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CHAPTER 4

CONSEQUENCES OF SPECIAL

ESTATE TAX PROVISIONS FOR FARM ESTATES

Despite congressional intent, special use valuation has not helped stop the decline of family farms in American agriculture. Farmers and their heirs continue to face pressures to expand their operations or to sell their land to other farmers who are expanding or to investors. Changes in estate tax valuation cannot alter the financial incentives and advances in farm technology that produce these pressures. Changes in the estate tax, however, can increase the incentive for a large farm to expand.

While electing special use valuation can reduce an estate's tax bill, the option appears to have other, undesirable consequences. The election may add to the administrative burdens of the IRS and estate executors and may force inheritors to deal with complex unanticipated statutory requirements. 1/ Furthermore, the possible estate tax savings may push up farmland prices, lessening opportunities for small farmers to establish or expand their operation.

While the Federal estate tax forces few farm estates onto the market, the tax burden on an estate can be sizeable. 2/ Farmers are becoming more aware of the taxes their estates may bear as they observe the value of their land increase. As a result, many farmers are paying more attention to their estate and financial plans. For many farmers, however, even a well prepared plan may not be sufficient to accomplish the property distribution they desire following their deaths.

SURVEY OF TAX PROVISIONS' EFFECT

In order to evaluate the contentions concerning the effects of Federal estate taxation on family farming, we conducted a survey of farm communities and farm estates that had used section 2032A valuation in filing Federal estate tax returns. 3/ (The survey methods are described in appendix II.) We addressed these questions during the survey:

1/ERTA should decrease the administrative burden on IRS associated with section 2032A. Increasing the unified credit and removing the marital deduction ceiling will eliminate many estates from the estate tax base, decreasing the number electing special use valuation.

2/The tax burden will be decreased by ERTA, however.

3/This survey was conducted before passage of ERTA.

1. Had the Federal estate tax so burdened farm families that they could not continue to operate their farms?

2.

Have sections 2032A and 6166 been instrumental in preventing forced sales of family farms?

3. What other effects, if any, have the two provisions had on family farming?

4. What has the cost of special use valuation been (measured by foregone tax revenues), and how have the benefits of the provision been distributed among different sized farms?

Although we did not document any sales forced by the Federal estate tax during our survey, over half of the inheritors believe that sections 2032A and 6166 were instrumental in avoiding the sale of some or all of their farm property. Of the 274 electing inheritors that we interviewed in the five target States, 47.6 percent said that they probably or definitely would not have been able to retain the farm without the special provisions. Slightly less than 40 percent of the inheritors, however, felt that they probably or definitely could have kept their shares of the inheritance without using the special provisions. However, because the electing heirs were not selected randomly, these findings may not be applicable to all farm inheritors.

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1/Figure does not include 0.7 percent who refused to respond.

We do not know how many of these inheritors would have been able to borrow money to pay the estate tax. Very few inheritors interviewed (21 percent) elected the section 6166 deferred and installment payment schedule.

Farmers may not effectively use available estate planning methods

Farmers may not be taking full advantage of estate planning devices that can reduce their estate taxes and ensure that their property is distributed in the manner they desire. Seventy-five

percent of the ASCS County Executive Directors who responded to our questionnaire felt that estate planning by farmers was inadequate. Only 10 percent felt that farmers paid sufficient attention to estate planning.

Eighty-four percent of the estate tax returns examined in our survey had wills attached, indicating that decedents made some effort to plan the disposition of their estates. We cannot say, however, if as large a fraction of farmers in the general population prepare wills because we selected our sample from returns containing apparently valid elections of special use valuation or deferral of estate tax payment and not from all farms.

The Contemporary Studies Project at the University of Iowa found some evidence that farmers' knowledge of estate planning may be limited. The attorneys they interviewed were almost evenly divided among three categories:

--those attorneys who believed that their clients were knowledgeable about estate planning,

--those who believed that their clients were not knowledgeable, and

--those who believed that their clients were becoming more
knowledgeable.

The opinions of the third group are unclear. We do not know if the attorneys believe that their clients are moving from poor to better understanding of estate planning or from a good to a superior understanding.

Several reasons may explain the farmers' lack of effective estate planning. To prepare an estate plan, including a will, a farmer must spend money now for a future event, and one that many persons find distasteful to contemplate. This spending competes with other claims on income that may seem more pressing, offer an immediate return, and be more appealing than confronting the prospect of death. Another possible reason for inadequate estate planning is that many farmers may not realize how wealthy they are. Property tax valuations may understate the fair market value of a farm, providing one possible source of confusion. Furthermore,

since the capital gains on farmland are not realized until the farm is sold, farmers may base their net worth estimate on current cash earnings or potential cash earnings from continued farming and disregard capital gains. 1/

1/The use of proper estate planning will allow couples to leave tax-free estates worth $1.2 million to heirs by 1987, as a result of changes to the unified credit and the marital deduction brought on by ERTA.

