The intricacies of special-use valuation.

EXECUTIVE SUMMARY

* The special-use valuation election allows qualifying real property to be valued according to its actual use, rather than its highest or best use, subject to restrictions.

* The decedent or family members must have used the qualifying property for five of the eight years prior to the decedent's death; qualified heirs must use the farm or business property for 10 years after the decedent owner's death.

* The qualified use requirements can be met in a variety of ways, including cash leases to family members, and farm crop-share and hybrid leases.

Heirs to family farms or businesses may be able to reduce estate tax when a large portion of the estate's value includes real property used for farming or business. This article discusses specialize valuation under Sec. 2032A, including qualified property, qualified use, tax consequences and various means for meeting the requirements.

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Sec. 2032A allows an executor to dec to value real property according to it actual use, rather than its highest or best use. This provision, called special-use valuation, can reduce or eliminate estate tax for estates containing qualified property used in family farms and businesses (e.g., campgrounds, parking lots, trailer parks, winter boat storage facilities or off-road driving parks). Of course, every tax advantage has restrictions and disadvantages; Sec. 2032A is no exception. Only certain heirs are eligible for the election; qualification and restrictions on the property's use or disposal apply.

Even though the estate tax is being gradually phased out, the election can still be an important tax saving strategy for estates settled during the transition period. (1) This article looks at the conditions for election of special use valuation, explains special-use value explores some advantages and disadvantages and presents strategies for qualifying for and maintaining such beneficial treatment.

Special-Use Valuation

Although Sec. 2032A permits qualifying real property to be valued according to its actual use, rather than at its highest or best use, the total decrease in the real property's value cannot exceed $850,000. (2) For instance, if the highest and best use of farmland is for development, valued at $2.3 million, but its value as farmland is $1 million, the estate can only be reduced by' $850,000, not the full $1.3 million difference.

To use Sec. 2032A to reduce an estate's value requires the executor to make an election with precise requirements and unforgiving deadlines. In addition, the property, decedent, heirs and size of the estate must meet certain criteria; these conditions are summarized in Exhibit 1 on p. 436.

Alternate Valuation Date

In rare cases, the alternate valuation date may be used in conjunction with the special use valuation election, if it reduces the gross estate's overall value, as well as the estate tax liability. The alternate valuation date is six months from the decedent's date of death (DOD). Any decrease in real property value between the DOD and the alternate valuation date could decrease the estate's total value.

Example 1: The DOD value of farmland at its highest or best use is $2.3 million, the alternate-use value is $1.9 million (e.g., because a major developer or development filed bankruptcy in the interim), and the value as farmland is $1 million. The election to use the alternate valuation date could reduce the property's value to $1.05 million, compared to $1.45 million, using the DOD value minus $850,000. This is because the two valuation tools work in tandem.

Partial Use

Special-use valuation is not an "all or nothing" election. In Est. of Thompson, (3) the Fourth Circuit stated that even if all of the land that would otherwise qualify for Sec. 2032A treatment is not used by a qualified heir for a qualified use, the remaining portion used by a qualified heir for a qualified use could still receive Sec. 2032A treatment. For example, if 98% of a decedent's farm passes to a qualified heir and a 2% interest passes to a nonqualified heir, the special-use valuation election is allowed if the 98% is used for a qualified use. The statute does not expressly require that all concurrent interests pass to qualified heirs.

Consequences of Election

One of the consequences of the special-use election is that it changes the heir's property basis. The lower special-use value becomes the basis, rather than the fair market value (FMV) at the DOD (or elected alternate valuation date).Thus, under Sec. 1040(c), the property's basis will be lower after electing special-use valuation.

Once a special-use election has been made, Sec. 2032A requires qualified heirs or member(s) of their family to materially participate in the farm or business operation for the next 10 years. Generally, material participation means the heirs either operate the farm or business themselves or, in leasing arrangements, bear financial risk and participate in decision making. The material participation issue has been the source of a great deal of debate and litigation with the IRS.

