The Lawyers' Corner
Eva gave her son Tom Senior a life estate “the remainder therein to his children living at the time of his death, share and share alike.” Eva’s will had no residuary clause. Tom Senior died in 2015. None of Tom Senior’s children survived him.
Eva had four additional children, who also survived her. Howard is one of those five children of Eva.
Question, who now has a right to the land that was subject to the Tom Senior life estate? his children or Eva’s children?
The question is whether or not a vested remainder interest was created for the children of Tom Senior. The case of Besch v. Schumacher, 89.app. 638, 599 NW. 2nd 846 (Neb App 1999) is clear that the remaindermen's interest is vested and passes as provided by the last surviving remainderman; in this case as provided in a joint tenancy deed. Tom Junior, the last surviving remainderman is the successor to the full interest in the real estate, the other remainderman did not survive the life tenant and are out. His joint tenancy deed ownership takes precedence.
Eva’s other four children will not have an interest in the real estate.
A QTIP, qualified terminal interest property trust grants the surviving spouse an income interest in the trust. The surviving spouse interest (life estate) is not subject to inheritance tax because of the spousal inheritance tax exemption, §77 2004. The remainder share is subject to inheritance tax. Basis is stepped up upon the QTIP trust grantor’s death.
The estate of the surviving spouse with QTIP trust with a testamentary power of appointment is fully exempt from inheritance tax §77 2004 and if she exercises or fails to exercise the power of appointment it is not an event subject to inheritance tax. See In re Estate of Nelson, 253 Neb. 414, 571 N.W.2d 269 (1997). “Section 77-2008.04 specifically states that the exercise or nonexercise of the power of appointment by the donee is not a transfer subject to the taxation provisions of Neb.Rev.Stat. §§ 77-2001 to 77-2008.02"
Upon the death of the surviving spouse without a power of appointment in the QTIP trust, the assets of the QTIP trust could be considered vested on the first death and on the second death are not subject to inheritance tax. Review the trust language, a general discretionary power for the trustee may not be considered a vested interest for the beneficiary and subject the surviving spouse’s QTIP to inheritance tax, see §77-2008.03 while a limited power of appointment in the trust will not subject the QTIP to inheritance tax. The concept is the same as no inheritance tax upon the death of a life tenant where the remaindermen have a vested interest.
Stepped up basis and federal estate tax are a different matter, on the death of the surviving spouse the QTIP trust is included in the estate of the surviving spouse for federal estate taxes and the basis is stepped up.
***Upon further reflection, to have the QTIP a part of the estate of the surviving spouse for stepped up basis on the second death, the first to die must elect the QTIP to be included as marital deduction assets. The filing of a 706 for the first death appears to me to be mandatory but not unwarranted since a 706 is needed anyway to preserve portability.
This analysis if to be viewed as a starting point in research of trusts as a disqualifying resource for medicaid purposes and one should reach their own conclusions after reading the cases in full.
Frank C. Heinisch
- The following are Nebraska cases dealing with trusts counted as disqualifying Medicaid resources.
If the Medicaid applicant contributes to trust (self funded) and the trust is irrevocable if there are any circumstance of benefit to the applicant or spouse, all the trust corpus is a disqualifying Medicaid resource, no matter that it is a discretionary trust. If the trust is self-funded irrevocable with no benefit to the applicant or spouse, it still is a transfer [gift] subject to the 60 month look-back rule.
A revocable trust is a disqualifying Medicaid resource regardless of source of funding.
A discretionary third-party trust funded by third party assets (i.e. parent for child) is not a disqualifying medicaid resource for the Medicaid applicant.
A support third-party trust funded by third party assets is a Medicaid resource to the extent of the maximum amount of support available.
A discretionary support trust is a disqualifying Medicaid resource to the extent of the maximum amount of support available. [Trustee has discretion to pay support, maintenance, health and education.]
- Betty L. Thorson v. NDHHS, 274 Neb. 322 (2007). Good history of Medicaid trust resource rules. A 1989 irrevocable self-funded trust giving independent trustee discretion to supplement government programs benefits. Case decided that trust was a Medicaid resource because the "any discretion to distribute assets [to Medicaid applicant] is sufficient."
- Hazel I. Wilson v. NDHHS, 272 Neb. 131 (2006). Good historical review of Medicaid trust resource, especially time line of look back limitations. Holding the transfer from third party trusts to widow to children were not subject to Medicaid resource disqualification if the transfer is beyond the look back term. Transfers from third party trust outside look back period are not a Medicaid disqualifying resource.
- Ruth Pohlmann v. NDHHS, 271 Neb. 272 (2006). Testamentary Trust from Husband 1982 Marital Trust - all net income - power of appointment in wife for principal (never funded). Family Discretionary Trust - all net income and discretionary principal distributions. Funded in 2002. Any circumstance test only relates to self settled trust, not testamentary trust. Failure to elect against will creating a transfer was not before court.
- Ronald D. Boruch v. NDHHS, 11 Neb. App. 713 (2003). November 6, 1993 irrevocable trust - use and possession of real estate and annual income for life. History of Medicaid trust resources was reviewed. If one creates an irrevocable trust after June 9, 1993 with own funds and is a trust beneficiary or can benefit under any circumstances the trust corpus is counted in the determination of Medicaid eligibility. Any circumstance test trumps need to use look back period.
- Iris A. Doksansky v. Norwest Bank Nebraska, N.A. 260 Neb. 100 (2000). Discretionary Support Trust - attempt to garnish trust to pay son’s child support. Held child support due by son was not part of the support to be provided to son therefore not a Medicaid resource. Look to support mandate in trust to determine if the discretionary trust is a support trust. Same trust: Iris A. Smith v. Richard D. Smith, 246 Neb. 193 (1994), "We find that In re Will of Sullivan 144 Neb. 36, 12 N.W.2d 148 (1943) does not stand for the proposition that in all cases the dependents of a beneficiary of a discretionary support trust can compel a trustee to make payments for their benefit. We interpret the case to mean that the trustee of a discretionary support trust can be compelled to carry out the purposes of the trust in good faith."
- William Hoesly v. State of Nebraska, Department of Social Services, 243 Neb. 304 (1993). Renunciation of a bequest with intention to continue to qualify for Medicaid is a disqualifying resource.
- Failure of a spouse to elect against a will is a disqualifying Medicaid resource. NEBRASKA DEPARTMENT OF HEALTH AND HUMMAN SERVICES Manual Letter #2-2014 Rev. January 1, 2014, 21-001.01 example 27.
NEBRASKA DEPARTMENT OF HEALTH AND HUMMAN SERVICES Manual Letter #62-2014 Rev. July 8, 2014,
"Where a trust includes the assets of another person or persons as well as the assets of the client and/or his/her spouse, the rules in this section apply only to the portion of the trust attributable to the assets of the client and/or the client’s spouse.
"2-009.07A6f(2)(a) Payment Can Be Made From Trust
The following applies when payment may be made to the individual and/or the individual’s spouse under the terms of the trust:
1. Payments from income, or from the corpus, made to or for the benefit of the client and/or the client’s spouse are treated as income to the client.
2. If there are any circumstances under which payment from the trust corpus could be made to or for the benefit of the client and/or the client’s spouse, the portion of the corpus from which payment to or for the benefit of the client or the client’s spouse could be made must be considered a resource available to the client.
3. Any portion of the corpus that could be paid to or for the benefit of the client and/or the client’s spouse is treated as an available resource.
4. Payments from income or from the corpus that are not made to or for the benefit of the client and/or the client’s spouse are treated as transfers of assets for less than fair market value.
Payments are considered to be made to the individual when any amount from the trust, including an amount from the corpus, or income produced by the corpus, is paid directly to the individual or to someone acting on his/her behalf, e.g., a guardian or legal representative."
Also see Discretionary Trusts, Support Trusts, Discretionary Support Trusts, Spendthrift Trust and Special Needs Trust under the Nebraska Uniform Trust Code, Nebraska Law Review, Volume 86, Number 2 page 231 2007 (use Casemaker).
The cases on life estate termination with farm leases is an interesting chase. I was inspired to read further when I found Beacom overruled. Bottom line, look to when the cash rent is due. Cash rent due before date of death is in the estate of the life tenant. Cash rent due after death is owned by the remainderman. It appears the crop share is due the life tenant estate. Read the following case excerpts.
I believe you will find the cash rent is income in respect of a decedent with no step up in basis.
