Wednesday, March 11, 2020
Normally, federal estate tax is due nine months after death. For estates that are illiquid, such as many taxable farm and ranch estates, there is a useful option. Upon satisfying two requirements, the estate executor can elect under I.R.C. §6166 to pay the federal estate tax attributable to the decedent’s interest in a closely-held business in installments over (approximately) fifteen years.
The two eligibility tests that must be satisfied for an estate to qualify for installment payment of federal estate tax are: (1) the decedent must have an interest in a closely-held business (I.R.C. §6166(a)(1)); and (2) the interest in the closely held business must exceed 35 percent of the value of the decedent’s adjusted gross estate. I.R.C. §6166(a)(1). An “interest in a closely-held business” means an interest as a proprietor in a trade or business carried on by a proprietorship; an interest as a partner in a partnership carrying on a trade or business; or stock in a corporation carrying on a trade or business. I.R.C. §6166(b)(1). Only those assets actually utilized in the trade or business are to be included in the decedent's interest in the closely held business. Treas. Reg. §20.6166A-2(c).
Does ownership of real property constitute a trade or business? That’s an important question for farmers and ranchers. Real estate (and associated real property structures) often is the largest asset (in terms of value) of the gross estate.
Owning real property as a “trade or business” for purposes of deferring federal estate tax – it’s the topic of today’s post.
Farming Activities, I.R.C. §6166 and “Trade or Business”
Real estate that the decedent holds passively will not qualify for deferral under I.R.C. §6166. For example, a mere royalty interest in oil and gas property is insufficient to constitute a trade or business. Rev. Rul. 61-55, 1961-1 C.B. 713. The real estate must be used by the decedent in the active conduct of a trade or business. Over the years, the IRS has provided guidance on where the line is drawn between the passive holding of real estate and the use of it in the trade or business of farming. In addition, the determination of whether the decedent had an interest in a closely-held business is made immediately before the decedent’s death. I.R.C. §6166(b)(2)(A).
1975 IRS Ruling. In 1975, the IRS laid out its position on the determination of a trade or business in a farm context under I.R.C. §6166. Rev. Rul. 75-366, 1975-2 C.B. 472. The ruling, is still applicable for determining the existence of a trade or business in the I.R.C. §6166 context. The facts of Rev. Rul. 75-366 involved a crop-share lease where the decedent as landlord paid 40 percent of the expenses incurred under the lease and received 40 percent of the crops. The IRS found it critical that the decedent’s income under the lease was based on the farm’s productivity rather than simply being a fixed rental amount. The decedent had also actively participated in farm management decisionmaking concerning the crops to plant and how the farming operation should participate in federal farm programs. The decedent also made trips to the farm on almost a daily basis to inspect the crops and discuss farming operations with the tenant farmers. He also sometimes delivered supplies to the farm. Based on these facts, the decedent’s involvement was deemed sufficient to constitute an interest in a closely held business for purposes of I.R.C. §6166 because the decedent was engaged in the trade or business of farming. The ruling also pointed out that a “plain vanilla” cash rent lease would be unlikely to constitute an interest in a trade or business.
1980s private rulings. The IRS followed-up its 1975 Revenue Ruling with several private letter rulings in the early 1980s. In Priv. Ltr. Rul. 8020101 (Feb. 25, 1980), the IRS concluded that a 97-year old farmer did not use his farmland in the trade or business of farming where he had given his livestock to his children less than a year before he died and then “leased” his land to them. He was not actively farming at the time of his death due to his health. The IRS based its conclusion on the basis that the livestock had been gifted before death and the children were not required to make rental payments for the land (in return for paying the real estate taxes and operating costs). They also didn’t manage the farm as the decedent’s agents. It’s interesting to note that for the year of the decedent’s death, the federal estate tax exemption was $134,000 and the maximum estate tax rate was 70 percent.
Contrast that private letter ruling with Priv. Ltr. Rul. 8020143 (Feb. 26, 1980). Here, the IRS determined that a decedent was engaged in the trade or business of farming where he cultivated, operated and managed farms for profit, either as the owner or tenant, and the rental income that he received was based on production (crop-share) rather than being a fixed amount. The decedent paid all of the property taxes, paid for maintaining fences and structures on the farm, and also paid for ditching, draining and general farmland maintenance. He also paid a share of farm input costs and other operating costs. He was also engaged in management decisions by determining what crops would be planted, the timing of planting and how the crops would be marketed. His decisionmaking involvement directly affected his economic return.
In the context of I.R.C. §6166, the management activities of an employee or agent are imputed to the owner of the land. For example, in Priv. Ltr. Rul. 8133015 (Apr. 29, 1981), the decedent operated two farms until becoming incapacitated by a stroke almost five years before he died. At that time, the decedent’s wife began actively managing the farms, but neither the decedent nor the decedent’s spouse performed any physical labor on the farms. The farms were crop-share leased to different tenants. The IRS determined that the decedent owned an interest in the farms via his wife (she was deemed to be managing the farms on his behalf) and was deemed to be engaged in the trade or business of farming.
