Wednesday, March 25, 2020
The Tax Cuts and Jobs Act (TCJA) has made estate and business planning much easier for most farm and ranch families. Much easier, that is, with respect to avoiding the federal estate tax. Indeed, under the TCJA, the exemption equivalent of the unified credit is set at $11.58 million per decedent for deaths in 2020, and with an unlimited marital deduction and the ability to “port” over the unused exclusion (if any) at the death of the first spouse to the surviving spouse, very few estates will incur federal estate tax. The TCJA also retains the basis “step-up” rule. That means that property that is included in the decedent’s estate at death for tax purposes gets an income tax basis in the hands of the recipient equal to the property’s fair market value as of the date of death.
But, with the slim chance that federal estate tax will apply, should estate and business planning be ignored? The answer is “no” if the desire is to keep the farming or ranching business in the family.
The basic estate planning strategies for 2020 and for the life of the TCJA (presently, through 2025) – that’s the topic of today’s post.
Existing plans should focus on avoiding common errors and look to modify outdated language in existing wills and trusts. For example, many estate plans utilize "formula clause" language. That language divides assets upon the death of the first spouse (regardless of whether it is the husband or the wife) between a "credit shelter trust," which utilizes the remaining federal estate tax exemption amount, and a "marital trust," which qualifies for the (unlimited) federal estate tax marital deduction. The intended result of the language is to cause the “credit shelter” trust’s value to be taxed in the first spouse’s estate where it will be covered by the exemption, and create a life estate in the trust property for the surviving spouse that will “bypass” the surviving spouse’s estate upon the surviving spouse’s subsequent death. As for the martial trust assets, tax on those assets is postponed (if it is taxed at all) until the surviving spouse dies.
It’s also important to have any existing formula clauses in current estate plans reviewed to ensure the language is still appropriate given the increase in the federal exemption amount. It may be necessary to have an existing will or trust redrafted to account for the change in the law and utilize language that allows for flexibility in planning.
In addition, for some people, divorce planning/protection is necessary. Also, a determination will need to be made as to whether asset control is necessary as well as creditor protection. Likewise, consideration may need to be made of the income tax benefits of family entities to shift income (subject to family partnership rules of I.R.C. §704(e)) and create qualifying deductions for the entity. The entity may have been created for estate and gift tax discount purposes, but now could provide income tax benefits. In any event, family entities (such as family limited partnerships (FLPs) and limited liability companies (LLCs)) will continue to be valuable estate planning tools for farmers and ranchers with wealth that is potentially subject to federal estate (and gift) tax.
For the vast majority of family farming and ranching operations, it is not beneficial from a tax standpoint to make gifts during life. Gifted property provides the donee with a “carryover” income tax basis. I.R.C. §1015(a). A partial basis increase can result if the donor pays gift tax on the gift. I.R.C. §1015(d). If the property is not gifted, but is retained until death the heirs will receive a income tax basis equal to the date of death value. I.R.C. §1014. That means income tax basis planning is far more important than avoiding federal estate tax for most people. But, some states tax transfers at death with exemptions that are often much lower than the federal exemption. In those situations, planning to avoid or minimize the impact of state estate/inheritance tax should not be ignored. Also, consideration should be made to determine whether insurance is still necessary to fund any potential estate tax liability
Other estate planning points to consider include:
- For life insurance, it’s probably not a good idea to cancel the policy before having that move professionally evaluated. That’s particularly the case for trust-owned life insurance. For pension-owned life insurance, for those persons that are safely below the exemption, adverse tax consequences can likely be avoided.
- Evaluate irrevocable trusts and consider the possibility of “decanting.” Decanting is the process of pouring the assets of one irrevocable trust into another irrevocable trust that contains more desirable terms. The rules surrounding trust decanting are complex concerning the process of decanting, but it can be a valuable option when unforeseen circumstances arise during trust administration.
- For durable powers of attorney, examine the document to see whether there are caps on gifted amounts (the annual exclusion is now $15,000) and make sure to not have inflation adjusting references to the annual exclusion.
- For qualified personal residence trusts (QPRTs) that were created when the estate tax exemption was $2 million, the conventional advice was to deed the house from the QPRT to the children or a remainder trust (which might have been a grantor trust), with a written lease agreement in favor of the parent/donor who would continue to live in the house. Now, it may be desired to have the home included in the estate for basis step-up purposes and the elimination of gain on sale.
- While FLPs and LLCs may have been created to deal with an estate tax value-inclusion issue, it may not be wise to simply dismantle them because estate tax is no longer a problem for the client. Indeed, it may be a good idea to actually cause inclusion of the FLP interest in the estate. This can be accomplished by revising the partnership or operating agreement and having a parent document control over the FLP. Then, an I.R.C. §754 election can be made which can allow the heirs to get a basis step-up.
- At least through 2025, the choice of entity for the operational side of the farm/ranch business should be reevaluated in light of the 20 percent qualified business income deduction for non-C corporate businesses and the 21 percent income tax rate for C corporations.
Other Planning Issues
While income tax basis planning (using techniques to cause inclusion of asset value in the estate at death) is now of primary importance for most people, asset protection may also be a major concern. Pre-nuptial agreements have become more common in recent decades, and marital trusts are also used to ultimately pass assets to the heirs of the first spouse to die (who may not be the surviving spouse’s heirs) at the death of the surviving spouse.
Powers of attorney for both financial and health care remain a crucial part of any estate plan. For a farm family, the financial power should be in addition to the FSA Form 211, and give the designated agent the authority to deal with any financial-related matter that the principal otherwise could.
For farms and ranches concerning about the business remaining viable into subsequent generations, the building of a management team is essential. This involves the development of management skills in the next generation, communication and recognizing various strengths and weaknesses of the persons involved. It’s also critical to ensure fair compensation for the inputs of labor and/or capital involved and adjust compensation arrangements over time as the changes in the inputs occur. Also, valuing ownership interests in a closely-held farming/ranching business is important. This can be largely achieved by a well thought-out and drafted buy-sell agreement as well as a first-option agreement.
While estate planning has been made easier by the TCJA, that doesn’t mean that it is no longer necessary. Reviewing existing plans with an estate planning professional is important. Also, the TCJA is only temporary. The estate and gift tax provisions expire at the end of 2025. When that happens, the exemption reverts to what it was under prior law and then is adjusted for inflation. If current law is not extended, it is estimated that the federal estate and gift tax exemption will somewhere between $6.5 and $7.5 million. While those numbers are still high enough to cover the vast majority of people, they are a far cry from the present $11.58 million amount.
One thing is for sure – a great deal of wealth is going to transfer in the coming decades. One estimate I have seen is that approximately $30 trillion in asset value will transfer over the next 30-40 years. That’s about a trillion per year over that timeframe. A chunk of that will involve farm and ranch real estate, livestock, equipment and other personal property.
These topics will be addressed in detail at the Summer Ag Tax and Ag Estate/Business Conference in Deadwood, South Dakota on July 20-21. You can learn more about the conference and register here: http://washburnlaw.edu/employers/cle/farmandranchtax.html.