There are several miscellaneous issues dealing with large estates and business planning that we have not yet covered in this fact sheet series. It is likely that these issues do not impact very many people, so we have not raised them until this last fact sheet. Discussed here are conservation easements, generation-skipping trusts, and limited liability companies. Although the issues surrounding business planning and entity selection are vast, we want to outline the basics of limited liability companies as they are becoming quite popular for business planning.
The term generation-skipping makes some people think they are disinheriting their children in favor of their grandchildren. While that could be the case, most generation-skipping plans benefit children as well. Generation-skipping features are becoming important aspects in overall estate planning.
There are two primary benefits of a generation-skipping estate plan. To begin with, a generation-skipping estate plan can create significant estate tax savings for those with large estates or for those who have children with large estates. However, it is important to realize that this type of estate plan does not save estate taxes in the parent's estate; rather, it saves estate taxes in the estates of children or grandchildren. For example, if a single, unwed child has a $5 million estate of his or her own and is set to inherit another $5 million (in the form of cash, stocks, land, or other assets) from his or her parents, a generation-skipping trust for the $5 million could save $1.75 million in federal estate taxes assuming the child dies in 2011 or 2012. This savings could be even greater if the assets appreciate in value prior to the child's death; in contrast, the savings could be less depending on the applicable exemption amount and tax rate for federal estate tax in the year of the child's death. Also, this estate tax savings might occur in the estates of grandchildren, great-grandchildren, and/or more remote generations.
Due to the recent change in portability of the federal estate tax exemption of spouses in 2011 and 2012, the use of trusts in estate tax planning might be less used in the parent's estate. However, the use of trusts as a tool to facilitate generation-skipping is as viable now as ever, despite the portability of the federal exclusion between spouses. The generation-skipping transfer tax exemption was not made portable in recent legislation.
In addition, a trust can be drafted to provide protection against the creditors of children in the event of financial difficulty. This can include some protection in the event of a divorce. The protection is not unlimited, and creditors for delinquent child support or for necessities such as food, clothing, and shelter have had some success in reaching the assets of a trust. However, in most situations parents want their children to have such necessities. A divorce court should not be able to transfer to the spouse the assets in such a trust. However, the court could consider the trust as a resource in determining the appropriate level of alimony.
The two primary negative aspects of a generation-skipping transfer relate directly to the two primary benefits. First, because the trust will not be taxable for estate tax purposes in the estates of your children, your grandchildren will not receive a step-up in basis for income tax purposes after the death of your children. For example, let's say a farm is worth $2,000 per acre at your death and the farm is worth $3,000 per acre at the death of your children. If you gave the farm to your children directly, the entire value of the farm would be in the taxable estate of your children for estate tax purposes. If the children's estate is in excess of the federal exclusion that year ($5.12 million in 2012), the value of the farm in the child's estate could be subject to federal estate tax (35% in 2012). However, if your grandchildren then sold the farm for $3,000 per acre, no income tax would have to be paid on any capital gains because of a step-up in basis to $3,000 per acre for income tax purposes at the death of your children. On the other hand, if you gave the farm to a generation-skipping trust for the benefit of your children during their lifetime and then to grandchildren, the federal estate tax is avoided in the estates of your children; however, your grandchildren would have a basis for income tax purposes of only $2,000 per acre. If your grandchildren decided to sell the farm for $3,000 per acre, they would have to pay income tax on the $1,000 of capital gain ($3,000–$2,000). The maximum federal capital gains rate is currently 15%, which is considerably less than the federal estate tax. The maximum Ohio income tax is currently around 6.5%. These might increase. If one is subject to federal estate tax, the capital gain liability will likely still be below estate settlement costs. However, if not subject to federal estate taxes, the capital gain liability might well be more than estate settlement costs.
Therefore, if your children's estates are or will be large enough to be subject to federal estate tax, this negative will be less than the benefit of the estate tax savings. In this case, a generation-skipping trust will minimize the tax rate and defer the payment of tax indefinitely until a sale is made and cash is available to pay the tax. If your children's estates will not be subject to federal estate tax, a generation-skipping trust will still defer the payment of tax indefinitely until a sale. This is fine if your family plans to hold onto property for the foreseeable future, but if your children's estates will not be subject to federal estate tax and if a sale is planned in the near future, the generation-skipping trust might cause more tax to be paid in the end than if the trust did not exist.
