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Chapter 6
Farms and
Closely Held Businesses
Growing a Big Liability

A farm or closely held business may be a very valuable asset, giving rise to a significant estate tax liability. Often, however, there is not enough cash available for the payment of this tax. The estate’s assets usually consist of land, crops, and livestock, in the case of a farm; or buildings, receivables, and inventory in the case of a business. In either case, the owner has usually been unable to invest in other assets to create estate liquidity.

There are provisions that give relief to the owner of a farm or closely held business. The purpose of these provisions is to allow a family farm or business to be passed down through generations without the necessity of a sale to pay estate taxes.

What Value Will Be Included in My Estate?

Current law allows real estate used in a farm or closely held business to be valued on the basis of its current use rather than its potential use. However, the benefits of this provision cannot reduce your gross estate by more than $750,000. For example, if your estate contains real property used in a farming operation or closely held business and its "highest and best use" value is $2.5 million, while the farming or other current-use value is only $1.5 million, it would be valued for estate tax purposes at $1.75 million. The law provides complicated methods of valuing qualifying property on the basis of its current use. The law also provides for the $750,000 ceiling to be adjusted periodically for inflation.

The benefits of the special valuation may be limited, since there are strict conditions for its use:

1. The value of the farm or closely held business must be at least 50 percent of the gross estate, reduced by mortgages and indebtedness on property included in the gross estate. Both real and personal property may be included in this test even though only the real property qualifies for the special valuation.
   
   
2. The value of the real property must be at least 25 percent of the gross estate reduced by mortgages and indebtedness on property included in the gross estate. The "highest and best use" value may be used for both the 50 percent and 25 percent tests.
   
   
3. The real property must pass to a qualified heir. Qualified heirs include your spouse, your children, and other close relatives.
   
   
4. The property must have been used for farming or in a business for five years of a specified eight-year period.

A further restriction on the benefits of the special valuation applies if the property is transferred to someone outside the family or if it is not used for farming or in a business within the next ten years. In either event, the benefits of the special valuation will have to be paid back.

Taxpayers dying after December 31, 1997, may be able to deduct, in addition to the $750,000 exclusion mentioned above, an amount equal to the lesser of the value of a qualified family-owned business or the excess of $1.3 million over the applicable exclusion amount. In 2006, the exclusion will be the lesser of the value of the business or $300,000. However, the requirements to make this election are very strict, and up to 100 percent of the estate tax benefit will have to be repaid if the qualified heirs do not materially participate in the business for five out of eight years in the 10-year period after the decedent’s death.

In order to have a business qualify for this exclusion, the business must be located in the United States and be owned at least 50 percent, 70 percent, or 90 percent by one, two, or three families respectively as long as the decedent’s family owns at least 30 percent of the business. Further, the decedent’s business interest must exceed 50 percent of the decedent’s adjusted gross estate and must be passed only to qualified heirs. In addition, the decedent must have materially participated in the business for five out of eight years prior to death.

These conditions limit the availability of the special valuation. It may also not always be advisable to use the special valuation. Your property will have a tax basis of either the special use amount or the fair market value, whichever is used on the estate tax return. The income tax savings of a basis increase may exceed the reduction in estate tax generated by the special valuation.

Will My Business Have to Be Sold to Generate Cash to Pay Taxes?

There is further relief to the estate with a liquidity problem caused by the ownership of a closely held business; a proprietorship, partnership, corporation, or any type of business or farm may qualify. There are certain requirements, however, regarding the estate’s percentage of ownership of the business interest.

The law provides that, if the value of a closely held business interest exceeds 35 percent of the adjusted gross estate, the estate taxes attributable to that interest may be deferred for up to 14 years. The estate must make an annual interest payment for the first four years and thereafter pay the balance in up to ten annual installments of principal and interest.

For taxpayers dying before December 31, 1997, a special 4-percent interest rate was applicable to the lesser of (1) $153,000, which is the tax on $1,000,000 of value reduced by the unified credit ($345,800 - $192,800), or (2) the amount of the estate tax attributable to the closely held business. Since the interest paid during the 14-year period was deductible as an administrative expense for estate tax purposes, the estate tax liability and each successive annual installment amount are recalculated and reduced accordingly.

