CHAPTER 1 INTRODUCTION The estate tax is a tax imposed on the privilege of transferring wealth to one's inheritors. Its supporters maintain it is a fair tax, since an inheritance is an unearned gain to an heir, and that it serves the socially desirable purpose of reducing inequalities of wealth. Further, Government protection of property rights may be considered a benefit for which a charge in the form of a tax might be imposed. Since the estate tax is imposed following a person's death, it is expected to affect one's economic behavior less than an income tax. Some persons also believe that the inheritance of wealth diminishes incentives to work or to invest wisely and that opportunities for the productive use of accumulated wealth are sacrificed if ownership remains concentrated among a "lucky few." The Federal Government has levied a progressive estate tax on the value of property owned by deceased U.S. residents since 1916. However, the Congress felt that this tax threatened the viability of the family farm: Land values, which compose such a large part of the estates of farmers who leave enough property to attract an estate tax, were likely to be so inflated that the heirs might be forced to sell the farms to pay the estate taxes. This feeling and the long standing American tradition of protecting family farms led to the passage in 1976 of two special estate tax provisions. Sections 2032A and 6166 (as enacted) of the Internal Revenue Code, added by the Tax Reform Act of 1976, provide a new method for valuing the land included in farm estates and an extended 15-year installment option for paying the Federal estate tax. These provisions were designed to benefit agricultural producers, but may have unintended effects that are contrary to other congressional policy goals. This study was undertaken and largely completed prior to enactment of the Economic Recovery Tax Act of 1981 (ERTA). This Act dramatically reduces the Federal estate tax for all estates. Over 6 years, the unified credit will increase sufficiently to exclude from the tax all estates valued under $600,000; present law exempts those valued under $175,625. ERTA further removes limits on the marital deduction allowed for surviving spouses; property left to a surviving spouse is no longer taxed. Finally, sections 6166 and 6166A, deferred and installment payment options, were consolidated, the limit on section 2032A reductions in estate value has increased, the tightly drawn restrictions on the use of section 2032A have been relaxed for farm heirs, and the top estate tax rates on cumulative transfers of estate and gifts are decreased from 70 to 50 percent as of 1985. These estate tax changes alter the financial situation for many farm estates. Some that would have taken advantage of the two provisions may no longer have to do so, since their taxes are now lower or removed. Fewer estates will now incur any estate tax liability, so fewer farm estates will use the provisions. In this report we consider the intended and actual effects of these two estate tax provisions. Chapter 2 contains a detailed description of the provisions. In chapter 3 we discuss the reasons why they were enacted and what they were expected to accomplish. Chapter 4 presents some findings about their actual effects. Chapters 5 and 6 discuss problems that have appeared in the law and have arisen in its administration. Chapter 7 offers our recommendations for improving the design and administration of these estate tax provisions. OBJECTIVES, SCOPE, AND METHODOLOGY This study was designed to evaluate the effects of sections 2032A and 6166 that are intended to benefit family farms. By examining the justifications presented to the Congress on behalf of these provisions, analyzing their actual effects, and determining whether they need to be modified to improve their effectiveness, we intend to point out the complications entailed in trying to aid a particular group of people through tax policy measures, especially those using the estate and gift tax. Reducing taxes on a special group of people is the practical equivalent of paying money to them directly; in fact, such tax reductions are frequently called "tax expenditures" to emphasize their similiarity to direct spending programs. Since they subtract from the resources that would otherwise be available for other public uses, it is generally accepted that such provisions should be evaluated in the same manner as direct spending programs. Although the provisions we are considering here have not been formally designated tax expenditures, we believe that the tax expenditures concept provides a useful framework for evaluating them. We used two approaches to evaluate these provisions. First, we analyzed a sample of all Federal estate tax returns that contained special use valuation elections (see appendix II). The statistical analysis of these returns provided estimates of the size of the tax saving and its distribution among different sized estates. The sample was constructed so that these estimates were representative of all farm estates that elected section 2032A. tried to collect a similar sample of returns containing elections of the deferred and installment payment option but were forced to abandon the attempt. 1/ The sample that we did collect was drawn 1/When we started to collect returns showing an election of the section 6166 deferred and installment payment plan, we discovered that many of the elections were actually of section 6166A installment payment plans. We believe the confusion from a population only of farm estates electing special use valuation, not from all farm estates or all farms. Drawing a sample from all farms or all farm estates would have been prohibitively expensive. Our second major analytical tool is a set of case studies that we conducted in agricultural counties in five farm States-California, Colorado, Indiana, Missouri, and Texas. Both the counties and the States were selected to provide a representative view of farming. Within each county we examined the Federal estate tax returns for farm estates electing either section 2032A or section 6166 and interviewed the inheritors of these estates. We also interviewed