Frank C. Heinisch
Heinisch and Lovegrove Law Office PC LLO
Beacom v. Daley 164 Neb. 120, 81 N.W.2d 907 (1957)
Since the mother died on June 22, 1952, the question arises, was appellant liable for rent for the year 1952? Death of the mother (life tenant) terminated her interest immediately and thereupon appellant became entitled to the possession of the real estate. Guthmann v. Vallery, supra. As stated in Guthmann v. Vallery, supra: "On the termination of the life estate the reversioner became at once entitled to the possession of the real estate; * * *."
The rent for 1952 was not due until March 1, 1953. As stated in 33 Am.Jur., Life Estates, Remainders, Etc., § 308, p. 813: "The right to rentals continues only until his death and no longer, if he is a life tenant for the duration of his own life." And in 31 C.J.S., Estates, § 65b, p. 81: "On the termination of a life estate, rights claimed through the life tenant cease and the remainderman is entitled to possession."
As stated in Johnson v. Siedel, 178 Iowa 244, 159 N.W. 677, 678: "The authorities seem to hold that, without a special provision in the lease or by statute, rents are not apportioned in respect to time, so that the person who owns the reversion on the date the rent becomes due, is entitled to the entire rental matured that day. 1 Tiffany on Landlord and Tenant, § 176; 2 McAdam on Landlord and Tenant [4th Ed.], § 291; 24 Cyc. 1185; Russell v. Fabyan, 28 N.H. 543, 61 Am.Dec. 629." See, also, 33 Am.Jur., Life Estates, Remainders, Etc., § 309, p. 813, § 310, p. 816, § 311, p. 816. As stated in 33 Am.Jur., Life Estates, Remainders, Etc., § 309, p. 813: "The general rule followed in the absence of contrary statute and in the absence of an intention in favor of apportionment appearing from the will or other instrument under consideration is that income consisting of rent money is not apportionable as between persons successively entitled, where the right of one person ends and that of another begins during a rent period."
And in 33 Am.Jur., Life Estates, Remainders, Etc., § 310, p. 816, it is stated: "If the estate of the life tenant terminates intermediate rent days, or before any rent has become due, the accruing rent becomes an incident of and is annexed to the estate of the reversioner. Whoever owns the reversion when the rent falls due is entitled to receive the whole sum, unless it is otherwise provided by contract or statute."
We think, in view of the above principles, that appellant was not liable for rents for the year 1952.
Ruwe's Estate v. Ruwe, 211 N.W.2d 610, 190 Neb 663 (Neb. 1973),
Defendant also questions the requirement that he pay rent for the March
1, 1969, to March 1, 1970, year [190 Neb. 666] as the life tenant died on January 20, 1970, and defendant was the remainderman. His contention is based upon the theory that the rent did not accrue until March 1, 1970, after the termination of the life tenancy. In support of his theory he cites Beacom v. Daley, Supra. That case holds that rents accruing after the death of the life tenant belong to the remainderman. There was no evidence to show when the rent accrued and it was therefore deemed to fall due when the lease period terminated. In the present case the uncontradicted evidence shows that cash rent would be payable in advance and that crop-share rents fell due when the crops were harvested which was prior to December 1, 1969. The rent had already accrued to the life tenant prior to her death. It was personal property and as such belonged to the executrix of the estate of the life tenant. This court held in In re Estate of Mischke, 136 Neb. 875, 287 N.W. 760: 'Where a tenant for life of farm land leases the land, with the rent payable in a share of the crop, and dies while the crop is growing, title to the share of the crop reserved as rent passes to the executor of the tenant for life as assets of that estate.' The decision is based on the well-founded theory that growing crops are personal property. It is in line with holdings generally in other jurisdictions. See Annotation, 47 A.L.R.3d 801.
The rule announced in Beacom v. Daley, Supra, is frequently unsuited for application to rentals of agricultural
Heinold v. Siecke, 257 Neb. 413, 598 N.W.2d 58 (Neb. 1999),
LaVerne Heinold also argues that In re Estate of Mischke, supra [136 Neb. 875, 287 N.W. 760 (1939)], was overruled by Beacom v. Daley, 164 Neb. 120, 81 N.W.2d 907 (1957), which held that rents accruing after the death of the life tenant belong to the remainderman. This argument ignores our statement in Estate of Ruwe v. Ruwe, 190 Neb. 663, 666, 211 N.W.2d 610, 613 (1973), that "[t]he rule announced in Beacom v. Daley, supra, is frequently unsuited for application to rentals of agricultural lands, and insofar as it may conflict with In re Estate of Mischke, supra, it is overruled."
LaVerne Heinold further contends that the warranty deed creating the
598 N.W.2d 64
life estate represents an intent on the part of the life tenants for their rights to the crops to terminate upon death. LaVerne Heinold correctly states that a life estate terminates on the date of death of the life tenant. See In re Estate of Glaser, supra. He further notes that the language in the deed reserves to the grantors " 'the full benefit and use of the above described premises and the rents, issues and profits therefrom for and during their natural lives.' " Brief for appellant at 2. LaVerne Heinold contends that such language indicates that upon the completion of the natural lives of the grantors, their reservation [257 Neb. 420] of "the rents, issues and profits" thereby was intended to immediately terminate, thus leaving the growing crops to the remainderman.
Although this court has not addressed the issue, other courts have held that certain language in the creating instrument can cut off the right of emblements. For example, inWilhoit v. Salmon, 146 Cal. 444, 445, 80 P. 705 (1905), the owner of land granted a deed conveying it in fee " 'together with all and singular the tenements, hereditaments and appurtenances thereunto belonging, or in anywise appertaining, and the reversion and reversions, remainder and remainders, rents, issues and profits thereof.' " The deed was deposited in escrow, to be delivered upon the death of the grantor. The court held that such deed postponed only the possession of the premises by the grantees until the grantor's death and that upon the life tenant's death, her estate had no right to emblements. Similarly, in Williams v. Stander, 143 Colo. 469, 471, 354 P.2d 492, 494 (1960), an agreement providing that "upon the decease of First Party, all of the rents, profits and all income whatsoever from said land, shall, thereupon, become the exclusive property of Second Parties or the survivor of them" was found to abrogate any right the estate had to emblements. The language in the warranty deed applicable to the present facts contains no similar language, and, assuming without deciding that certain language in the creating instrument can cut off the life tenant's right to emblements, the deed before us here does not demonstrate an intention on the part of the grantors to relinquish such right.
Lastly, LaVerne Heinold contends that the Nebraska Principal and Income Act, Neb.Rev.Stat. §§ 30-3101 to 30-3115 (Reissue 1995), applies to the present facts and that under such act, the income from the growing crops properly belongs to the remainderman. The act provides that it governs "the ascertainment of income and principal and the apportionment of receipts and expenditures in trusts and decedents' estates, to the extent not inconsistent with the provisions of a creating instrument." § 30-3101. As the county court correctly held, the act does not apply to the present facts. The "creating instrument" at issue here is the warranty deed creating the life estate, and it is those [257 Neb. 421]provisions of law pertaining to this type of estate that apply, not those applicable to decedents' estates and trusts.
Because the corn and soybean crops at issue were planted during the existence of Adolph Heinold's life estate and harvested after his death, the doctrine of emblements requires that the proceeds of his reserved share of the crops be treated as property of his estate. The judgment of the county court therefore is affirmed.
Large Estate Gifting and Bequests to Multiple Generations
By: Frank C. Heinisch
Quackmore and Hortense Duck have one son, Donald Duck (who is married for the purposes of this article). Donald and his wife have three children: Huey (who is married and has no children of his own), Dewey (who is married and has three children of his own), and Louie (who is divorced and has two children of his own).
Quackmore and Hortense Duck have an estate valued at about $14.5mm, mostly comprised of separate pieces of farm ground. The exempt level is $5.430mm times 2 or $10.860mm with a federal estate tax rate of 40% that would result in a federal estate tax of $1.456mm on $3.64mm if nothing is done.
First level: place the farm land in an entity such as an LLC and claim a discount for minority interest and lack of marketability of 25%. Without an appraisal, a discount of 20% to 35% is generally permitted depending on circumstances. The higher the discount the greater the risk of an audit and the necessity of proving the discount by expert appraisals.
The real estate value at $9k per acre is $13.250mm. A 25% discount is $3.312mm and a 30% discount is $3.975mm. A 30% discount would eliminate the federal estate tax if the values were accepted.
Second level: make annual gifts of the LLC units of $14,000 per year per donor per donee (the gift tax exemption for reporting purposes). Quackmore and Hortense can give a total of $28,000 per year per person. A gift to Donald, his wife and 3 children, a total of $140,000 (5 x $28k) per year reduction in the estate value. The gifted LLC units would be valued with the discount for minority interest and lack of marketability. $200k of land x 30% discount is $140k that can be removed from Quackmore and Hortense’s estate each year.
