CHAPTER 3 THE ORIGINS OF SPECIAL ESTATE TAX TREATMENT OF FARM ESTATES The estate tax preferences that the Congress enacted for farm estates in 1976 were largely prompted by two complaints. First, advocates of special treatment argued that it is unfair to tax a farm estate the same as other estates of equal fair market value, primarily because a farm estate is ordinarily less "liquid"--i.e., contains fewer assets that can be readily converted into cash-at the time of the owner's death. A farm estate's fair market value, according to the advocates of special tax treatment, often overstates the value of the farm in agricultural use. The farm heirs are less able to pay the estate tax from the estate's cash or readily marketable assets than the heirs of nonfarm estates and thus are unfairly compelled to sell more illiquid assets, such as land. Second, farm groups and other observers claimed that by forcing the sale of farm estates the Federal estate tax contravenes the public policy goal of encouraging family farming. If a part of the farm has to be sold to pay the tax, the farm may be so reduced in size that it is no longer an efficient unit or able to sustain itself. Taxing farm estates less severely than others would remedy this effect and encourage family farming. Generally, the Congress believed that when land is being used for farming by owners or their families before the owners' deaths and the succeeding members of their families want to continue farming, it would be inappropriate to value the land on the basis of its "highest and best use." To do so might discourage the continued use of property for farming purposes. The Joint Committee on Taxation stated that Valuation on the basis of highest and best use, rather Also, where the valuation of land reflects speculation to such a degree that the price of land does not bear a reasonable relationship to its earning capacity, the Congress believed it unrea 1/The Joint Committee on Taxation's General Explanation of the Tax Reform Act of 1976, H.R. Rept. No. 10612, 94th Cong., (1976) p. 537 (hereinafter H.R. 10612). sonable to require that this "speculative value" be included in an estate devoted to farming or in closely-held businesses. The Congress recognized, however, that it would be a windfall to the beneficiaries of an estate if real property used for farming were valued for estate tax purposes at its farm value unless the beneficiaries continued to use the property for farm purposes, at least for a reasonable period of time after the decedent's death. And, the Congress believed that it would be inequitable to discount the speculative values if the heirs of the decendent realized these speculative values by selling the property within a short time after the decedent's death. For these reasons, the 1976 Act provides for special use valuation in situations involving real property used in farming or in certain other trades or businesses and further provides for recapture of the estate tax benefit where the land is prematurely sold or is converted to nonqualifying uses. Other than these very general statements of congressional intent, there is little indication in the legislative history of the reasons behind the Act's specific requirements. The alleged tendency of the estate tax to force the sale of property may not be accidental. Some tax authorities maintain that the purpose of this tax is not primarily to raise revenue but to inhibit the transfer of large estates as unbroken units. 1/ Forcing estates to sell a part of their holdings is one method of serving this objective. ARE FARMS UNFAIRLY BURDENED BY THE Farm estates are said to be unusually illiquid because so much of a typical farm estate's value is attributable to a single asset: farmland. If farmland itself is unusually illiquid, the case is proved. But is farmland illiquid, and if it is, does illiquidity justify preferential tax treatment? Are farm estates inherently illiquid? Only a few empirical studies have been conducted to determine whether illiquidity is a serious problem among farm estates and their findings are inconclusive. They do demonstrate, however, that farm estates are not unavoidably illiquid and thus do not warrant special tax treatment. All the studies assumed that farmland is illiquid and that executors would attempt to meet claims against the estate from other assets. 1/See, for example, Gerald R. Jantscher, "The Aims of Death Taxation," in Death, Taxes and Family Property: Essays and an American Assembly Report, ed. Edward C. Halbach, Jr. (St. Paul, Minn: West Publishing Co., 1977), pp. 40-55. The Contemporary Studies Project at the University of Iowa examined farm estate planning and found that The conclusion seems inescapable that whatever liquidi- In the Iowa study, the authors reported that, on average, liquid assets (cash, stocks, and bonds) composed 25 percent of the value of a probate farm estate in Iowa--enough, the authors judged, to pay all estate expenses. Farmers who were surveyed for the Iowa study, however, had only 9.5 percent of estimated gross estates in cash accounts and investments and could face estate illiquidity in the case of sudden death. The Iowa study demonstrates that farm illiquidity may not necessarily cause unusual hardship. The illiquidity of living farmers may be "merely symptomatic of that middle stage of the family farm cycle in which most of the (living) subject farmers found themselves at the time." 2/ Furthermore, farmers were able to exert some control over the liquidity of their estates and therefore presumably could alleviate the problems that a shortage of liquidity might create. A similar study in Illinois supports the University of Iowa findings. Examining the financial condition of farm estates, agricultural extension economist Harold Guither reported that, on average, the estates in his sample had adequate liquid assets to pay death taxes and estate costs. Guither pointed out, however, that 43 percent of the estates were not sufficiently liquid to pay the costs and taxes. "Estate and financial planning is often needed that will provide for liquid assets in order to meet tax obligations and other claims," he concluded. 