In some cases it might be hard to know whether your children will be subject to federal estate tax. The facts and desires related to each family need to be examined on a case-by-case basis to see if generation-skipping trusts make sense.
Finally, because the trust is generally not subject to the claims of creditors, the trust assets are not available to secure the personal debts of your children. The trustee, in his or her capacity as trustee, can buy and sell property, and borrow money using trust assets as security. However, this activity occurs within the trust and does not relate to personal obligations. Further, it is much less complicated from an accounting standpoint to avoid debt all together within the trust.
Limitations on Generation-Skipping Transfers
Because of the large potential tax savings that could result from such a trust, the government has placed some limitations on the amount of generation-skipping transfers that can be made without causing the transfer to be subject to a 35% tax in addition to the gift or estate taxes payable. Each person can transfer up to $5 million in a generation-skipping transfer, free of generation-skipping transfer tax in 2011 and 2012. In addition, gifts each year that do not exceed the $13,000 annual exclusion for gift tax purposes or that are made directly to a qualifying school or medical provider also avoid the generation-skipping transfer tax.
However, if the annual exclusion gifts are made through the use of a trust, additional requirements must be met in order for the gift to qualify for the annual exclusion for generation-skipping transfer tax purposes. Accordingly, it is possible for a gift to qualify for the annual exclusion for gift tax purposes but not for generation-skipping transfer tax purposes.
In most cases, if the estate—after paying estate taxes—exceeds the exemption amount for generation-skipping transfer tax purposes, the excess should be distributed directly to children. There are some exceptions (such as where the entire family is extremely wealthy or where the children have sizeable estates and are not expected to live a long time) where paying the generation-skipping transfer tax on a direct skip to grandchildren will minimize the total tax liability.
Historically, Ohio law required a trust to terminate at an arbitrary point in time. In general, the trust could continue for 21 years after the death of the last to die of the person's lineal descendants living at the date of the person's death. As of March 22, 1999, a trust can be prepared so that the assets held by the trust—whether cash, stock, land, or any other assets—will never be subject to estate tax at the death of the children or younger family members, based on current laws, for as long as it remains in the trust. The trust must in some manner expressly indicate that the rule against perpetuities does not apply, and either the trustee must have an unlimited power to sell all trust assets or someone else must have an unlimited ability to terminate the entire trust. It might make sense to set up the trust from the outset with the potential to last forever but to give each generation the right to terminate the trust as to future generations. This gives maximum flexibility in deciding how the trust will be administered.
These factors present very wealthy families with a big opportunity for planning in 2011 and 2012. Because there is a $5.12 million exemption and the maximum gift tax rate is 35%, you might be able to transfer large sums to a generation-skipping trust with relatively low transfer tax cost and have it outside of the estate tax system forever, even if the laws do not change. However, you will pay gift tax for gifts exceeding the $5.12 million gift tax exclusion.
As you can see, there are many tax issues to consider when deciding whether a generation-skipping trust is appropriate for your family. The tax savings can be significant to your children and grandchildren. At the same time, you might be able to accomplish other family objectives such as protecting your family's resources from creditors or making sure that some assets will be available to help pay for the educational expenses of your grandchildren. A generation-skipping trust could also be used to protect the family farm for generations. In many cases you will need to communicate with your children to know whether this type of trust is either desired or suitable for your family. We know that this is not for everyone, but we encourage you to consider whether it makes sense for you.
Limited Liability Company
A limited liability company (LLC) is an extremely flexible entity of choice for business purposes. It provides limited liability protection for a corporation, with the option of taxation as a sole proprietorship if a one-member company, or as a partnership or a corporation if more than a one-member company. Similar to articles of incorporation for corporations, LLCs have articles of organization that are filed with the Secretary of State. An LLC also has operating agreement, similar to a partnership agreement and bylaws. We would also encourage the use of buy-sell provisions. The owners are called members (instead of partners or shareholders), and the ownership interest is called membership interest (like a partnership interest).
