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How to convey a family business without raising a bumper crop of inheritance taxes.

In response to concerns that estate taxes were destroying the family farm, Congress enacted two laws in 1976 designed to mitigate the liquidity problems of farms and closely-held businesses: the 14-year installment method of paying estate tax and the special use valuation. Key to using special use valuation is meeting the "material participation" requirement of Sec. 2032A. This article reviews administrative and judicial developments in the material participation requirements and the related "qualified use" requirements.

Special Use Valuation

The special use value is designed to approximate the value of the property as it is used in the farm or business rather than its highest value, which could be for real estate development, recreation, speculation or the like. The maximum decrease in the gross estate resulting from the special use valuation is $750,000.(1)

Five independent requirements must be met for the estate to be eligible to elect special use valuation.(2) The requirements are:

1. At least 50% of the "adjusted value of the gross estate" must consist of the "adjusted value" of real or personal property which on the date of death was used by the decedent or a "family member" for a "qualified use."(3) The "adjusted value of the gross estate" is the value of the gross estate before this adjustment, but reduced by mortgages or other indebtedness on the property in the gross estate. The "adjusted value" is the value of the farm or closely-held property before this adjustment, but reduced by mortgages or other indebtedness on the property.(4)

"Qualified use" means that the property is used as a farm for farming purposes or in a closely-held business.(5) "Family member" is defined as ancestors of the decedent, spouses, lineal descendants of either the decedent or the decedent's spouse, parents of the decedent or the spouse of any lineal descendant.(6)

2. At least 25% of the adjusted value of the gross estate must consist of the adjusted value of real property that meets the two criteria in requirement 1 mentioned above, i.e., the qualifying use by a family member.(7)

3. On the date of death, the property must have been used for a qualified use by either the decedent or by a family member.(8)

4. The property must pass to a "qualified heir."(9) A "qualified heir" is a family member (as defined in requirement 1) who acquired the property (or to whom the property was passed) from the decedent. In turn, if the qualified heir disposes of the property to his/her family member, that family member becomes the qualified heir.(10)

5. During any five years out of the eight years ending on the date of death, the property was owned by the decedent, was used for the qualified use and either the decedent or a family member "materially participated" in the business."(11) This time requirement is changed if the decedent was, for a continuous period ending on the date of death, either retired (receiving Social Security benefits) or disabled. In either case, the eight-year time period ends on the date of retirement or disability.(12)

Qualified Use and Material Participation

Of the requirements listed above, the qualified use and material participation requirements are the most difficult to operationalize. In defining qualified use, the regulations contrast active businesses with property rentals, stating:

"Under Section 2032A, the term 'trade or business' applies only to an active business such as a manufacturing, mercantile or service enterprise, or to the raising of agricultural or horticultural commodities, as distinguished from passive activities. The mere passive cash rental of property to a party other than a member of the decedent's family will not qualify."(13)

The prohibition of passive rentals appears to be in accordance with the intent of Congress. The House report noted that the "mere passive rental of property will not qualify."(14) Similarly, the Senate noted that "during any period when the decedent leases the real property to a nonfamily member for use in a qualified use pursuant to a lease under which the rental is not substantially dependent upon production, the qualified use is not satisfied."(15)

The "qualified use" and "material participation" tests are interrelated and easily confused. The Seventh Circuit contrasts them in this way: the qualified use test focuses on how the property is used, while material participation focuses on the activities performed by the decedent or his family.(16)

The interrelationship of the Code and the regulations with respect to material participation is less than totally clear. As previously mentioned, the Code states that material participation is to be determined in a manner similar to the definition of net earnings from self-employment purposes provided in IRC Sec. 1402(a)(1).(17) Sec. 1402 provides that rentals from real and personal property are to be considered self-employment income only if the owner has engaged in material participation.(18) The regulation requires that the landlord and the tenant have a rental arrangement (either oral or written) that provides for material participation in the production or management of production of agricultural or horticultural commodities.(19) "Production" refers to both the physical work involved and the furnishing of the necessary inputs, such as machinery and seed. However, merely furnishing such inputs will not in and of itself constitute material participation.(20)


