farm and those comparable to it by using crop yields or yield ability based on soils. 1/

Under ERTA a farm estate may be valued under the formula method by using net crop share rentals rather than cash rentals. However, a tax attorney representing the Illinois Bar Association testified before the Subcommittee on Taxation and Debt Management that the present form of the proposed bills might still deny special use valuation to many farmers. 2/ He said that IRS' first set of proposed regulations required crop share information that could only be obtained by inspecting the private income tax returns and records of a neighboring farmer. He said it would generally be impossible to persuade a neighboring farmer to divulge this information or to find an appraiser who would attempt to obtain it. This tax attorney proposed that in cases where there are no comparable farms rented on a cash basis in the 10cality, the executor should be permitted to determine crop share rental based upon areawide averages of net crop share rental for farms of comparable soil quality. 3/ Under ERTA and prior law the farm estate is to be valued using the multiple factor method when no comparable land is available from which a cash or share rental can be determined.

An article by two Iowa State University agricultural economists points out that converting crop shares to a cash rent equivalent would raise several questions regarding price, yield, and costs. First, what price should be used? The price for the crop or crops could be the actual price received, harvest time price, or some average market price. Using actual price may cause problems because the crop may have been stored and not sold, and land values might be based on marketing decisions rather than land productivity. Second, what yield should be used? Yield could be based on actual yields, average county yields, or long-term average yields. Third, how are costs accounted for in the computation?

1/J.H. Atkinson, "Estimating Cash Rental Rates for Indiana Farmland," in "Use Valuation of Farmland for Estate Purposes in Indiana: I.R.C. Section 2032A (e) (7)-(8)," by Gerald A. Harrison in Proceedings of Symposium on Farm Estate Issues Raised by the Tax Reform Act of 1976, U.S. Department of Agriculture, FSCS-73, (Washington, D.C., 1979), pp. 40-42.

2/Robert M. Bellatti, U.S., Congress, Senate Committee on Finance, Miscellaneous Tax Bill V, hearings before the Subcommittee on Taxation and Debt Management, March 4, 1980, pp. 386-387.

3/Farmland tenancy or rental is common in many parts States. Someone other than the owner operates the the use of leasing arrangements or a farm manager.

of the United land through Three major

Various procedures are used to handle harvesting, drying, storage, and depreciation costs. 1/

Five or multiple factor method

The alternative to the formula method--the five or multiple factor method--merely increases the uncertainty in farm valuation. The factors are:

--capitalizing income over a reasonable period of time under prudent management using traditional cropping patterns for the area,

--capitalizing the fair rental values of farmland,

--assessed land values in a State that provides a differential or use-value assessment law for farmland,

--comparing selling prices for other farms in the same geographical area far enough removed from a metropolitan or resort area so that nonagricultural use is not a significant factor in the sales price, and

--any other factor that fairly values the farm.

Besides the ambiguity and uncertainty created by the last factor, confusion is increased because no weights are assigned to the various factors, and there is no guidance on which factor will be used to resolve conflicting values. The two capitalization formulas, expected income and fair rental values of the land, leave open the question of what capitalization rate is appropriate.

types of farm leases are recognized: the crop share, the livestock share, and the cash lease. The landowner's involvement and participation in the farm business is greatly different under these lease types. Under the crop share lease the landowner receives a share of the crops, usually one-third, twofifths, or one-half of the gross rent share. The landowner generally shares proportionately in seed, fertilizer, and other expenses. It is a useful method whereby two or more persons or families (the tenant, landowners, or investors) share the cost of land, labor, capital, and management in organizing and operating the farm business. Generally the livestock share landlord shares equally with the tenant all farm income and most variable costs and is a virtual partner. Under the cash lease the rent is usually a fixed number of dollars with no participation in operating costs by the landowner.

1/Michael D. Boehlje and Neil E. Harl, "Use Valuation Under the 1976 Tax Reform Act: Problems and Implications," in Symposium on Farm Estate Issues, pp. 9-10.

A witness testifying before the Subcommittee on Taxation and Debt Management of the Senate Finance Committee said that this five factor formula does not appear to be either beneficial or workable in the case of the average family farm. He maintained that for all practical purposes special use valuation is not available to a family farm unless it can be valued under the mathematical formula. 1/

One IRS group manager stated that the IRS favors the comparable sales factor because they more clearly reflect the value of the farm as farmland. According to the IRS manager, farmers and ranchers, as well as attorneys and accountants, resist this approach since in many cases it produces the same result as fair market value. Furthermore, farming is often the highest and best use of land in a farming area, so any element of speculation relates to agricultural value, not development potential. Under these circumstances, the five or multiple factor method would not provide any tax relief to inheritors of a farm.