LLCs are relatively new in Ohio. The law became effective July 1, 1994, but LLCs have been used in this country since 1977. However, the form has been used for a long time in Europe and South America. LLCs were developed in Germany in 1892. (When you see "GmBH" behind a German company name, it's a limited liability company.) Part of the reason for the lagtime in making LLCs official in the United States was because the IRS needed to decide if it was going to permit partnership tax treatment. The IRS has done so, and the rulings coming down have been quite favorable. Social security and workers' compensation treat members as they would partners in a partnership. Members are treated as self-employed, unless the member is not a manager and would be considered a limited partner if the business had been formed as a limited partnership.
LLCs do have some limitations. For crop farmers concerned about government payment limitations, a general partnership will give the business more persons than an LLC. Also, the IRS has not ruled on some tax issues, although this is becoming less of a concern because so many of the rulings have been favorable. Because LLCs are new, some professionals, such as accountants, are hesitant to work with them. Also, an LLC can become cumbersome if the business covers several states.
Compared to limited partnerships, LLCs provide liability protection for everyone, regardless of their involvement in day-to-day management. As with any entity, you might still be liable personally for an act such as driving an LLC-owned vehicle and causing an accident. In limited partnerships, only limited partners have liability protection. However, limited partners only have protection if they do not participate in daily decision-making. General partners are treated as partners in general partnerships and have no limited liability protection. In other words, LLCs provide more flexibility in who can be involved in management decisions without worrying about losing limited liability protection. Other than these factors, limited partnerships and LLCs are nearly interchangeable. Both serve a land-holding entity well, and both provide a way to transfer ownership interests to future generations.
Limited partnerships and LLCs have been used for a number of years in estate planning. Because many families have a large percentage of equity in real estate, they find it difficult to make gifts to decrease the size of their taxable estates. A limited partnership or an LLC is a tool to make gifting easier by giving membership or partnership interests.
Using a partnership or an LLC as a separate land-holding entity might also provide a way to involve the whole family in the dirt that holds an attachment for them, while keeping off-farm children out of the operating entity. You can structure the operating or partnership agreement so that the managers or general partners are also the persons operating the family business. In the buy-sell, the managers/general partners can have a right to purchase the other members'/partners' interests. This also works well in situations where spouses have contributed to land purchases but are not owners of the operating business. The separate land-holding entity gives them the ownership rights reflecting their contributions. In addition to the management benefits, an entity often allows for valuation discounts for gift and estate tax purposes. The discounts range in value based on the facts and circumstances in each case, but a typical discount for a minority interest in the business entity is 35%. The IRS recently has had some success in attacking the discount concept, so it is important to revisit old documents and to pay close attention to how the company documents are prepared.
LLCs are becoming quite popular because of their flexibility for income tax purposes and their additional liability protection as compared to a limited partnership or sole proprietorship. Nonetheless, there are still some situations where the other entities might be a better fit for what you hope to accomplish.
The purchase of development rights or purchase of an agricultural easement has brought conservation easements into the limelight in the agricultural community. Among conservationists, conservation easements have been in existence for years, but in Ohio, agricultural easements have become popular only recently. In the case of a conservation easement, land in a natural state is prohibited from development, whereas the farmland in an agricultural easement is prohibited from non-agricultural development. Forest, grassland, historic, and open-space easements also protect those private lands from development. During the rest of this fact sheet, all of the above easements will be lumped together under the descriptor conservation easement.
What is an easement?
A conservation easement is a legally binding covenant that is publicly recorded and runs with the property deed for a specified time or in perpetuity. It gives the holder the responsibility to monitor and enforce the property restrictions imposed by the easement for as long as it is designed to run. An easement does not grant ownership nor does it absolve the property owner from traditional owner responsibilities such as property tax, upkeep, maintenance, or improvements.
An easement is the legal instrument to make binding the retirement of most development rights. Development rights are not transferred but are instead extinguished. Usually when we think of an easement, we think of putting into writing permission for someone other than the owner to use the land in a very specific way. In the case of a conservation easement, the landowner grants to a land trust, conservancy, or government agency the right to enforce the extinguishment of the terminated development rights.
Even though property in its entirety can be transferred to an entity to protect the property from development (as is often the case with an easement), only the right to protect the property from development is transferred. Keep in mind, there are costs to protect the property; therefore, some property owners might be asked to fund annual monitoring and maintenance costs of easements when donated to a nonprofit organization.
What is the landowner giving up with an easement?