I suggest gifting to the 5 great grandchildren. Another 5 gifts would reduce the estate by another $200,000 x 30% discount = $140,000 (5 x 2 x $14k).
Hortense wants to keep the gifts equal between the grandchildren. That being the case, there should be 9 gifts for great grandchildren: 3 for Huey with no children, 3 for Dewey’s 3 children and 3 to be divided between Louie’s 2 children.
Gifts to grandchildren and great grandchildren are generation skip transfers, subject to generation skipping transfer taxes 40% and, in addition, to federal estate tax of 40%. The tax computation is complex, but could exceed the amount of the gift with the generation transfer tax computed on the amount of estate tax paid. The allocation of generation skipping transfer tax exemption is more complex than the tax computation, especially with the interplay between gift taxes and estate taxes and generation skipping transfer taxes.
The bottom line is that generation skip gifts and bequests are great as long as you stay under the Generation Skipping Transfer Tax [GSTT] exemption, $5,430,000 (same amount as the estate tax exemption [unified credit]). The annual $14,000 gifts are also exempt from Generation Skipping Transfer Taxes. The idea is that IRS wants to tax each generation and if generation is skipped there is a double tax, if not more, unless the transfers are less than the exemptions.
Thus, $14,000 annual gifts are great and do not use up the Estate Tax exemption or the Generation Skipping Transfer Tax exemption. Note that the $14,000 includes all gifts in the year, e.g., birthday, Christmas and the annual gift. If all the gifts to a single donee exceed the $14,000, a gift tax return is required and the life time estate tax exclusion is decreased. The $14,000 (current as of 2015) is indexed to change with inflation.
The problem is that the annual gift must be a present interest gift, that is: the donee has immediate access to the gift. A gift to a grandchild or great grandchild of LLC units worth less than $14,000 in 2015 is a home run--free of taxes.
But a gift to a trust is not a present interest gift since there are strings attached per the terms of the trust. The Crummey Family won the case where a gift made to a trust is a present interest gift if the donee has a right to withdraw the gift after notice and a reasonable time limit (90 days). If the power to withdraw is not exercised, it lapses which normally is a gift from the donee. (In other words, the donee had the right to take the LLC units and failed to take the LLC units which is a gift back from him to the trust.)
The lapse of a $5,000 (or 5%) less current power to withdraw from the trust is de minimis and not considered a gift. Thus, gifts of $5,000 (or 5%) or less to a trust with a Crummey power to withdraw the gift after notice within a reasonable time is a present interest gift free of federal estate tax and free of Generation Skipping Transfer Tax.
The $5,000 de minimis rule alterative limitation is the greater of $5,000 or 5% of the value of the trust. If the trust value is $280,000 then the $5,000 is increased to $14,000 (5% of $280.000).
A hanging Crummey Trust power of withdrawal can be added to the trust that provides that if the power to withdraw is greater than the de minimis rule, then the right to withdraw is continued until there is trust value for the 5% limitation to fulfill the de minimis rule.
Remember gifts to grandchildren and great grandchildren are generation skipping events.
Thus if the value of the donor’s share of the trust is in excess of $280,000 the 5% rule will meet the annual exclusion. When there are multiple donees, computations will have to made to be sure the donor has adequate value in the trust to fund all the potential 5% withdrawals. Still the $280,000 minimum value should be adequate. Payment of the withdrawals may be in kind, that is: units of the LLC, not in cash.
We provide that those qualified to withdraw may be removed with regard to any future gifts, leaving leverage that generally persuades the person with the power to withdraw to be hesitant in the exercise their power to withdraw (because it may preclude future gifts to him or her).
In transferring assets upon death the rules of annual exclusion and present interest gifts do not apply. Upon death, units of an LLC may be transferred by Will or by Trust. The Will may create a Trust within the Will or transfer to a Trust then in existence.
The transfer of LLC units may be made directly to a beneficiary or held by a Trustee for the benefit of a specific beneficiary for a term (an age, or it could be for life). If the beneficiary is a class and the trustee has discretion in determining distribution, the beneficiary or creditors of a beneficiary have no identifiable right to trust assets. This is helpful if a great grandchild is applying for college assistance and, thus, would not need to disclose assets held in trust for them. Also a trust created by a third party with discretionary distributions is not a disqualifying resource for Medicaid. Only the amount distributed is considered a disqualifying resource.
The Federal Estate Tax exemption of $5.430mm per person can be shared between husband and wife. If all is not used by the first to die, the unused portion is available upon the death of the survivor as long as they have not remarried. This is called portability. Generation Skipping Transfer Tax exemption of $5.430mm has no portability. If the GSTT exemption is not used on the first death, it is lost. If, upon death, substantial value is to be transferred to the grandchildren or great grandchildren, provision should be made for each estate of Quackmore and Hortense to have in their name sufficient assets to give by will either directly or by trust to skip generations.
Remember that an LLC is normally taxed as a partnership, with each member having taxable income corresponding to their ratio of the LLC. Customarily, the LLC distributes funds to help the member pay the income taxes on their share of the LLC income. Such distributions are not mandatory. Distributions should be made in proportion to numbers of units owned and different members have different tax rates; thus some will have more than taxes reimbursed to make the distributions equal.
I suggested two LLCs: one for gifting and one to shelter the rest of the land to gain death tax valuation discounts. Gifted LLC units have no step up in basis upon death, therefore the land gifted to Mallard LLC should have a high basis. The income earned by the gifting LLC may be easier to control with transfers to Mallard LLC of one or two quarters. The rest of the land can be owned by Drake LLC. Some time in the future the two LLC could be merged, but keeping the gifting LLC smaller will have benefits of keeping the rest of the farm land, Drake LLC, segregated.
Gifts of the Drake LLC could be made outright to Donald and his wife each year. Everyone else would receive Mallard LLC gifts. The Mallard LLC gifts can be in trust or outright generation skipping gifts.
Ultimately, how long the trusts should last is a hard question? After Quackmore and Hortense pass, should the trust continue for Donald’s life then Huey ’s life or should Huey have the authority to extend the term of the trust? Upon termination of the trust the LLC units are distributed and the members decide to continue or sell the farms by a majority vote or will a super majority vote be required? With the LLC, a partition sale of the farm land cannot be forced. Generally, control of the LLC is by a majority of members although members may have non-voting units.
The trusts and LLCs can have whatever rules Quackmore and Hortense establish.
Consider Donald as trustee and if he fails or declines to serve as trustee then Huey; and if he fails or declines to serve as trustee a committee of your grandchildren decide the successor trustee.
The law is unsettled on whether the LLC earnings are subject to the 15.3% self-employment tax to all members. The argument against self-employment tax is that members that are not active in the LLC business are receiving a return on their capital, not earned income. S Corporation status recognizes earned income subject to self-employment tax and passive income from return on capital. This is not established for LLCs. As the income distribution increases for inactive members, it may be appropriate for an S Corporation election to escape self-employment tax. An excellent discussion of this issue was in Forbes, September 10, 2012, and is available on the internet: http://onforb.es/1BsmVFX.
This issue of all earnings being treated as self-employment income to all members from an LLC may increase the self-employment tax for Quackmore and Hortense where we now treat rental income as not subject to self-employment tax. An option is to have Drake as a S Corporation and Mallard as an LLC. An interesting twist is to have trust ownership of LLC membership units which will further confuse the earned income, self-employment tax approach. If the LLC pays a management fee (to Donald or Huey) that may further differentiate between active earned income and return on capital income for the LLC.
As always, would welcome you input and questions regarding the content of this web page. We look forward to serving you in the future.
By: Patrick Sullivan, JD
What are the factors that are considered in determining material participation for the purpose of IRC §2032A?
Can the requirements of material participation be met by a farm manager (other than the owner)?
Although the primary source of analysis for this Memorandum has been gleaned from a Dickinson Law Review article entitled "Material Participation Under Section 2032A: It Didn’t Save the Family Farm But it Sure Got Me Tenure", pp. 561-604, written by Marin D. Begleiter in 1990, I have checked most of the citations and they are still good law. I also sheppardized the cases which also appear to still be good law, and according to RIA Tax Desk Analysis (hereinafter "RIA") ¶771,020 are still cited as most authoritative. A review of RIA ¶771,020 affirms much of what is set forth in this Memorandum. Finally, I confirmed much of what is in this Memorandum with the treatise by Neil E. Harl (an imminent authority in this area) entitled Farm Estate & Business Planning (16th Ed.). Therefore, in the interest of time and keeping the costs down, little other in depth case law research was performed, other than to do searches for federal cases using the search terms "2032A" and "material participation" which proved unproductive in finding better or more current authority for the analysis set forth herein.