After electing special-use valuation, the heirs cannot dispose of the property (fully or partially) or cease using it in a qualified use for the 10-year period after the decedent's death, without recapturing estate taxes. The recaptured estate tax is based on the number of years after the decedent's death that the disqualifying event occurs and the amount or proportion of the specially valued real property disposed of or that no longer qualifies. These restrictions are summarized in Exhibit 2 on p. 438. The recapture provision remains in effect, even if the 10-year period extends beyond repeal of the estate tax.

Determining Special-Use Value

Under Sec. 2032A(e)(7), the special-use value of farms is computed by dividing the excess of the average annual gross cash rental for comparable local land used for farming, minus state and local real estate taxes, by the average annual effective interest rate for all new Federal Land Bank loans. The average should be computed for the five most recent calendar years ending before the decedent's death. If no comparable cash rented land is available for comparison, the average of the value of the produce received by the lessor over the cash operating expenses of growing such produce can be used in lieu of average annual gross cash rental. Alternatively, the executor can elect under Sec. 2032A(e)(7)(C) to value the farm using a method specified for valuing other closely held business interests.

Several methods are available for determining the special-use value of closely held business interests, under Sec. 2032A(e)(8):

* Capitalization of income produced by the property over a reasonable period of time under prudent management;

* Capitalization of the land's fair rental value;

* Assessed land values in a state that provides a differential or use-value assessment law for farmland or closely held businesses;

* Comparable sales of land used as a farm or closely held business in the same geographical area, if nonagricultural use was not a significant factor in the sales price; or

* Any other factor that fairly values the Farm or the property's closely held business value.

Nonparticipating Heir

If an estate has multiple qualified heirs and one or more do not wish to own the property or continue the qualified use for 10 years, savings from the special valuation election can still be realized if the other heirs are willing to purchase the property. The estate can sell the property to qualified heirs and distribute cash proceeds to the heir who does not want the property, if the estate distributed the property to all of the heirs, and one heir sells his or her share to the other qualified heirs for more than the special-use value, the seller would recognize a taxable capital gain. This can be prevented by having the estate sell the property to qualified heirs and distribute the proceeds (instead of real property) to the heir who does not wish to own or continue using the property. Under Sec. 1040, the estate will not have a taxable gain from the sale, as long as the price does not exceed the FMV at the DOD (or alternate valuation date). The disadvantage of having the estate sell the property to avoid the capital gain tax is that the qualified heirs who purchase the property will take a basis equal to the special-use value.

Example 2: A property's FMV is $1.8 million and the special-use value is $1 million. The estate can sell the property at a price up to $1.8 million, without incurring taxable gain. However, the buyers will have a basis of just $1 million, even though they may have paid more. If the estate sells the property for more than $1.8 million, it has a taxable gain and an upward adjustment in the property's basis. The estate's realized gain is added to the special use value in determining the purchasing heirs' property basis, if qualified heirs later purchase the property from the estate for $2 million, the estate would have a taxable gain of $200,000 ($2 million-$ 1.8 minion), and the purchasing heirs' property basis would be $1.2 million ($1 million special-use value + $200,000 gain).

Disposal after Election

Although a special-use election can result in significant estate tax savings, the heir's property basis is the lower special-use value. This can be a disadvantage if the heirs plan on selling the property after fulfilling the 10-year qualified-use requirement. Higher capital gain from a sale of the property can result in increased income taxes. The time value of money factors, the possibility of changing tax rates and individuals' different brackets all determine which is more attractive lower estate taxes with higher income taxes or vice versa. If the current estate tax savings has a greater present value than the future income tax on the capital gain, election of special-use valuation may be attractive. On the other hand, if the heirs plan on retaining the property and passing it to their heirs, reduced basis is not an issue.

Recapture: During the 10-year qualified use period, disposal of the property will result in estate tax recapture. If disposal occurs during this period, the heirs could elect to increase the property's basis. For instance, if a qualified heir sells a portion of the land to a nonqualified person or to a qualified heir for a nonqualified use, the seller could elect to pay the recaptured estate taxes and increase the land's income tax basis to the FMV at the decedent's DOD (or the elected alternate valuation date).

