A lower discount rate means higher estate values, however, and for this reason the proposal faces strong opposition. The current discount rate reflects (as best as any one rate can) the costs that farmers face in borrowing. In a sense, the price that a farmer is willing to pay to borrow reflects the value placed on continuing to operate the farm. The rate may also reflect some of the risk associated with farming. Selecting an "appropriate" or "proper" discount rate is always a difficult process that requires some subjective assessment of preferences for short- and long-term returns, of the risk that a future stream of income will not continue, and of expected inflation. In this case, no reasons exist for preferring either the current 5-year average loan rate or, as Treasury proposed, the estimated return on equity. The discount rate under current law has been around 9 percent since the 1976 law became effective, while the Treasury estimated the return on equity to be 4 percent. The choice between these two rates, or between these and other alternatives, rests on the policy goals of special use valuation and the size of the estate tax revenue loss that results from different discount rates. Treasury's proposal, for instance, would reduce the capitalization rate for special use value by about half and reduce the revenue losses. How much revenues would increase is difficult to predict. POOR PROGRAM DESIGN OR EADLY PHRASED LEGISLATION? The operating farmer must be aware of the restrictions in the law that are designed to exclude nonfarm investors. The qualification criteria in section 2032A are supposed to restrict special use valuation savings to active farmers whose estates consist primarily of farm assets. Sections 6166, 6166A, and 2032A do not definitely distinguish between nonfarm investors and bona fide operating farmers. 1/ Problems arise because the Code (1) contains an imprecise definition of active farmers, (2) excludes some estates of active farmers from the benefits of section 6166 when they elect special use valuation, and (3) does not contain a liquidity test. Liquidity and percentage eligibility requirements The full-time owner-operator of a family farm, which includes a large amount of real property devoted to farming, can generally satisfy the requirements of section 2032A with no estate planning. A business that includes a moderate amount of farmland with a wide difference between its fair market value and special use values can also readily meet the 50 and 25 percentage requirements of section 2032A by using estate planning techniques and qualify for special use valuation. Whether a decedent's estate meets the 1/ERTA repealed section 6166A. percentage requirements or not tells nothing, however, about its liquidity. SIMILAR PROVISIONS HAVE DISSIMILAR REQUIREMENTS Section 6166A, which permits estate taxes to be paid by installments over 10 years, was in the Code long before the Tax Reform Act of 1976 was passed. The 1976 Act added the provision for a more favorable 4 percent interest rate and payment-extension and deferral that are found in the new section 6166. In order to qualify for the estate tax deferral under new section 6166, not only must an estate include an interest amounting to at least 20 percent by value of a closely-held business, including a farm or a ranch, but also the value of the interest must amount to at least 65 percent of the adjusted gross estate. The requirement under new section 6166 is a strict 65 percent test that features a more liberal installment payment of estate tax with a much lower rate of interest than under the older provision, which has been retained and redesignated as section 6166A. The test for section 6166A was left at 35 percent. For an estate to qualify for an estate tax deferral under section 6166A, it must include an interest that exceeds only 35 percent of the value of the gross estate or 50 percent of the taxable estate. It is unclear why a new section 6166 was added instead of using and merging the best features of the old and the new sections. 1/ It has been reported that estates that qualify for the privilege of paying their taxes over a 15 year period have encountered problems with earlier Revenue Rulings used to determine qualification under section 6166A, the 10-year installment payment. 2/ Some IRS districts contend that Revenue Rulings, which preceded the 1976 Tax Reform Act, are applicable to new section 6166. "Section 6166 allows an executor to elect to extend payment of part or all of the portion of the estate tax which is attributable to a closely-held business interest (as defined in section 6166 (b)(1))." 37 Some sole proprietors have had difficulty meeting the trade or business requirement in section 6166(b) (1) stemming from the earlier Revenue Rulings when the farm is leased by a sole proprietor. For a farmer to qualify, some IRS districts contend that qualification requirements are as rigorous as those for section 2032A material participation. At the IRS national level, the interpretation has been that a farmer who is a sole 1/ERTA consolidated the most liberal provisions of sections 6166 and 6166A. Section 6166A has been repealed and section 6166 was expanded to cover all estates in which the value of an interest in a closely-held business exceeds 35 percent of the value of the adjusted gross estate. 2/Revenue Rulings 75-365, 75-366 and 75-367. For additional discussion of this matter see chapter 6. 3/IRS Regulations Section 20.6166-1(a). proprietor and rents the land must be engaged in an active THE DIFFICULTIES THE PERCENTAGE RESTRICTIONS Executors electing special use valuation can choose among three provisions for deferring the payment of estate tax and then paying it by installment. 