If the requirements of section 2032A are met, real property used in a farm for farming purposes is valued for estate tax purposes at its value as a farm or business. I.R.C. § 2032A(a)(1), (b)(2)(A). I will not detail the (at least) eight requirements unless asked to do so; they are obvious from a reading of the Code provision. I will draw attention to one requirement of relevance:
For fiver or more years during an eight year period ending on the date of decedent’s death (a) the real property must have been owned by the decedent or a member of his family and used for a qualified use, and (b) the decedent or a member of is family must have materially participated in the operations of the farm or other business.
I.R.C. § 2032A(b)(1)(c).
In addition, the statute has a recapture provision that is activated under certain conditions. If, within ten years of the date of the decedent’s death and before the death of the qualified heir, the qualified heir disposes of his interest in the qualified real property (other than by disposition to a member of the qualified heir’s family), or ceases to use the property for the qualified use, and additional estate tax (or recapture tax) is imposed in order to recapture the savings made possible by special use valuation. I.R.C. § 2032A(c)(1). One method of ceasing to use the property for a qualified use is if, during any eight year period ending after the decedent’s death, there are periods aggregating three years or more during which the decedent or a member of his family (before the decedent’s death) failed to materially participate in the operation of the farming business. I.R.C. § 2032A(c)(7)(B).
WHAT IS CLEARLY NOT MATERIAL PARTICIPATION:
Passively collecting rents, salaries, draws, dividends, or other income from the farm is not material participation. Nor is merely advancing capital and reviewing a crop plan or other business proposal and financial reports each season or business year. Treas. Reg. § 20.2032A-3(a); RIA ¶771,020.
STATUTORY DEFINITION OF MATERIAL PARTICIPATION:
Section 2032A(e)(6) provides: "Material participation shall be determined in a manner similar to the manner used for the purposes of paragraph (1) of section 1402(a) (relating to net earnings from self-employment). I.R.C. § 2032A(e)(6). The legislative history does not elaborate on this definition. Therefore, attention must be given to Code section 1402(a).
CODE SECTION 1402(a):
Code section 1402(a) defines net earnings from self-employment for the purposes of imposing the tax on self-employment income. See I.R.C. § 1401 (imposes a tax on self-employment income and prescribes the rates). Rental income from real estate is excluded from the definition unless the rental income is derived from an arrangement with the tenant which "provides ... that there shall be material participation by the owner ... in the production or the management of the production" in the agricultural commodities produced and such material participation actually takes place. I.R.C. § 1402(a)(1). If such is the case, the rental income derived in included in the owner’s self-employment income and is subject to tax.
Both an arrangement providing for material participation and actual material participation by the owner in the production or management of production are required. Treas. Reg. § 1.1402(a)-4(b)(1) (1986). Services performed by an employee or agent are excluded for this purpose. Thus, the test for material participation will focus on the meaning of production and management of production.
Production is composed of two major elements: physical work and the furnishing of resources. Treasury Reg. § 1.1402(a)-4(b)(3)(ii) (1986) provides:
The term "production", wherever used in this paragraph, refers to the physical work performed and the expenses incurred in producing a commodity. It includes such activities as the actual work of planting, cultivating, and harvesting crops, and the furnishing of machinery, implements, seed, and livestock. An arrangement will be treated as contemplating that the owner or tenant will materially participate in the "production" of the commodities required to be produced by the other person under the arrangement if under the arrangement it is understood that the owner or tenant is engaged to material degree in the physical work related to the production of such commodities. The mere undertaking to furnish machinery, implements, and livestock and to incur expenses is not, in and of itself, sufficient. Such factors may be significant, however, in cases where the degree of physical work intended of the owner or tenant is not material. For example, if under the arrangement it is understood that the owner or tenant is to engage periodically in physical work to a degree which is not material in and of itself and, in addition, to furnish a substantial portion of the machinery, implements and livestock to be used in the production of the commodities or to furnish or advance funds or assume financial responsibility for a substantial part of the expenses involved in the production of the commodities, the arrangement will be treated as contemplating material participation in the production of such commodities.
Although physical work alone may constitute material participation, the regulation provides that the furnishing of materials and being responsible for expenses alone cannot. (However, this part of the regulation has been rejected in dictem. Henderson v. Flemming, 283 F.2d 882, 888-89 (5th Cir. 1960).) The furnishing of resources and expenses becomes important in cases when the physical work does not rise to the level of material participation.
Management of Production:
Management of production is a term employed primarily to refer to the responsibility for and the actual making of decisions, and other regulations list a number of decisions that will be taken into account; these decisions and activities are:
"[W]hen to plant, cultivate, dust, spray, or harvest the crop";
"[M]aking inspections of the production activities";
"[A]dvising and consulting";
"[M]aking decisions as to matters such as rotation of crops, the type of crops to be grown, the type of livestock to be raised, and the type of machinery and implements to be funished."
Treas. Reg. § 1.1402(a)-4(b)(3)(iii) (1986). The regulations single out as particularly important making inspections of the production activities and advising and consulting with the actual producer, which together will create a "strong inference" of material participation. Id. Selection of crops, machinery, or implements and deciding on crop rotation are downplayed, but may become significant in the overall determination of material participation. Id.
Few cases exist under Code Section 1402(a), but the Social Security Act Section 211(a)(1), which mirrors the language of Section 1402(a)(1) of the Code, including the material participation test, is fertile ground for analogy. Both require an arrangement for and actual material participation and both require participation in either production or management of production, or both. 20 C.F.R. 404.1082(c) (1979).
ANALOGOUS CASE ANALYSIS:
The existence of material participation "is a factual determination that can only be made on a case-by-case consideration." Hoffman v. Ribicoff, 305 F.2d 1, 9 (8th Cir. 1963). "Material" is to be given "its common and well-understood meaning" of "solid or weighty character; substantial; of consequence; not to be dispensed with; important." Foster v. Celebrezze, 313 F.2d 604, 607 (8th Cir. 1963). As previously stated, material participation can be accomplished in either the production of the commodity, management of the production of the commodity, or a combination of the two. Treas. Reg. §§ 1.1402(a)-4(b)(3)(I), 1.1402(a)-4(b)(4) (1986); 20 C.F.R. § 404.1082(c) (1979).
The regulations indicate that some physical work is necessary to material participate in the production of a commodity. Treas. Reg. §§ 1.1402(a)-4(b)(3)(ii) (1986) (stating that production refers to "the physical work performed and the expenses incurred in producing a commodity" but further states that "the mere undertaking to furnish machinery, implements and livestock and to incur expenses is not, in and of itself, sufficient," thus implying that some physical work is required. However, this position was rejected in the oft-quoted dictum of Henderson v. Fleming, 283 F.2d 882 (5th Cir. 1960):
[W]e know that at least to day that agriculture is or may be big business. It takes more than land and a willing hand. It takes working capital, frequently in considerable amounts. An owner of land who is required to (and does) furnish substantial amounts of cash, credit or supplies toward this mutual undertaking which are reasonably needed in the production of the agricultural commodities and from the success of which he must look for actual recoupment likewise makes a "material participation."
In Bridie v. Ribicoff, 194 F. Supp. 809 (N.D. Iowa 1961), the owner’s only physical work consisted of watering livestock on a few occasions, helping the tenant load the cattle for market, driving the tractor during haying, and helping the tenants innoculate soybeans. Id. at 813. These activities alone were not deemed to have come close to material participation. However, other factors were viewed as satisfying material participation. The owner/plaintiff leased the farm (a livestock operation in which the crops grown on the land were fed to the livestock) on a stock share basis. Id. at 810. Although the tenant furnished the machinery, the owner/plaintiff was required to furnish one-half of the expenses of threshing, combining of soybeans, twine and other associated expenses. Owner/plaintiff advanced all the money to buy the feeder cattle and sows and the tenants did not reimburse him until the animals were sold. Id. The court held that the plaintiff’s furnishing of expenses and advancement of capital, combined with his periodic advice and consultation with the tenants, periodic inspection of livestock, and involvement in management decisions constituted material participation. Id. at 815-16.
