Ben Franklin might just as well have been talking directly to today’s farmers when he famously said, “In this world, nothing can be said to be certain except death and taxes.”
Even though most will admit continually reducing tax liability each year through deferral is a short-term solution to a long-term problem, few farmers are willing to part with the cash flow and opt to defer the tax liability anyway.
The problem with this deferral strategy is the fact that someday, we may have to “pay the piper.”
Ironically, the ultimate “get out of jail free card” for a farmer is death, as tax is forgiven in an estate due to the basis step-up rules in our current estate tax law.
Kicking the can down the road can be a good strategy as long as these rules do not change against us along the way.
My concern for agriculture is that income and estate tax changes could be on the horizon. These changes, if implemented, would create a significant tax on families who have appreciated assets (farmland) or tax-depreciated assets (equipment, livestock and grain).
As farmers, we need to educate ourselves on the current law as well as proposed changes that could genuinely influence our way of life.
Estate tax history
Most of us remember the estate tax law from 1982 to 1997. During that time, an estate of $600,000 was exempt from tax. Assets greater than $600,000 were gradually taxed up to the maximum rate of 55% (assets above $3 million). We have come a long way since then, thankfully.
By 2002, $1 million of estate assets were exempt from federal estate tax. In 2009, the exemption equivalent jumped to $3.5 million.
The estate tax was repealed in 2010 for one short year. In that year, basis step-up was limited to $1.3 million of assets chosen by the executor.
A 2011 law temporarily brought the exemption equivalent to $5 million with a 40% tax on estates above this amount. This law was to sunset on Jan. 1, 2013, to $1 million but was later made permanent at $5 million plus inflation.
In 2017, the Tax Cuts and Jobs Act (TCJA) made tax reforms, one of which was to immediately double the estate tax exemption equivalent amount from $5.6 million in 2018 to $11.2 million.
For deaths in 2020, the exemption asset equivalent is $11.58 million. This amount is scheduled to continue to increase with inflation until Jan. 1, 2026, when it will sunset back to the 2011 amount of $5 million plus inflation (estimated to be between $6.2 million and $6.5 million at that time).
One constant for an estate has been a new adjusted basis (basis step-up) at the time of death to the appraised value of the asset in the estate, with the exception of income with respect of decedent assets (IRD) such as retirement plans, annuities and trapped gains inside of a contract.
As an example, if Mom and Dad purchased a farm for $1,000 per acre and their estate shows a value of $8,000 per acre, the basis is adjusted at the time of death to $8,000 per acre (the appraised value at death) under current law.
The current basis adjustment also holds true for depreciated assets like equipment and building sites and untaxed business assets like livestock and grain inventories (not held inside a corporation).
The Democratic presidential nominee has proposed a tax plan that includes the repeal of the 2017 Tax Cuts and Jobs Act. Although not all of the proposed changes will directly affect farm families, there are three specific proposals that are of interest to the topic of this column.
First, the repeal of the 2017 TCJA will immediately reduce the federal estate tax exemption back to the 2011 asset equivalent of $5.79 million (indexed with inflation).
Second, qualified dividends and long-term capital gain tax rates would rise to ordinary income tax rates for income over $1 million, and 1031 Exchanges would be eliminated for taxpayers with annual income over $400,000.
In addition, corporate tax rates are proposed to increase to 28% (from 21% current).
Third is changes to the current basis step-up rules. It is not accurate to say that the proposal eliminates the basis step-up. If basis step-up were to be eliminated, the person inheriting the asset could choose to not sell the asset and the tax would not be forced to be recognized.
This may not be ideal, but at least the heir would have an option. The proposal is to tax all gain at death to the estate.
If we use the example of an $8,000 per acre farm with a $1,000 per acre basis at death, the gain of $7,000 per acre would be forced to be recognized at capital gains rates.
If we assume an average 30% tax rate for simplicity, this would be as much as $2,100 per acre in capital gains tax created by death. A 240-acre farm estate would be required to pay $504,000 in federal capital gains tax in that example.
It is important that we understand the difference between past proposals that have suggested eliminating the basis step up and this proposal that forces all deferred gain to be taxed in the estate at death.
So far, the proposal only talks about capital gain (real estate as well as any stock appreciation of a closely held farm corporation). We assume but will have to wait and see how income from grain and livestock as well as depreciation recaptured from equipment and buildings would be taxed.
Agriculture is no stranger to change. Our grandfathers’ accounts of planting with horses and a trip wire will eventually be replaced with our grandchildren’s versions of managing their planting progress with driverless tractors.
Some changes, however, are easier to accept than others.
As with any important decision that will affect your farm’s future, please consult with your tax and legal advisors as this information may or may not be of value to your specific situation.
My hope is that the inevitability of death and taxes will incentivize your family to plan for the worst and hope for the best by improving upon the things that you can while accepting the things that you cannot.
For 28 years, Steve Bohr has been a partner in the farm continuation firm of Farm Financial Strategies, Inc. For additional information on farm continuation issues or if you have a question, please contact Steve via email at Bohr@FarmEstate.com or by phone at 1-800-375-4180.