In general

B. Present Law

If certain requirements are met, present law allows family farms and real property used in a closely-held business to be included in a decedent's gross estate at current use value, rather than full fair market value, provided that the gross estate may not be reduced more than $500,000 (sec. 2032A).

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An estate may qualify for current use valuation if: (1) the decedent was a citizen or resident of the United States at his death; (2) the value of the farm or closely-held business assets in the decedent's estate, including both real and personal property (but reduced by debts attributable to the real and personal property), is at least 50 percent of the decedent's gross estate (reduced by debts and expenses); (3) at least 25 percent of the adjusted value of the gross estate is qualified farm or closely-held business real property; (4) the real property qualifying for current use valuation must pass to a qualified heir;3 (5) such real property must have been owned by the decedent or a member of his family and used or held for use as a farm or closely-held business ("a qualified use") for 5 of the last 8 years prior to the decedent's death; and (6) there must have been material participation in the operation of the farm or closely-held business by the decedent or a member of his family in 5 years out of the 8 years immediately preceding the decedent's death (secs. 2032A (a) and (b)).* If, within 15 years after the death of the decedent (but before the death of the qualified heir), the property is disposed of to nonfamily members or ceases to be used for farming or other closely-held business purposes, all or a portion of the Federal estate tax benefits obtained by virtue of the reduced valuation will be recaptured by means of a special "additional estate tax" imposed on the qualified heir.

Requirement that farm must "pass" to qualified heir

Under the fourth requirement, above, the real property must have been acquired from or passed from the decedent to a qualified heir. Section 2032A (e) (9) provides that the real estate is considered to pass

2 For purposes of the 50 percent and 25 percent tests, the value of property is determined without regard to its current use value.

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The term "qualified heir" means a member of the decedent's family, including his spouse, lineal descendants, parents, and aunts or uncles of the decedent and their descendants.

In the case of qualifying real property where the material participation requirement is satisfied, the real property which qualifies for current use valuation includes the farmhouse, or other residential buildings, and related improvements located on qualifying real property if such buildings are occupied on a regular basis by the owner or lessee of the real property (or by employees of the owner or lessee) for the purpose of operating or maintaining the real property or the business conducted on the property. Qualified real property also includes roads, buildings, and other structures and improvements functionally related to the qualified

use.

(13)

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to a qualified heir when the property receives a stepped-up basis under present law (sec. 1014 (b)). Under these rules, property which is purchased from a decedent's estate is not considered to have passed from the decedent to a qualified heir and is not eligible for current use valuation.

The legislative history of the 1976 Act stated that property passing in trust is considered to pass to a qualifled heir to the extent that the heir receives a present interest in the trust." The Treasury Department has interpreted this requirement to provide that, unless a qualified heir receives a present interest and that interest is specially valued, no other interests in the same property are eligible for current use valuation (Treas. Reg. 20.2032A-3(b)). In addition, the Treasury regulations define the term "present interest" by reference to the gift tax definition of that term under section 2503 (Treas. Reg. § 20.2032A-3 (b) (1)). That definition is used to determine whether a $3,000 per donee annual exclusion from gift tax is available. Under this definition, trust interests which are subject to the trustee's discretion are not present interests. This is true even if all such interests belong to qualified heirs.

Requirement that property must be used for a qualified use

Under the fifth requirement, above, current use valuation is available only for real property that is used in a qualified use. A qualified use is a use as a farm for farming purposes or in a trade or business other than the trade or business of farming (secs. 2032A (b) (2), (3) and (4) and 2032A (e) (5). Although the Code requires that the property be used in a trade or business, it does not indicate who must be engaged in that trade or business. The Treasury regulations interpret the trade or business requirement to mean that the decedent-owner (rather than the family member that materially participates in the operation of the trade or business) must be engaged in the trade or business. (Treas. Reg. § 20.2032A-3(b)). This interpretation is supported by statements in the legislative history that current use valuation was not intended to be available for a use that was a "mere passive rental." "

General tax principles require that a person have an equity interest in a trade or business for that person to be considered engaged in that trade or business, and the Treasury regulations so require. Subsequent IRS rulings define an equity interest as an arrangement under which the owner's return on the land is contingent on farm production. Under this interpretation, current use valuation would not be available when the decedent leased the farmland on a net cash lease basis. This would be true regardless of whether the cash lease was to immediate family members, distant relatives, or third parties. Material participation requirement

Under the sixth requirement above, current use valuation is available for real property only when the decedent or a member of his family materially participated in the operation of a farm or other trade or business in connection with that real property. The term "material

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participation" is defined in section 2032A (e) (6) by reference to the tax on self-employment income (sec. 1402(a)). Under the self-employment income tax rules, the determination of whether material participation occurs is based on the facts of each case. Material participation does require assumption of a role in the business operation by the participant, even though relatively little activity is necessary to satisfy the test.