"Management" refers to services performed in making managerial decisions. They include such decisions as when to plant, cultivate and harvest the crop, as well as deciding on the types of crops to be grown.(21) Services considered to be of particular importance are those concerned with inspecting the production activities and advising and consulting with the tenant as to the production of the commodities.(22)

Even though Congress did not provide a new definition of material participation in Section 2032A, the section provides both detailed rules and several examples of material participation. When in conflict, the regulations of Section 2032A apparently take precedence over the regulations of Section 1402 (e.g., paying self-employment tax on the farm earnings is a necessary but not sufficient condition to meet the material participation requirement.(23) However, the Eight Circuit, in Estate of Mangels held that separate payment of the self-employment tax is not necessary; it may be offset against the savings of the special use valuation.(24)

Generally, if the individual works thirty-five hours a week or more managing the farm, material participation would be met.(25) However, working fewer hours would also suffice as long as the necessary functions are being performed. If the land is used by any nonfamily member, and the involvement of the family member who seeks the material participation is part-time, an oral or written arrangement is necessary.(26)

The principal factors to be considered in determining if there is material participation are physical work and participation in management decisions.(27) At the least, the individual should regularly advise and consult with respect to the operation of the business. The individual should also participate in a substantial number of managerial decisions.(28) Production activities should be regularly inspected, and the individual should assume financial responsibility for a substantial portion of operation expenses. Furnishing machinery and livestock for the farm operation would go far toward determining material participation.(29) Maintaining a residence on the premises is a positive factor.

Partners are required to pay self-employment tax on their share of earnings. However, if the partner is not an active participant in the business, the requirements of Section 2032 are not met even if the individual is considered self-employed for income tax purposes.(30) If a corporation owns the property (and the decedent's interest is therefore indirect), the individual would be an employee rather than self-employed. In that event, individuals are to be viewed as if they were self-employed (i.e., the relevant test is whether their duties, if in a sole proprietorship, would constitute self-employment income).(31)

In all cases where the ownership is indirect (as through corporation, partnerships and trusts), there must be an arrangement calling for material participation in the business by the individual who specifies the services to be performed.(32) A formal arrangement is not always necessary; holding a corporate office in which material participation is inherent in the job may suffice.(33) On the other hand, merely holding corporate office will not constitute material participation if the duties are only nominal.

Examples of material participation in the regulations

Material participation is interpreted fairly liberally by the IRS in the regulations. One example in the regulations concerns a decedent who leased the land to another but who consulted with the tenant on where crops were to be planted, supervised marketing of the crops and shared equally in expenses and income with the tenant. The decedent was present at planting time for consultation. Once planting was completed, the decedent left for his retirement cottage; he did not return until late summer when he supervised marketing of the crops. This decedent was deemed to have materially participated in the business.

In another example, a qualified heir living in town contracted with another person to manage a farm for him. The heir supplied all machinery and equipment and was responsible for all expenses. The manager submitted a crop plan and a budget for the heir's approval. The heir also inspected the farm regularly and approved all expenditures over $100. The heir visited the farm weekly during the growing season and helped decide what fields to plant and how to utilize the subsidy program.

The heir was considered to have materially participated. His actions were regarded as more than merely managing an investment. However, merely assuming financial responsibility and reviewing annual crop plans would not constitute material participation.(34)

As previously mentioned, the criteria to determine coverage under self-employment tax (Section 1402(a)) is important in determining material participation. The Farmers Tax Guide provides some guidance in landlord/tenant situations, stating that material participation is achieved if one out of the following four tests are met:

1. The landlord does any three of the following:

* Advance, pay or stand good for at least half of the direct costs of producing the crop;

* Furnish at least half the tools, equipment and livestock used in producing the crop;

* Consult with his tenant; and

* Inspect the production activities periodically.

2. The landlord regularly and frequently makes, or takes an important part in, managerial decisions which substantially contribute to or affect the success of the enterprise.

3. The landlord works 100 hours or more spread over a period of at least five weeks in activities connected with crop production.

