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Keeping it together: how to help small business clients keep their estates intact.

The tax laws realize a special need to keep intact estates that include a relatively large amount of interest in a closely held business, including the business of farming. This objective is achieved in two principle ways. I.R.C. 2032A permits an estate to elect to value real estate in a closely held business, including a farm, at its actual use value rather than its potentially much higher "highest and best use." In addition, I.R.C. 6166 permits estates with relatively large holdings in small businesses and farms to elect to defer tax payments for a period up to 15 years with interest at a meager four percent.

This article will examine these two code sections to show how they can help to reduce and defer estate taxes. The potential negative aspects of these sections will also be discussed.

I.R.C. 2032A--Valuation

Under I.R.C. 2032A, if certain conditions are met, estates can elect to value real estate used in a closely-held business, including farm real estate, at its actual use rather than the typical "highest and best use." Thus, if farm property would have a value several times greater if used for a residential development, the estate can significantly decrease the value of the estate by making the election at LR.C. 2032A.

Limitation in reduction

The maximum reduction in the valuation of qualified real estate cannot exceed $750,000. (1) For instance, if there was qualified real property in an estate with a fair market value of $5,000,000 based on its "highest and best use" and a fair market value of only $3,000,000 based on its actual use in farming, it would be included in the estate at a value of $4,250,000. Accordingly, this provision has the effect of disproportionately helping the small farmer or small business person.

Qualified property

For real property to qualify for the special valuation under I.R.C. 2032A, two conditions must be met:

1. Both the real and personal property used in the decedent's business or farm must be at least 50% of the adjusted value of the estate; and

2. The real property used in the decedent's business or farm must be at least 25% of the adjusted value of the estate. (2)

The adjusted value of the estate is equal to the total gross estate less the unpaid mortgages on property included in the estate. (3)

Qualified use and qualified heir

To qualify for the special valuation, the real property subject to the actual use valuation had to have been used in the decedent's business or for farming purposes for at least five of the eight years prior to the death of the decedent. (4) Moreover, the property must descend to one of the following of the decedent's relatives:

1. ancestor; 2. spouse; 3. lineal descendent; or 4. spouse of a lineal descendent. (5)

To be eligible for the special use valuation, the qualified heir must materially participate in the operation of the business or farm for ten years. (6) According to the regulations, material participation is determined on the facts and circumstances of each case. Passively collecting rents, salaries, draws, dividends or other income from the farm or other business is not sufficient for material participation, nor is merely advancing capital and reviewing a crop plan or other business proposal and financial reports.(7)

Additional tax for disposition or failure to use for qualified use

If within ten years after the decedent's death, the qualified heir either disposes of the property subject to the election or fails to use the property for a qualified use, the heir becomes personally liable for an additional tax.(8)

The additional tax is essentially the tax saved by using this election.(9) It should be noted that the law provides for a two-year grace period. That is, the heir has up to two years after the decedent's death to commence active management of the business or farm.(10)

Adjusted basis of property in the hands of the heirs

If the election is made to use the special valuation under I.R.C. 2032A, the adjusted basis of the property in the hands of the heir will be the same as its valuation in the estate.(11) This is not a bad trade-off if the estate is in a higher tax bracket than the heir's income tax bracket. Since the top estate tax rate is substantially higher than the top individual income tax rate, it is likely that the estate's tax bracket will be higher than the heir's individual income tax rate. Moreover, since the estate tax bill is likely to come due before there is an impact on the heir's individual taxes, there is a present value savings as well.

If the additional tax at I.R.C. 2032A(c) is imposed because of a disposition or discontinuing a qualified use, the heir is entitled to elect a retroactive increase in the basis of the property.(12) Such increase in the basis of the inherited property is deemed to occur immediately prior to the event resulting in the imposition of the additional tax. Thus, such election can have a favorable impact on the gain or loss that the heir must recognize. However, in order to make the election, the heir must pay interest on the additional tax going back to the time the estate tax return was required to be filed.(13)

Gift giving and planning for I.R.C. 2032A

Taxpayers can make gifts of a present interest up to $10,000 a year without making a taxable gift.(14) This limit can be increased to $20,000 if a joint gift is made with a spouse.(15)

Making gifts during one's lifetime can generally reduce estate taxes. Additionally, making the right type of gifts can have a profound impact on reduction of estate taxes when the election for actual use comes into play. That is, by making gifts of nonbusiness or nonfarm assets, it is easier to meet the 50% and 25% thresholds.

