For some people, but fewer under modern law, estate planning is a way to minimize estate taxes and maximize the wealth transferred to the next generation. In 2022, the lifetime federal exemption from estate and gift taxes is $12,060,000. This amount is adjusted annually for inflation. Because of this high exemption amount, very few farmers currently owe any estate tax at death. This high exemption, however, is only temporary. In 2026, the exemption will roll back $5,000,000, indexed for inflation. This is the same exemption amount that was in effect before 2018.
Even if your estate is not large enough to generate estate tax consequences under current law, estate and gift taxes should be considered if your estate is near the pre-2018 exemption amount. Most farmers own a considerable amount of real and personal property. The value of the property may trigger estate tax if the exemption amount does not keep pace with the asset appreciation. This article is an introduction to the federal estate and gift tax and its impact on estate and succession planning for farmers.
The Federal Estate Tax
The federal estate tax is a tax imposed on estates that are valued at more than the lifetime exemption amount, currently $12,060,000. Estates that have a value of more than the exemption amount pay a 40% tax on the excess. This tax is generally paid out of estate funds and is not the responsibility of the heirs of the estate. In general, if an estate passes to the surviving spouse, it will be exempt from estate taxes at the first spouse’s death. This, marital exemption, however, can lead to a large taxable estate at the second spouse’s death, if that spouse still holds the majority of the property when they pass away. To combat the imposition of taxes at the second death, the surviving spouse can elect “portability” of the estate tax exemption. Upon the death of the first spouse, any exemption amount that is unused (deceased spouse unused exclusion) may be passed to the surviving spouse to be used at the death of the surviving spouse. At the current exemption amount, this would result in the surviving spouse having a total $24,120,000 exemption if none of the exemption was used when the first spouse died. To elect portability, the executor of the estate of the first spouse to die must file an estate tax return, IRS Form 706, even if no estate tax is due.
An estate tax return is similar to an income tax return but focuses solely on the property the decedent held at death and the value of that property. For taxable estates (those with property valued above the exemption amount), the Form 706 is due nine months after the decedent dies and the return has many important features that can be useful, such as the ability to elect portability. Whether or not the decedent has a taxable estate (an estate over $12.06 million), it may sometimes be beneficial to file a Form 706 to lock in the tax basis of a hard-to-value asset. If an estate tax return is filed, the IRS has three years to challenge the value of listed assets. After that time, the IRS may not challenge the listed value when that asset is later sold by a beneficiary.
The taxable estate is determined by valuing the decedent’s gross estate. The gross estate includes all property or interests in property that the decedent holds at death. The most difficult part of the estate tax can be determining what is included in the gross estate. The property or interests held at death are generally valued as of the date of death. If the property is devised or passed at death, it will receive what is often called a stepped-up basis. This is because the person receiving the property from the decedent will take that property with a basis equal to the fair market value of the property at the time of the decedent’s death. Although the value at death is usually greater than the basis in the hands of the decedent, that is not always the case. “Basis adjustment” is a better description of the what the law does because if the asset declined in value, the basis in the hands of the beneficiary will be lower than the basis of the decedent. Because of the basis adjustment rule, the estate will have no gain recognition for property that appreciated in value during the decedent’s lifetime. In other words, no capital gain tax will be owed. Likewise, the estate will have no loss recognition if the property declined in value while the decedent owned it.
The Federal Gift Tax
The federal gift tax is a tax imposed on lifetime gifts if the gift amount exceeds the lifetime exemption amount. The gift and estate tax share a combined $12,060,000 lifetime exemption. While living, a donor is required to filed a Form 709 gift tax return for any gift given to an individual if the value of the gift exceeds the annual exclusion amount. Beginning in 2022, the annual exclusion amount is $16,000. This allows the donor to gift $16,000 each year to any number of individuals without having that gift amount count against the lifetime exemption. If a husband and wife each make a gift to the same person, their combined exclusion for that split gift is $32,000.
If a donor gives more than $16,000 in one year to one individual, the donor must file gift tax return, and the amount of the gift that exceeds the annual exclusion amount reduces the donor’s lifetime exclusion amount. Gift tax is due only if the sum of lifetime gifts exceeds the combined lifetime exemption for the gift and estate tax ($12,060,000 in 2022). Otherwise, the executor will apply the reduced lifetime exemption against the value of the gross estate when determining whether estate tax is due.
Unlike transfers at death, a lifetime transfer by gift does not yield a basis adjustment. Instead, the donee receives the property with the donor's basis. For example, if the donor bought land at $1,000 per acre and gives the property to the donee when the land is worth $10,000 per acre, the donee will receive the land with a carryover basis of $1,000 per acre. If instead the donor dies and passes the land to the beneficiary through the estate, the beneficiary receives the land with a stepped up basis of $10,000 per acre. High lifetime exemption amounts have made basis planning an important part of the succession plan.
The Center for Agricultural Law and Taxation is a partner of the National Agricultural Law Center (NALC) at the University of Arkansas System Division of Agriculture, which serves as the nation’s leading source of agricultural and food law research and information. This material is provided as part of that partnership and is based upon work supported by the National Agricultural Library, Agricultural Research Service, U.S. Department of Agriculture.