Some common long-term planning objectives of farming and ranching families are to keep the property in the family, maintain the operations even if it means creating multiple streams of income for financial support, and passing it all down to the next generation. Working with farm and ranch owners to accomplish all of this can be a challenge. Here are a few issues to consider in this process.
1. CONSERVATION EASEMENTS
Conservation easements continue to be popular and they provide an excellent tool to ensure that the farm or ranch will remain as a farm or ranch for future generations. With most or all of the development potential given away in the easement, the next generation doesn’t have the usual incentive to sell or develop it in a residential or commercial manner. However, when establishing a conservation easement, make sure to consider how the next few generations will be able to continue to support the operations or the future family members may be forced to sell the property. Selling the property does not fulfill the family’s original wishes, and careful planning is needed to avoid this result. A conservation easement gives rise to a charitable contribution for federal tax purposes and disallowed deductions can be carried forward to future tax returns. In Colorado and some other states there is an added advantage where a portion of the contribution amount can be sold to third party taxpayers. If the farm or ranch family cannot use all of the state credits, others can purchase them at a discount to cover some of their own Colorado income tax. An intermediary is typically involved to handle the sale of the credits and remit the remaining funds to the family. In creating a conservation easement, the key to achieving the desired tax benefits is the appraisal. This is no place to skimp on costs or quality, and the appraiser must have special qualifications and significant experience in this arena. Conservation easement appraisals are difficult and expensive because the appraiser has to determine what the value of developing the property is as well as its value as a farm or ranch. In recent years there have been many problems concerning these valuations with the IRS and state departments of revenue. This can be especially stressful because the money moves faster than the tax filing. If the rancher or farmer is having trouble getting the easement approved, or the IRS later rejects the appraisal, there can be a lot of upset taxpayers. One important factor is to have the best appraiser you can find in this field and make sure that they have a good track record regarding farm and ranch appraisals for conservation easement purposes. In cases involving conservation easement issues, the quality of the appraisal can be instrumental in getting the eventual approval of the department of revenue. Also beware of any future rights that are retained within the conservation easement – they can be potential time bombs. A recent tax court case went against the taxpayer for having a right to adjust a parcel’s boundary (See Balsam Mountain Investments, TC Memo 2015-43). In one case, the revenue agent was concerned over some reserved signage rights in the easement. They were able to convince the IRS that the client did not intend to sell billboard space, in a manner satisfactory to the agent. This is one example of many issues that, if not properly vetted, may become problems later on.
2. SPECIAL USE VALUATIONS
The special use valuation provisions of the tax laws have been around a long time and in the past have been a huge benefit to farmers, ranchers and small business owners. Given the current estate tax thresholds that are significantly higher than the benefits under these laws, this tool is
no longer widely used. But in the past when there were lower estate tax thresholds, there were a lot of farm and ranch operations that easily exceeded the thresholds in land alone. As a consequence these special use valuations were recorded on many tracts of real property across the country. Farm and ranch owners can be given a special use valuation estate tax break if certain requirements are met. Generally, a property’s fair market value at the property owner’s death is the highest and best use value. However, for farm and ranch owners, their property can be valued according to the current actual use value versus the highest and best use. There are three basic requirements for this special valuation: (1) the net value of the business property must be at least 50% of the decedent’s gross estate (reduced by certain deductible debts, expenses, claims, and losses); (2) the decedent must have transferred the business to close family relatives; and (3) the farm or ranch must have been owned and operated by the decedent or a close family relative for a period of time before the death, disability, or retirement of the decedent. There is also a ten-year rule that applies where the estate tax savings could be lost if the heirs sell or otherwise dispose of the property to outsiders within 10 years of the owner’s death or if the heirs begin using the property for another non-qualifying purpose. In a recent experience with a family that took advantage of the special use valuation, the IRS protective lien came to light about 15 years after the farm owner died. The farmland was already owned by the next generation but the IRS lien on the property was still in place. It was not discovered until the highway department wanted additional right-of-way that would affect the property. When the issue arose, it became a larger problem when it was determined that there is no automatic release of the IRS lien after the termination of the restrictive period of the special valuation. As a result, the family incurred extra expenses to get the lien released. If farm and ranch owners have inherited land that could have been special use property or if the owners are aware of a prior special use valuation, they should conduct a title review to determine if there are any unreleased IRS liens on the property, and get the liens released if the time restrictions have expired.
3. ENTITY SELECTION
Many farm and ranch clients hold farm property and operations in a limited liability company (“LLC”) entity, and may not have fully considered the myriad of issues regarding taxation. These entities have elements of both a partnership and a corporation, and can also be owned by a single member. Since the introduction of the LLC, even the IRS has had a hard time determining what kind of taxpayer it is. This created an administrative mess for everyone for many years until the IRS implemented the “check the box rule.” This makes it easy for the taxpayers to choose whether they desire to file a corporate or partnership tax return. A single member LLC is taxed as a disregarded entity and there is no need to file its own tax return – an IRS Schedule C is included on the single member’s tax return. However, even with the “check the box rule,” LLC owners can run into problems as their businesses grow. Problems can arise when a single member LLC becomes profitable and the client wants to consider being taxed as an S corporation for its tax advantages relating to self-employment taxes and other benefits of S-corporations. Despite filing the appropriate forms along with an S-corporation election, some of these businesses meet with resistance from the IRS. It may require extra CPA and/or attorney expenses to resolve these types of issues. Another common problem area with LLCs is where there are two or more members and they need to file a partnership or S-corporation return. The owners may think that they have done everything right until they get a letter from IRS informing them that a partnership tax return is required. Farm and ranch clients need to be aware of these types of problems that can result in more expenses later on if they do not engage experienced and qualified legal and tax help in the entity formation stage of their businesses.
4. FAMILY LIMITED PARTNERSHIPS
An FLP for a farm or ranch operation is designed to gradually transfer ownership and management to the next generation. Generally, the senior family members contribute assets to the entity and then make annual gifts of the partnership interests to their children and grandchildren. These transfers can be eligible for the annual gift tax exclusion, and can also be discounted based on various factors, such as lack of control and marketability. The discounts available can be substantial as seen in the Litchfield case. See Litchfield, T.C. Memo 2009-21. In this probate case, there were two companies; one was a real estate company and the other held only liquid securities. The realty company had a fair market value of $14 million and the securities company had a value of $12 million. The potential estate tax was $13 million. The tax court ended up allowing total discounts of 48% in the realty company and 46% for the securities company, which resulted in about $9 million in estate tax savings. The primary reason for the tax court’s acceptance of the discounts was the quality of the business valuations and the expertise of the taxpayer’s advisors. Similar to the quality of an appraiser in a conservation easement situation, it is essential to use good professionals in establishing the discounted values and to take advantage of other benefits of an FLP. An FLP must be structured with both the present and future owners in mind, protecting the generations of today as well as generations to come. Care should be taken when creating the FLP and in observing the formalities of operating the FLP as a family business. Be sure to investigate state laws and the rights and obligations associated with transferred property, and always discuss any of these decisions with the family’s team of professionals.
There are many opportunities for efficient generational transfers and effective tax planning for farming and ranching families. However there are many serious potential pitfalls if the tools available are not carefully implemented with the assistance of specialized and qualified advisors. Farm and ranch owners who are interested in multi-generational planning should not be farm wise and tax foolish!