farm estate inheritors who did not receive or elect these tax preferences, current farm owner-operators and tenants, local attorneys, accountants and bank trust officers, and public officials (see appendix II). We also supplemented these two sources of information with questionnaires sent to estate tax attorneys and County Executive Directors of the Agricultural Stabilization and Conservation Service (ASCS) and interviews with both Department of the Treasury and Department of Agriculture officials in Washington and with academic researchers known for their work in this area. The questionnaires sent to the sample of estate tax attorneys and ASCS County Executive Directors were designed to determine how well understood the two provisions were and how important these groups felt the provisions were. The analysis of sections 2032A and 6166 was completed prior to enactment of ERTA. ERTA substantially changes the base of the estate tax and the operation of the two provisions that we examined. Where possible, our report reflects these changes. Our basic findings concerning the operation of the two provisions, however, are still germane. The reductions in the estate tax, however, will make these provisions less important than they were during the time during which we examined them. arose because the current section 6166A was numbered 6166 prior to the Tax Reform Act of 1976. Whatever the reason, it prevented us from identifying the universe of section 6166 returns from which a sample could be drawn. CHAPTER 2 ESTATE TAX PROVISIONS--A BACKGROUND OVERVIEW OF THE FEDERAL ESTATE TAX SYSTEM Although the tax liability of an estate depends on its value, the tax is reduced by available credits, deductions, and exemptions. For instance, estate expenses are deductible, generally the first $175,625 of an estate is exempt, and if the property is left to a spouse, one-half of the adjusted gross estate or $250,000, whichever is greater, is also exempt. Usually, an estate tax must be paid by the estate of a married person if the value of that estate, net of debts and expenses, is $425,000 or more. 1/ As a result, approximately 93 percent of all estates do not owe estate and gift taxes. In fact, some tax experts believe that by adroit planning the tax can largely be avoided, so that any tax liability is "voluntary." 2/ Thus, the estate tax is not a major source of Federal revenue. For instance, in fiscal year 1979 estate and gift taxes generated $5,411 million of revenue, out of total budget receipts of $465,940 million. 3/ Analysts generally believe that the tax is intended to prevent perpetuating large inequalities of wealth by enforcing redistribution of the wealth at the time of death. GENERAL ESTATE TAX PROVISIONS In the Tax Reform Act of 1976, Public Law No. 94-455 (hereinafter cited as the 1976 Act), the Congress made the most sweeping revisions of the Federal estate and gift tax laws since 1942. As stated by the Joint Committee on Taxation, the purpose of the estate and gift tax provisions in this Act were 1/ERTA made several substantive changes in the two special estate tax provisions examined in this report. See the conference report on ERTA H.R. Rep. No. 97-215, 97th Cong., 1st sess., 247-255 (1981). It also increased the unified credit, in steps over 6 years, from $47,000 to $192,000, thus excluding estates valued up to $600,000 immediately from the tax. It also removed the limit on the marital deduction. Increasing the unified credit and removing the marital deduction limit can allow a couple to leave an estate valued at $1.2 million to their heirs without paying any tax under certain circumstances. 2/George Cooper, A Voluntary Tax? (Washington, D.C.: Brookings Institution, 1979). 3/Economic Report of the President, 1980, Table P-69, p. 285. --to provide substantial relief for modest-sized estates, --to remove tax avoidance devices from the estate and gift tax system, and --to alleviate the liquidity problem for estates largely Tax rates were adjusted to maintain estate tax revenues. To meet these objectives, the 1976 Act established a unified credit and rate schedule for gift and estate taxes, increased the estate tax marital deduction, provided a new installment method for paying estate taxes, and authorized special valuation rules for farm estates. In enacting the installment and special valuation provisions, the Congress intended to help preserve the family farm, an important American institution. New installment plan for estate taxes Prior to the 1976 Act, two provisions allowed estate tax payments to be deferred. First, the Code provided a year-to-year extension, not to exceed 10 years, based on a showing of undue hardship by the executor. 1/ This extension was available to everyone. Second, section 6166 (renumbered as 6166A in the 1976 Act) provided for annual installment payments over a period of 2 to 10 years. 2/ To qualify for this extension, the estate had to contain a specific amount of property in a farm or closely-held business. 3/ The value of such property had to amount to at least 35 percent of the value of the gross estate of the decedent or 50 percent of the value of the taxable estate. These two provisions, however, contained several features that discouraged their use. First, the IRS had become unwilling to grant extensions based on undue hardship and thus they had become difficult to obtain. If the extension were granted, a bonding requirement was levied on the executors who remained personally liable until the entire tax was paid. Second, the installment provision of up to 10 years was thought to be insufficiently generous because it may take more than 10 years for a farm to regain its financial strength to generate enough cash to pay estate taxes. A part of the estate may have to be sold so that the estate tax could be paid. Also, some farms were not profitable enough to pay both the estate tax and interest, especially if the interest rate were high. 1/The 1976 Act changed this to simply require a showing of reasonable cause by the executor. 2/ERTA repealed section 6166A. 3/Generally a closely-held business is either (1) a sole proprietorship, (2) a small partnership in which the decedent had at |