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Planned Giving
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Friday May 29, 2015

Article of the Month

Gifts of Farms

Introduction


There are significant tax advantages and great opportunities for individuals who make a planned gift using a farm or farmland. Given that the value of farmland has increased significantly over the past several years, many farmers now have significant net worth. As these individuals move towards retirement, they will necessarily sell part or all of the farm to generate retirement income.

Planned gifts can be a great component of any farmer’s plan to sell their farm. Planned gifts can help farmers offset the potential capital gains tax liability that selling a farm would produce. In addition, planned gifts help farmers achieve their estate planning goals. Creative planning enables farmers to use property to achieve personal, estate and charitable planning objectives.

Donor Demographic


Gifts of farm property will appeal to donors who are close to retirement and find it difficult to continue running an ongoing farming operation. These donors have substantial farm assets consisting of land, buildings, equipment, crops or livestock.

Farms often include highly appreciated assets with a low cost basis that would produce a large capital gain if sold. Because of the increased income and capital gains tax rates resulting from the American Taxpayer Relief Act, many taxpayers who would have otherwise paid taxes at lower rates in the past will now be subject to the top federal capital gains rate of 23.8% and income tax rate of 39.6%. In some states, there also will be large potential state income and capital gains taxes.

Therefore, a farmer contemplating retirement may benefit from a plan with charitable components. Adding charitable components to a taxpayer’s retirement and estate plan may avoid the negative effects of taxes normally associated with an outright sale of the farm.

The Farm Property


The typical farm donor has owned and lived on the farm for decades. For these donors the farm has been a huge part of their lives. They may have seen their children and now their grandchildren grow up on the farm. However, as they have gotten older, they have found it increasingly difficult to keep up with the rigors of farming life. As such, these donors will retire from farming by leasing the land. More often than not, the donors’ children are not interested in continuing the farm.

Farm donors will own a number of assets as part of the farm. First, most of these donors will have a home on the farm that they have lived in for many years. They may be interested in continuing to live in that home during their retirement. Second, the bulk of the farm will consist of the farmland itself, which may be currently used for grazing purposes or the production of crops. Third, the farm will include equipment, buildings, harvested crops or livestock. Farm donors have a variety of goals, including retirement income and inheritance for family. Finally, farmers who are interested in a planned gift will also often have a desire to benefit their favorite charity.

Each farm asset has tax characteristics that make it more or less suitable to achieve certain donor goals. Common planned gifts using farm property include a sale and unitrust, life estate, a "rawhide" trust, and the unitrust and insurance trust.

Sale and Unitrust


For farm donors who desire to sell their property, a great planned giving solution is a charitable remainder unitrust. A charitable remainder unitrust is a tax-exempt trust. The donor may transfer an appreciated long-term capital gain asset to the trust and receive an income tax deduction for the present value of the remainder interest. The asset may then be sold inside the trust tax free, bypassing capital gains on the sale. Most unitrusts pay a fixed percentage of assets each year to the trust beneficiaries.

While a farm donor can transfer all of the farmland to a unitrust, many will find it advantageous to transfer only a portion of the farmland into the trust. Known as the “sale and unitrust,” this concept allows the donor to receive an income tax deduction and lifetime income from the trust along with a lump sum distribution of cash from the portion of the property sold outside the trust. Generally, this latter “sale portion” will produce a capital gains tax liability for the donor. Fortunately, the donor can use the deduction from the unitrust gift to offset all or a portion of the capital gains tax liability. The donor may even be interested in a “zero-tax” result where the smallest amount of farmland is transferred to the unitrust sufficient to produce an income tax deduction capable of offsetting all of the capital gains tax liability on the sale portion.

The sale and unitrust is a popular option with donors because it generates immediate liquidity and retirement income. With this option, the deduction will be an appreciated property deduction subject to the 30% deduction limit.

Example 1

Ed and Florence are ages 75 and 70. Ed has farmed 500 acres of almonds, peaches and walnuts for the past forty years. When Ed and Florence got married, he promised her that someday he would retire, sell the farm and move with her into the city. Since all of their children grew up and moved to the city, Florence convinced Ed that it is time to make good on his promise. To that end, Ed and Florence have been working with their attorney, Thomas, on a sale of the property. The farmland is valued at $4 million, but Ed and Florence only have a cost basis in the property of $200,000. As such, Thomas recognizes that they have a potentially large capital gains tax liability if the property is sold. To reduce Ed and Florence’s capital gains tax liability, Thomas recommends a zero-tax sale and unitrust. Under this plan, Ed and Florence transfer an undivided 56.16% interest in the farmland, with a value of $2,245,818, to a FLIP unitrust while retaining an undivided 43.85% interest in the farm. The FLIP unitrust will be a net income plus makeup trust until the sale of the land. On January 1 after the sale, the trust transitions to a standard payout unitrust. The deduction from the unitrust is over $1 million, producing tax savings over $396,000. The tax savings from the deduction offset the capital gains tax liability on the sale portion of the property. Ed and Florence and the trustee of the unitrust jointly sell the property. Ed and Florence bypass capital gain on the sale of the property inside the unitrust and receive lifetime income from the trust. With net cash to Ed and Florence of $1,754,182 from the sale portion, they will have substantial investment reserves and a fund for a future home purchase in the city. Ed and Florence are pleased with this plan and how it helps them offset capital gains taxes on the sale portion.