In Celebrezze v. Miller, 333 F.2d 29 (5th Cir. 1964), plaintiff was eighty-two years old and spoke no English. Id. at 30. His physical activities had been greatly reduced seven years prior ot the years in question. Id. at 31. Two tenants cultivated the cotton, corn, and sweet potatoes on the 121-acre farm and received two-thirds of the crop. The oral arrangement requiring plaintiff to inspect the crops three or four times a month, pay one-third of the costs of fertilizer, poisons, and labor hired, absorb one-third of the losses, and advise and consult with the tenants during the inspections as to where to plant the crops and the application of fertilizer and poisons. Id. at 30-31. The tenants conducted the farm operation, furnished the seed, tilled the crops, arranged for additional hired labor when necessary, and applied the fertilizer and poisons. Id. at 31. In a short opinion, the court held that the plaintiff materially participated in the production. This decision stands for the proposition that the furnishing of one-third of the expenses, together with periodic inspection of the crop, constitutes material participation.
Many other decisions could be discussed. It should be noted that many of the cases have focused in some way on the risk assumed by the owner. Begleiter, M.D., Material Participation under Section 2032A: It Didn’t Save the Family Farm But it Sure Got Me Tenure (1989). One example of the origin of this analysis is Henderson v. Flemming, 283 F.2nd 882 (5th Cir. 1960) which involve Mrs. Poole, a ninety-one year-old invalid confined to a wheel chair. The arrangement required her to break ground and to plant the crop, which she did through a family member (her son) on a contract basis. Id. at 885. The court held that the physical work involved was apparently insufficient to constitute material participation. Id. at 887-88. The owner was required to furnish seed, to pay one-half of the cost of insecticide, to pay the fuel costs, and to absorb the depreciation on the machinery. These costs were substantial, especially in relation to her income from the farming operation. Id. at 855-86. Although the responsibility for the expenses combined with the physical work of her son could have been the basis for a finding of material participation, the court based its decision on the risk taken by the owner. Id.
After noting in Henderson v. Flemming the significance of capital in operating a modern farm, the court emphasized the importance of this risk:
An ower of land who is required to (and does) furnish substantial amounts of cash, credit or supplies toward the mutual undertaking which are reasonably needed in the production of the agricultural commodity and from the success of which he must look for actual recoupment likewise makes a "material participation." One is hardly a mere landlord in the traditional sense if he must risk considerable funds in addiiton to the land in the success of the venture. And what he gets–or hopes to get–is more than rent. It is profit from the operation of a business, a business fraught with financial risk–the business of producing agricultural commodities.
Id. at 885.
Management in the production–decision making–is also important in the determination of material participation despite the emphasis of the regulations on physical work. The courts have instead focused on the furnishing of resources and the risk undertaken by the owner. A similar process has occured in the other means of satisfying the material participation test: the management of production. The regulations specify two factors–the making of managerial decisions relating to the production of the commodity, and advising, consulting, and inspecting the production facilities–to be considered in the decision on material participation. Treas. Reg. § 1.1402(a)-4(b)(3)(iii) (1986); 20 C.F.R. § 404.1082(c)(2)(iii) (1979). Despite the language in the regulations, the decided cases have, on the whole, taken the more logical position that the decisive factor should be who makes the final and more important decisions and that inspections, consultation, and advice are only a factor to be considered in the determination.
Perhaps the clearest case illustrating the emphasis of the courts on decision making is McCormick v. Richardson, 460 F.2d 783 (10th Cir. 1972). On his retirement, Id., McCormick became active in managing a 160-acre farm he owned in Illinois, which had become badly run down. Id. at 784. He hired a person to clear a woodland area, remove the timber and stumps, and prepare the land for planting. Id. He and the tenant (who farmed the land under an oral arrangement with McCormick for the past seven years) agreed that modern farm machinery was required, which was purchased by the tenant. Id. Under the arrangement, McCormick was responsible for the cost of furnishing and spreading lime and rock phosphate, the real estate taxes, insurance, building and fence repair, the cleaning and maintenance of a drainage-ditch on the farm, the cost of clover seed, nitrogen, poison and weed killer, and forty percent of the cost of fertilizer. Id. at 785
Although the court might have based its decision on the resources furnished by the owner, instead it emphasized McCormick’s management in finding he materially participated in the management of production. McCormick determined when soil tests should be made and had them done, and he carefully and regularly inspected the production activities. During his inspections each fall, he particularly focused on the production of each grain, how the ground was seeded, and the use of weed killer. Id. He also had aerial photographs made of the different fields. Id. From these inspections, McCormick determined a detailed plan for the following year’s crops. Id. Though McCormick and the tenant usually agreed, it was understood that in the event of disagreement, McCormick reserved the right to make the final decision. Id. at 785 (emphasis added). McCormick prepared a careful plan of crop rotation each fall, and decided whether a government crop plan should be used. Id. He also devised several innovative methods to deal with problems of the farm that greatly increased the farm’s production. Id. at 785-86. The court ruled that McCormick made a "very substantial and helpful contribution to the management of production, which resulted in a very large increase in the amount of crops produced," which constituted material participation. Id. at 787.
Another leading case in this area is Foster v. Celebreezze, 313 F.2nd 606 (8th Cir. 1963). The lease provided that the tenants agreed "to put in such crops in such manner as the landlord may direct." Id. at 608. The court ruled that this provision gave the owner "broad managerial powers," including the rights to direct and supervise the preparation of the seed bed, the time and method of planting the seed, the amount of seed planted, and other matters "which would appear to be substantial managerial functions which would have a material bearing upon production." Id. Together with other lease provisions that gave the owner the rights to approve seed planted, to designate the fields on which manure was spread as fertilizer, to determine which meadows and fields were to be ploughed, to direct weed cutting and clipping of clover, and to determine participation in government support programs, the court determined that the quoted provision constituted an arrangement for material participation under the normal meaning of that term. Id. Although the court mentioned that the exercise of the owner’s reserved rights would require numerous and periodic advice and consultation, the decision is clearly based on the decision-making power of the owner. Id.
Perhaps the two most important cases to illustrate the importance of decision-making are Hoffman v. Gardner, 369 F.2d 837 (8th Cir. 1966), and Colegate v. Gardener, 265 F. Supp. 987 (S.D. Ohio 1967).
In Hoffman, supra., the claimant lived in Missouri. His farms in Iowa were supervised by his brother-in-law, who farmed land near the claimant’s farms. Hoffman v. Gardner, 369 F.2d 837, 839 (8th Cir. 1966). The only evidence of advice, inspections, and consultation were that the claimant consulted periodically with his brother-in-law and occasionally with the tenants directly by telephone and letter, sometimes instructing the tenant about crops, and that claimant and his daughter spent one week a year on the farms. Id. All other advice, consultation, and inspections were made by the brother-in-law, who kept claimant advised of the conditions and relayed claimant’s instructions to the tenants. Id. The leases, however, gave claimant complete managerial control; the tenants were only permitted to make suggestions. Id. The owner determined the crops to be planted, the time and location of the planting, the type of seed, the crop rotation plan, the price and time of sale of the crops, and conservation measures. Id. He kept charts showing crop information and each year sent the tenants a map showing where to fertilize, the type of fertilizer, terracing, and other matters. Id. at 839. The court had no trouble holding that the owner made important decisions concerning the production and that this constituted material participation, despite the limited inspections. Id. at 841-42.
In Colegate, the claimant owned and lived on a 65-acre farm. Colegate v. Gardener, 265 F. Supp. 987, 988 (S.D. Ohio 1967). She entered into an arrangement with a neighbor to farm most of her acres. Expenses were shared equally, except that the tenant provided the machinery. Id. At planting time, claimant made two inspections of the area, each lasting about 15 minutes. Id. at 989. She made no regular inspections during the growing season, but went "around the outside of the crops." Id. When the crop was harvested, claimant made sure that her share of the crop was put in the proper place. Id. The only evidence on managerial decisions made by the owner was that she decided what she wanted planted, a subject on which there was apparently some disagreement between the owner and the tenant. Id. at 989. The court did not view the joint nature of most decisions or the near absence of disagreement between the owner and tenant as unusual or as reflecting on the material participation of the owner’s participation. Id. The court made short work of the argument that the claimant did not materially participate because she made only two inspections of fifteen minutes each and that consultation between the owner and the tenant took place so infrequently. The court held that the owner material participated.
From the above cases, it would appear that the courts have had an expansive view of what constitutes decision-making for material participation purposes for Social Security purposes.
