During each winter, our organization presents workshops to discuss various topics that concern our clients.
In preparation for this workshop season, we decided to focus on the risks involved with not being prepared for multiple scenarios in areas of current uncertainty in agriculture.
We believe agriculture is at a historical point in two of these key areas of concern — farm continuation (land values at levels that won’t cash flow at a time when estate distributions are more common due to the high percentage of aging land owners) and estate shrinkage (federal estate tax, state inheritance or death tax, income tax, administration costs and debts).
Pessimism or optimism?
Most farm families seem to pessimistically believe there is a decent chance the current federal estate tax exemption of $5.12 million will expire as scheduled on Dec. 31, 2012, and the previous exemption of $1 million will return to wreak havoc on their farm estate.
Interestingly, the opposite is true for most advisers. A majority of them optimistically believe we will keep our current $5.12 million estate tax exemption.
Most find it inconceivable our lawmakers would allow the federal estate tax exemption to reduce to $1 million.
It seems impractical we could be in a situation where a $5.12 million estate would generate no federal estate tax in 2012, but when the calendar turns over to 2013, that same estate could generate $2.11 million in federal estate tax.
As a side note, it seems equally impractical our federal government could rack up over $14 trillion in debt.
What are the chances?
I asked the audience at a recent meeting for an estate planning council in Northwest Iowa, “What is the chance that the $1 million exemption will return in 2013?”
An attorney in the back of the room raised his hand and answered, “One percent.”
His answer was attention grabbing to me. Partially because a large part of me agrees with his logic and partially because 1 percent is the same probability we use to illustrate a classic worst-case scenario.
We are not comfortable with a plan where there is a 1 percent chance of paying $2.11 million in estate tax. Even though the probability of this tax may be low, the bottom-line is the potential tax cost is not worth taking any chance.
Potential strategy to mitigate risk
Last week a question was asked at a workshop in Independence that cut to the heart of the matter.
A man wondered, “Is there one strategy that will help to both reduce the estate and continue the farm operation?”
What a weighty question that turned out to be as we explored the advantages of separating long-term assets (farmland and building sites) from the short- and medium-term assets of the operation (grain, livestock and machinery).
The short answer to his complex question is an entity (or a series of entities) cannot only pave the way for a concise and well-planned farm continuation strategy but can also put an estate in an advantageous position of discount that could save millions of dollars in potential estate tax.
In a real situation, we would need to review the differences of multiple types of entities (general partnership, corporation, limited-liability company, family limited partnership or limited-liability partnerships) and how these possible entities could change a client’s personal situation.
For the purpose of this discussion, let’s assume an S-Corporation for the short- and medium-term assets (grain, livestock and equipment) and a limited-liability company (LLC) for the long term assets (farmland and buildings).
The S-Corporation for the operating assets creates separation that could limit personal liability and allow for potential Social Security tax savings by setting a salary and allocating profits above salary to pass-through to the owners of the corporation.
More importantly, it can create clarity in the farm continuation plan in identifying asset distribution.
There is no doubt the farm heir should own and control these operating assets.
At a minimum, there should be detailed buy-out options that will guarantee the business continue after management and/or ownership changes hand with each generation.
The LLC for the long-term real estate assets allows for rules for farm continuation. We like to see lease options for the land with purchase options in the event the children wish to sell their interest in the entity.
The long-term assets may also need to wind up with the farming heir (most successful operations have flourished owning and controlling the land as well as the operational assets).
A majority of families we work with decide to keep the land together as a unit, whether they find a way to transfer the land to the farming heir or to establish an entity with rules for continuation.
The notable advantage
A significant potential advantage of an entity is the ability to gift (either the annual exclusion gift of $13,000 or the lifetime exclusion of up to $5.12 million).
An entity provides for a conduit to reduce an estate via gifting but potentially more importantly can put an estate in a position of discount for the remaining value of the entity in the estate.
As an example, if a family establishes an LLC with 500 acres with Mom and Dad each owning 50 percent of the entity, there may be some discount allowed for an undivided ownership interest in an estate.
If Mom and Dad transfer 1 percent to each of their four kids, they not only have reduced their estate due to the gift, but now Mom owns 48 percent, Dad owns 48 percent and each of the four kids owns 1 percent.
Assuming the value of the LLC is $4 million (500 acres at $8,000/acre) Mom and Dad would have reduced their estate $160,000 by the amount of the 4 percent interest gifted to heirs.
With proper language in the LLC, some families may decide to aggressively gift to grandchildren to increase the pool of recipients of $13,000 annual exclusion gifts.
If the estate could get a 25 percent discount for minority interest and potential lack of marketability, their estate could be reduced by another $960,000. This is the real potential advantage of this strategy.
Other planning opportunities to reduce a farm estate may include Section 2032A (Special Use Valuation), Self Cancelling Installment Note (SCIN), a Private Annuity (PA), Grantor Retained Annuity Trust (GRAT), Intentionally Defective Irrevocable Trust (IDIT), Irrevocable Life Insurance Trust (ILIT) or a Qualified Personal Residence Trust (QPRT).
When navigating this alphabet soup of estate-reduction strategies, remember farm-continuation issues loom just as large for the family farm.
We cannot control future tax laws or future land values. We can control how you prepare for the changes that we will undoubtedly experience in the future.
It’s not only the analysis, but also the response that will influence the competitive advantage or disadvantage you will experience in the future of your farm operation.
For 19 years, Steve Bohr has been a partner in the farm continuation firm of Farm Financial Strategies, Inc. For additional information on farm continuation issues or if you have a question, contact Bohr via email at Bohr@FarmEstate.com or call 800-375-4180.