For example, if three qualified heirs inherited qualified real property valued (at the DOD) at $1.2 million or $400,000 each, with a special use value of $900,000 or $300,000 each, basis can be increased when one of the heirs stops using the property or sells his or her parcel. The estate tax savings from the special-use valuation will be recaptured, but the basis for purposes of calculating capital gain will become $400,000.This increase in basis takes effect immediately before the sale or cessation of qualified use. The qualified heir must make the election for the increase in basis to occur. This election can be advantageous if tax savings on the sale exceed the estate tax recapture. If a partial disposition of the specially valued land occurs, the basis increase under Sec. 1016 will be in proportion to the potential additional estate tax.

Estate tax recapture can also occur as a result of an involuntary conversion. In Morgan, (4) the taxpayer was personally liable for payment of estate taxes as a result of an involuntary conversion by foreclosure and a sheriff's sale, as no reinvestment in similar qualified-use property occurred. The court reasoned that the result was equitable, because the debtor had been able to voluntarily encumber property subject to an IRS lien and had benefited through a reduction of mortgage debt. The debtor had agreed to be personally liable under the Sec. 2032A election provisions.

Qualified-Use Leases

Cash Leases to Family Members

To qualify for special-use valuation, a decedent must have used the property for a qualified use for five or more years during the eight years prior to death, retirement or being disabled; the heirs have to maintain the qualified use for 10 years. If the decedent or heirs do not wish to, or are unable to, farm or operate the business, these qualifying periods can be a problem. One solution is to lease the property--a cash lease to a family member can be used to obtain or maintain the property's qualified use. (5)

Exhibit 1 presents a list of qualifying family members. Family members include spouses; however, divorce severs the marriage relationship--divorced spouses stop being family members. Thus, a divorced son-in-law is not a family member, but a widowed son-in-law remains a family member, under Sec. 2032A(e) (2). (6) Although the natural children (lineal descendents) of a decedent's spouse are family members, the children of a decedent's divorced spouse are not family members, unless adopted by the decedent. (7) Any change in family relationship resulting from a divorce must be considered when leasing the business. If the lessee ceases being a family member due to divorce, either the business has to be leased to another individual who is a family member, or a different form of lease (e.g., a crop-share lease) has to be negotiated to maintain the qualified use.

Leasing to family partnerships or corporations may be deemed a lease to a family member. The IRS has accepted the decedent's cash rental of farm property to a partnership consisting of the decedent's sons (or other members of the decedent's family). (8) The sons' use of the farm for farming within the partnership was attributed to the decedent, and the property was eligible for special-use valuation.

In Minter, (9) the Eighth Circuit ruled that a cash lease to a family farming corporation qualified the property for special-use valuation. The parents leased their farmland under an annual cash lease to a family farm corporation owned by the parents and their son. When the mother died, her will directed the Farmland and stock to be placed in a trust for the benefit of the Father and her children, which included the son and other siblings. At the time of her death, special-use valuation was elected, and the land qualified. The trust continued to lease the farmland annually on a cash basis. When the father died years later, his stock was also placed in a trust, with the children as beneficiaries.

Six years after his death, the IRS assessed a recapture tax, based on its assumption that the daughters' interests in the farmland did not rise to the level of a qualified use because of the cash lease. The court held, however, that the lease satisfied the qualified-use requirement, despite the fixed cash lease, because the rental income depended on the farmland's productivity; the sisters' risks were the same as if they farmed the land themselves. Although the above examples relate to Farming, cash leases may also be used For other family businesses that qualify for special-use valuation.

Crop-Share Farm Leases

If farm property is leased to a nonfamily member, material participation by the decedent prior to death and by the qualified heirs For 10 years after death are needed to meet the qualified-use requirement. Crop-share leases on Farms can meet this requirement. The IRS has long recognized crop-share leases (as opposed to cash leases) as a continuation of a qualified use, even if the crop-share lease is with a nonfamily member. These leases typically provide that the lessor is paid a percentage of the crops or livestock (or of the sales of the crops or livestock) grown or raised on the farmland. Other "typical" clauses have the lessor sharing equipment and costs, participating in management decisions that involve production and land use, inspecting and monitoring land and production and living on the land. The more involvement the decedent had or qualified heirs exercise, the more likely the IRS will concede that the land obtains or continues its qualified use. Material participation in managerial decisions is the key. (10)

