President Trump promised and will pursue tax reform, but Congress must agree to any proposal. For the most part, a majority vote in both houses would allow tax reform for about a decade, and at least sixty Senate votes would be required for “permanent” tax reform. Getting even a majority vote in both houses could be a chore. Therefore, any tax reform is likely to be temporary. Tax law uncertainty, however, should not prevent farming business succession planning as part of overall estate planning.
Relevant Tax Law Changes and Overview
Federal gift, estate and generation-skipping transfer taxes may apply to farmers and others. (California has no such transfer taxes.) There is one unified exemption for gift and estate taxes, and an identical one for generation-skipping transfers.
Two decades ago, these exemptions were a mere $600,000 and the top tax rate was 55%. Today, the exemptions are $5,490,000 (rising with inflation) and the top tax rate is 40%. Spouses may now transfer their gift/estate tax exemption to each other.
Interests in closely-held businesses and fractional interests in real estate are valued based on what an informed and motivated buyer would pay (although certain farm special use valuation rules may apply). This leads to valuation discounts because, for example, a buyer would not pay 25% of a property’s value or company’s value for a 25% interest. That buyer would not have control of the property or company and could not easily market the interest. Due to valuation discounting under rules that ignore whether family members own the entire property or entity, estates that would initially appear taxable are actually below the exemption.
Although these valuation discounts are generally good if they reduce transfer taxes, these days they can actually be bad. As property passes through estates, it generally receives a new market value income tax basis. This basis adjustment can, among other things, reduce or even eliminate taxable gains if the next generation sells.
The valuation discounts have a dampening effect on market value and, therefore, this basis adjustment. If the estate will not be subject to transfer taxes due to the large exemption now in effect, discounts reduce tax basis without saving transfer taxes – a bad result. Current estate planning often focuses on the interplay of valuation discounts and basis adjustments (along with some income tax planning). It is more complicated than ever and involves uncertain outcomes.
President Trump wants to eliminate the “death tax” and change the basis adjustment rules in estates. The details of his plan are not clear.
Importance of Non-tax Planning
Farmers like other family business owners cannot simply stop succession planning as part of their estate plans because we have significant tax law uncertainty. Uncertainty about the laws and everything else will exist. In many ways, uncertainty creates a need for good planning.
Tax laws are relevant but should not drive planning. Focus first on business and family issues. Run a mental movie regarding how the farm or other business might stay within the family. Think about how family members might interact with each other and whether they are likely to stay in the business. Some may remain in (and even run) the business, while others might be a poor fit. Family members who do stay should be treated fairly (not necessarily equally) and in a manner that does not drive non-family key personnel away.
Consider limiting business ownership to those involved in operations while allowing a broader family group to own the land and even equipment. Choosing appropriate ownership structures and having proper agreements can be important. Centralizing ownership and decision-making in long-term trusts can promote long-term family ownership.
Good succession planning requires a focus on estate planning and business planning, and in the family farm context it involves family members and real estate. It is complicated, and tax laws are just one factor.
This article appeared in Spotlight Fall (2017) and is republished with permission. © Farm Credit West.