Property owners should keep in mind that once the authority to protect the property from development is granted, neither the granting property owner nor future owners can dissolve that power, even if a change of mind occurs. For that reason, it is imperative for the grantor to spend much time thinking about how he or she wants to designate future development.
A conservation easement is designed to protect a property according to the owner's wishes. The landowner determines what is prohibited and what rights are given to the land trust/conservancy/government agency. Common rights reserved by landowners are for restricted home sites on predetermined sites for children and grandchildren to build houses if they so choose. In the case of farmland, development (such as the building of barns) that is necessary for the continuation of a viable farming operation is allowed. Another common right is annual access to the land trust/conservancy/government agency to document and ensure that easement restrictions are being followed. The right for public access is usually not included in a conservation easement.
The owner of the property is the only one who can decide to place an easement on his or her property. When a property is owned by several individuals, all owners must agree to place the easement. If the property is mortgaged, the mortgage holder must also be in agreement for the easement to be placed. A conservation easement is a voluntary land protection tool that is privately initiated.
What are the responsibilities of the easement holder?
Whether the easement holder is a public or a nonprofit organization, the holder has the responsibility to enforce the requirements stipulated in the easement. This responsibility generally includes . . .
- establishing the baseline documentation and ensuring that the language of the easement is clear and enforceable. This includes developing maps, property descriptions, and baseline documentation of the property's characteristics.
- monitoring the use of the land on a regular basis. This might require personal visits to the property to ensure that the easement restrictions are being upheld.
- providing information and background data regarding the easement to new or prospective property owners.
- establishing a review and approval process for land activities stipulated in the easement.
- enforcing the restrictions of the easement through the legal system, if necessary.
- maintaining property/easement related records.
There can be income tax and estate tax benefits to the charitable donation of an easement, but the operative words here are charitable donation, not sale. The Agricultural Easement Purchase Program (AEPP) offered by the Ohio Department of Agriculture (ODA) is at most a 75% purchase and at least a 25% charitable donation. Because the AEPP is available only to a select few who are chosen by the ODA each year, sale or partial sale of development rights is generally not available to most farmers in Ohio. Also, the tax benefit, even with AEPP, is from the donation portion. Therefore, the tax benefit portion of this fact sheet will concern the donation, not the sale, of development rights.
Requirements for Tax Benefits
For either income or estate tax benefits to accrue, the following must apply.
- The easement must be perpetual, meaning the agreement is forever! The easement is not considered enforceable in perpetuity until recorded, so it must also be recorded.
- There must be a qualified real property interest, such as an easement.
- The easement must be donated to a qualified conservation organization such as a nonprofit in the conservation or historic preservation field or a government unit. General private foundations without a track record in conservation or historic conservation are not considered to be a qualified conservation organization.
- The easement has to provide significant public benefit, which can be justified by preserving open space, farmland, habitat, and/or an ecosystem. Extra documentation (such as the property being listed on the Federal Register, being of archeological importance, or being of other unique historical importance) is generally necessary for historic preservation.
- A qualified appraisal must be done no more than 60 days prior to the gift and no later than the due date of the return, including extensions. The appraisal must support the claimed charitable donation (assuming that the claimed gift will exceed $5,000).
A title search must be done to investigate mortgages and mineral rights.
If a mortgage exists on the property, the lender must subordinate his or her property rights to the easement holder so that the lender cannot force sale to a developer. A lender can still force a sale but cannot force the sale without the development restriction.
If the mineral rights are not owned, it is necessary to show that surface extraction is not and likely won't be economically feasible. Otherwise, the easement is not enforceable if the holder of the mineral rights decides to surface mine.
Amount of Tax Benefits
First, let it be said that most easements are not driven by income tax benefits. One has to have sufficient income to use up the charitable deduction; therefore, landowners often don't realize the total amount of charitable deduction theoretically allowed. Second, the charitable deduction is determined by the appraisal and is only a portion of the property value. Simplistically, the easement value is the difference between the full market value (development value) and the value after the easement restrictions are implemented.
There is a limitation on deductions that can be taken from a charitable gift of property or from property rights given to charity. Such deductions are generally limited to 30% of the adjusted gross income (AGI) the year of the donation. The portion of the deduction that is not used in the first year can then be carried forward for as many as five additional years. However, after six years, any portion that is not used is lost. Large deductions require significant taxable income (AGI) to take advantage of the deduction.