4. The landlord does things that in the aggregate indicate a material and significant involvement in the production of the farm commodities.(35)

Judicial Decisions - Qualified Use

In the Estate of Sherrod v. Comm'r, the decedent owned 1,478 acres of land, most of which was in timber. The IRS claimed that the managerial activity was not sufficiently extensive, since the decedent and his trustee had not constructed fire trails, pruned dead growth and thinned the timber. Finally, the IRS argued that the managerial functions did not consume much time.(36)

The Tax Court rejected all of these arguments, noting that there was an active farm business consisting of the planting, growing, cultivating and caring of timber. In support of this decision, the court noted that the decedent:

* Paid the local property taxes each year;

* Inspected the timberland several times each year;

* Regularly determined what needed to be done to protect the timber from trespassers, fire, insects and disease;

* Each year negotiated the rental agreements; and

* Decided whether he should permit his investment to remain in the acreage.(37)

Ultimately, the Eleventh Circuit reversed the Tax Court decision due to the presence of crop land and pasture land that did not qualify. However, the Eleventh Circuit did not change the position of the Tax Court on the eligibility of the timberland.(38)

In Estate of Abell v. Comr.,(39) the decedent leased her ranch for a fixed sum. The decedent lived on the ranch and was primarily responsible for maintenance and repair of the fences, wells, corrals, buildings and windmills. The court ruled that the ranch was not used for the qualified use, citing the House Ways and Means Committee report,(40) which stated that the mere passive rental of property will not qualify.

In this case it appears that the petitioner was unimaginative, while the court was overly restrictive in determining qualified use. In reality, there were two separate businesses being conducted on the ranch: the raising of cattle and the raising and selling of grass. The decedent was only incidentally involved in the first business but was certainly materially involved in the business of raising grass.

In Estate of Selma N. Donahoe,(41) pastureland was rented for the summer months for five years. The total months rented amounted to 35 out of the eight-year period. The IRS claimed that since the pastureland could not be grazed in the winter, the winter months could not be counted as being a qualified use. The Tax Court ruled for the petitioner, stating that in the winter months the decedent exercised dominion and control over the property. The court contrasted this case with Estate of Abell, where the decedent had "little or no involvement in the activities of the farm use."(42)

The results in Donahoe appear inconsistent with Abell, and in fact the Seventh Circuit reversed the Tax Court in Donahoe. The Seventh Circuit said that the Tax Court erred in equating physical activity with meeting the "qualified use" requirement; qualified use can only be met if the decedent or the decedent's family incur the risk of farming. Since they were involved only in the nonproductive winter months (when presumably there was no risk), qualified use was not met.(43)

Recall that the Senate Finance Committee said that qualified use could not be achieved if rent income is not substantially dependent on production. In Estate of Schuneman,(44) the Seventh Circuit held that this amounts to a negative implication that qualified use is satisfied if the income from the rental is substantially related to production. The lease in question involved a pure cash rental arrangement, although it consisted of a base amount of $26,000, with a possible $6,520 addition if production averaged 70 bushels per acre.

The Seventh Circuit held that this rent agreement allocated to the decedent a portion of the risk of poor crop yield and therefore the income derived was substantially dependent on production. In a more clear-cut case, the Court of Claims in Estate of Trueman(45) ruled that cash rentals of two residences, a parking lot and two gas stations to unrelated parties did not meet the qualified use test.

Cash rental to a member of a decedent's family who operates the property meets the qualified use test, even if the operating entity is a partnership and even if it is held indirectly though a corporation.(46) However, after death, if the qualified heir has a cash lease, even if to a relative, the qualified use test may not be met. In Williamson,(47) the qualified heir had a cash lease with his nephew. In upholding the Tax Court,(48) the Ninth Circuit held that the qualified use test after death of the decedent may be met only by the qualified heir, not by a relative of the qualified heir. However, it should be noted that there was a lengthy dissent to this opinion. To summarize, leasing the property for fixed amounts should be avoided. A cash rental by the qualified heir will likely not meet the qualified use test. Instead, the lease payments should be structured so that the landlord bears at least some risk with respect to income.

