In my last post, I gave an update on the current estate tax law and how it my apply to farmers for 2010.  In that post, I referred to the term “Step Up” and I am using this post just to explain what the term Step Up or Step Down means.

Up until this year, when a person died, the property that passed through to their heirs received a step up or down in cost basis to the fair market value at the time of death.  When the heirs would sell the property, this is the amount they would use for their cost basis.  For example, if a farmer owned land that he paid $100,000 for and it was worth $500,000 when he died, the heirs would be able to use the $500,000 when determining their capital gain when they eventually sold the land.  Conversely, if the fair market value at death was $50,000, then that would be the value they would use.

For the last several decades, this has been rule for inheriting property and then selling it by the heirs.  Starting this year, the IRS requires to Step Down any property, but use cost only on the other property that is worth more than what was paid for it originally.  However, the executor can make an election to step up value of up to $1.3 million or an additional $3 million for a surviving spouse.  In addition, the final income tax return for the person dying will be required to fill out a schedule showing the cost basis of all assets passed on to their heirs.  This cost basis is what the heirs will have to use in computing their capital gains tax when they sell any of these inherited assets.

As you can see, although there might not be any federal estate tax, there will be extra capital gains taxes and a lot more work for the executor and their professional to do.

I am currently in a financial investment conference in Chicago for a couple of days and during one of the sessions, the current estate tax situation was discussed.  There appears to be at least 6 billionaires that have died this year and under the current law, they will owe no federal estate taxes, however, in most cases, they will owe state estate taxes.  Now, this appears to be a good deal, however, there is an income tax cost to not have an estate tax.

This cost relates to there being no step up in basis of the assets that are inherited by the heirs.  They can elect to step up $1.3 million in assets or an extra $3 million going to a surviving spouse.  Lets see how this might affect a farmer with a decent size estate.  Lets assume that a farmer dies with land valued at $10 million and equipment valued at $2 million.  Assume there is no other assets and the basis in these assets is only $1 million.

There will be no federal estate tax due, however, most likely about $1 million of state estate will be due.  Now lets assume the heirs elect to step up the equipment by $1.3 million and then they sell the assets in 2011.  The capital gains rate for the land including state income taxes will be about 30% so, they will owe about $2.7 million of federal and state income taxes.  On the equipment, there will be a gain of $700 thousand and assumption top bracket of about 50% for federal and state taxes will result in total taxes on this gain of about $350 thousand.

Therefore, in total, the estate and heirs have paid estate taxes of $1 million and income taxes of about $3 million for total taxes of $4 million.  Under the law in effect for 2009, there would have been estate taxes of about $4.5 million and no income taxes. 

So you can see that even there is no federal estate tax for this year, a farmer who passes away with certain tax facts can almost pay the same amount in state estate and related income taxes. 

Please make sure to review your situation with your tax advisor.

Also, these laws are most likely to change during this year or next and we will keep you posted.

Congress back in 2001 dropped the maximum tax rate on dividends received by a taxpayer from 39.6% to 15% (plus any applicable state income taxes).  But under the so-called Sunset Rule, these special low rates expire at the end of 2010.  Beginning in 2011, the top rate is expected to go back to 39.6% and beginning in 2013, the effective top rate will be 43.4% after taking in account the new Medicare surtax of 3.8%.

What this means to a farmer who has a C corporation that is in the top tax bracket both at the corporate level and at the individual level is as follows:

• For 2010, your maximum combined corporate and individual income tax rate will be 44.75%
• For 2011 and 2012, your maximum combined rate will increase to 60.74%
• For 2013 and thereafter, your maximum combined rate will be a whopping 63.21%.  This represents a huge 41% increase since 2010.

A tax planning tip is to review your current retained earnings and see how much you should drop out to you in the form of dividends.  If the corporation needs the working capital, you can always loan it back to it at very cheap interest rates.

One of my readers sent me a question about a farming operation that applies to many farm families.  I am going to summarize the question as follows:

Scenario:

160 acre cropland is titled as Kevin XXX and Mary XXX, JTWRS (50%) and The Jane M YYYY Trust (50%).  Kevin and Jane M are brother and sister.  Mary XXX is Kevin’s wife.  Kevin and Mary also have a 240 acre operation of their own.

Is a partnership return REQUIRED to be filed or can Jane M and Kevin XXX each allocate their share of expense/income attributable to the 160 acre operation.

Can you provide me some info?  What’s the penalty for not doing it correctly.

As you can see from the facts, this is a fairly normal situation where property was probably inherited from a mom or dad and it is titled as co-owners in the brother (including wife) and sisters name.  The brother is also farming other property.

Normally, anytime property is owned by more than one party, a partnership of some type is involved.  This usually requires the filing of a partnership income tax return.  Until a few years ago, the penalty for not filing a partnership income tax return was minimal as long as all of the partners reported their share of the income timely.

