Many economists say the American economy is meandering along at a tepid pace. But there is at least one group of American businesses that seem to be performing very well. You might think it is manufacturing, high tech, professional services or precious metals trading. But no! It is one of America’s most basic businesses-farming!
American farmers who are avoiding the drought seem to be doing quite well. The problems and opportunities they are dealing with may provide useful lessons to other business owners.
Good News!
From many reports, this appears to be a great time to be a farmer. Statistically, many farmers’ net worths seem to have grown substantially over the last decade. Smarter management practices such as crop protection and increasing prices for crops and commodities have helped farm values consistently increase across much of the country. Generally speaking, the appraised value of farm land in many states has more than doubled during the last 10 years. In some cases appraised values currently exceed $4,500 per acre! See Table 1, which shows selected state values from the U.S. Department of Agriculture’s National Agricultural Statistics Service.
Bad News!
Sometimes you can have too much of a good thing. Drinking too much alcohol-even the very best quality-can cause a painful hangover. Although an increased net worth is good for most farmers, in several respects increased land values actually may create some new financial problems that may need immediate attention-a “financial hangover.” Among those potential problems are: (1) finding funds to pay federal and state estate/inheritance taxes and (2) designing a family wealth transfer plan that is fair to both on-farm and off-farm children.
Increased Federal (And Perhaps State) Estate/Inheritance Taxes
If the value of a farm has doubled during the last 10 years, it is likely that federal estate taxes due at the farmer’s death could also increase significantly. This can be especially troubling if the federal estate tax exemption is reduced and federal estate tax rates increase. That’s what is scheduled to happen on January 1, 2013.
The estate tax exemption is to be reduced from $5.12 million per person to $1 million per person and the maximum federal estate tax rate will increase from 35 to 55 percent. Higher land values could also increase state estate/inheritance taxes in states that impose such taxes.
In order to reduce federal and state estate/inheritance taxes, it may be wise for farm owners to make some gifts before January 1, 2013. That’s because the lifetime gift tax exemption is $5.12 million in 2012 but will be reduced to $1 million in 2013.
A married couple owning farmland could combine their lifetime exemptions to gift land and/or other assets worth $10.24 million gift tax-free in 2012 before the lower exemption limit kicks in during 2013. In addition, any growth in value of gifted assets after the date of the gift will be passed on to the donee free of transfer taxes.
Unfortunately, many farm families who could potentially benefit from gifting strategies may not make gifts before the end of 2012. It is often physically and emotionally difficult for farm owners to give away part of their farm. Like most business owners, farmers have a reputation for wanting to retain full personal ownership and control over their land and business for as long as possible.
A Liquidity Analysis
Regardless of whether farm owners decide to make gifts, they need to understand how much it will cost to pass on their farms and other assets. Just like you would when you’re thinking about investing in assets like real estate, carrying out a liquidity analysis in this situation can help them get a feel for the potential costs, and this will help to determine why liquidity is important as you continue through the process. To sum it up, a liquidity analysis estimates the potential costs that may be triggered when the farm is transferred to the next generation, and 2012 presents a unique opportunity to offer to do a liquidity analysis.
Most farm families don’t want to sell their farm; they want to keep it in the family. The increase in the value of farm land, the scheduled decrease in the estate tax unified credit and increase in the maximum federal estate tax rates likely mean that transfer tax costs will increase and more cash may be needed to keep a farm in the family.
Families who conducted liquidity analyses several years ago may benefit from reviewing them. Increasing farm values may have made an earlier analysis outdated. Farmers without a liquidity plan should consider adopting one now. A useful liquidity analysis does more than estimate the costs of passing down the farm; it also considers alternatives for reducing and paying those costs over a period of years. Special use valuation and installment payment of taxes under IRC Section 6166 are sometimes appropriate.
For a farm owner in good health, life insurance death benefits should be one of the alternatives considered in the plan. A farm owner’s life insurance policies that are owned in an irrevocable life insurance trust (ILIT) or by an adult child designated as the farm “successor” could provide part or all of the cash needed to pay the federal and state transfer taxes and other costs due at the farm owner’s death.
If a workable liquidity plan is not in place and a farm owner’s estate doesn’t have enough cash, the farm may have to be sold to outsiders to generate the funds needed to pay the tax. A sale of all or part of a farm will likely be the end of that family’s farm legacy. The same is true for all business owners who haven’t adopted a workable liquidity plan.
A Family Buy/Sell Arrangement
For many families it is important to transfer family wealth in a way that treats all children equally. This usually means transferring the same amount of wealth (although not necessarily the same assets) to each child after the parents are gone. One way to do this is to leave each child an equal percentage of all the assets, including the business. For example, if there are four children, each would get 25 percent of the business whether they were involved in operating it or not.