Even if the decedent was active and the qualified heirs are active in management decisions, financial risk in the operations is also needed. Specifically, if the cash rent paid to the decedent or qualified heirs did not hinge on the operation's success, the activity will be deemed a passive rental, not a qualified use. (11) Becoming physically incapacitated during the qualifying period is not a reason for lack of material participation. In Hohenstein, (12) the court ruled that Sec. 2032A(c) recapture tax was justified against a physically incapacitated heir who cash leased a Farm to nonfamily members two years before the 10-year post-death period expired. The court ruled that cash leasing was a cessation of qualified use, because passive cash leasing to unrelated parties does not provide sufficient equity interest when the payment does not hinge on farm production. However, a crop-share lease, even to a nonrelated person, would have been a qualified use.

Hybrid Farm Leases

A hybrid lease with nonfamily members can meet the qualified-use requirement. Such a lease has a two--level rent structure that calls for a fixed cash rent, unless certain production and/or price levels are not obtained. To meet the qualified-use requirement, payments under hybrid leases are based on production. For example, ranch property owned by a decedent and rented to a nonfamily member under a lease that provided for an initial semiannual rental payment of a stated amount, with the remaining semiannual payment based on a percentage of the gross income from the tenant's ranching and hunting operations, qualified for special-use valuation. The IRS found that the payments under the lease depended on production. (13)

The courts have also accepted hybrid leases with cash rent reduced when certain production levels were not met. In Schuneman, (14) the Seventh Circuit ruled that a two-level rent structure qualified a farm for special-use valuation. A decedent entered into a lease agreement with a neighbor that provided for fixed cash rent, except the rent would be reduced 20% if certain grain production and price levels were not met. After she died, her estate elected to value the farm land under Sec. 2032A. The IRS challenged this, contending that the property had not been used for a qualified use; the district court agreed. The Seventh Circuit, however, held that the rent income under the lease was substantially dependent on production; thus, the decedent bore a financial risk substantially equivalent to that she would have borne had she personally operated or crop-shared the farm. The court warned, however, that such a two-level lease might riot be substantially equivalent to, or dependent on, production if the clause was not likely to be triggered.

Limits

The special-use valuation election for Farms and closely held businesses is only one of many possible estate tax planning strategies. A sound estate plan might also include the use of trusts or disclaimers to allow assets to bypass the estate, the use of life insurance to fired estate tax payments or other planning devices. In addition, Federal gift, income and generation-skipping transfer taxes, as well as state income and estate taxes, are also a consideration. A sound, comprehensive estate plan is always the best approach.

Conclusion

Election of special use valuation can reduce or eliminate estate tax liability for estates with qualified property. The tax savings, however, require qualified use of the property before a decedent's death and impose restrictions on the property's use and disposal after death. Proper planning can meet these restrictions. Leasing arrangements can be used when the decedent or heirs do not wish (or are unable) to meet the qualified-use restrictions themselves. Special-use valuation also reduces the property's basis to the lower special use value. Disposal of the property by the heirs after their 10 years of qualified use can produce higher capital gain. Thus, the estate tax savings must be weighed against the restrictions on the property's use and disposal for 10 years after the decedent's death and the potential for higher capital gain on subsequent sale of the property. Knowledge of the rules, combined with proper planning, can minimize the combined estate and income taxes.

Exhibit 1: Conditions for electing special-use valuation

Item             Requirement                        Authority

Property         Property is real property          Sec. 2032A(b)(1)
                 located in U.S.

                 Property is used for farming or    Sec. 2032A(b)(2)
                 in a trade or business by the
                 decedent or a member of the
                 decedent's family at the DOD
                 (qualified use).

                 Property was owned and used by     Sec. 2032A(b)(1)(C)
                 the decedent or a member of the
                 decedent's family for periods
                 totaling five years or more
                 during the eight-year period
                 prior to the decedent's death,
                 retirement or being disabled
                 (qualifying period).

Decedent         Decedent was a citizen or          Sec. 2032A(a)(1)(A)
                 resident of the U.S. at the DOD.

                 Decedent or a member of the        Sec. 2032A(b)(1)(C)
                 decedent's family materially       and (4)(A)
                 participated in the operation
                 of the farm or other business
                 during the qualifying period
                 (defined above).