SPECIAL USE VALUATION MAY HAVE

UNINTENDED CONSEQUENCES

Special use valuation may create problems that were not anticipated at the time of the 1976 Act's passage. For example, while the Federal estate tax explicitly treats farm and nonfarm estates differently, it may also implicitly treat some farm estates differently from others.

Some farm estates may not benefit at

all from the provision. The different treatment of farmland in the estate tax may cause changes in the market for land, which may make it more difficult for a small farmer to purchase land.

Not all farm estates gain

from section 2032A

The special use valuation provision favors those who own land, not necessarily those who actively farm. As chapter 2 notes, a landowner's estate may qualify for special use valuation if the landowner or a qualified family member materially participated in the operation of the farm. The landowner did not have to be an active farmer (i.e., a farmer who is physically involved in farm operation)--assuming financial responsibility may help qualify the estate for special use valuation in some cases. 1/ The wealth of a so-called "contract" farmer, 2/ or "custom" farmer, however, may be concentrated in farm machinery and structures that are not eligible for special use. As appendix III notes, contract farming is common in many areas of the country.

Since special use valuation necessarily benefits only estates containing land, the provisions may promote greater concentration of farm wealth than would otherwise be the case. The qualified heirs of farmers who owned land receive the benefits of use valuation, giving them a substantial advantage over the heirs of contract or custom farmers whose bequests are mostly of assets other than land. Assisted by this tax advantage, farmland owners may be able to expand their holdings. Special use valuation thus may contribute to increased concentration of land ownership by decreasing the opportunities for contract or custom farmers and others with little or no land holdings to purchase farmland. Although section 2032A's effect on the concentration of farmland

1/Chapter 2 addresses the qualification requirements of section 2032A. Assuming financial responsibility for an operation is one of several tests for material participation in that operaation. Further, financial risk (i.e., ownership) in the farm operation is a necessary condition for proving that the estate was used in a "qualified use, as section 2032A requires. For a more complete explanation, see chapter 2 of this report or H.B. Hartley, "Final Regs. under 2032A: Who, what and how to qualify for special use valuation," Journal of Taxation, (November 1980), pp. 306-12.

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2/Contract farmers generally rent the lands they farm.

ownership cannot be gauged because too little time has passed since section 2032A was enacted, the effect sketched above is a plausible outcome. 1/

The risks and costs associated with electing special use valuation also affect farmers differently. The original delay in issuing IRS regulations to administer the section, the prospect of a lengthy audit and exposure to tax recapture, the placing of a tax lien on the inherited property, and the additional appraisals and high quality legal representation that the provision requires create risks and costs that a large farm can bear more easily than a small farm. 2/

Cash rent capitalization

The cash rental capitalization formula for special use valuation 3/ may also create inequities. Estates in regions where it is uncommon for farms to be rented for cash have more often been unable to use special use valuation than estates located elsewhere. While ERTA now permits use of crop share rental data and might seem to alleviate this inequity, the approach still entails several problems. First, while the crop share itself may be stable over time (i.e., neither the agreed shares nor the harvestable yield change during several years), the cash equivalent of the crop share will fluctuate substantially, depending on commodity prices. While land values rarely change dramatically over a short time, commodity prices may change very rapidly. Second, farmland owners and renters might be reluctant to disclose their exact share rental agreements to permit the special use value of another farm to be calculated. Third, a wide assortment of crop share arrangements could exist for a single property, making it difficult to compare rents among different properties. The renter's obligations could vary, for example, as could the owner's involvement in management decisions or the sharing of financial risk between renter and owner.

Cash rents, when available, generally do not share these drawbacks. First, cash rents do not vary with commodity prices and need not be converted to a cash equivalent. Second, although owners and renters may be as reluctant to disclose cash rental data as they are to disclose share rental data, cash rental data are already collected by the USDA. Even if these data do not re

1/The decreased estate taxes resulting from ERTA probably will affect this scenario, but too little time has passed to be sure of how it will do so.

2/For a discussion of farm size, see U.S. Department of Agriculture, A Time to Choose: Summary Report on the Structure of Agriculture, (Washington, D.C.: Government Printing Office, 1981), pp. 41-69.

3/Section 2032A(e)(7). See chapters 2 and 5 for explanation of this formula.

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