Shared ownership of a farm is often a highly emotional issue to both those children working in the business and those who are not. Those in the business usually don’t want the others involved in daily operations and those outside the business don’t want to inherit assets they can’t sell. Instead, they want to inherit cash or assets which can be easily converted into cash. Shared ownership by children working in a business and those who are not could easily damage or destroy family relationships.
In order to preserve family relationships, a workable strategy for cashing out the interests of non-business children needs to be in place. One alternative is a buy/sell arrangement between the children themselves. Let’s look at an example. Suppose only one of the four children (a son) works on a family’s farm. He inherits his pro rata 25 percent share of the farm directly. If he has an agreement with each of his three siblings (or with the estate of the parent), he can have the ability to purchase the 25 percent each of them inherits when the last parent dies.
This purchase right can be given by the parent in the estate planning documents or can be individually negotiated among the adult children. If the parent is in good health, a farm-based child may be able to purchase a life insurance policy on the parent’s life to fund the purchase.
Of course, the on-farm child needs cash to pay the policy premiums. If he doesn’t have enough cash to pay the premiums personally, the parent could potentially supply the funds through annual exclusion gifts or advance them through inter-family loans or a private split dollar agreement. There is also the possibility of using a combination of gifts, loans and/or advances. If adequately funded, this approach allows the off-farm children to be cashed out and the child on the farm winds up with 100 percent ownership.
In addition, the farm-based child doesn’t need to purchase the entire farm from the parent’s estate. If he inherits his portion of the farm directly, he needs to buy the remaining interests only. In our example, the son inherits 25 percent and thus only needs to buy the remaining 75 percent. This approach may also work for non-farm businesses.
Families who have existing buy/sell arrangements in place need to consider whether the increase in farm land prices (or other business assets) negatively impacts their ability to follow through on the terms of their agreement. If the value of the business has increased, additional life insurance coverage may be needed to fund the promises made in the agreement. It may also be wise to get a new appraisal.
Sometimes it makes sense to purchase the interests of the children outside the business from the estate, before distribution. If the on-farm child purchases the remaining 75 percent of the farm from the deceased parents’ estate before the 25 percent units are distributed to the non-farm children, then the estate may have enough liquidity to pay federal and state estate taxes and other costs of estate administration. That is not to say that the burden of estate taxes and administration should fall exclusively to the off-farm children. The parent’s wealth transfer plan may require that some assets (which might have otherwise been designated for the on-farm child) may be used to pay his share of the estate’s taxes and other costs.
Five Lessons for All Business Owners
The current success of family farmers offers several lessons for other business owners:
?1.?The value of a business will change over time. Sometimes a business becomes more valuable; other times its value falls. Owners need to keep a close eye on their business’ value so that liquidity plans and business succession plans remain realistic and appropriately funded. It is probably wise to have the business’ value reviewed by an expert every three to five years.
?2.?Every business owner is mortal; have a plan ready. All will eventually leave their businesses, whether they want to or not. They just don’t know when-sometimes they get to choose the time; sometimes they don’t. To preserve the value they’ve built and to protect the people they love, realistic and funded succession plans are needed.
?3.?A liquidity analysis and cash reserves are important. By their nature, most businesses are illiquid. Some cash will likely be needed to pay debts, taxes and transfer costs. A liquidity analysis estimates these costs and identifies from where the money to pay them will come. Plans need to be backed up by money in order to succeed.
?4.?Wise planning considers what is best for the entire family. Just because it’s a family business doesn’t mean everyone in the family should be in it. Putting every family member in the business can be devastating to both the family and the business. Have an exit strategy for family members who shouldn’t be in the business.
?5.?Talk is cheap; only action counts! It’s important to have a long term vision for the future of a business. However, a long term vision can’t implement itself. Owners need to take action and put the necessary legal and financial tools in place if their vision for their family and their business is to become a reality.
Conclusion
Now is an excellent time to talk to farmers and other business owners about business succession, wealth transfer planning and estate liquidity. Many businesses are worth more than they have ever been. Although business owners are traditionally asset rich and cash poor, many of them have more cash and liquid assets than they have had in some time.
Increased business values may result in increased federal and state wealth transfer taxes. If the $5.12 million per person lifetime gifting exemption is going to help them reduce their wealth transfer taxes, they need to act before the end of 2012. A liquidity analysis can estimate how much may be needed to pay state/federal transfer tax obligations and estate administration costs. Different alternatives should be considered for providing the funds that will be needed.
Life insurance is one of the financial tools which should be considered. A family buy/sell agreement could also be part of a workable strategy for providing the needed liquidity and converting the interests of the non-business children into cash. With sound planning the business can continue in the family, and family relationships can be strengthened.
These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws may change and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding their individual situations.