Judicial Decisions & Administrative Decisions - Material Participation

As previously mentioned, paying self-employment tax is a necessary but not sufficient condition to establish material participation. If the decedent has not paid self-employment taxes, can the executor achieve material participation by filing amended returns? And if so, for which years? In Rev. Rul. 83-32, the IRS held that filing amended returns for the open years is sufficient; amended returns for years in which the statute of limitations has expired are not necessary.(49)

The IRS has explained its position in several other rulings. In a 1984 ruling, it held that a crop lease by heirs to a corporation owned solely by a family member met both the qualified use and material participation standards.(50) In a 1985 ruling, it held that a ranching operation in which the heirs were to receive 25% of the calf crop and were to pay 7.5% of the operating expenses satisfied both the material participation and qualified use requirements.(51)

The Tax Court, in Estate of Coon,(52) applied tough material participation standards. The decedent's brother had acted as agent for the decedent and sought to qualify his management of farmland for material participation. The brother's activities consisted mainly of discussing the planned crops for the next year, directing the tenant where to purchase the landlord's share of the seed and fertilizer, and consulting about improvements and major repairs. The landlord also drove past and through the three farms following major storms. The court felt that these activities did not constitute material participation.

The court seemed most impressed by the fact that the tenants had made the major operating decisions as to when to plow, fertilize, disk, plant and harvest. The court also noted that the tenants were experienced farmers, that little equipment was furnished by the landlord, and that the landlord did not reside on the premises. About the only factor in the landlord's favor was that he furnished a substantial portion of the financial responsibility in producing the crops.(53)

It is not surprising that the taxpayer lost this case; still, it is distressing that the court placed so much emphasis on such routine functions as when to disk and plow. A landlord could be extensively involved in management without making these day-to-day decisions. Further, the regulations do not appear to require participation in such minute detail. In Estate of Coffing,(54) a case with somewhat similar facts, the Tax Court also held against the taxpayer. In Estate of Heffley,(55) the facts were more straightforward: the lease was a cash arrangement and the tenant made all managerial decisions. The landlord was paid partly in fixed quantities but, not surprisingly, the Tax Court ruled against the estate. In affirming the Tax Court, the Seventh Circuit noted that the landlord had a commodity price risk but not a production risk.(56)

The Tax Court distinguished Coon from Ward,(57) but in doing so appeared to take a more liberal view of material participation. Again, this involved a share-crop lease. The decedent furnished no equipment but shared equally the expenses of seeds, fertilizer, etc., and did reside on the farm. She inspected the planting and discussed with the tenant such matters as the quality of the grain, moisture levels, price, herbicides and general crop conditions. She also decided when to harvest her one-half of the crop; the Tax Court appeared to give this considerable weight. However, she did not pay self-employment taxes on the income.

In Mangels,(58) the Eight Circuit applied a much less strict standard in determining material participation. The District Court had ruled against the taxpayer on the grounds that the activities of the landlord were less than in the typical crop-share arrangement. However, the Eight Circuit considered such requirements to be unnecessary under the regulations. The landlord (in this case a bank acting as a conservator) had monthly and annual conferences with the tenant in which decisions concerning crop patterns and rotation, level of fertilizer application, chemical, weed and insect control, fence repair, plowing and minimum tillage techniques, seed purchasing and crop planting and harvesting were discussed. In addition, the bank made quarterly two-hour inspections of the growing crop and the farm land. One-half of such expenses as fertilizer, seed, etc. were paid by the landlord. The amount of participation in managerial decisions in this case appears to be minimal, but the Eight Circuit ruled it to be adequate.


Although the decedent can have met the qualified use requirement by having a cash rental lease with a relative, heirs should, if at all possible, avoid leasing the property (even to relatives) for fixed amounts. However, generally a crop-share lease should meet the qualified use test, since the landlord will be at risk with respect to the amount of income to be received.