Example. The decedent, a sole proprietor, owned real estate used in his business with a "highest and best use" of $500,000 and a value as real estate used in his business of $300,000. In addition to the real estate used in his business, he owned the following property:
 Fair Market Value
Business personal property $100,000
Stocks and bonds 250,000
Certificates of deposit 100,000
T-bills 125,000
Personal effects 50,000
Personal residence 240,000


Assuming the decedent has no estate tax deductions, is not married and has not used up any of his unified credit, his estate tax would be as follows:
Business real estate ("highest and
best use") $500,000
Business personal property 100,000
Stocks and bonds 250,000
Certificates of deposit 100,000
T-bills 125,000
Personal effects 50,000
Personal residence 240,000
Gross and taxable estate $1,365,000
Tax before unified credit 497,750
Less: unified credit (192,800)
Tax due $ 304,950


The estate does not qualify for the election at I.R.C. 2032A since both the business real and personal property are not at least 50% of the adjusted value of the estate (in this example, $1,365,000). However, if the decedent had entered into a gift-giving program whereby he made gifts of his stocks and bonds in the amount of $165,000, the estate would meet the 50% and 25% tests. This allows the estate to value the business real property at its actual use value of $300,000 instead of $500,000. Accordingly, by making gifts of $165,000, the estate reduces its tax bill to $153,000 from $304,950. The computation of tax due by making gifts and taking advantage of the special use valuation is as follows:
Business real property (actual use) $ 300,000
Business personal property 100,000
Stocks and bonds 85,000
Certificates of deposit 100,000
T-bills 125,000
Personal effects 50,000
Personal residence 240,000
Gross and taxable estate $1,000,000
Tax before unified credit 345,800
Less: unified credit 192,800
Tax due $ 153,000


NOTE: A potential drawback of making gifts of nonbusiness and nonfarm property is that the donee receives a carryover basis rather than a "stepped-up" basis. Therefore, where possible, these gifts should be of property that has the least amount of appreciation.

Even though the heir, as in the previous example, will have a lower basis in the inherited property if the election is made, presumably the heir will be retaining the property for the long term. Therefore, whether or not there is a step-up in basis (to the extent of its "highest and best use") may not be an important consideration. Additionally, an estate will generally be in a higher tax bracket than the income tax bracket of the heir. For instance, in the prior example, the estate was in the 43% marginal tax bracket, while the heir's marginal tax bracket generally can't exceed 31%.

I.R.C. 2032A and the marital deduction

Where the property has a fair market value for its "highest and best use" that is much more than its actual use value and the spouse will be active in the business or farm, such property should be bequeathed to the spouse and the special valuation not elected. With the unlimited marital deduction of I.R.C. 2056, the estate and the spouse can have the best of both worlds--the estate can value the property at its "highest and best use" and receive a deduction for the entire amount bequeathed to the spouse. The spouse then has a substantially "stepped-up" basis for the property.

Gifts in contemplation of death

In planning for a gift-giving program to lower the adjusted value of the estate, it should be noted that for purposes of I.R.C. 2032A, gifts made within three years of the decedent's death are added back to the adjusted value of the estate.(16)

I.R.C. 6166--Extension of Time for Payment

According to the old phrase, "time is money." I.R.C. 6166 gives an estate the election to substantially defer paying taxes at a very attractive interest rate.

If the value of an interest in a closely held business, including a farm, exceeds 35% of the adjusted gross estate, the executor can elect to pay the estate tax in installments. The adjusted gross estate is defined at I.R.C. 6166 (b)(6) to be the value of the gross estate less the deductions at I.R.C. 2053 and 2054. The installment period is for up to 15 years with interest being paid only in the first five years and then principal plus interest thereafter. It is important to note that regardless of the liquidity of the estate, the installment election can be made. Hence, the election can be made to obtain the attractive financing rate that is offered by the Treasury Department regardless of the ability of the estate to pay the estate taxes.

Unlike I.R.C. 2032A, the installment election under I.R.C. 6166 does not make a distinction between real and personal property.

"Dual expenses"

The adjusted gross estate is reduced by the deductions of I.R.C. 2053 (funeral and administration expenses, and claims and indebtedness against the estate), and I.R.C. 2054 (casualty losses). According to Req 1.642 (g)-2, only the administration expenses and the casualty losses can be used as deductions for either the estate tax (Form 706) or the estate's income tax (Form 1041). Electing to use these "dual deductions" on the estate tax return rather than on the fiduciary return can help the estate reduce its adjusted gross income to a level low enough to allow the decedent's business interest to exceed 35% of the adjusted gross estate. Moreover, using these dual deductions on the estate tax return is also beneficial since the estate tax rates are generally higher than the estate's income tax rates.

Tax trap

An election under I.R.C. 2032A may prevent the estate from making an installment election under I.R.C. 6166. If the value of real property using its actual use value reduces the total value of all business property to a value of less than 35% of the adjusted gross estate, the estate will be precluded from using the installment method.(17)

If an estate does not qualify to use the installment method under I.R.C. 6166, it can get a ten-year extension for a reasonable cause under I.R.C. 6161 (a)(2). However, interest is charged at the regular rate.

Limitation

The total amount subject to the deferral is the first $1 million reduced by the amount of the unified credit.(18) Further, the maximum amount of tax that may be paid in installments is an amount bearing the same ratio to the estate tax as the value of the closely held business property bears to the amount of the adjusted gross estate.(19)

Example: A decedent left a sole proprietorship with a value of $500,000 and an adjusted gross estate of $1,000,000. The estate tax after credits is $100,000. Accordingly, the amount of the tax subject to the deferral is $50,000 |($500,000/$1,000,000) @ $100,000~.