3/ In testimony before the House Committee on Ways and Means in 1976, 4/ James Smith, Professor of Economics at the Pennsylvania State University, used 1972 estate tax return data provided by the 1/Contemporary Studies Project, "Large Farm Estate Planning and Probate in Iowa," Iowa Law Review, vol. 59 (April 1974), p. 930. 2/Ibid., pp. 929-30. ་་ 3/Harold D. Guither, "Death, Taxes, and Farmland Transfers,' Cooperative Extension Service, University of Illinois at UrbanaChampaign (August 1978), p. 3. 4/James D. Smith, "The Distribution and Composition of Wealth Holdings and Their Implications for Estate Tax Reform," in U.S., Congress, House, Committee on Ways and Means, Public IRS to note differences in the liquidity position of farm and nonfarm estates. About 16 percent of the estate tax returns filed in 1973 with business and/or farm assets had a ratio of Federal estate taxes plus costs equal to 75 percent or more of their liquid assets once debts had been subtracted, compared to 4 percent for estates without business and farm assets. This ratio is used as an index of the estate's ability to pay estate taxes without the forced liquidation of less marketable assets. The data did not permit the noncorporate property and farm property to be disaggregated, however, so the figures may not be representative of farm estates. In his testimony, Smith noted that estate illiquidity is a problem for the inheritors only if it hinders the inheritors' ability to receive the land. Inheritors who can pay the tax on an illiquid estate with either their own or borrowed funds are not as burdened as those who cannot. If the decedent's spouse is the sole inheritor of the property and is as wealthy as the decedent was, he found, using a simulation model, that the liquidity problem would largely disappear, facilitating the inheritance. Alternative wealth assumptions, different inheritors, and other more realistic (and complex) scenarios were not possible given the limits of Smith's data, however. Available evidence thus shows that estate illiquidity may be characteristic of farmers' property holdings at some point during their lives, but it may also be corrected in time with proper financial planning. One component of such a plan might be life insurance to help pay death taxes and estate costs. Another component would be an adequate will that distributed property in the manner incurring the least taxes. A will taking full advantage of the marital deduction in the Federal estate tax or similar provisions in State estate and inheritance taxes would be such an estate planning device in many, although not all, situations. 1/ Are illiquid estates unfairly taxed? Advocates of estate tax preferences for farm estates argue that the problem of estate illiquidity justifies preferential treatment. It is not fair, they argue, to tax a farm estate, whose value is concentrated in assets that cannot be readily sold, as heavily as an estate whose assets may be quickly and easily sold. The farm estate is not able to pay the tax as easily as a more liquid estate. Hearings and Panel Discussions, Federal Estate and Gift Taxes 94th Cong., 2d sess., pp. 1311-1330. 1/In some cases, claiming the full marital deduction may not be the best way to minimize taxes. See D. Reinders, M. Boehlje, and N. Harl, "The Role of Marital Deduction in Planning Intergenerational Transfers," American Journal of Agricultural Economics, vol. 62 (August 1980), pp. 384-394. The Federal estate tax is levied on the net value of the estate and is not affected by the types of assets that the estate contains. An estate composed solely of a $1 million portfolio of traded stocks (a relatively liquid estate) is subject to the same tax as an estate valued at $1 million but composed solely of real estate (a relatively illiquid estate). Adjusting tax burdens according to liquidity differences would add complexity to the estate tax. Liquidity is a continuous variable that rarely takes on the extreme values of the preceding illustration. Estates cannot be classed simply as liquid or illiquid. Most are liquid to some extent, lying somewhere away from the extremes of the liquidity spectrum. If the tax is to be adjusted for an estate's liquidity, tax differences must accurately reflect liquidity differences. So far, no method has been found to adjust taxes for liquidity. Consider a $1 million estate composed of equal values of cash and real estate. How much more liquid or illiquid is it than the two estates in the previous example? By how much should the estate tax be adjusted to reflect the differences in liquidity among the three estates? Even if an acceptable line could be drawn between liquid and illiquid estates the distinction would have no tax consequences unless it were agreed that estates of equal fair market value should not bear the same tax if they are not equally liquid. Several reasons may be offered for taxing them differently. First, the forced sale of certain illiquid assets may be more detrimental to an enterprise than the forced sale of the same value of liquid assets. That is, $100,000 of land may in general be more nearly essential to the health of an enterprise than $100,000 of cash. It may also happen that a forced sale never yields the full value of a good and that the forced sale of illiquid assets yields less than the forced sale of liquid ones. In order to pay taxes when due, it is argued, farm assets may have to be sold even though they would fetch a higher price if they could be held out for sale longer. Another argument advanced for special estate tax treatment of farms is a claim that farm estates are inherently overvalued. The fair market value of farmland does not always reflect what it is worth in farming, according to this argument, but sometimes is determined by the value of the land in an alternative use. Speculation and outside investment in farmland overstate the true "worth" of a farm estate. The price of farmland will reflect development potential only if an alternative use is more attractive than farming. If the current and prospective highest and best use of land is in farming, it is doubtful that developers will seek it for another use. Land may be purchased in anticipation of future development, of course, but it is questionable whether such speculation has been an important cause of rising farmland values. |