AgDM newsletter article, May 1997

Federal Estate and Gift Tax reform

Neil HarlBy Neil E. Harl, Charles F. Curtiss Distinguished Professor in Agriculture, Professor of Economics, 515/294-6354, harl@iastate.edu

Some proposals would increase the federal estate and gift tax unified credit from the current level of $192,800 (equivalent deduction of $600,000) to a level of $248,300 (equivalent deduction of $750,000).  Other proposals would increase the credit (deduction) even more.  Yet others would eliminate the Federal Estate and Gift Tax altogether. 

A phased increase of the unified estate and gift tax credit to $750,000 over six years would be justified on the grounds of catching up with inflation since 1987.  In contrast, repeal of the federal estate and gift tax would amount to a substantial windfall for the estates of the wealthiest property owners in the country, including many with only an investor’s connection with a business, if that.

Impact on farms and small business

The need to save the family farm is a frequently cited justified for a decrease in federal estate and gift taxes.  This argument seems to have been uncritically accepted at face value.  More reflective consideration suggests that the increase would miss most of the alleged target group.  In fact, it may well have a counterproductive effect on further concentrating the ownership of land.  Moreover, family farms are more at risk from persistent budget deficits (which a tax cut would increase) than from federal estate tax liability.

Business life cycle -- The popular belief is that family farms are handed down from generation to generation like some sort of heirloom.  That is rarely the case.  Typically, farm businesses last a lifetime and cease to exist when the farmer retires or dies.  The land may remain in the family, but the farm business ends with the retirement or death of the farmer.

Need for capital -- Even when there is a child who wants to farm, the child will not be a young enterprising farmer on the rise (one who typically has great need for capital to expand an operation that may be struggling).  Rather, he/she will typically be 50 years of age or more when the parents die and will be looking to the retrenchment and disposition of farm assets rather than acquisition and expansion.

Also, he/she will find that inheriting the family farm will likely complicate and increase the need for tax planning.  Thus the tax reduction does nothing to help those most in need of help and imposes additional planning burdens on those who may already have a tax problem.

Off-farm heirs -- In the case of two or three surviving children, usually only one of them will return to the family farm.  A reduction in estate taxes will be shared with those who are not farming and usually live some distance from the farm.  The cost of providing lower estate taxes for the farming child comes at the price of giving the same tax reduction to those who no longer have any connection with the farm.

Land values down from peak levels

The existing estate law allows a great deal more farmland to be passed tax free to heirs now than it did when the present tax free levels were set in the early 1980s.  In 1981, the $600,000 tax-free level (when fully effective) protected about 280 acres of average Iowa farmland from tax.  Today, the same tax-free level would protect more than 350 acres.

Special breaks available

Since 1977, farmland (and other land used in a business) has been eligible for a special valuation procedure for federal estate tax purposes.  That procedure, referred to as special use valuation, can reduce the gross estate by as much as $750,000.  Although few achieve that level of savings, special use valuation typically produces values ranging from 40 to 70 percent of fair market value of farmland, depending on the geographic region and the year of death.

Double taxation

The point is sometimes made that the federal estate tax is not needed because the wealth involved has already been subjected to income taxation.  While that is the case with some property, there are vast amounts of asset value that represent appreciation in value that have not been subject to taxation.  Stock market gains and investments in real estate are prominent among the assets with substantial amounts of potential income tax gain.

If the Federal estate tax is repealed and the income tax basis adjustment of the property to its fair market value at the death of the owner is left in place, vast amounts of asset value will escape taxation altogether.  On the other hand, if the Federal estate tax is repealed and property does not receive a new basis at death, which is the more likely outcome, land transfer would be discouraged and land sale would be accompanied by major income tax consequences.

Wealth concentration

The beneficiaries of a reduction in Federal estate and gift taxes would be the richest property owners in the country (fewer than the top 5 percent of estate owners).  Although it is not politically correct to bring up this topic, it is my view that in the decades to come one of the great problems in this country will be the growing disparity in wealth position between the haves and the have-nots.  This modest effort (federal estate and gift tax), in place since 1916, to tax the most wealthy asset holders at death seems appropriate.

Suggestions

The proportion of farms that are trying to defy the family farm cycle and to survive into the next generation and succeeding generations as going farm businesses is growing but is still a small percentage of the total.  A good case can be made for a modest increase in the unified estate and gift estate tax where a farm or other small business is involved and the owner plan to continue the business.

Also, if the desire is to benefit farms and small businesses, a targeted approach to business continuation makes more sense than benefiting investors in all sectors.  Making installment payments of federal estate tax more attractive is one such targeted approach.  While the four percent interest rate on unpaid federal estate taxes is generous, reducing the rate further, extending the payment period, and enlarging the amount deferrable would seem to be beneficial for small businesses.

 

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