Taxpayers Want Their Cake, Frosting and Candles!

Published on: 20:25PM Oct 22, 2013

In a Tax Court case issued on Monday, October 21 (Van Alen and Tomlinson vs. Commissioner), we find taxpayers who inherited farmland property subject to a Special Use Valuation adjustment under Section 2032A.  This adjustment allows an estate to elect to reduce the value of the land from its "true" fair market value downwards to its value based upon its rental income stream.  For 2013, the maximum downward adjustment allowed is slightly more than $1 million.

In the court case, the estate obtained a value for the farmland of about $1.963 million, however, when the estate Form 706 was prepared, it listed a fair market value for the farmland of $427,500 and then took a Section 2032A adjustment to reduce the net value reported on the return to $144,823.  Even after all of these downward adjustments, the estate still owed about $100,000 in estate taxes.

Several years later, the two children who inherited a substantial part of the farmland, sold an easement for about $900,000 and essentially argued a basis in the farmland based upon the $1.963 million fair market value, not the actual $144,823 fair market value shown on the original estate tax return.  The Tax Code generally states that the basis of inherited property is its fair market value, however, in several situations including values under Section 2032A, a different value is used.  Section 2032A and the related basis rules requires the net value shown on the return ($144,823) be used as the basis for any future sales, not the "gross" fair market value of $1.963 million that it might have been worth at the time of the estate.

The taxpayers argued that the fair market value of $1.963 million obtained in the year of the estate should have been used for the basis.  The Tax Court  shot down all arguments put forward by the taxpayers.  If the estate had reported a $1.963 million value, it would owe close to $500,000 more in estate taxes (there was a marital transfer that would most likely not make all of the extra value taxable at that time).  Therefore, if the court allowed them to use this value, they would escape the extra $500,000 in estate taxes owed at that time and not have any capital gains tax owed at the time of sale.  This is what I would call getting their cake, frosting and candles.  Instead the Tax Court decided to blow out their candles and did not grant any wish to them.   On top of it, the Tax Court allowed an 20% accuracy penalty assessed by the IRS.

The tax laws can be very favorable to farmers at times, but it is important to follow the rules associated with those laws.  If not, it can be very costly as these taxpayers found out.