Qualified heir   Heir must be a member of the       Sec. 2032A(e)(1)
                 decedent's family who acquired
                 property from the decedent.

                 "Members of decedent's family"     Sec. 2032A(e)(2)
                 include the decedent's ancestor,
                 spouse, adopted child or lineal
                 descendant; lineal descendant of
                 decedent's spouse; lineal
                 descendant of decedent's parent;
                 or spouse of any previously
                 described lineal descendents.

Estate           50% or more of the value of the    Sec. 2032A(b)(1)(A)
                 adjusted estate consists of real
                 or personal assets used for
                 farming or in a trade or
                 business.

                 25% or more of the value of the    Sec. 2032A(b)(1)(B)
                 adjusted estate consists of farm
                 or business real property for
                 which special-use valuation is
                 sought.

Exhibit 2: Restrictions resulting from election of special-use valuation

Activity   Requirement                              Authority

Property   Disposal or partial disposal of          Sec. 2032A(c)(1)
disposal   property cannot occur within 10 years
           after the decedent's death and before
           the death of the qualified heir. Any
           disposal or partial disposal results
           in estate tax recapture.

           Disposal of some interests in the        Sec. 2032A(c)(2)(D)
           property may constitute partial          and (E)
           disposal and, thus, partial recapture.
           For instance, in the case of qualified
           woodland, disposal of any standing
           timber is treated as a partial
           disposal.

Property   Property must continue to be used by     Sec. 2032A(c)(1)
use        the heir for its qualified purpose for
           a 10-year period after the decedent's
           death and before the death of the
           qualified heir.

           Heir must commence using the property    Sec. 2032A(c)(7)(A)
           within a two-year period after the
           decedent's death. The 10-year use
           period begins when the heir begins
           using the property.

           Lack of material participation by a      Sec. 2032A(c)(7)(B)
           qualified heir or any member of his or
           her family will be treated as a
           cessation of qualified use. Active
           management and financial risk are
           considered material participation.

(1) Although the estate tax will be completely phased out by 2010, without further action by Congress, it becomes fully effective again in 2011.

(2) The amount of decrease to value has been adjusted for inflation for decedents dying after 1997, and was adjusted to $820,000 for 2002, $840,000 for 2003 and $850,000 for 2004; see Rev. Procs. 2002 70, IRB 2002-46, 845, Section 3.23. and 2003-85 IRB 2003-49, 1184, Section 3.25.

(3) Est. of James U. Thompson, 864 F2d 1128 (4th Cir. 1989).

(4) Dorothy W. Morgan, Bkrptcy. Ct., ED OK, 1/22/90.

(5) See. 2032A was amended in 1997 to allow cash rental to a family member to be a qualified use of the property Prior to that, the heir had to materially participate in the farm or business use of the property.

(6) See GCM 38698 (4/23/81).

(7) See IRS Letter Ruling 8444034 (7/27/84). See IRS Letter Rulings 8147100 (8/27/81) and 8249014 (8/23/82).

(9) Marilyn Minter, 19 F3d 426 (8th Cir. 1994).

(10) See IRS Letter Rulings 8444016 (7/26/84), 8939031 (6/30/89), 8508081 (11/28/84) and 8429058 (4/18/83), and Rubin W. Mangels 828 F2d 1324 (8th Cir. 1987).

(11) See Est. of Flora J. Abell, 83 TC 696 (1984); Mary J. Martin, 783 F2d 81 (7th Cir. 1986); List. of Trueman, 6 C1.Ct. 380 (1984); and Foster G.D. Bruch, ND IN, 9/3/86.

(12) Richard D. Hohenstein, TC Memo 1997-56.

(13) IRS Letter Ruling 8516012 (12/28/84).

(14) Mode Schuneman, 783 F2d 694 (7th Cir. 1986).

Thomas Zupanc, J.D., LL.M.

Assistant Professor, Business Law and Accounting

Carol B. Gaumnitz, Ph.D., CPA (Inactive)

Assistant Professor, Accounting

Bruce R. Gaumnitz, Ph.D., CMA, CIA

Professor, Accounting

St. Cloud State University

St. Cloud, MN