We’ve all heard the term, “don’t bet the farm,” which warns against risking everything you own on something. Farmers and ranchers who neglect to put a proper estate plan in place should take this advice literally, as their heirs may well have to sell the family’s sole income producing asset–in effect “betting the farm”–in order to pay inheritance taxes. Fortunately, there are estate-planning solutions that can prevent this undesirable outcome. Farmers and ranchers seeking a sound estate plan can utilize certain techniques that take advantage of the historically high gift tax exclusion and historically low interest rates to avoid estate taxes. These strategies might also provide benefits in the form of creditor protection and family harmony. Farmers and ranchers who are not inclined toward sophisticated tax planning can also take advantage of life insurance as a palatable alternative for dealing with estate tax exposure.
The techniques I am referring to are:
- Family Limited Partnerships
- Grantor Retained Annuity Trusts (GRATs) and
- Sales to a Grantor Trust
When properly implemented, these are not aggressive or risky strategies; they are legitimate approaches to reducing or eliminating estate taxes. In fact, they are such good approaches that each of these ideas is currently under scrutiny by the Administration and various members of Congress, as mounting deficits create pressure to find additional sources of revenue. The threat of losing these strategies means that farmers and ranchers should take advantage of them now, while they are still available.
The gift tax
Let’s begin our discussion of the above techniques with the understanding that if your clients want to save estate taxes, they must be willing to give something away. Although individuals can gift significant amounts of property tax free through utilization of their gift tax annual and applicable exclusions, the bulk of gift and estate tax savings result from gifting at a discount. Restructuring how property is owned before it’s given away can entitle the donor to discounts on the value of their gifts for lack of marketability and lack of control. These discounts relate to the fact that a non-family member would not pay full price to purchase an interest in a family business in which they would not have a controlling interest and for which there would not be a ready resale market. The significance of such discounts is that they enable the donor to leverage or increase the amount of property they give away gift tax-free, using their gift tax annual and applicable exclusions.
Family Limited Partnerships
Assume that a couple would like to transfer a farming operation worth $20,000,000 to their three children. If the parents formed a family partnership in 2013 and transferred the farm to the partnership in return for partnership interests, they could gift those interests to the children using their gift tax annual and applicable exclusions. However, without discounts, the parents could only transfer $10,584,000 gift tax-free. (Their $10,500,000 combined applicable exclusions plus $84,000 of combined annual exclusions.) On the other hand, assuming a 35 percent discount on the gifts for lack of marketability and lack of control, the parents could transfer $16,283,076 of partnership interests to the children gift tax-free. This means that through the partnership structure, the parents could transfer an additional $5,699,076 gift tax-free using the same gift tax annual and applicable exclusions. In subsequent years, the parents could continue using their annual exclusions to make gifts of their remaining partnership interests until all of the partnership interests are transferred to the children.
Grantor Retained Annuity Trust
A GRAT is an irrevocable trust to which the donor transfers property in return for an income interest paid by the trust for a period of years. At the end of the income period, the trust may terminate and the remainder of the interest is then transferred to family members. That remainder interest is deemed to be a gift at the time the trust is set up and is valued using government discount rates. This means that if the property donated to the trust produces a rate of return in excess of the government discount rates, the remainder interest is undervalued for gift tax purposes. Farmers or ranchers looking to transfer their operation to the next generation at minimal gift tax consequences, while still retaining an income interest, should consider a GRAT.
Sale to a Grantor Trust
Besides giving their operation to the next generation, a farmer or rancher can sell it to a grantor trust for their benefit. This involves establishing an irrevocable trust with certain provisions that cause the trust’s income tax consequences to be reported to the farmer or rancher. The farmer or rancher then seeds the trust with a gift of income producing property that is offset by their $5.25 million gift tax applicable exclusion. Then the owner sells the farm or ranch to the trust for an installment note. The rule of thumb is that for every dollar gifted to the trust, the farmer or rancher can sell $10 worth of property to the trust because a 10-to-1 ratio gives the Internal Revenue Service confidence that the trust will have sufficient assets to pay off the installment note. Otherwise, the IRS might take the position that the trust is not adequately funded to pay off the note and treat the transaction as a gift, rather than a sale, with attendant gift tax consequences. The trust uses the income from the gifted property and the farm or ranch to pay off the installment note. Since the sale is to a grantor trust, the farmer or rancher recognizes no taxable gain on it.
The Palatable Alternative
The ideas discussed above are both legitimate and effective, however, they share a feature that’s common to all estate tax saving concepts: they require the client to change how they own or manage their property in order to make large estate reducing gifts. The problem with this requirement is that, as clients get older, they often don’t like change and may be resistant to taking such advice, despite the potential estate tax savings. In such cases, professional advisors need an alternative solution to dealing with potential estate tax liability that does not upset their clients’ lives. Life insurance is often the perfect solution because it does not require clients to change their lives or make large gifts. Rather, for a relatively moderate sum, they can have their lawyer draft an irrevocable life insurance trust that authorizes the trustee to purchase coverage on their lives. To fund that purchase, the clients make affordable gifts to the trust that the trustee uses to buy the life insurance in an amount sufficient to provide the needed estate tax liquidity.
Farmers and ranchers must devise estate-planning strategies that satisfy both their short-term needs and long-term estate planning goals. Fortunately, there are currently several strategies available to accomplish the short- and long-term goals at the lowest tax cost possible. Not all clients are predisposed to engaging in complicated and expensive tax saving techniques, however. Fortunately, life insurance provides those clients with a palatable alternative, ensuring that neither they nor their heirs must “bet the farm.”