However, with last year’s new tax laws, the penalty for filing a late partnership income tax return can now be pretty steep.  The penalty is now equal to $195 per partner for each month that the return is late with a maximum of 12 months.  Therefore, under the current case, if a partnership return is required and they never file one, the IRS could assess penalties on three partners for twelve months at $195 per month.  This penalty would equal $7,020 which is substantial.

If the parties want to not to file a partnership return, then can make an election to opt out of the partnership rules.  I will discuss this election in a near future post, but as you can see, the penalty for not making the election can be substantial.

I will have a couple more posts on this subject over the next week or two.

Some of my readers may have noticed that I have started writing a blog on the Agweb.com site.  From my web traffic, I can see that many of those readers have checked out this site.  I am honored to be doing the blog, but with three weeks left in tax season, I am hoping that I can keep up the pace.  Many times I will post the same content on each site, but there will be times when it is unique to one or the other.

I got an interesting question from a reader on the Agweb site and I am posting that post here for your review.  The estate tax situation for this year is the craziest I have ever seen it in my 25 years plus as a CPA and who knows how it will end up.  This is a reply to a question that I think many farm families will have.

Here is my original post:

We have gotten a response from one of our readers asking the following:

“Our mother has transferred the farm to her two sons and there is a clause stating they will get a step up in basis when she passes away.  They are wondering if she dies in 2010, will this property get a step up in basis?”

There are not enough facts in the question to make a complete answer, but I will outline what the rules are for 2010 as they stand now.

Under the old law, any assets passing to a heir received a step up or down in value to what it was worth at the time of death (or in some cases 6 months after death).

For 2010, this rule has been eliminated.  This means any property passing to an heir will have a basis equal to the lessor of:

• Their current basis (in most cases this is the cost) of the property, or
• Fair market value

The estate can make an election to write up any property to fair market value not to exceed $1.3 million to be allocated to any asset (or $4.3 million if the assets are going to a surviving spouse).  The estate will also have to file a report with the IRS and the heirs letting them know what the basis of all assets are.

So, in our readers case, if Mom bought the land for $200,000 50 years ago and it is now worth $5,000,000, there is:

• No estate tax owed;
• The estate can step up the cost basis to $1.5 million;
• And the remainder of $3.5 million will be subject to capital gains tax when sold, which may be upwards of $800,000 assuming current federal and state income taxes.

Also, many states will assess an estate or inheritance tax if the estate exceeds a certain amount.

This means that income tax planning for 2010 estates is very complex and we are waiting to see if Congress will fix this.  We will keep you posted.

As advisors, we are actively involved in succession planning for farmers and other businesses.  This is usually a long process and will change over time and as the generations involved grow and mature, their goals will usually change.

There are three main goals related to this planning:

1. Protect – The primary goal of any succession plan is that both generations involved are still protected in the following areas:

                Financial – Are the owners transferring the business still protected from a financial standpoint.  Did they create enough retirement and other assets outside of the farm to protect their retirement income

                Operational – Does the succession plan provide protection from operational issues such as the new generation being ready to take over the farm operation.  Nothing will ruin a farm family quicker than the next generation taking over sooner than ready.

                Entity – Does the succession plan provide for legal and entity protection.  Are they taking advantage of limited liability companies, corporations and trusts where appropriate.

   2.  Provide – Once protection is taken care of, the next step is to provide for both generations.  Is there enough cash flow to provide a normal living standard for both the current generation and the new generation.  If not, how will the farm family address this.  Will they have a spouse work off the farm or one of the heirs.  Will they do custom farming, etc.

  3.  Prosper – After the farm family is protected and provided for, then comes the time to prosper.  Does the farm family have enough management time and experience to expand the farm operation with more acres.  Or do they have excess machine time and people to do custom farming.  Each farm family has different goals when it comes to the prosper stage, but they must always remember to protect and provide first.

What stage is your farm operation in?

For an online video presentation of my “chalk talk” on this subject on the AgDay special “The Legacy Project” go to this link.  Here you will see a farm family discussing their succession plan with Kevin Spafford, host of The Legacy Project” and myself giving him advice.  Later in the show, Kevin and I have a chalk talk on the three P.

I hope you enjoy watching it and let me know of any future discussion topics that you would like to see addressed.

Having just recently returned from my taping for the Legacy Project on farm succession planning, I will be trying to do several posts over the next few weeks on this very important subject.

Elizabeth Williams from the DTN/Progressive Farmer had a very good post on the five steps needed for the farm transition.  The article dealt with a young farmer who lost his mother due to brain cancer.  The estate did not owe any current tax since the assets passed free of estate tax to the husband, but if he had passed away that same year, they would have had a major estate tax problem.