The adoption by the Code of the material participation test for determining eligibility for current use valuation interacts with the social security laws. Under the social security laws, eligible benefits are reduced when the individual has earned income in excess of a specified amount. The social security laws also use the material participation test to determine whether income is earned (and, thus, reduces benefits) or is passive. Thus, if an individual engages in sufficient activity to meet the material participation test in order to qualify for current use valuation, the income he derives from the trade or business would be considered earned and might reduce the amount of his social security benefits.

Determination of current use value

Under present law, the current use value of eligible real estate can be determined under either of two methods: (1) the multiple factor method or (2) the formula method.

Multiple factor method. The current use value of all qualified real property may be determined under the multiple factor method (sec. 2032A (e) (8)). The multiple factor method takes into account factors normally used in the valuation of real estate (for example, comparable sales) and any other factors that fairly value the property.

Formula method.-If there is comparable land from which the average annual gross cash rental may be determined, then farm property may also be valued under the formula method (sec. 2032A (e) (7) (A)). Under the formula method, the value of qualified farm property is determined by (1) subtracting the average annual State and local real estate taxes for the comparable land from the average annual gross cash rental for comparable land used for farming, and (2) dividing that amount by the average annual effective interest for all new Federal Land Bank loans."

If the formula method is used, the Treasury regulations require that the executor document the actual tracts of cash-rented land upon which he relies. (Treas. Reg. § 20.2032A-4(b) (2) (1)). The Treasury Regulations provide that comparability has the meaning generally ascribed to it under real property valuation rules (Treas. Reg. § 20.2032A-4(d)). Thus, the determination of properties which are comparable is a factual one that must be based on numerous factors, no one of which is determinative. The Treasury regulations then provide that it frequently will be necessary to value farm property in segments where there are different uses or land characteristics included in the specially valued farm. For example, if the formula

'Each average annual computation must be made on the basis of the five most recent calendar years ending before the decedent's death.

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valuation method is used, rented property on which comparable buildings or improvements are located must be identified for specially valued property on which buildings or other real property improvements are located.

In cases involving areas of multiple land characteristics, actual comparable property for each segment must be used, and the rentals and taxes from all such properties combined (using generally accepted real property valuation rules) for use in the formula method given in this section. However, any premium or discount resulting from the presence of multiple uses or other characteristics in one farm is also to be reflected. All factors generally considered in real estate valuation are to be considered in determining comparability under section 2032A. The Treasury regulations provide the following list of factors to be considered in determining comparability

(1) similarity of soil as determined by any objective means, including an official soil survey reflected in a soil productivity index;

(2) whether the crops grown are such as would deplete the soil in a similar manner;

(3) the types of soil conservation techniques that have been practiced on the two properties;

(4) whether the two properties are subject to flooding;

(5) the slope of the land;

(6) in the case of livestock operations, the carrying capacity of the land;

(7) if the land is timbered, whether the timber is comparable to that on the subject property;

(8) whether the property as a whole is unified or whether it is segmented, and where segmented, the availability of the means necessary for movement among the different segments;

(9) the number, types, and conditions of all buildings and other fixed improvements located on the properties and their location as it affects efficient management and use of property and value per se; and

(10) availability of, and type of, transportation facilities in terms of costs and of proximity of the properties to local markets. The Treasury regulations provide that crop share rentals may not be used under the formula method. Consequently, under the regulations, if no comparable land in the same locality is rented solely for cash, the formula method may not be used and the qualified farm property may be valued only by the multiple factor method.

C. Issues Involving Treasury Implementation

Several issues have arisen in the Treasury implementation of section 2032A. Among these are the following:

(1) Whether the definition of "present interest" contained in the Treasury regulations is a proper interpretation of the law.

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(2) Whether the Treasury Department's definition of "qualified use" correctly implements the law when applied to cash leases by the decedent to family members.8

(3) Whether the Treasury is justified in interpreting the formula valuation method so as to disallow the use of cash equivalents for crop share rentals.9

(4) Whether the standards set forth in the Treasury regulations for determining when land is comparable provide adequate guidance or are too burdensome administratively.

8 This issue is addressed in several bills introduced in the Senate during this Congress. See, S. 392 (sponsored by Senator Riegle and Senator Eagleton), S. 395 (sponsored by Senator Wallop and 29 others), and S. 612 (sponsored by Senator Boschwitz and 9 others). Additionally S.J. Res. 204, passed in December 1980, initially would have prohibited the Internal Revenue Service from enforcing its regulation in respect of cash leases to family members. This prohibition was deleted from the final version of the resolution.

'S. 23 (sponsored by Senator Dole and 2 others), S. 392, and S. 395 would allow use of net crop share rentals in the formula.