(Note: this article is a continuation of a several part series)
Last month, we discussed the Federal Estate Tax (FET), and the impact it has on passing on a family farming operation. In short, we examined that starting in 2011 a husband and wife will each only have a $1 million dollar exclusion amount (a.k.a the “tax free briefcase”) from the FET. In addition, the importance of a husband and wife holding assets solely, instead of jointly, so each spouse can utilize their tax free briefcase was explained.

For farming operations with a value of over $2 million dollars, more work than simply splitting the assets between spouses is needed. For example, let’s say we have a farm estate worth $6 million dollars. As we know, next year each spouse’s “tax free briefcase” can hold $1 million dollars. So, if the proper estate planning is performed, the farm in our example will be able to have $2 million dollars excluded from the FET, but the other $4 million dollars will be taxed. With a maximum tax rate of 55 percent, the amount of tax generated would be approximately $2 million dollars. More than likely the heirs to the farming operation would have to sell off assets just to pay Uncle Sam.

Generally, there are two ways to discount the value of a farming operation’s assets for valuation purposes when dealing with FET. The first is the Minority Interest Discount, which is a discount that reflects the lack of majority control in a corporation. The second is the Lack of Marketability Discount, which is a discount that reflects the inability to obtain market price for shares of a tightly held corporation. Combining these two discounts can reduce the value of a farming operation in the eyes of the IRS by as much as 40 percent.

Let’s run through an example to illustrate how important these discounts are. Suppose our $6 million dollar farm has a husband, a wife, and two children. The husband and wife set up a corporation with 100 shares and put all the farm assets in the corporation. The wife makes a tax free gift of one share to one of the children, and the husband gifts one share to the other child. Now, the husband owns 49 shares, the wife owns 49 shares, and the children each own one share. Because no single person owns 50 percent of the corporation or more, the corporation is afforded the Minority Interest Discount. In addition, because it will be hard to sell any of the interests for fair market value (who wants to pay full price to have a minority share in a family farm?), the Lack of Marketability Discount is available.

Because we can take advantage of both discounts, let’s assume we establish a conservative devaluation of 33 percent between the two discounts. Now, our $6 million dollar farm is only worth about $4 million dollars in the eyes of the IRS.  Since the husband and wife can each shield $1 million dollars from the FET, only $2 million is subject to the tax. In essence, we are doubling the amount of assets each spouse can stick into their “tax free briefcase.”

Instead of the family in our example paying approximately $2 million dollars in tax, their tax liability is decreased to approximately $1 million dollars. Safe to say, saving a million dollars in tax is nothing to take lightly. Even better, by using some more estate planning techniques, the family could probably get the estate tax liability down to almost zero.

You can see that by reducing a farming operation’s value in the eyes of the IRS can provide a huge tax savings. What are the drawbacks? Mostly, the main drawback is that a husband and wife will give up ownership of a portion of the farming operation. Most times the children are continuing on with the farm, so this is not a big deal. However, some people are not too comfortable with giving up control prior to their death. To help with this situation, proper agreements can be drawn up that provide buy back options for the parents should a child wander astray.

We’ll talk more next month on other ways to minimize the FET liability.

John J. Schwarz, II, is a farmer and attorney in Steuben County, Ind. He focuses his practice on agricultural law and legal issues important to farming communities. He can be reached at 260-665-9779 or jschwarz@cresslaw.com"

These articles are for general informational purposes only. If you have a specific legal question, you should consult an attorney. The views and opinions expressed in this column are those of the author and not necessarily those of Farm World.