MATERIAL PARTICIPATION UNDER SECTION 2032A:
The above cases form a backdrop with which to view material participation under Section 2032A. The Code only provides that material participation "shall be determined in a manner similar to the manner used for purposes of paragraph (1) of section 1402(a) (relating to net earnings from self-employment). I.R.C. § 2032(e)(6). The apparent purpose of this requirement was to keep the qualified real property in farm or business use in furtherance of the statute’s purpose of preserving the family farm. H.R. Rep. No. 94-1380, 94th Cong., 2d Sess. 22 (1976). Material participation can be accomplished either by the decedent or a member of his or her family (prior to decedent’s death) and by either the qualified heir or a member of the qualified heir’s family (after the decedent’s death). I.R.C. § 2032A(b)(1)(C)(ii), (c)(6)(B). The Internal Revenue Service has issued regulations designed to delineate the activities that will constitute material participation. Tres. Reg. § 20.2032A-3 (1986). (It should be noted, however, that the Service has ruled that material participation is a factual determination (made by the courts) and that the Service will not issue advanced ruling on whether, under a given set of facts, material participation exists. Priv. Ltr. Rul. 86-10-073 (Dec. 12, 1985).
The first test is that "[a]ctual employment of the decedent (or a member of the decedent’s family) on a substantially full-time basis (35 hours a week or more) or to any lesser extent necessary to personally manage fully the farm or business in which the real property to be valued under Section 2032A is used constitutes material participation." Treas. Reg. § 20.2032A-3(e)(1) (1986). (Note, the regulations require that, if the individual is self-employed with respect to the farm, his or her income from the farm must be earned income for self-employment tax purposes for the participation to be materially participating. However, nonpayment of the tax creates a presumption of lack of material participation and requires that the executor demonstrate to the Service that material participation occurred and explain the reason for why taxes were not paid. In addition, all self-employment taxes due must be paid. Id.) The activities of agents or employees (other than family members) are not considered in the determination of material participation. The income tax regulations are similar. Treas. Reg. § 1.1402(a)-4(b)(5) (1986).
If the involvement is less that full-time, the activities "must be pursuant to an arrangement providing for actual participation in the production or management of production where the land is used by any non-family member, or any trust or business entity, in farming or another business." Treas. Reg. § 20.2032A-3(e)(1) (1986) (emphasis added). (It is important to note that the same words, production or management of production, as are used in the regulations under § 1402 and in the Social Security Act, are used here.)
At the heart of the regulations is section 20.2032A-3(e)(2), which enumerates the factors considered in determining material participation:
No single factor is determinative of the presence of material participation, but physical work [Treas. Reg. § 1.1402(a)-4(b)(3)(ii) states work is a major ingredient in the production of a commodity] and participation in management decisions [an important factor under the Social Security case] are the principal factors to be considered. As a minimum, the decedent and/or a family member must regularly advise or consult with the other managing party on the operation of the business. While they need not make all final management decisions alone, the decedent and/or family members must participate in making a substantial number of these decisions. Additionally, production activities on the land should be inspected regularly by the family participant, and funds should be advanced and financial responsibility assumed for a substantial portion of the expenses involved in the operation of the farm or other business in which the real property is used. In the case of a farm, the furnishing by the owner or other family member of a substantial portion of the machinery, implements, and livestock used in the production activities is an important factor to consider in finding material participation. With farms ..., the operation of which qualifies as a trade or business, the participating decedent of heir’s maintaining his or her principal place of residence on the premises is a factor to consider in determining whether the overall participation is material....
Therefore, the same tests are used in section 2032A regulations (participation in the production or management of production) as are used in the regulations under section 1402 of the Code. All of the factors enumerated in section 2032A regulations are contained in the section 1402 regulations or have been recognized by case law under the Social Security Act. The sole difference is that section 2032A regulations appear to contemplate involvement in several of the enumerated activities in order to constitute material participation. As shown in the early cases under section 2032A, there appears to be an unstated element or provision that even if, for example, the decedent and the qualified heir (or members of their families) made most of the final management decisions, this would not be enough to constitute material participation without inspections or advice and consultation, or the assumption of financial responsibility for a substantial portion of the risk, or the maintenance of a home on the farm. (See, e.g., Estate of Coon v. Commissioner, 81 T.C. 602 (1983) (a poorly decided case where the court found no material participation despite the fact that the landlords assumed a substantial portion of the operating expenses of the farms and that decedent’s brother did participate in management decisions, ostensibly because the tenants made many of the operating decisions); Estate of Coffing v. Commissioner, 53 T.C. Memo (CCH) 1314 (1987) (relying exclusively on seciton 2032A regulations, although some of the decisions were made by the decedent, almost all decision-making powers were delegated to a corporate farm operator, the court found no material participation–as should be the case); Estate of Ward v. Commissioner, 89 T.C. 54 (1987) (Although the court found material participation, it required a higher standard than evidenced by the case under section 1402. The court emphasized that decedent consulted with the tenant directly, rather than using a farm manager or other agent [which is correct in this regard].). As shown above, this is not in keeping with the cases under section 1402 or its regulations.
Later cases under section 2032A take the position that management of operations in the typical crop share arrangement [if indeed there is one] is sufficient for material participation. See Mangels v. United States, 828 F.2d 1324 (8th Cir.1987), rev’g, 632 F. Supp. 1555 (S.D. Iowa 1986). Some attention need to be paid to both the district court case and ruling, and that of the circuit court which reversed the district court’s ruling.
Decedent, Mangels, died in 1980. From 1966 until her death, decedent was physically and mentally incapacitated and unable to handle her own affairs. Id. at 1325. She was a ward of a voluntary conservatorship. From 1974 until her death, Northwest Bank served as decedent’s court-appointed conservator, the Lage, a vice-president of the bank, performing all acts for the conservator relating to the management of the farm. Neither decedent (or a family member) resided on the farm during the eight years preceding her death. Id. at 1555. The farm income was not reported as self-employment income on decedent’s tax returns because the conservator did not understand the "complex provisions of the Internal Revenue Cod and related regulations." Id. At least two tenants were experienced farmers. All machinery and implements used on the farm were furnished by tenants, but decedent, through the conservator, paid one-half of the costs of fertilizer, seed, pesticide, and herbicide and the full cost of installing tile lines. Id. at 1557, 1560. From 1974 until 1980, Lage’s activities respecting the farm were:
1. Giving daily attention to farm market reports for about fifteen minutes a day.
2. Execution of futures contracts to market the decedent’s share of grain for about three and one-half hours a year. (The farm had no on-site storage.)
3. Physical inspections of the growing crop and farm ground for fence and tile repairs once each quarter for about two hours each inspection.
4. Contact with tenant once a month concerning progress of the crop, cultivation, herbicide, and pesticide decisions lasting approximately on hour each consultation.
5. During the winter, counseling the tenant concerning crop decisions for the next year and the next year’s operating plans and operating loan application for one and one-half to two hours.
6. Analyzing the cash equivalent rental of the crop-share proceeds to evaluate the advisability of renewal of the lease for about four hours.
7. Undertaking extraordinary projects such as the construction of drainage tile in 1979. This project occupied twenty to twenty-five hours.
Almost all decisions regarding the operation of the farm were made jointly by Lage and the tenants.. Major conservation practice decisions, the marketing of the conservator’s share of the crop, and installation of the tile lines were the exclusive responsibility of the conservator. Id. at 1557. Lage stated that though there were few disagreements with the tenant as to operating decisions, the conservator did override the tenant’s suggestions on occasion. Id. at 1558.
In short opinion, the District Court held that the conservator’s activities did not constitute material participation, emphasizing that the frequency of consultation with the tenant was low, the inspections did not take much time, and that no agent of the conservator lived on the farm, did any physical work on the farm, or furnished any machinery used in production. The court stated: "In short, the conservator’s participation appears to have been no greater than that of the landlord in the typical crop-share lease arrangement.
The court of appeals reversed and remanded for entry of a judgment in favor of the estate. 828 F.2d 1324, 1325-26 (8th Cir. 1987). The court stated that the major factors in determining material participation were advising and consulting with the tenant on the operations of the farm and participation in a substantial number of final management decisions. Id. at 1327. The court found that the monthly and annual conferences between the conservator and the tenant and the joint decision-making process as to crop patterns and rotation, fertilizer application, chemical, weed, and insect control, fence repair, plowing and minimum tillage techniques, seed purchasing, and crop planting and harvesting met these minimum standards. Id. at 1327-28. The court also noted that of the four other factors listed in the section 2032A regulations, two were present in this case. Id. To the IRS’s contention that the inspections were inadequate because they took only two hours each, the court responded that the sufficiency of the inspections is to be measured against the need for inspections; regularity does not necessarily mean time consuming. Id. at 1328. The court also ruled that the failure to pay self-employment taxes on the farm income was not fatal when the failure was explained and material participation is demonstrated. Id.
