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.

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.

I received two excellent comments on my post from Monday of this week regarding the cost to some farm families of not having an estate tax for this year.  The comments had additional information which is all applicable for this year.  The main intent of my post was to let farm families know that without proper planning, an estate in 2010 can cost your farm operation a large amount of current or future taxes.

Also, the key problem with the 2010 estate law is that effective January 1, 2011, it reverts back to the law in effect in 2001.  This means that all estates larger than $1,000,000 will be subject to federal estate taxes.  A quarter section of good farmland can exceed this amount alone.  Congress needs to take action and soon to correct this, or thousands of farm families will be much worse off on January 1, 2011 than they were on January 1, 2009 or 2010.

I will keep you posted and keep sending me the comments.

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.