Time is short. The compromise on the gift, estate and generation skipping tax law passed by Congress on Dec. 17, 2010, provides federal tax largesse — an unprecedented two-year opportunity to make tax-free lifetime farm wealth transfers.
Because of misconception and uncertainty, many are waiting and pondering. Run to your CPA, tax and estate planning attorney and other trusted advisors now.
There are opportunities to consider in passing the family farm down to the next generation.
Before the end of 2012, you and your spouse may transfer farm assets up to $10 million (reduced by any taxable previous gifts) to your children or even grandchildren. Such transfers to the next generation are estate, gift and generation skipping tax-free, relieving the burden of paying significant estate taxes for the next generation of farmers, who may be asset rich but cash poor.
Additionally, giving farm assets now removes future appreciation in the farm assets from being taxable in your estate. Assume a farm consists of several acres of land valued at $5 million. If the land appreciates at a rate of 5 percent for the next 20 years, the land will be worth about $13 million. By giving the farmland within the two-year window ending Dec. 31, 2012, the additional $8 million in appreciation is protected from estate tax in the future.
(It is unclear whether Congress may “claw back” gifts after 2012 in a year where the estate tax exemption is less than $5 million. For example, if a farmer gives $5 million in 2011 and subsequently dies in a year in which the estate tax exemption is only $1 million, then estate tax could be due on the $4 million of the previously non-taxable gift. However, tax commentators believe it is unlikely that appreciation of the gifted property would be subject to estate tax from a “claw back”.)
You also locked in the benefits of the generous current lifetime gift tax exemption of $5 million (which reverts to $1 million in 2013). You can choose anyone to be your gift recipient.
In addition to transferring $5 million tax free, or $10 million for a farmer and spouse combined, you may make as many gifts as you desire as long as no one person gets more than $13,000 of value in any one year. If spouses use the split gift election, then the annual gift may be up to $26,000.
If you live in a state that has a state inheritance or estate tax, you could save state inheritance or estate taxes by getting these assets out of your estate before your death since only two states, Connecticut and Tennessee, impose gift taxes.
Trusts are effective tools, which can be used to properly structure gifts and generate additional economic benefits. If your gift recipient is a person who needs protection from creditors or divorcing spouses, you could give the farm into an irrevocable trust with a spendthrift provision and provide to your recipient proven protection.
If handled properly, a farm transferred into a grantor trust is not includable in your estate for estate tax purposes and the annual income tax is paid by you allowing the trust to grow faster for the beneficiaries of the trust. Also, by paying the income taxes earned by the farm in the trust, you are reducing your own estate subject to estate tax.
If you decide to take advantage of the two-year window now, tax advisors can help you potentially transfer farm assets valued in excess of $10 million by using various techniques. You and your spouse could gift $10 million in farm assets to an irrevocable trust for the benefit of a child or grandchild and the trust could buy an additional $10 million of farm assets financed by an intra-family loan at today’s low interest rates. If the trust is a grantor trust, the grantor pays the income tax on the income earned on the $20 million trust.
An older concept, which could fit beautifully into some of these options, is the discount for lack of control or marketability. For example, a business entity such as a limited liability company (LLC) could be created to own the farmland or other farm assets. Discounts such as marketability and minority discounts of 20 percent or more are usually appropriate for the interests in the LLC that are transferred, resulting in a higher value of the underlying assets being transferred tax-free.
If a 20 percent discount is applied to an interest transferred by a farmer and spouse worth $12.5 million, then the discount applied is $2.5 million and the gift is deemed only $10 million, which is tax-free.
This structure would also allow you to transfer farm assets while maintaining control of the farm by giving non-voting interests of the LLC to your children or grandchildren, while you retain the voting interests.
A very large amount of life insurance could be purchased with a gift exemption of $5 million or $10 million, if spouses choose to use the split gift election. Structured properly into an irrevocable life insurance trust, the insurance proceeds can pass free of probate, income and estate taxes to younger generations.
The generation skipping tax lifetime exemption law which expires in 2013 is also $5 million, and in conjunction with the gift tax exemption provides a time-limited opportunity to shift wealth to skip persons (such as grandchildren) during your lifetime without paying transfer taxes.
A possible disadvantage of making a gift of farm assets during your lifetime instead of giving the farm assets at your death is there is no step-up in basis for farm assets given during your lifetime.
Assume you originally purchased the farm’s several acres of land for $250,000. The land is currently worth $5 million, and will be worth about $13 million when you die. If the farmland is given to the next generation of farmers now, the recipients will have a basis in the farmland of $250,000 (your basis, the amount you originally paid for the farm). If the farmland is given to the next generation of farmers at your death, the recipients will have a step-up in basis to $13 million (the market value of the farm at your date of death).
The fact that the family member who receives the gift now only gets the basis that you have in the farm assets, and does not get the step-up in basis could be considered a drawback. However, significant appreciation is removed by gifting the farm assets now.
Since family farmers often intend to keep the farm and farms assets within the family, basis issues would not be relevant until the farm is sold and capital gains need to be calculated.
There is important news for farm families with less than $5 million in assets — particularly those with second marriages.
There is a misconception that couples, who own $5 million or less in farm assets, do not need to think about the new gift, estate, and generation skipping tax law. There are likely a lot of out-dated formulas based on pre-2010 rules in estate plans which affect the estates valued under $5 million more than any other.
One of the fundamental estate planning tools for couples is to have language in their plan that upon the death of the first spouse, a family trust would be funded with the unused lifetime exemption amount, which today could be $5 million and in 2013 will be back to $1 million.
Why do you care? The language in the new law shifting the first $5 million of the first-to-die spouse’s estate into the family trust will, in turn, in many estates leave no assets to fund the marital trust for the primary benefit of the surviving spouse. There has been a valid reason to use this technique in the past, as it ensured both spouses’ lifetime exemptions from estate taxes are not wasted. However, we have seen some of the unintended consequences of such formulas and the issue is even more compelling now with the new law.
If the surviving spouse and beneficiaries are the same for the family trust, which may be fully funded, and the marital trust, which might receive no assets, and the surviving spouse is the trustee of both, then the outcome may be no big deal. However, if the family trust beneficiaries are children from a prior marriage and the access by the surviving wife is more stringent with no assets available to fund the marital trust to which she has better access, then such a scenario will likely leave a second surviving spouse in an unintended bind.
It is important to understand what your beneficiaries will receive at your death and pursuant to your gifting plan. Ask your CPA or attorney to provide an example with dollar amounts of your current net worth of how much and in what form (outright or in trust) each beneficiary receives pursuant to your estate plan. Then consider whether it reflects your intent.
After 2012, farmers will only be able to give $1 million during their lifetime or at their death free of estate, gift and generation skipping tax. An excellent opportunity to pass on significant farm assets to the next generation and reduce a large estate tax burden expires at the end of 2012. Now is the time to act.
Co-author Lillian Dee Davenport of Little Rock, Ark., is an attorney and senior vice president of trust services at Delta Trust and Bank (www.delta-trust.com). She is licensed to practice law in Arkansas and Texas. She may be e-mailed at [email protected].
Co-author Lacey LaRue of Little Rock, Ark., is an attorney at Frost, PLLC (www.frostpllc.com). She is a 2006 graduate of the University of Arkansas at Fayetteville and a 2009 graduate of the Leflar College of Law at University of Arkansas at Fayetteville. She attended the University of Florida and received a LLM degree in taxation. Her practice centers on estate planning, taxation of businesses, and closely-held family corporations. She may be e-mailed at [email protected].