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Why Repeal of the Federal Estate Tax Hurts Virginia Farmers

Farm Business Management Update, December 2004/January 2005

By Jesse J. Richardson, Jr., J.D. Associate Professor, Urban Affairs and Planning, Virginia Tech

On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001. This act included a phased repeal of the federal estate tax (or "death tax" as it is called by its detractors). The act increases the amount of estate value exempt from federal estate tax on a phased basis until 2010, when the federal estate tax is eliminated. However, if Congress fails to act, the federal estate tax will revert to its prior status in 2011, with a $1 million unified credit against the federal estate tax (essentially, $1 million in estate value will be exempt from estate taxation). The tax rate on estates above $1 million will start at 55%.

Throughout the debates preceding the passage of federal estate tax repeal, during debates on whether the federal estate tax repeal should be made permanent, and during debates in the Virginia General Assembly on whether the state estate tax should be repealed, the family farmer has been held out by proponents of repeal as the primary beneficiary of a repeal. This article discusses why permanent repeal of the federal estate tax may prove harmful to the family farmer and agriculture.

The Estate Tax Impacts Very Few Farmers
Relatively few estates incur estate tax liability under the old rules. In 2001, only 51,841 of the 2.3 million deaths (2.2% of all deaths) incurred estate tax liability. In that year, estates paid a total of $23,532,542 in estate tax, or an average of $453,936 per estate.

Of the 51,841 taxable estates, 2,601 (5%) reported some farm property in 2001. This figure represents 0.11 percent (or about 1/9 of 1%) of all deaths. Table 1 shows the number of estates in each bracket and the average amount of farm property. As shown in Table 1, the 44 estates with assets of $20,000,000 or more reported significantly more farm property than any other group (almost five times that reported by estates between $10 million and $20 million).

Table 1. Average Value of Farm Property by Estate Tax Bracket
Tax Bracket Number Average Value of Farm Property
625,000 - 1,000,000 916 36,772
1,000,000 - 2,500,000 1,192 38,057
2,500,000 - 5,000,000 319 263,467
5,000,000 - 10,000,000 71 612,775
10,000,000 - 20,000,000 60 735,067
20,000,000 or more 44 3,389,841

Estate tax returns fail to include a separate category for farm real estate, which is included under "Other Real Estate." A 2003 Congressional Research Service report estimates that in 2001, decedents with taxable estates owned $1.6 billion in farm real estate. This figure represents 1.28 percent of all taxable estate value. Total farm assets equaled 1.6 percent of total taxable estate value in 2001. In addition, the bulk of these assets are concentrated in taxable estates above $20 million.

In 1998, 642 of the 47,483 taxable estates included farm assets, including farm real estate, of at least one-half of the value of the gross estate. This represents 1.35% of taxable estates and almost 3/10 of 1% of decedents. Of the 2.3 million decedents in 1998, only 1,418 (6/100 of 1 percent) estates held family owned businesses or farms comprising a majority of the estate. The United States Department of Agriculture estimates that fewer than 6% of all farms had a net worth in excess of $1.3 million in 1998 and that only 1.5% had a net worth of over $3 million.

Several special provisions of the tax code allow farmers to avoid estate tax on a large portion of assets. Special use valuation can reduce the value of eligible farmland by 40-60% and sometimes more. Minority discounts for co-ownership (up to 20%) and discounts for lack of marketability of interests held by an entity like a corporation or limited liability company (up to 35%) also significantly reduce estate values for farmers. Internal Revenue Service regulations also allow a low interest rate (2%) for installment payment of federal estate tax attributable to a closely-held (i.e., family) businesses.

Under the old estate tax rules, each individual could pass $675,000 worth of assets to the next generation free of estate taxes. This amount was to increase to $1 million in 2006. If a husband and wife engaged in simple estate planning, with each spouse fully using the exemption, the couple could shield $1.35 million in 2001 and $2 million in 2006 under the old rules. Few farmers hold assets exceeding those values. In addition, the special rules that apply to farmers and closely-held businesses allow exemptions for values several times the standard exemptions. Simply put, very few farmers paid federal estate taxes under the old rules.

