Recent estate tax trends can help northeast farmers with succession planning.
by John H. Lavelle, CPA, LL.M., Attorney at Law
Congress and some state governments in the Northeast have been handing family farmers a series of presents in the last few years. Specifically, estate and death taxes, one of the major obstacles in transitioning family ownership in smaller farms, have almost become a thing of the past. With one less thing to worry about, farmers can concentrate on the other issues that must be handled to keep the farm in the family.
At the federal level, the transition was not as fast as it was stunning. Starting with the 2001 Tax Act, estate tax exemptions were raised to $1 million (doubled for a properly planned married couple), with added increases scheduled every year or two. This culminated with a $3.5 million exemption in 2009, followed by a year of no estate taxes. After that, Congress panicked with a series of generous temporary laws, with exemptions at $5 million and adjusted for inflation.
Out of nowhere, Congress made these new temporary regimes permanent in the 2012 Tax Act. Effective January 1, 2013, finally some certainty was achieved for federal estate taxes after over a decade of temporary and expiring changes. Taxpayers can now plan with this new law. Currently, these provisions provide an estate tax exemption of $5.45 million, which again is doubled for a married couple, or $10.9 million in total.
There is even some good news starting to happen at the state level. New York is most informative. Two years ago, New York still had a $1 million exemption at the time the federal exemption was $5 million plus, making estate planning more complicated for taxpayers domiciled in New York or nonresidents with New York farmland. Two years ago, out of nowhere, New York enacted a five year phase in to eventually equal the federal estate tax exemption. Currently, the New York exemption is $4,187,500, and by January 1, 2019, it will link up with the federal exemption. Properly planned, this means a married couple has $8,375,000 to work with before a dollar of state estate tax is due.
So what does this mean to Northeast family farmers? For all but the largest farms in the most valuable areas, these exemption levels will exclude the entire value of many farm operations, land and all, from estate taxes. Compared to family succession planning done as little as seven years ago, this changes everything. In addition, successful farmers’ estate plans that are as little as three years old may be woefully out of date because of this major change in the tax environment.
The New Planning Paradigm
As estate taxes recede as an obstacle to successful farm transitions, income taxes become much more important. In the ninety plus years that the federal estate tax and income tax have co-existed, this is the first time that income tax rates generally exceed the estate tax rates, and the latter are often “zero”. In estate planning, there is usually a choice that has to be made: save estate taxes, or, save income taxes. Often, both cannot be done at the same time. When the estate tax rate was much greater than the income tax rate, the farm family usually chose the strategy that saved the most dollars. Now, the rules are almost reversed, and income tax techniques can be more important than anything else.
Every successful farmer always has income tax issues. Estate planning and farm transition planning must catch up with this new importance of the income tax. Out of date plans can now cost more in income taxes on the next generation than the estate taxes imposed on the senior generation’s estates. While this is not exactly an apples to oranges comparison, the long term economic impact of reliance on a 20th century plan in today’s world, can be very costly to our future farmers.
So the new planning challenge is to transition the farm to the next generation while not burdening them with the income tax problems of the senior generation. This could be everything from fully depreciated buildings and equipment to land with an original cost of $100 an acre that is now worth $5,000 an acre or more. Traditional estate planning would have reduced or mitigated estate tax costs at the price of transferring the same income tax problems to the next generation. This had the advantages of making the inter-generational transfer more affordable, while locking in the next generation to a history of outdated income tax practices and problems.
Retooling Old Strategies for New Purposes
Fortunately, to assist today’s successful farm families, there are a number of income tax strategies that can be deployed, now that estate taxes may not apply. Your advisers today must be well-versed in income tax planning as well as family dynamics, estate planning, and business planning in order to bring together all the aspects of a successful transition plan. Here are a few examples of things that work under this new era of planning that would not have been considered a few years ago.
Die with the Farm
For the first half of my career, this would have been the worst plan ever. High estate taxes would have put a big strain on most small farm families. These costs often made it difficult or impossible for the next generation to succeed at farming, and led directly to the sale of the family farm. Most of us spent a lot of time advocating for various transfer strategies that the senior generation could use to get the farm over to the children without a huge estate tax.
What a difference a few decades make! Now only the largest, most valuable farms have to spend any time on the estate tax issue. For everyone else, letting the senior generation die owning the farm can be a huge benefit. For income tax purposes, all of the farm property owned by the senior generation at their deaths receives a new cost basis. So in the case above, for income tax purposes, the land with an original cost of $100 an acre would get a $5,000 an acre “stepped up” basis for the next generation. Same would apply to the buildings, equipment, livestock and so forth inherited by the children. So no inherited gains on the sale of these assets, new depreciation starts over, and the whole income tax history of the senior generation is wiped clean.
Now, when we say “Die with the Farm”, there is more to it than that. What if the senior generation is worried about long term health care and nursing home costs? This can be a bigger cost to the farm family than estate taxes ever were. Is there a way to get the income tax benefits above and protect the farm from the senior owners’ long term care costs? Absolutely. By visiting a competent elder law adviser, farm families can learn how to better position themselves for care costs, while continuing to have the property receive the income tax benefits associated with ownership. Part of any transition plan should be protection for the farm property retained by the senior generation as they age.
Cashing in with Purchased Development Rights (PDRs)
Many senior generation family farmers believed that their farm real estate would be the source of their retirement funds. With any degree of success, the farm operation would allow their children and successors to buy them out from their farm ownership. Unfortunately, most seniors are finding that the profits are not sufficient to fund anywhere near a fair price for any portion of the real estate, without leaving the children strapped for cash for decades. Sometimes mortgage financing at today’s low interest rates can help. But more often than not, it leads to the subdivision and sell off of the most valuable road front property, which ultimately leads to more development pressure on the remaining farm, and the ultimate loss of the farm business.
State and local governments and conservation organizations have noticed this destructive pattern and have come up with better solutions. The purchase of development rights, known as a PDR, allows farmers in developing areas, to realize cash proceeds in exchange for giving up their ability to develop the property for something beyond farming. In many cases, family farms have no intention of doing anything but farming, so this source of cash does not upset the transition plan. Although it is a taxable sale, it is generally at favorable rates and solves the retirement income needs of the senior generation. If a farm has high conservation values and is located in a heavily developing area, it may qualify for some of these scarce PDR funds.
Conservation Easements (CEs)
Along with all the tax goodies that the year end 2015 tax act made available, was the restoration of the enhanced conservation easement tax benefits. For successful farmers in high income tax brackets, this technique can be a home run. CEs work like PDRs in the sense that future development is prohibited on the farm property. Unlike PDRs, the development rights are donated in whole or part to a land trust. This donation can now offset up to 100% of the income of a qualified farmer. In addition, the existence of the CE lowers the value of farm property, making it easier for the next generation to acquire either by purchase or gift. Or, if the property is very valuable and the senior farmers have a taxable estate in excess of the exemptions, a CE can lower the value for estate tax purposes and provide additional estate tax benefits.
This is a thumbnail sketch of the exciting new world of planning farm transitions in a world with a lot less estate taxation. Working with a qualified adviser, farm families may find that more solutions are available to them compared to just a few short years ago.
John H. Lavelle, CPA, LL.M., is a founding partner of Lavelle & Finn, LLP, Attorneys at Law, in Latham, NY and co-owner of Windhorse Thoroughbreds and Cotton Hill Farm in Middleburgh, NY. He can be reached at (518) 869-6227 or firstname.lastname@example.org.