It is possible to elect to deduct 50% of AGI the year of the donation; however, this is only advantageous to those who donate an easement for property with little appreciation and who have a much higher income in the year of the donation than is expected in the next five years. The total deduction allowed for this election is calculated using the original value or basis (purchase price or value when inherited) of the property. Because most property appreciates, the original basis is usually lower than present value; thus, this election usually lowers the total deduction allowed. However, Congress raised the limit to 50% of AGI for certain contributions and 100% for eligible farmers, and the carryforward was increased to 15 years for gifts made through the 2012 tax year.
As a rule of thumb, each $1,000 of donated easement value creates an income tax savings of $80–$330, depending on your tax rate. The higher your tax rate, the higher your savings. Numerous factors, including alternative minimum tax, influence where you fall within this range. To estimate specifically the income tax benefit of a qualified conservation easement, contact your tax advisor.
There are two main reasons estate taxes can be reduced with a qualified donation of a conservation easement. First, the land value is reduced by the amount of the easement. Because the land can no longer be developed, the land is worth less than before. The lower value is used in calculations, resulting in a smaller estate and lower estate settlement costs. Next, the Qualified Conservation Easement Exclusion (QCEE), or section 2031(c) allows for up to an additional 40% of the value of the land (subject to a $500,000 cap) to be excluded from the estate when the landowner dies.
It is important to note that a conservation easement can be created before death via your will or postmortem via your heirs during the estate settlement process. Either way, either you or your heirs will benefit from the resulting lower valuation and QCEE. If you wish to have your heirs create an easement, you might want to include express authority in your will or trust so that the executor or trustee has the express authority to do so.
Example for Federal Estate Tax
Assume that Dad and Mom own a farm worth $11 million, plus $500,000 cash. If Dad wills everything to Mom and Mom's spending equals the appreciation, Mom will die with an $11.5 million estate. Here is an approximate estate tax calculation for the estate if Mom dies in 2012:
|Adjusted Gross Estate||11.5 million|
|Federal Tax Per Schedule||3,923,605|
|Federal Tax—After Unified Credit||339,605|
Now assume that before or after Dad and Mom died, they put a qualified conservation easement on the farm, reducing the original $11 million value to $7 million. Assume also that a QCEE was used, further reducing the value by the $500,000 cap. Here is an approximate estate tax calculation for this scenario:
|Adjusted Gross Estate||7 million − $500,000 QCEE cap + $500,000 cash = $7 million|
|Taxable Estate||7 million|
|Federal Estate||7 million|
|Federal Tax Per Schedule||2,450,000|
|Federal Tax—Unified Credit||- 0 -|
|Federal Tax||- 0 -|
Although a conservation easement can offer income tax and estate tax benefits, it really is only for those who share a strong conservation ethic with their family, particularly with their younger family members. Whether an easement is designed to preserve farm land, natural land, forest land, grass and/or open land, or historic land or structures, easements that qualify for income and estate tax benefits are permanent. Because most easements are permanent, the aspirations and ethics of current generations as well as all future generations need to be considered.
Keep in mind that those who agree to a conservation easement are dictating to future property owners the restrictions agreed to in the easement. Assuming the property will stay in the family, children, grandchildren, great-grandchildren, and all future generations will be saddled with the easement restrictions. For that reason, some consider the most appropriate easement grantor to be a property owner who has a strong preservation ethic but no heirs.
The development of a conservation easement is a long, drawn-out process that sometimes takes many years to accomplish. Therefore, it is imperative for the parties who start the process to feel comfortable working with each other so that each party is confident that the other party has their best interest in mind. The easement grantor has to make sure that his or her rights as well as the rights of his or her heirs are protected. The easement acceptor has to make sure that the easement is able to further his or her (or his or her organization's) conservation aims and be easily enforced.
Given that the easement is most likely permanent, it is appropriate to take the time to work out all the details at the time of setup. This has two implications. First, if you are sure that you wish to grant an easement, begin the process right away since it will take a long time to complete. Second, if you have reservations about the conservancy, land trust, or government entity with whom you are working, find another or terminate the process immediately.
These fact sheets should in no manner be considered as a replacement for consulting with estate planning professionals, nor should the general principles in these fact sheets be applied to specific situations without consulting with an attorney.