1/ The executor's choice depends on how large a percentage of the adjusted gross estate is composed of farm property. The requirements of these provisions that must be satisfied differ from those for special use valuation. If special use valuation is elected, the reduced value of real property must be used in calculating whether an estate meets the 65 percent test of a section 6166 deferral or the 35 percent test of a section 6166A deferral. The qualification requirements for special use valuation include the 50 percent and 25 percent tests. The restriction that at least 50 percent of the adjusted value of the decedent's gross estate must consist of the adjusted value of real and personal property that is used in farming attempts to address the farm liquidity problem. The reduction in the value of a farm business due to the election of special use valuation may prevent a farm estate from qualifying for the privilege of paying taxes by installments because the reduced value of the decedent's interest in the business is less than 65 percent of the adjusted gross estate. An election under 6166A for installment payment of estate taxes may be disallowed if special use valuation reduces the value of the decedent's interest in the business below 35 percent of the adjusted gross estate or 50 percent of the taxable estate. It was reported that the reason for adding section 6166 in 1976 was that 6166A had been inadequate to deal with the liquidity problems faced by estates in which a substantial portion of the assets consisted of an interest in a closely-held business or other illiquid assets. It appears that the stricter 65 percent test excludes nonfarm investors from the benefits of the more liberal provision; however, the interaction with section 2032A may also cause bona fide farmers to lose the section 6166 benefits. 1/Under section 6161, the IRS may extend the time for payment of the tax for a period not to exceed 12 months. The extension will be granted on a reasonable cause basis. CHAPTER 6 PROBLEMS ARISING FROM THE LAW UNRESOLVED PROBLEMS AFFECT EXECUTION Executing sections 2032A and 6166 has not been easy or entirely successful. Certain problems relating to valuation methods, material participation, and liens prohibit some and discourage others from receiving benefits of the law. Although the provisions were enacted in January 1977, final regulations were only issued in July 1980. The complexity of the provisions and lack of final IRS regulations for the past several years has not only created confusion and controversy but also increased the workload on IRS and added a burden on the people wanting to use the provisions. Valuation methods contribute to uncertainty Section 2032A provides two approaches for valuing farmland: the more attractive formula or farm method and the five or multiple factor method. Although the Congress intended that executors should be able to value farmland with reasonable certainty, subjectivity is still present in the calculations. The two ap proaches and a "catch-all" factor included in the multiple factor method contribute to the uncertainty in farm valuation. that: Formula method In discussions of section 2032A(e) (7) the Congress stated The special farm valuation method is provided to permit 1/H.R. 10612, p. 540. The According to IRS regulations, once the executor of an estate has elected to use section 2032A the values of farmland eligible for the special valuation are determined by the formula or socalled "farm" method, unless the executor elects otherwise. formula method sets the value of the land equal to the average annual cash rental for comparable farmland (net of State and local real estate taxes) divided by the average annual effective interest rate for all new Federal Land Bank loans. Average annual rent and interest rate is the average of these quantities over the five most recent calender years before the decedent's death. This formula appears to simplify the calculations, but considerable controversy remains regarding comparability, crop share agreements, real estate taxes, and interest rates. For example, the cash rent depends on the meaning of the terms "comparable" and "locality," neither of which is defined in the statute. Where is comparable land to be located? In the same county, adjacent counties, throughout the State, or in adjacent States? What constitutes comparable land? Must it be identical in all respects--acreage, crops, soil composition, water availability, and yields? The statue gives no answers. IRS regulations specify factors to be considered in determining comparability, but the factors are still subjective. An unreasonable, narrow definition of comparability and locality would greatly limit the number of estates using the formula method. Representatives of the legal and accounting profession told us that IRS' interpretation of comparable cash rental is too strict and often requires identifying identical land tracts. The requirements that rentals must be cash rentals means that in-kind rental or crop sharing agreements are excluded. In 1978, the proposed IRS regulations provided that where no comparable real property is leased solely on a cash basis, crop shares could be used for determining cash rental value. However, its final regulations provided that crop share rentals may not be converted to cash rentals and used in the formula method. This denies the formula method to a major portion of the Nation where crop share agreements predominate and cash rentals are rare. Attorneys and appraisers find it difficult to find comparable cash-rented land. In addition, many farmers who rent their land for cash are reluctant to disclose the rent they charge. One agricultural economist from Purdue University describes cash rentals as being difficult to obtain on an individual farm or county basis; however, USDA publishes State average rents annually, and estimates are available for some crop reporting districts. The economist proposed that the USDA estimates be used to estimate the cash rent of a given |