Perhaps most importantly, the court of appeals repudiated the district court’s statement that the typical activities of a landlord under a crop-share lease are insufficient to constitute material participation. Id. at 1327. In order to materially participate, a decedent need not perform acts exceeding those of a landlord in a typical crop share lease, which is consistent with the case law under the Social Security Act previously discussed (and, indeed, the court in Mangels used the standards of the Social Security cases.) See id. at 1326-30. Mangels strongly implies that the Social Security Act cases will be regarded as presidents in cases under 2032A. Mangels v. United States, 828 F.2d 1324, 1327 n.7 (8th Cir. 1987).
MATERIAL PARTICIPATION AND FARM MANAGERS:
From some of the cases above, and according to Neil Harl (a renowned expert in the area of estate and business planning and taxation) in his treatise "Farm Estate & Business Planning at 48 (16th Ed.): "Material participation cannot be attained through an agent for those producing agricultural or horticultural commodities." Also, the activities of an agent or employee other than a family member my not be considered in determining material participation. Treas. Reg. §20.2032A-3(e)(1); RIA ¶771,020 n. 5. However, the use of a farm manager does not preclude a finding of material participation by the owner/landlord who qualifies in his or her own right. Treas. Reg. §20.2032A-3(e)(2); RIA ¶771,020 n. 3.
ACTIVE MANAGEMENT INSTEAD OF MATERIAL PARTICIPATION:
"Active Management" of a farm or other business by an "eligible qualified heir" (but not by a member of the heir’s family) is treated as material participation (or an alternative to material participation that qualifies for special use valuation) by that qualified heir for purposes of the recapture rules. I.R.C. § 2032A(c)(7)(B). An eligible qualified heir includes only:
The decedent’s spouse, I.R.C. 2032(c)(7)(C)(I);
A qualified heir who has not attained the age of 21, I.R.C. 2032(c)(7)(C)(ii);
A qualified heir who is disabled, I.R.C. 2032(c)(7)(C)(iii); or
A qualified heir who is a student, I.R.C. 2032(c)(7)(C)(iv).
In the case of an eligible qualified heir who has not attained the age of 21 or who is disabled, the active management may be that of a fiduciary (e.g., a guardian or trustee, but not an agent).
In the case of a surviving spouse, if real property qualified for special use valuation in the estate of a decedent spouse and that property was acquired from or passed from the decedent spouse to his or her surviving spouse, then active management of the farm by the surviving spouse is treated as material participation by the surviving spouse in the operation of the farm for purposes of determining whether the real property qualifies for special use valuation in the estate of the surviving spouse. I.R.C. § 2032A(b)(5)(A); RIA ¶771,024. The alternative active management test also applies for purposes of applying the recapture rules in the case of the surviving spouses estate. I.R.C. § 2032A(b)(5)(A).
Active management means making business management decisions other than daily operating decisions. I.R.C. § 2032A(e)(12). The determination of whether active management occurs is factual, and the requirement can be met even though no self-employment tax is payable by the spouse with respect to income derived from the farm or other trade or business operation. Among the farming activities, various combinations of which constitute active management, are inspecting growing crops, reviewing and approving annual crop plans in advance of planting, making a substantial number of the management decisions of the business operation, and approving expenditures for other than nominal operating expenses in advance of the time the amounts are expended. Examples of management decisions are decisions such as what crops to plant or how many cattle to raise, what fields to leave fallow, where and when to market crops and other business products, how to finance business operations, and what capital expenditures the trade or business should make. H Rept No. 97-201 (PL 97-34) p. 170; RIA ¶771,025.
By analogy to cases under I.R.C. § 1402 and those under the Social Security Act, as well as the more recent cases under I.R.C. § 2032A, material participation may be evidenced either by production activities or the management of production activities, or both, rising to the level of at least the typical crop share lease. The factors considered are as varied as the cases and the courts decide each case on the facts and circumstances at hand. However, it is clear that material participation cannot be made through the production or management of production activities of a farm manager.
This was taken from an April 15, 2015, email Frank sent to the NSBA Real Estate, Trust and Probate Section list serve.
County assessed value as discounted to 75% is a starting point in valuation but does not often reflect FMV of Nebraska agricultural land. Review the University of Nebraska Agricultural Economics Publication, Nebraska Farm Real Estate Market Highlights 2013-2014 published June 2014, http://agecon.unl.edu/2015-trends-in-nebraska-farmland-values-and-rental-rates and the updated valuations as of February 1, 2015, http://agecon.unl.edu/2015-trends-in-nebraska-farmland-values-and-rental-rates.
For Nebraska Real Estate Transfer Statement form 521 line 14 “What is the current market value of the real property,” the county assessed value is generally accepted. Computation of life estates for form 521 the county assessed value is also generally accepted.
For the clear market value for inheritance tax, at a minimum use the county assessed value. Often a higher value, reflecting FMV is appropriate to take advantage of stepped up basis. Federal estate tax and gift tax requires FMV that is generally higher than the assessed value of farm ground. In Fillmore County the pivot irrigated land is about 160% of the 2014 county assessed value.
We often use county assessed values for houses and improvements and value the farm land at average sales rates representative of the UNL reports. There are IRS restrictions on using averages for valuation rather than actual sales, but the average will generally reflect a FMV in the ball park of what is acceptable and the level of error in FMV is insignificant in many estates. The next step is to hire an appraiser for larger estates involving taxable federal estate tax or recite actual comparable sales as the basis for determining FMV.
469 NAC 2-009.07A-6c(2)(a) "Annuities Excluded from Resources" states:
An annuity which has been annuitized will be excluded from countable resources if it meets the following conditions:
1. The annuity is considered either an individual retirement annuity according to the Internal Revenue Code (IRC) or a deemed Individual Retirement Account under a qualified employer plan; or
2. The annuity is purchased with the proceeds from a simplified employee pension; and
3. The annuity is irrevocable and non-assignable, the individual who owned the retirement account or plan is receiving equal monthly payments, and the scheduled payout period is actuarially sound based on the individual’s life expectancy.
The applicant or recipient must verify that the annuity meets these requirements.
469 NAC 2-009.07A-6c(2)(b) deals with "Deprivation of Resources for Annuity Transactions" and provides:
For long term care services (see 469 NAC 2-009.10B), an annuity transaction after February 8, 2006, is treated as a disposal of an asset for less than fair market value unless the State of Nebraska is named as the remainder beneficiary in the first position for at least the total amount of Medicaid expenditures paid, or is named as the remainder beneficiary in the second position after the community spouse and/or minor or disabled child. An annuity is also treaded as a disposal of assets for less than fair market value unless it is irrevocable and non-assignable, actuarially sound, and provides for payments in equal amounts during the term of the annuity, with no deferral and no balloon payments. This provision also applies to the community spouse.
The issuer of an annuity must notify the Department when there is a change in the amount of income or principal withdrawn from the annuity.
In order for an annuitized annuity to not count as a resource we must be able to satisfy one of the two requirements of 469 NAC 2-009.07A-6c2 (the annuitized annuity is considered an individual retirement annuity per IRC or a deemed Individual Retirement Account under a qualified employer plan OR the annuity is purchased from the proceeds from a simplified employee pension [which we may not be able to meet]) AND the annuity is:
- irrevocable and non-assignable;
- the individual who owned the retirement account or plan is receiving equal monthly payments with no deferral or balloon payments;
- the scheduled payout period is actuarially sound based on the individual’s life expectancy; and
- the applicant or recipient verifies that the annuity meets the above requirements.
Even then, the annuitized annuity must not be considered a "Deprivation of Resources," which seems to require that:
- The State be named as the remainder beneficiary in the first position at least up to the total amount of Medicaid expenditures, or in second position behind a community spouse and/or Minor or disabled child;
- The annuitize annuity must be irrevocable and non-assignable;
- It must be actuarially sound;
- It must provide for payments in equal amounts during the term of the annuitized annuity; and
- It must have no deferral or balloon payments.
Web research confirms that an annuity that the owner can withdraw is a countable resource. Nothing in the web (or the NAC (below)) speaks to whether a private annuity vs. a commercial (though and insurance company) is a countable resource for Medicaid purposes; although, most all web-based articles speak to commercial annuitized annunities are non-countable. The NAC (below) is unclear on this point (but leaves the door open to a private annuitized annuity may be uncountable where actuarially sound and the applicant or recipient verifies that the annuity meets the requirements of the NAC. Some of the web articles indicate that an annuitized annuity for a fixed number of years is not a countable resource, but the NAC (below) does not address this specifically. The purchase of an annuitized annuity is not a resource for medicaid unless (under the NAC (below), it runs afoul of the "Deprivation of Resources for Annuity Transactions."
