Rallying a family to discuss the physical and emotional future of a farm operation and its land can be challenging. Throw in the financial dynamics and tax considerations, and the problems become more complex.
As you work through your business succession plan, I hope stories like the one that follows will encourage you to evaluate numerous scenarios. The financial future of your family and farm depends on it.
You have options. A father was ready to step out of the family business. We had planned for the addition of one of his two sons, who went through the standard two-year internship program before the second generation can start acquiring an interest in the family business.
We often divide the farm operation into "tenant" and "landlord" to determine how to structure the operation. Farming heirs need to own the "tenant" side of the operation without the influence of the non-farming heirs.
This particular operation was conducted as an S Corporation, one of the best ways to handle the tenant side. The only assets in the corporation were the farm equipment, and the only liabilities were a few loans for that equipment.
While the father intended to contribute some labor, he was otherwise going to exit the operation, and the son was going to take over.
The father had been a good steward of his talents and had a substantial retirement plan. He also owned 400 tillable acres outside the corporation. He and his wife were nearing 60 and had no debt.
After performing a valuation of the S Corporation, we determined the value of the corporate stock was $300,000. At this point, most people think the next step in the succession process is for the son to pay his parents $300,000 for the corporate stock for a period of time.
In this situation, that’s not the case. The father and mother didn’t realize they had a couple of partners: The Internal Revenue Service (IRS), and since they resided in Illinois, the Illinois Department of Revenue. Our calculations indicate they would have lost about 17% of the $300,000 to taxes. That’s a $51,000 loss of family wealth.
Since the parents didn’t need the net $249,000 they would have received from the sale, they gifted the corporation to their farming son.
If you remember, there’s a second son. The father and mother wanted to leave their estate equally to both sons. They revised their estate plan so that their non-farming son would receive a specific piece of farmland to offset the value of their gift to the farming son, realizing that the farming son had received a portion of his inheritance now, rather than waiting for their death.
The next step in the process was filing a gift tax return for the gift of corporate stock. An individual is allowed to make an annual non-taxable gift of $14,000 in 2014 to any number of people. It’s possible to exceed the $14,000 gift limit in cases where medical expenses are paid directly to the medical providers or when certain education payments are made directly to the educational institution.
Since the parents made a substantial gift in excess of $14,000, one would think they owed gift tax, right? Wrong. Under a unified gift and estate tax system, until the parents each gave away the maximum taxable estate limit ($5,340,000 for 2014) they would not owe any gift tax.
However, when a person dies, the IRS looks at the value of the assets owned by the deceased and adds back in the taxable gifts to get the taxable estate. As long as the value of the taxable gifts and the assets still owned by the deceased did not exceed $5,340,000 (2014 limit), there would be no tax due on the transaction.
When moving forward with your succession plan, consider gifting farming assets to your heirs, and then balance your plan with the distribution of farmland or other non-farm assets to your non-farming heirs down the road. In the end, you will not only meet your goal of passing the farm to the next generation, but you will also preserve family wealth that would otherwise be lost to income taxes.
This column is not a substitute for seeking individual accounting advice.
- March 2014