parents will owe tax on the gain. Parents cannot claim a loss on the sale of the farm to a related party. Also, it is not possible to sell something for less than it is worth. If you transfer the farm to a child for $1 you have sold $1 worth of the farm and gifted the remainder of the value to the child.
Farmers who hope to leave their farm to one or more of their children should consult a tax professional for help developing a plan. The sooner you start planning, the more you can accomplish.