As the majority of a family farm’s wealth is generally tied up in land and equipment or needed for working capital, paying an estate tax within nine months of the death of the farm owner can be a burden. The last thing most farm families want after spending a lifetime building the farm operation is to have it liquidated so the next generation can pay the estate tax. Fortunately, there are several planning strategies and tax advantages available to reduce the estate tax burden when passing down the family farm.
Oregon Natural Resource Credit (ORS 118.140)
Estates in which the farm operation accounts for at least 50% of the owner’s total estate qualify for an Oregon Estate Tax credit of up to $7.5 million. The amount of the credit is based on the ratio of the farm to the total estate. For example, if the farm is 70% of the total estate, then the credit will be for 70% of the Oregon Estate Tax. To qualify for the credit, the total estate of the farm owner must not exceed $15 million, and the farm must pass to family member(s) who operate the farm for 5 out of 8 years following the farm owner’s death.
Farmland is often owned 100% by parents, either individually or in an LLC. As such, when the parents pass away, 100% of the LLC’s value will then be included in parents’ estate for estate tax purposes. One way to reduce the percent included in parents’ estate is to gift an interest in the LLC to the farm heir(s) so that both parents have minority interests. Upon the parents’ deaths, the values of their separate minority interests receive a discount for estate tax purposes, thereby reducing the value that is included in their estate and subject to estate tax. The trick here is to ensure that one parent’s interest does not pass outright to the surviving parent (or to a general power of appointment marital trust), thereby turning what initially were two separate minority interests into one majority interest owned by the surviving parent. Transferring the deceased parent’s interest to a Bypass or QTIP-type trust for the life of the surviving parent will enable the parents’ interests to be valued separately, thereby preserving the minority discounts.
In the common instance where the farm operation is land rich and cash poor, life insurance can provide the liquidity needed to pay estate tax. Life insurance can also provide an inheritance for non-farm heirs, rather than leaving the entire estate to the farm heir, or worse, splitting the farm between a farm and non-farm heir. Additionally, if the life insurance is owned in a special trust called an Irrevocable Life Insurance Trust (“ILIT”) and certain procedures are followed, the insurance will not be included in the insured’s estate, and therefore not subject to estate tax.
Special Farm Use Valuation (IRC2032A)
Farms passed down to family members who continue to farm for at least 10 years following the owner’s death may elect to have the land valued at its agricultural use value, rather than its fair market value, for Federal Estate Tax purposes. The agricultural use value (which is set by a formula) is often lower than the fair market value, resulting in a lower estate tax. Like the Oregon Natural Resource Credit, to qualify for the Special Farm Use Valuation, the value of the farm operation (real and other business property) must exceed 50% of the owner’s total estate. The real property itself must exceed 25% of the owner’s total estate.
As a side note, it is important to consider how these mechanisms interact with each other. For example, lifetime gifts of LLC interests for the purpose of receiving valuation discounts could reduce the parents’ farm ownership below 50% of the parents’ total estate, thereby disqualifying them from the Oregon Natural Resource Credit and Special Farm Use Valuation. Additionally, while a strategy that lowers the estate value results in lower estate taxes, the lower value will also lower the income tax basis at death and eventually cause more capital gains tax if the farm is sold by the heirs.
Tax Deferral and Installment Payments of Estate Tax (IRC 6166)
In certain situations where estate tax is due, the IRS will allow the portion of Federal Estate Tax attributable to a farm operation to be deferred and paid in installments. To qualify, the value of the farm operation must exceed 35% of the decedent’s estate. The executor of the estate may then elect to pay all or part of the estate tax in up to ten equal annual installments, with the first installment being due within 5 years of the original due date of the estate tax. However, the IRS will charge interest on the deferred portion of estate tax (at a reduced rate), and the IRS will likely require a bond or property lien until the tax is paid.
Although there are several mechanisms available to farmers to help reduce the estate tax burden, advance planning is generally needed to take full advantage of these benefits. Please call our estate planning group if you have questions regarding the strategies farmers can use to reduce estate taxes.