To get more specific answers to the above issues that the NAC (below) does not specifically address, I will have to call a specialist in the Nebraska Medicaid department and ask the questions. Even then, I may not get the answers, but just be referred to the provisions of the NAC I have already found.
NEBRASKA ADMINISTRATIVE CODE (NAC):
NAC 2.009.07 [Effective 5/8/05] "Types of Resources deals with various things which are and are not countable resources for Medicaid purposes (hereinafter "countable resources"). The general provision NAC 2.009.02 [Effective 5/8/05] "Definitions of Available Resouces" deals with various things were are countable resources as well; it lists 21 things that are countable resources, but annuities are not included in the definition unless it comes under:
12. Income received annually, semi-annually, or quarterly which is prorated on a monthly bases and included in the budget. This income is excluded as a resource over the period of time it is being considered as income.
Generally, annuities are countable as "liquid resources." 469 NAC 2-209.07 and 469 NAC 2-009.07A-6c ("Annuities"). The administrative code distinguishes between "Purchased or Annuitized Before February 8, 2006,"469 NAC 2-007.07A-6c(1), and "Annuity Transaction On or After February 8, 2006. 469 NAC 2-007.07A-6c(2). 469 NAC 2-007.07A-6c(2) provides that the following annuities are countable as follows:
- Revocable and assignable annuities are a countable resource.
- A salable annuity which has not been sold is a countable resource for the amount annuitized, less the payment(s) amount already received.
- A saleable annuity which has been sold for a value consistent with the secondary market is a countable resource in the amount of the proceeds.
- If a saleable annuity is sold for less than a value consistent with the secondary market, it will be valued at the current secondary market amount and the difference will be subject to deprivation of resources regulation.
Should the $5,120,000 gift tax exclusion for 2012 be utilized by making a mega-gift before it expires? In 1976, Congress adopted a unified credit approach to federal estate and gift tax computations. The basic premise is that a taxable gift that is included on a Form 709 Gift Tax Return must be included on line two of the Form 706 Federal Estate Tax return.
In other words the previously taxable gifts must be added to the estate value as of date of death to compute the federal estate tax which is reduced by the unified credit to determine the balance of federal estate tax due nine months after death. A gift in excess of the annual gift tax exclusion in a calendar year ($13,000 per donee in 2012), is a taxable gift.
Over the years since 1976 the approach of combining the previous taxable gifts with the date of death value of the estate has not changed. The amount of the unified credit has been increased several times. Now the federal estate tax is equivalent to the current unified credit of $5,120,000.
Table of Unified Credits (Recalculated at Current Rates) [IRS Pub 950]Period Recalculated Unified Credit
1977 (Quarters 1 and 2) $6,000
1977 (Quarters 3 and 4) $30,000
1987 through 1997 $190,800
2000 and 2001 $217,050
2002 through 2010 $330,800
A unified credit is applied to the gift tax return and generation-skipping tax return in computing the balance of the tax due. Currently the gift tax unified credit and the generation-skipping tax exemption is the same as federal estate tax unified credit. Since 1976 the taxable gifts and generation-skipping taxes have often varied from the federal estate tax unified credit. In 2013, the gift tax and estate tax unified credit equivalent will be $1 million and generation-skipping exemption will be approximately $1.4 million ($1.0 million, indexed from 1997).
If a taxable gift is made, the federal estate tax return currently includes the previous taxable gift on line two of the Form 706 (Estate Tax Return). The advantage to making a taxable gift is to eliminate the appreciation of the value of the gifted item from the federal estate tax return as of date of death as well as removing the income earned by such gifted items.
The disadvantage of making a taxable gift is losing the step up in basis of assets included in a federal estate tax return. If an asset is gifted with a low tax basis [often the cost of the asset], there will be no step up in basis upon death. When that gifted asset is sold, the donee will pay capital gains tax on the difference between the sale price and the donor's basis. Gifted assets may be subject to both an income tax on the capital gains when the asset is sold (plus federal estate tax on the value of the asset as of date of death).
This year, federal capital gains are 15% and a Nebraska maximum rate of 7%, totals 22% in capital gains tax. Next year the federal capital gain rate is expected to be 20% and 7% Nebraska, totaling 27%. This year, the federal estate tax rate is 35% with a $5.12 million unified credit equivalent and under current law, next year the federal estate tax rate will be 55% with a one million-dollar unified credit equivalent.
If an estate is under $5.12 million, and property with a low basis is likely to be gifted in 2012, the gift should wait until the end of the year to eliminate the risk of a premature death in 2012. If a death would occur in 2012 after the gift was made, there is no federal estate tax yet an opportunity for a tax free stepped-up basis would be lost with the 2012 gift.
When assets gifted in 2012 are included in future estate tax computation, the source of payment of the estate tax must be considered. After the mega-gift the remaining estate value may not be sufficient to pay the estate taxes. If there is a $1 million unified credit equivalent and the total estate is $7 million including a prior $5 million gift, the remaining $2 million assets in the estate will not be sufficient to pay the federal estate, [55% of $6 million [7m - 1m] is $3,300,000].
Although Congress may not intend a clawback (taxing previous tax-free gifts), since 1976 the structure and history of the unified credit equivalent includes taxable gifts in the computation of federal estate tax. I doubt the 1976 unified credit approach of gift tax and estate tax will change. To increase the unified credit above the $5,120,000 and/or to add a credit equivalent to gifts made in 2012 appears to be improbable.
The Obama approach advocates a $3,500,000 unified credit federal estate tax equivalent and a $1 million unified credit gift tax and generation skipping tax unified credit equivalent. The Obama taxing approach favors taxing those of substantial means and it is not probable that a special tax dispensation will be given for those who made mega-gifts in 2012.
The Romney approach advocates the termination of death taxes but realistically with the national debt and deficit issues the federal estate tax will continue. The $5,120,000 index unified credit equivalent may simply be kept under this current unified credit philosophy.
The most likely short term scenario seems to be kick the can forward and delay the sunset for a year. To increase the unified credit equivalent above the $5,120,000 and to add a credit equivalent for gifts made in 2012 appears to be improbable.
The decrease of the unified credit for gift and generation-skipping to $1 million appears to be under serious consideration. Just because a gift is tax free when made has not stopped taxing the gift in the federal estate tax return with the past unified credit approach to gift and estate tax computation. If gift tax is paid when the gift is made, there is a credit for the paid gift tax on the federal estate tax return, although the gift tax credit on the Form 706 is the gift tax recalculated to the gift tax rates as of date of death not as of date of gift.
In making the decision of 2012 mega-gifts one must consider the tax basis of the gifted items, and whether the retention of assets is sufficient to pay federal estate taxes that are computed with the inclusion of previous taxable gifts. The donor needs to be aware that should the gifted asset decline in value, their estate will include the value of the gift at the date of gift not the value of the gifted asset at date of death. A critical question, is the donor willing to lose the dominion, control and income of the gifted assets?
There are benefits of making a lifetime gift such as removing future appreciation and income from the estate, and qualifying for $5.12 million generation-skipping transfer tax exclusions. In the final analysis for federal estate tax purposes there is a strong possibility that an estate subject to federal estate tax will be substantially the same regardless of whether the mega-gift was made in 2012, but hope springs eternal that Congress will give estate tax relief to those who have made mega-gifts in 2012. My view is contrary to the vast majority of estate planning professionals who anticipate an estate benefit for those making a mega-gift that will only be available in 2012. Some advisors are so bold to counsel a mega-gift is free of gift tax in 2012 will also be free of federal estate tax. Those receiving such counsel may be in for a rude awakening. Such an approach has no historic precedence and is simply in the hands of Congress and Presidential veto.
For estates well in excess of $5.12 million, a mega-gift may be prudent as long as the lost stepped up basis is not an issue. There is little to lose and a remote possibility of a great reward. Estates under $5.12 million should carefully weigh the advantages of making a mega-gift in 2012 and estates under $3.5 million should be cautious of whether the advantages of 2012 mega gift is warranted. Such analysis is by individual worth and a couple’s worth must be separated, as each has their own unified credit, in effect doubling the tax free estate tax planning opportunities. The probability of the unused unified credit to be used upon the death of a surviving spouse will expire the end of 2012 under current law.
Mega-gifting during 2012 is not for the faint hearted and should be done only with appropriate counsel of understanding the risks and advantages.
Frank C. Heinisch