C. Issues Concerning Treasury Implementation On August 29, 1980, the Treasury published proposed regulations to adjust the interest rates imputed under sections 482 and 483 to more accurately reflect market interest rates. Under the proposed regulations, the safe haven rule for loans and advances under section 482 would consist of a range from 11 percent to 13 percent per annum simple interest. If the interest charge is within this range, that the rate actually charged is presumed to be at arm's length. If the rate actually charged does not fall within this range and the taxpayer does not establish a more appropriate rate (i.e., an arm's-length rate), the interest rate imputed under section 482 would be 12 percent per annum simple interest.2 The interest rate imputed under section 483 on the sale of property subject to deferred payments would be 10 percent compounded-semiannually. The test rate used to determine whether the imputed rate will be applied would be changed to 9 percent per annum simple interest. The notice of proposed rule making states that the difference between the interest rates under sections 482 and 483 is explained by the fact that the 10-percent rate in section 483 is absolutely binding whereas the range of interest rates in section 482 is only a safe harbor. Therefore, the Treasury decided that the proposed regulations should take a more lenient approach under section 483 than under section 482. In response to concerns raised by members of the Congress with respect to the proposed regulations, former Assistant Secretary of the Treasury Lubick agreed in a letter to Senator Melcher that no final action would be taken on the proposed regulations before July 1, 1981. The Treasury also announced, as part of the notice of proposed rulemaking, its intention to consider whether the interest rates under sections 482 and 483 should be adjusted automatically in the future. In addition to increasing concern over existing issues such as whether section 482 applies to intra-family transactions or whether section 483 should provide for an array of interest rates depending upon the kind of property sold or the seller's location, the notice raises several other issues. The first issue is whether the same interest rate should apply for purposes of both section 482 and section 483. The Treasury proposed differing rates and justified these on the grounds that section 482 may be avoided by proof that the rate actually used is more appropriate whereas section 483 may not be avoided in that manner. On the other hand, it is not clear that lending transactions subject to section 482 differ enough from those subject to section 483 to predict that in arm's Under another proposed rule, section 482 would not apply to loans or advances, when the interest or principal amount is expressed in a foreign currency. This proposed change was not addressed by the Subcommittee's hearing announcement and is not described in this pamphlet. (9) length transactions higher rates would be charged in section 482 transactions. If different rates are set, a second issue arises which is whether section 482, section 483, or both will apply in a transaction subject to both provisions. Existing regulations under section 482 provide that the treatment of unreleated taxpayers should govern related taxpayers. This implies that section 483 should apply. However, the section 483 regulations contemplate the application of other provisions in addition to section 483. An added difficulty arises from the fact that under section 482 a taxpayer may prove that a rate below the safe haven rate is appropriate but is not permitted to prove the appropriateness of a lower rate for section 483 purposes. How these various provisions might be applied probably would depend on the particular case in which the issue arose. For example, a transaction using a rate lower than the section 482 rate but higher than the section 483 rate would be more likely to survive scrutiny under section 482 than one in which no interest is charged. A third issue raised by the Treasury in the notice of proposed rulemaking is whether some system for automatically adjusting interest rates under sections 482 and 483 should be adopted. The Treasury has the authority to adopt such a system without additional legislation. Related to this issue are the questions of how closely interest rates under sections 482 and 483 should reflect market rates of interest charged with respect to such instruments as mortgages, Treasury bills, and corporate bonds. In 1965, when the first regulations under section 483 were issued, the test rate was set at 4 percent and the imputed rate at 5 percent. At that time, the prime rate was approximately 42 percent, mortgage rates were approximately 52 percent, and government and corporate bond rates were approximately 42 percent. In 1975, when the rates were last adjusted, the test rate was set at 6 percent and the imputed rate was set at 7 percent. At that time, the prime rate was at 7% percent and corporate bonds were yielding 82 to 9 percent. II. CURRENT USE VALUATION (SECTION 2032A) A. Legislative History and Background In the case of decedents dying before January 1, 1977, the value of all property included in the gross estate, for purposes of determining the Federal estate tax, was the fair market value of the property interest at the date of the decedent's death (or at the alternate valuation date, if elected). The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of property will depend upon the use to which it is, or may be, put. If the fair market value of real property is subject to dispute, there are several valuation techniques which the courts tend to accept. These methods include the income-capitalization technique, the reproductioncost-minus-depreciation technique, and the comparative sales technique. Courts generally will use one of these methods, or a combination of these methods, in determining fair market value. However, in the case of land, it is presumed that the price between a willing buyer and a willing seller will be based on the "highest and best use" to which that land could be put, rather than the current use of the land at the time it is transferred. As part of the Tax Reform Act of 1976, Congress enacted a new section (sec. 2032A) that permits an executor to elect to value real property on the basis of the property's value as a farm or in a closelyheld business 1 rather than on the basis of its highest and best use. This election is available to estates of decedents dying after December 31, 1976. The legislative history of the Tax Reform Act of 1976 stated that the Congress believed that, when land is actually used for farming purposes or in other closely-held businesses (both before and after the decedent's death), it is inappropriate to value the land on the basis of its full fair market value since it is desirable to encourage the continued use of property for farming and other small business purposes. In some cases, the greater estate tax burden from valuing property at its highest and best use could make continuation of farming, or the closely-held business activities, infeasible because the income potential from these activities is insufficient to service extended tax payments or loans obtained to pay the tax. Thus, the heirs may be forced to sell 1 While the special valuation method provided by section 2032A is generally referred to in this pamphlet as "current use valuation method", it should be noted that, where the formula method (discussed below) is available, the value of real property under section 2032A may be (and often is) less than the current use value of the real estate. (11) the land for development purposes. Also, when the valuation of land reflects speculation to such a degree that the price of the land does not bear a reasonable relationship to its current earning capacity, the Congress believed it unreasonable to require that this "speculative value" be included in an estate with respect to land devoted to farming or closely-held businesses. To date, the current use valuation provision has been used almost exclusively for the valuation of real estate used in the trade or business of farming. When estates are eligible for current use valuation, the benefits have been substantial. Table 1, below, sets forth the results of a survey by the Internal Revenue Service indicating the average reduction in value (i.e., average discount) for farms eligible for current use valuation. TABLE 1.-PERCENTAGE REDUCTION IN VALUATION OF FARM LAND UNDER CURRENT USE VALUATION IN DIFFERENT IRS REGIONS Des Moines, Iowa-- Southwest Region Albuquerque, New Mexico-‒‒‒ Dallas, Texas.. Cheyenne, Wyoming Denver, Colorado___ Little Rock, Arkansas- New Orleans, Louisiana. Southeast Region Greensboro, North Carolina___ Atlanta, Georgia___ Central Region Columbia, South Carolina....... 57 San Francisco, California_. 40 Source: Treasury Department testimony of March 4, 1980, before the Subcommittee on Taxation and Debt Management of the Senate Finance Committee, based on IRS survey of November 1979 showing reduction in fair market value of property (as reported by executors) resulting from election of current use valuation. 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). 3 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; 2 (4) the real property qualifying for current use valuation must pass to a qualified heir; (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 non family 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. 3 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) |