The five steps mentioned were:

1. Get Experienced Legal Help – Find a good agricultural estate tax attorney (or a good farm cpa) to help design an estate plan to meet the unique needs of the farm estate plan.
2. Recognize that your Paperwork will Increase – If your estate goal is to reduce estate taxes, transfer property to the next generation with the least income/capital gain tax and divide your assets equitable among your children, that usually means multiple farm entities.  This requires separate bank accounts, year-end meetings and compliance, etc.  However, to do it right, more paperwork will result.
3. Allow the Next Generation to Control or Own Something that is “Theirs” – It is important for the children to have some skin in the game to promote the pride of ownership.
4. Listen and Talk to Each Other – No one can read your mind.  Not being transparent can cause a multitude of problems.  “A lot of animosity can build up when off-farm family members don’t know what the deal is. What is the on-farm sibling getting?”
5. Respect the Division of Labor – The most successful family farm operations have distinct, complementary divisions of labor.  As I said on my TV taping, find what each member does best and let them do it.  The farm will be better off and the family member will feel best about themselves.  Part of that comes from clearly defining the expectations that go along with ownership and management of the farm.

The cost of not planning can be very high!  Even a 500 acre farm can generate a large amount of estate tax starting in 2011 if no changes are made to the estate tax laws.

For a primer on “Transferring the Farm”, go to the University of Minnesota’s Center for Farm Financial Management.

Just wanted to give all of my readers a heads up that I will be appearing on the Leave a Legacy TV show this Thursday morning (the 25th).  It will generally take the place of AgDay and you may want to check your local listings for time.  You will also be able to view it on the Leave a Legacy site at Agweb after the show at a later time.

I enjoyed doing the show, but as my wife would say, don’t plan on changing your day job.

Most farmers are assuming that since there is no estate tax for 2010, that this must be a good thing for all taxpayers.  The reality is that many farmers may end up paying more in taxes than under the law in effect for 2009.  This is due to the fact that carryover basis will no longer be in effect for many estates.

Under the old law, when a person died, all of their assets were revalued for income tax purposes  based upon the value at the time of death.  Then when the heirs sold the assets, this was the “cost” that they could use in determining their gain or loss.

For example, suppose, a farmer died owning equipment that was worth $1 million dollars that had been fully written off.  Under the old law, you could step up the value to $1 million dollars and depreciate it over 5 to 7 years.  If instead, you decided to sell the farm equipment for $1 million immediately, there would be no tax owed.

Now, when you inherit the equipment, you get no step up in basis, and when you elect to sell the equipment, the gain will be completely taxable.  Also, this sale will not qualify for capital gains treatment, therefore it will be subject to ordinary income tax rates.  At a 35% bracket, this would result in owing $350,000 of tax.

Therefore, due to not having an estate tax, we went from (1)  complete step up in value to date of death value, (2) no estate tax being owed for all estates under $3,5 million, and (3) full write of assets over time as depreciation against other income  to owing $350,000 in income taxes.  This does not sound too good to me. 

I am hoping that Congress gets their act together and fixes this, but I am not too hopeful.  I will keep you updated.

As a CPA, I have been involved in many family meetings.  Sometimes, I act as an advisor to the participants.  At other times, I may actually be part of the family that is having the meeting.

I remember having a client several years ago that had several children that were actively involved in the business during their lifetime.  We hada family meeting with several advisors and it became apparent very quickly that strains of the family dynamic and how it affected their relationships.  Very quickly, the perceived problems of childhood, parenthood and other factors came out and you almost had a civil war on your hands.  We were able to get it back on track, but it was touch and go for a while.

Dr. Donald Jonovic writes a monthly column in Successful Farming that I think is always worth reading.  A recent column from the print version of the magazine dealt with  Family Rules of Conduct for these meetings.  Dr. Jonovic listed several rules for effective meetings.  Some of the ones that I feel are especially relevant are:

• Always treat each other the way you would treat important friends or colleagues.  – Too many times I find that family will treat each other worse than any other friend or acquaintance.  We should really treat our family better than our friends.  If we do, many of our family problems would be cured.
• Keep your business and personal disagreements confidential and within the family. – Disagreements should be handled in-house.  Don’t put them in the “outhouse” so to speak. 
• Keep meetings fun – Farming is fun and having meetings about farming and family should be fun.  Have some type of family interactive game or other ice breaker to keep things loose.
• Do not equate difference of opinion with disloyalty – Remember that having people always agree with you means they go over the cliff with you when things go wrong.  Encourage people to give you a different viewpoint.  This is always the best way to learn.
• Leave your cell phones at the door – This may be tougher for our Gen X and Gen Y family members, but it is only for an hour.  They can survive and will learn to enjoy it.

There are many other good points, but to make your meetings effective, implement as many as you can.