Farmland in an Estate – Special Use Valuation and the 25 Percent Test

Overview

Fifty years ago, concerns began to arise in the farm sector about farmland being valued in decedents’ estates at values reflecting commercial development potential rather than values reflecting agricultural purposes.   The concern was particularly acute if the family desired to continue the farming operation after their family member died.  At the time, the federal estate tax exemption was $60,000 and the top rate was 77 percent on gross estate values exceeding $10 million.

The Congress responded by enacting I.R.C. §2032A – special use valuation.  This allows, by election, farmland to be valued in a decedent’s estate for federal estate tax purposes at its value for farming purposes.  But it’s a very complex provision.  One of those complexities, the “25 percent test,” is a key component with an interesting history.

Special use valuation’s 25 percent test – it’s the topic of today’s post.

 Special Use Valuation – Background and Basic Qualification Requirements

The Tax Reform Act of 1976 provided a legislative solution to the perceived problem facing rural landowners of having the farmland in their estates taxed at fair market value (based on a “willing buyer/willing seller” test) reflective of commercial development potential, and based the ability of the IRS to use fluctuating values in agricultural land markets to its advantage.  That solution, in the form of the enactment of I.R.C. §2032A, allows the executor of a decedent’s estate to value farmland in the estate at its value for agricultural purposes rather than fair market value.  The basic idea of the provision is to relieve farm families from having to sell an eligible family farm or business when the income from its present use is insufficient to pay the tax calculated upon its highest and best use.  In recent months, the heightened uncertainty over the future level of the federal estate tax exemption (as well as federal estate tax rate(s)) has increased interest in the utilization of special use valuation. 

Because of the significant tax benefits that can be derived by a decedent’s estate making an election to value qualified elected land under a special use valuation election, numerous requirements must be satisfied.  The following is a listing of the pre-death requirements that an estate must satisfy to make an I.R.C. §2032A election:  

• The real estate used in farming together with the farm personal property must make up at least 50 percent of the adjusted value of the decedent’s gross estate, using fair market value figures, and that amount or more must pass to qualified heirs. I.R.C. § 2032A(b)(1)(A). 
• The decedent or a member of the decedent’s family must have had an equity interest in the farm operation at the time of death and for five or more of the last eight years before death. I.R.C. §2032A(a)(1), (b)(1)(C)(i).
• The real estate must have been owned by the decedent or a member of the family and held for a qualified use during five or more years in the eight-year period ending with the decedent’s death. I.R.C. §2032A(b)(1)(C)(i). 
• The decedent or a member of the decedent’s family must have materially participated in the farming operation for at least five out of the eight years immediately preceding the earlier of the decedent’s death, disability or retirement. I.R.C. §2032A(b)(1)(C)(ii). 
• The farmland and personal property used in farming must have been “acquired from the decedent to a qualified heir or passed from the decedent” to a qualified heir. I.R.C. 2032A(e)(9). 
• For land owned by a partnership, the decedent must have had an interest in a closely-held business. I.R.C. § 2032A(g); 6166(b)(1)(B).

The 25 Percent Test

An additional test requirement that must be satisfied for a decedent’s estate to be eligible to make a special use valuation election is that the farmland that is eligible for a special use valuation election must also make up at least 25 percent of the adjusted value of the decedent’s gross estate. I.R.C. §2032A(b)(1)(B).  That requirement sounds simple enough.  However, a question has been raised whether the 25 percent test be satisfied only with property that is subject to a special use valuation election?  Historically, the IRS thought that it did, and adopted a regulation specifying just that.  See Priv. Ltr. Rul. 8042009 (Jun. 30, 1980); Treas. Reg. §20.2032A-8(a)(2).  In 1988, however, the Federal District Court for the Central District of Illinois invalidated the regulation. Miller v. United States, 680 F. Supp. 1269 (C.D. Ill. 1988).  But, the IRS kept auditing and re-litigated the issue, culminating in another court opinion on the matter in 2012.  The IRS lost again. 