Stepped-Up Basis
Prior to the Act, property owned by decedents at their death received a "stepped-up" basis. The basis of property, in simple terms, is the purchase price plus the cost of any improvements, less depreciation deducted on a tax return. At death, the basis increased, or "stepped-up" to the fair market value of the property on the date of death. The federal government forgave income taxes on the increased value (capital gains).

Step-up will be limited if the estate tax is repealed. Under current law, after December 31, 2009, the stepped up basis will no longer apply. There will be a new requirement to file a return known as a Section 6018 return, the purpose of which is to report the cost basis to the heirs. Gift tax returns will be called a Section 6019 return.

The basis of property acquired from a decedent will then be the basis in the hands of the decedent or the fair market value of the property at the decedent's death, whichever is less.

A limited step-up exception of $1.3 million per decedent, which may be allocated among the various assets of the estate, remains after repeal under present law.

For property passing from husband to wife and vice versa there is an additional $3 million basis step up at death. Since these can be aggregated there will thus be a $4.3 million basis step up at the first death of a husband and wife and a $1.3 million step up at the second death. However, these exceptions cannot be applied to certain assets, like IRAs, qualified plans and annuities.

However, if the estate tax is repealed, the step-up will likely be eliminated, meaning that someone will pay income taxes on any increase in value of property, particularly real property. This would hurt farmers greatly.

Implications for Agriculture
Estate tax is paid by the wealthiest 2% of decedents. An even smaller proportion of farm estates pay the estate tax. If the estate tax is eliminated, the basis step-up at death will undoubtedly also be eliminated. Heirs at all levels of income will then pay income tax on the gains at the time of sale. Although the marginal income tax rates are lower than estate tax rates, a large number of farmers will have to pay the tax. In addition, the effective estate tax rate, due to the large exemptions, ranged from 5.45% to 26.81% in 1997. Those with estates between $5 million and 10 million paid the highest rate, while those with assets of $20 million or more paid only 14.6%. Effective income tax rates are likely comparable, but are paid by lower income taxpayers, like farmers. The income tax will tend to lock assets into families. In addition, it will be very difficult to prove basis.

Members of the over $20 million tax bracket receive an average benefit of $10,374,200 from federal estate tax repeal. Over time, this extremely wealthy group of landowners will presumably use this savings, in part, to purchase more farm assets. The proportion of land rented would therefore rise as farmers would increasingly struggle to compete for land ownership (Harl 2004).

Thus, elimination of the estate tax may will accelerate the trend of increasing concentration of wealth in the United States. Increasing concentration of wealth will lead to more non-farm investment capital flowing into farm assets.

Revenue lost from the estate tax shifts the burden to other taxes, most likely the income tax. Far more farmers pay income tax than pay estate tax. Therefore, farmers will likely pay more in overall taxes if the estate tax is eliminated.

Rhetoric in the debate over the estate (or "death") taxes leads one to believe that the family farmer suffers horribly under the old federal estate tax rules. When one examines the facts, however, very few farmers pay federal estate tax. Special rules give farmers the opportunity to shield far more than other Americans from the estate tax. Estate and transition planning allow farmers to take advantage of these benefits. Horror stories of heirs forced to sell the farm to pay estate tax result far more often from lack of planning than from the estate tax. Such a crippling burden only results when the farm family owns assets of over several million dollars and fails to plan. Farmers often suffer more from the force sale of assets to satisfy the needs of the non-farm heirs.

On the other hand, elimination of the estate tax would undoubtedly be coupled with the loss of stepped-up basis, a concept that greatly benefits owners of land, like farmers. Instead of a few extremely wealthy farmers paying estate tax, almost every farmer would pay income tax upon sale of property.

The federal estate tax repeal benefits only the incredibly wealthy. Farmers will potentially pay more.

This author predicts that Congress will reinstitute the federal estate tax but exempt estates of some amount greater than $1 million from the tax. The full stepped-up basis benefit will also return. Farmers will be better off in that scenario than with elimination of the federal estate tax. With relatively simple estate planning and more complex transition planning, farmers will pay no estate tax under this projected regime.

Congressional Research Service, Report for Congress- Asset Distribution of Taxable Estates: An Analysis, updated May 23, 2003.

Harl, Neil H. "Selected Policy Issues of Importance in Agriculture", Presented at the 25th Annual Meeting and Educational Conference of the American Agricultural Law Association, Des Moines, Iowa, October 1, 2004 (on file with author).

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