Qualifying property other than land

Another problem with valuation involves qualifying property other than land. As noted in chapter 2, qualifying property includes the farmhouse or other residential buildings and related improvements located on the farm if the buildings are occupied on a regular basis by the owner, a lessee, or employees to operate or maintain the farm. Although such property qualifies for special use valuation, the law contains no explanation of how to value these improvements.

Meeting material participation requirements

One of the most important requirements in section 2032A is that of material participation, both before and after the decedent's death. The Congress scarcely explained, however, what material participation should be taken to mean. The only reference to the matter appeared in a publication by the Joint Committee on Taxation:

whether there has been material participation by an
individual in the operation of a farm or closely held
business is to be determined in a manner similar to the
manner in which material participation is determined
for the purposes of the tax on self-employment income
with respect to the production of agricultural or hor-
ticultural commodities under present law. 2/

1/Robert M. Bellatti, Miscellaneous Tax Bills V, p. 386. 2/H.R. 10612, p. 538.

The Congress noted that if, for example, the decedent had owned real property that was leased to a partnership for use as a farm in which he or she and two children each had a one-third interest in profits and capital, the real property could qualify for special use valuation. However, if the property is used in a trade or business in which neither the decedent nor a member of the family materially participated, the property would not qualify. 1/ Apparently special use was not to be available to nonoperating farm investors or to anyone not actively engaged in farming. While it is clear that the Congress wanted the decedent or the heir to be active in farming, it is unclear how active or in what manner. 2/ The IRS guidelines for material participation are found in Revenue Ruling 57-58 and the final regulations that contain several examples of material participation. Since the ruling states that each case must be decided on its own facts, material participation remains undefined. More concrete examples are given by IRS in the Farmers Tax Guide, which states that a farmer has materially participated in the operation of a farm if any of the following are done:

Test One. The farmer does any three of the following: (1)
advance-pays or stands good for at least half the direct
costs of producing the crop; (2) furnishes at least half
the tools, equipment, and livestock used in producing the
crop; (3) advises and consults with his tenant periodically;
and (4) inspects the production activities periodically.

Test Two. The farmer regularly and frequently makes, or takes an important part in making, management decisions substantially contributing to or affecting the success of the enterprise.

Test Three. The farmer works 100 hours or more, spread
over a period of 5 weeks or more, in activities connected
with producing the crop.

Test Four. The farmer does things which, considered in their total effect, show that he is materially and significantly involved in the production of the farm commodities.

Only the third test really provides definitive limits to remove subjectivity in measuring material participation. The other three tests still leave material participation to be administratively

1/U.S., Congress, House, Joint Committee on Taxation, H. Rept. 94-1380, 94th Cong., 2d Sess., August 2, 1976, p. 23.

2/ERTA contains a number of changes that ease material participation requirements for special use valuation, particularly relating to active participation and 8-year periods that precede and succeed the death of the decedent.

determined and create uncertainty in estate planning. Also, under these guidelines, it is possible for non-operating investors to qualify for special use valuation either by crop sharing or the hiring of farm managers, a result seemingly contrary to congressional intent. 1/

These guidelines provide general rules to landowner's participation when leasing farmland on a crop share or cash rent basis. When the landowner conducts the farming activities, proving material participation is no problem. The material participation issue becomes relevant under a lease arrangement because the landowner is no longer the operator and receives income in the form of a rental. In a leasing arrangement it is very important for participation purposes that the landowners or qualified members of their families actually participate to a material degree in the farming operation.

A recent article in the Brigham Young University Law Review points out two problems with the postmortem material participation rules. 2/ One complication arises during the 8-year periods that precede and succeed the death of the decedent. The persons whose activities must satisfy the material participation requirements are the decedents or their family members prior to the decedents' deaths and the qualified heirs or their family members subsequent to the decedents' deaths. This shifting of reference points for material participation may prove to be a problem for the unwary not familiar with the provision's complexities. For example, the requisite material participation prior to the decedent's death can be supplied by the decedent's first cousin, but if land passes to the decedent's son or daughter (the qualified heir) the tax savings under section 2032A will be recaptured unless the necessary participation is furnished by a member of the son's or daughter's family, which does not include the decedent's first cousin. In this example the provisions may disrupt continuity in operation of the decedent's farmland. In order to avoid recapture the heir or a member of his or her family is forced to assume a material degree of participation and the decedent's first cousin will probably be forced to quit using the land. 3/

Another problem of the postmortem participation rule is illustrated by the qualified heir's ability to obtain interestfree deferral of estate tax payment in which the decedent has continuous material participation and ownership during the 5

1/Internal Revenue Service, Farmers Tax Guide, and Social Security Regulations, sections 1224-1233.

2/"The Family Farm and Use Valuation," pp. 406-7.

3/A crop share lease arrangement could be developed that meets the material participation requirements and allows the first cousin to still farm the land. The definition of family member is expanded by ERTA to include lineal descendants of the surviving spouse who are not descendants of the decedent.