The 2012 Case -Finfrock v. United States

In Finfrock v. United States, 860 F. Supp. 2d 651 (C.D. Ill. 2012), the decedent owned 61.05 percent of the stock of Finfrock Farms, Inc. The corporation owned four tracts of real estate – tracts of 40 acres, 122.5 acres, 377.21 acres and 165 acres.  There was no question that the ownership test was satisfied, or that the 50 percent or 25 percent tests were satisfied.  Indeed, the adjusted value of the gross estate was $2,608,848 including the farmland which was valued at 1,775,000.  For the entire eight-year period preceding the decedent’s death, a son farmed the land, and upon the decedent’s death the ownership of the corporation passed to qualified members of the decedent’s family.  The estate elected special use valuation as to the fourth tract of farmland because that was the only tract that the family wished to continue to farm.  The other tracts were sold to unrelated persons shortly after the decedent died.  The fair market value of the fourth tract was $402,930, or about 15 percent of the estate’s adjusted value. The special use value election on that tract dropped its value reported on the estate tax return to $227,233.00.  On audit, the IRS denied the election because the land subject to the election did not exceed 25 percent of the adjusted value of the gross estate. 

The IRS position.  The position of the IRS in Finfrock was that not only must the estate satisfy the 25 percent test to be eligible to make a special use valuation election, the election must be made applicable to at least 25 percent of the value of farmland that is included in the estate (using fair market value figures). 

As noted, the Treasury Regulation at issue in Finfrock had previously been invalidated in 1988 by the same court. Miller v. United States, 680 F. Supp. 1269 (C.D. Ill. 1988).  In Miller, the court held Treas. Reg. §20.2032A-8(a)(2) invalid insofar as it attempted to impose a non-statutory requirement that 25 percent of the adjusted value of the gross estate must consist of farmland subject to the special use valuation election.  The court determined that the regulation was not simply interpretative of the statute, but was legislative in nature because it imposed a requirement that the statute did not contain.  So, the regulation was invalid to the extent it went beyond merely procedural matters (e.g., the proper form to file or information to include on prescribed forms).

After Miller, it was believed that the IRS no longer enforced the regulation against estates.  Obviously, that wasn’t the case in Finfrock, where the IRS again asserted the application of the regulation.  The estate pointed to the 1988 Miller decision, arguing that the statute was clear and unambiguous in that the 25 percent requirement only meant that 25 percent of the adjusted value of the gross estate had to be comprised of farmland.  It did not mean that the election must also be on at least 25 percent of the farmland in the estate.  The IRS argued that the statute was silent on the matter, and that the regulation merely clarified the statutory ambiguity.  But, the court disagreed, noting that the statute’s plain language did not require that the property constituting 25 percent or more of the adjusted value of the gross estate also be subject to the election.  The court held that the statute unambiguously allows an executor to make the election on land comprising less than 25 percent of the adjusted value of the gross estate, and that the regulation impermissibly imposed a requirement in addition to the statute’s plain meaning.  Because the statute was neither silent nor ambiguous, the issue of whether the regulation was a reasonable interpretation of the statute was not in issue. 

Planning Implications

Finfrock reasserts the point that any attempt by the Treasury to limit the scope of a special use valuation election beyond the statute is impermissible.  That’s a key point, particularly when the issue involves the amount of land that must be subjected to a special use value election.   When an election is made, an amount equal to the adjusted tax difference becomes a lien in favor of the United States. I.R.C. §6324B(a). The lien applies “on the property in which such interest exists.”  The lien arises at the time the election is filed and continues until liability for the tax ceases, or the recapture tax has been paid.  I.R.C. §6324B(b).   

The ability to limit the amount of property subject to the lien allows for tailoring of the special use valuation election.  Such tailoring can aid in minimizing the potential for recapture tax being triggered during the ten-year period following the date of the decedent’s death by restricting the election to the land most likely to be continued in farm use during the recapture period.

Conclusion

The present concerns about a potential reduction in the amount that can be excluded from federal estate tax is real in the agricultural sector.  That concern is separate from that over a possible change in the income tax basis rule for property included in a decedent’s estate at death.  Consequently, it may be time to “dust off” the special use valuation provisions and refamiliarize ourselves with its detailed rules.  The 25 percent test is an important one of those.