For taxpayers dying after December 31, 1997, a 2-percent interest rate is imposed on the estate tax liability assessed on the first $1,010,000 of taxable value above the applicable exemption amount. For example, in 2006, the taxable value subject to the 2-percent rate will be $1,010,001 to $2,010,000. Any estate tax assessed on a value in excess of $2,010,000 will be subject to an interest rate equal to 45 percent of the underpayment of tax interest rate. Because of the decreased interest rate, the interest paid on the deferral will be nondeductible. Thus, the estate tax liability will no longer need to be revised for additional interest and administrative expenses. The $1,010,000 ceiling will be adjusted periodically for inflation.

If one-half or more of the business is disposed of, the payment schedule will be accelerated.

Generally, only property held at death may be used to qualify for the extension of payment. Therefore, it is very important to consider the composition of assets to be held at death when formulating any lifetime-gift or sale-of-assets program. Gifts of a farm or other closely held business interests will reduce the percentage of your estate made up of that business. Thus, it may be better to give away other assets and retain the business interests to meet the percentage requirements of the extension provision.

Are There Provisions for the Redemption of Closely Held Stock to Receive Capital Gain Treatment?

Current law provides methods by which closely held stock passing from a decedent may be redeemed with capital gain treatment. Without these provisions the redemption might be considered a dividend, which would make the entire proceeds subject to ordinary income tax treatment.

To qualify, the closely held stock must exceed 35 percent of the adjusted gross estate. Two or more businesses may be combined to meet the 35-percent test, but additional requirements are imposed. It is important to remember to select carefully the property to be disposed of before your death to allow your estate to pass the 35-percent test.

Another requirement is that the stock to be redeemed be inherited by a beneficiary who shares in the taxes and debts of the estate. Therefore, most bequests of closely held stock qualifying for the marital deduction will not qualify for this redemption provision. Further, the value of closely held stock that can be redeemed is limited to an amount equal to the estate’s taxes plus funeral and administrative expenses.

The general rule is the stock must be redeemed within approximately four years of the decedent’s death. However, the redemption period may be extended to match the deferral period over which the estate qualifies and elects to pay its estate taxes. If stock is redeemed faster than the required estate tax payments, the proceeds may have to be used to reduce the outstanding estate tax liability. Therefore, the redemption agreement should be carefully drafted to match the payout of estate taxes. This will provide both the estate and the closely held business with maximum cash flow.

Caution: Combining a redemption with the 14-year deferral of estate
payments requires very careful planning.

The owner of a farm or closely held business has unique estate-planning problems. It is especially critical to plan the estate carefully, not only to avoid liquidity problems but also to prevent control of the business from passing into the wrong hands.

Can I Limit the Estate or Gift Tax Value of the Business to Current Fair Market Value by Transferring All or Part of the Business to a Family Member or Intended Party?

Although the answer to the question is yes, there may be current gift tax con-sequences if the transaction is not executed with careful planning and documentation. Freezing or limiting the value of a business, with all future appreciation passing to the recipient of the business interest, used to be possible with relative ease. Before December 17, 1987, the classic estate freeze used different classes of corporate stock or partnership interests. Basically, you would retain a preferred income interest (although dividends were rarely paid) and the management (voting) control while transferring an appreciation or growth interest (common stock) to family members or intended beneficiaries. After the 1987 and 1990 Tax Acts, many of these techniques generally either do not work or do not provide the tax savings that business owners were able to realize previously.

Currently, family limited partnerships (FLPs) are being used to decrease the estate and gift tax value of the business. Since a third-party investor would pay less for an interest in an FLP than for an interest in a business, the value of the partnership interest will be decreased by a lack of marketability discount. Further, the same investor would be willing to pay less for a minority interest in the partnership, because he or she would have no control in the management of the partnership. Thus, the value of the partnership will also be decreased by a minority interest discount.

A common FLP includes the father and mother contributing a family business to a limited partnership in return for a 1-percent general-partner interest and a 49-percent limited-partner interest each. The parents then gift a portion of their limited-partnership interest to their children. The parents retain all management decisions for the business with their 1-percent general-partnership interests.

Note: The Internal Revenue Service is paying close attention to FLPs and the discounts claimed. Thus, you should consult with your tax adviser or attorney prior to establishing an FLP in order to meet all of the legal requirements. In addition, the FLP will need to file income tax returns every year.

You should also have your FLP appraised by a qualified appraiser to support the discounts claimed on your gift (or estate) tax return.

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Disclaimer: This guide is not intended to be a substitute for specific individual tax, legal, or investment planning advice, as certain of the described considerations will not be the same for every taxpayer or investor. Accordingly, where specific advice is necessary or appropriate, consultation with a competent professional adviser is strongly recommended.

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