Interest in a closely held business

In addition to meeting the 35% test, it is important that the decedent has a qualified interest in a closely held business. (20) There are three different types of interest that qualify.

First, the decedent is a proprietor in a trade or business. Second, the decedent is a partner in a partnership and he owns at least 20% or more of the total capital interest in the partnership. Alternatively, if the decedent does not own a 20% capital interest in the partnership, the estate can still qualify for the deferred payments if there are 15 or fewer partners.

Third, the decedent owned 20% or more in value of the voting stock of a corporation. Like the rule for interests in a partnership, if the decedent fails to meet the 20% rule, the estate can still qualify if the corporation has 15 or fewer shareholders.

Gift giving

As was the case for qualifying for the special valuation under I.R.C. 2032A, a well-planned gift-giving scheme can help the estate qualify for deferred payments under I.R.C. 6166. That is, by making gifts of nonbusiness or nonfarm property, it will be possible for the business and farm property in the estate to meet the 35% test. However, any property transferred within three years of death will be included in the adjusted gross estate for purposes of meeting the 35% test.(21)

Attribution and "estate-freeze" rules

Many times, a founder of a corporation who is nearing retirement age will want to transfer the common stock of his closely held corporation to his children, especially if they are interested in continuing the business. He will then retain the preferred stock. Such a maneuver places the appreciating type of stock in the hands of a younger generation. At the same time, it locks in the estate value of the preferred stock for the aging founder. In addition, it provides a steady stream of income for the older generation via preferred dividend payments.

Even though such transfers will reduce the founder's shareholderings to less than 20% of the voting stock, the estate may still be able to make the election for installment payments because of the attribution rules. For purposes of meeting the 20% threshold for interests in corporations and partnerships, the decedent will be attributed with the ownership interests held by his family members, including brothers, sisters, spouses, ancestors and lineal descendants.(22) This allows the estate to achieve the best of both worlds for the older generation--freezing the value of the estate as well as qualifying for deferred payments.

Caveat

Under the Chapter 14 estate freeze rules, when a shareholder transfers common stock to a family member and retains preferred stock, the amount of the transfer is deemed to be equal to the value of both the common and preferred stock.(23) However, the transfer will be taxed on the value of the common stock only if the preferred stock pays a dividend on a periodic basis at a fixed rate and is cumulative.(24)

Husbands and wives

For purposes of the 35% rule and the 20% rule, if a husband and wife live in a community property state or own a stock or partnership interest as joint tenants, tenants by the entirety or tenants in common, each will be attributed with the other's half interest.(25)

As a practical matter, in noncommunity property states, owning stock or a partnership interest jointly has the advantage of achieving the best of both worlds: it not only splits the estate between a husband and wife but also makes it easy to meet the ownership thresholds for qualifying for deferred payment under I.R.C. 6166.

Interest paid under I.R.C. 6166

If an estate elects to pay its taxes in installments under I.R.C. 6166, it should be noted that such interest is deductible as an administration expense.(26)

Acceleration of payment

There will be an acceleration of the deferred tax if, during the period of deferral, 50% or more of the qualified property is disposed of or ceases to be qualifying property.(27)

Conclusion

In doing estate planning for an individual who has an interest in a small business or farm, it is imperative to consider the impact of I.R.C. 2032A and I.R.C. 6166. In many cases if an estate qualifies to make an election under one of the code provisions, there is a strong probability it can make an election under both of the provisions, which can substantially reduce and defer payment of estate tax.

Footnotes

1 I.R.C. 2032A (a)(2) 2 I.R.C. 2032A (b)(1) 3 I.R.C. 2032A (b)(3) 4 I.R.C. 2032A (b)(1)(C) 5 I.R.C. 2032A (e)(2) 6 I.R.C. 2032A (c)(7)(B) 7 Req. 2c 2032A - 3(a) 8 I.R.C. 2032A (c)(1) 9 I.R.C. 2032A (c)(2) 10 I.R.C. 2032A (c)(7)(A) 11 I.R.C. 1014 (a)(c) 12 I.R.C. 1016 (c)(1) 13 I.R.C. 6075 14 I.R.C. 2503 (b) 15 I.R.C. 2513 (a) 16 I.R.C. 2035 (d)(3)(B) 17 I.R.C.6616 (b)(4) 18 I.R.C.6601 (j) 19 I.R.C.6616 (a)(2) 20 I.R.C.6616 (k)(1) 21 I.R.C.2035 (d)(4) *-22 I.R.C.6616 (b)(2)(D) 23 I.R.C.2701 (a)(3) 24 I.R.C.2701 (c)(3) 25 1.R.C.6616 (b)(2)(B) 26 Todd, James Jr. Est 57 TC 288A 27 I.R.C.6616 (g)(1)(A)

Philip R. Fink is the Chairman of the Accounting Department and a professor at the University of Toledo in Toledo, Ohio. He holds a BBA and MBA from the University of Toledo and a JD from Ohio Northern University. He has published in several professional journals.
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Author:Fink, Philip R.
Publication:The National Public Accountant
Date:Feb 1, 1993
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