A similar result was reached in Priv. Ltr. Rul. 8244003 (May 1, 1981), where the farm was operated by the decedent’s daughter and son-in-law on a crop-share basis. The decedent was elderly and infirm. The IRS concluded that it was immaterial that the decedent didn’t pay self-employment tax on her income from the farm. For purposes of I.R.C. §6166, payment of self-employment tax was determined to be irrelevant on the issue of whether the decedent was engaged in the trade or business of farming. See also Priv. Ltr. Rul. 8432007 (Apr. 9, 1984).
In Priv. Ltr. Rul. 8515010 (Jan. 8, 1985), the IRS concluded that the cash rental of a pasture and barn failed did not constitute the trade or business of farming and, thus, did not qualify as interests in a closely-held business. The decedent’s only involvement with respect to the pasture and barn was to provide routine maintenance. Conversely, where a decedent leased an orchard for a fixed rental to a family corporation (of which the decedent was the majority shareholder) that conducted farming operations, the decedent was deemed to be engaged in the trade or business of farming because he was determined to be closely involved in both the leasing of his farm properties and the running of the family corporation. Gettysburg National Bank v. United States, No. 1:CV-90-1607, 1992 U.S. Dist. LEXIS 12152 (M.D. Pa. Jul. 17, 1992).
More private rulings. In Tech. Adv. Memo. 9403004 (Oct. 8, 1993), the IRS concluded that the decedent was not engaged in the trade or business of farming where he received a fixed rental amount for leasing land. It was deemed to be a passive income-producing investment asset. In Tech. Adv. Memo. 9635004 (May 15, 1996), the decedent operated a cattle ranch at the time of his death with his son via a partnership owned two-thirds by the decedent and one-third by the son. There was no question that the cattle ranch was an active trade or business or that the decedent actively participated in all aspects of the ranch’s management and operation. Both the decedent and his son owned land individually that was used in the ranching business. The partnership paid the real estate taxes on the land as well as the cost of maintaining fences and insurance. No rent was paid to either the decedent or his son. The IRS determined that the land the decedent owned that the partnership used in the cattle ranching business was used in the trade or business of farming for purposes of I.R.C. §6166. The IRS based its conclusion on the fact that the decedent’s activities were conducted in the overall scope of his income-producing cattle ranching business and the real estate was a fundamental part of the overall ranching business. The IRS also noted that the decedent owned the land at the time of his death. These were all important key factors and persuaded the IRS even though the partnership didn’t own the land.
The multi-factor test. In 2006, IRS clarified that, to be an interest in a trade or business under I.R.C. §6166, a decedent must conduct an active trade or business or must hold an interest in a partnership, LLC or corporation that itself carries on an active trade or business. Rev. Rul. 2006-34, 2006-1 C.B. 1171. In the ruling, IRS set forth a list of non-exclusive factors to determine whether a decedent’s interest is an active trade or business. The factors are: (1) the amount of time the decedent (or agents or employees) spent in the business; (2) whether an office was maintained from which the activities were conducted or coordinated and whether regular office hours are maintained; (3) the extent to which the decedent was actively involved in finding new tenants and negotiating and executing leases; (4) the extent to which the decedent provided landscaping, grounds care or other services beyond the furnishing of the leased premises; (5) the extent to which the decedent personally made, arranged for or supervised repairs and maintenance on the property; and (6) the extent to which the decedent handled tenant requests for repairs and complaints.
In addition, the IRS stated in Rev. Rul. 2006-34 that an independent contractor (or other third-party) can conduct some of the activities and the underlying activity can still constitute a trade or business unless the third-party activities simply constitute holding investment property.
The present $11.58 million exemption for federal estate tax means that very few farms and ranches will be subject to the tax. That makes installment payment of federal estate tax largely irrelevant. But, for those that do face federal estate tax liability, the opportunity to pay the tax over time rather than in full within nine months after death can be very important. In addition, if the political winds change and the exemption collapses, many family farms and ranches could be subject to the tax. It’s also important to remember that under present law, the exemption automatically drops significantly for deaths after 2025.
The closely-held business requirement as applied to real estate and as defined by use in the active conduct of a trade or business, is a large component of eligibility for land in a farming or ranching operation. Land leases should be something other than a straightforward cash lease with at least active involvement in decision making by the decedent-to-be, or an agent or employee of the decedent-to-be. Self-employment tax is not a crucial factor, but passive rental arrangements such as cash rent leases, are not eligible. For assets leased to business entities, the test is applied separately to the business entity and the leased assets. Land held in a revocable living trust is eligible for installment payment of federal estate tax if it is a “grantor” trust.