A key to substantiating material participation is the existence of a written agreement between the landlord and the operator. Such an arrangement should clearly indicate a substantial participation in management decisions; involvement in some of the routine decisions would also be helpful. The furnishing of some equipment and residing on the premises are not required but are factors to be considered in determining material participation.

Special use valuation can be a great aid to the executor in reducing estate taxes and lessening the liquidity crunch often confronting farm estates. Careful planning is required to meet the very complicated requirements previously discussed.


1 IRC Sec. 2032A(a)(2)

2 For an excellent discussion of meeting the technical election requirements, see Bost and Rembolt, "The Special Use Election Can Reduce Farmer's Estate Tax Liability," Journal of Agricultural Taxation & Law, Vol. 13, # 4,327 (1992).

3 IRC Sec. 2032A(b)(1)(A).

4 IRC Sec. 2032A(b)(3).

5 IRC Sec. 2032A(b)(2).

6 IRC Sec. 2032A(e)(2).

7 IRC Sec. 2031(A)(b)(1)(B).

8 IRC Sec. 2032(A)(b)(1).

9 Ibid.

10 IRC Sec. 2032(A)(e).

11 IRC Sec. 2032A(b)(1)(C).

12 IRC Sec. 2032A(b)(4).

13 Reg. 20.2032A-3.

14 House Comm. on Ways and Means, H.R. Rep. No. 1380, 94th Cong., 2d Sess. 755-758.

15 Senate Comm. on Finance, S. Rep. No. 144, 97th Cong., 1st Sess. 412, 464 (1981).

16 Estate of Donahoe, 90-1 USTC para. 60,026 (7th Cir., 1990).

17 IRC 2032A(e)(6).

18 IRC 1402(a)(1).

19 Reg. 1.1402(a)-(4)(b)(3)(i).

20 Reg. 1.1402(a)-4(b)(3)(ii).

21 Ibid.

22 Ibid.

23 Reg. 20.2032A-3(e).

24 87-2 USTC para. 13,734 (8th Cir., 1987).

25 Reg. 20.2032A-3(e).

26 Ibid.

27 Reg. 2032A-3(e)(2).

28 Ibid.

29 Ibid.

30 Reg. 20.2032A-3(f)(2).

31 Ibid.

32 Reg. 20.2032A-3(f)(1).

33 Ibid.

34 Ibid.

35 Farmers Tax Guide 64 (1991).

36 Estate of Sherrod v. Commm'r, 82 T.C. 523 (1984).

37 Ibid.

38 85-2 USTC, para. 13,644 (1985).

39 83 T.C. 696 (1984).

40 Supra, n. 14.

41 56 TCM 271 (1988).

42 The court's evaluation of Abell seems faulty, given that in that case the decedent did such tasks as fixing fences, painting buildings, eradicating prairie dogs and touring the ranch property several days per week.

43 90-1 USTC, para. 60,026 (7th Cir., 1990).

44 86-1 USTC para. 13,561 (7th Cir., 1986).

45 84-1 USTC, para. 13,590 (Ct. Cl., 1984).

46 See PLR 8147100 (8-27-81), PLR 8249014 (8-23-82), and PLR 8121011 (2-20-81).

47 92-2 USTC para. 60, 115, aff'g 93 TC 242 (9th Cir., 1992).

48 The Tax Court ruled similarly, in Shaw, 62 TCM 396 (1991).

49 Rev. Rul. 83-32, 1983-1 CB 226.

50 PLR 8429058 (April 18, 1984).

51 PLR 850801 (Nov. 28, 1984).

52 81 T.C. 602 (1983).

53 Ibid.

54 53 TCM 1,314 (1987).

55 89 TC 265 (1987).

56 89-2 USTC para. 13,812, aff'g 89 TC 23 (7th Cir., 1989).

57 89 TC 54 (1987).

58 87-2 USTC para. 13,734 (8th Cir., 1987).

Gary L. Maydew, PhD, CPA, is an associate professor of accounting at Iowa State University in Ames, Iowa.
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Author:Maydew, Gary L.
Publication:The National Public Accountant
Date:Apr 1, 1995
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