Note: Because the deduction from the unitrust will normally be a fair market value deduction subject to the 30% limit, Ed and Florence may not be able to achieve the zero-tax result in year one. Instead, the zero-tax result may have to be achieved in future years using the potential five-year carry forward for unused deductions.

Life Estate


Many farm donors have lived in their farmhouse for many years. As such, these donors may be interested in continuing to live in that house even after the rest of the farm property is sold. If farm property is to be sold, one way for these donors to offset their capital gains tax liability upon the sale is to make a charitable gift to generate an income tax deduction. A charitable life estate permits a donor to live in the farmhouse and receive an income tax deduction to offset other income taxes.

With a life estate a donor deeds a remainder interest in the farmhouse and surrounding land to charity and reserves life use of the property. The donor could also reserve use of the property for someone else’s life. By setting up the life estate, the donor is allowed a deduction for the present value of the remainder interest in the property. For a life estate to be deductible the property in question must either be a personal residence or farm property, i.e., land used for agricultural production.

When donors establish a life estate, it is also important that they execute a maintenance, insurance and taxes (MIT) agreement with the remainder charity. This agreement makes clear that donors have the responsibility of maintaining and caring for the property during their lifetime in the same manner as they had before establishing the life estate. The primary purpose of the agreement is to protect the charitable remainderman and ensure the property provides a benefit to that organization.

Many donors may be concerned that the creation of the life estate will deny the life estate holder flexibility in the future if their circumstances change. Thankfully, although a life estate is an irrevocable transfer, the life estate is a valuable property interest which affords the holder of the life estate several "rollover" options. First, the life estate holder and the remainder charity could jointly sell the property and receive their respective shares of the sale proceeds. Depending on the value of the property and the life estate holder's age, a joint sale could produce significant sales proceeds for the holder. Second, the life estate holder could gift their life estate to the remainder charity for an additional charitable income deduction. Third, the donor could transfer the life estate to fund a charitable remainder trust or in exchange for funding a charitable gift annuity with the remainder charity.

Example 2

Assume that several years before Ed and Florence decided to sell the farm that they lived in a $150,000 farmhouse on the property. Ed and Florence had a successful harvest and hoped to offset some of their increased income. Mike, the gift planner at their local charity, talked to them about the possibility of a retained life estate for the farmhouse. Based on their ages of 70 and 65, Mike told Ed and Florence that the value of the charitable remainder would be $82,263. Mike also said that this deduction would be an appreciated property deduction subject to the 30% deduction limit. After visiting with their CPA, Ed and Florence learned that any unused deduction that year may be carried forward up to five additional years. Ed and Florence liked this plan, so they decided to move forward and establish the life estate using the farmhouse.

Rawhide Trust


Most farm donors will have two types of assets suitable for a unitrust. The largest asset will be the farmland, which is long-term capital gain property. Other farm assets are tangible personal property -- farm equipment, crops or livestock. Unlike long-term capital gain property, gifts of these assets are usually deductible at cost basis and subject to the 50% deduction limit. Crops or livestock are typically categorized as "inventory" for purposes of federal tax law. As a result, they are considered ordinary income assets, which mean they will produce ordinary income upon sale.

Donors with long-term capital assets, such as farmland, and ordinary income assets, such as crops, should consider establishing two separate charitable remainder trusts. The first unitrust will hold capital gain assets, usually the land. The second unitrust will hold the tangible personal property and inventory assets.

The two trust approach has significant tax planning advantages. Unitrust one is funded with capital assets and most of the payouts may be capital gain. Due to the tax treatment of tangible property, livestock and crops as ordinary income assets, unitrust two will pay out ordinary income.

Under the four-tier accounting structure of charitable remainder trusts, the trust must pay out the ordinary income in tier one first before it can pay out the capital gains in tier two. Accordingly, if both capital gain assets and ordinary income assets are placed into a single unitrust, payouts from the unitrust would be tier one payouts taxed at the higher ordinary income tax rates. If all current and prior ordinary income is distributed, then it may be possible to distribute capital gain amounts. This is unusual because of the large ordinary income amounts in tier one.

By setting up two different unitrusts, one with capital gains assets and the other with ordinary income assets, farm donors are able to receive the same total payout from the trusts. This strategy, however, allows the capital gains asset unitrust to immediately begin part of the annual payout from tier two, which means those payouts will be taxed at capital gains rates. The effect of the two trusts, then, is to provide the donor with the same amount of income but to provide more favorable tax treatment in the early years after funding the trusts.

Note: When tangible personal property is transferred into a unitrust, the transfer creates an "intervening interest" under Sec. 170(a)(3). With a charitable remainder trust, Sec. 170(a)(3) causes the deduction to be delayed until the asset is sold. Accordingly, professional advisors and gift planners need to be cognizant of the intervening interest rule when using tangible personal property to fund a unitrust.

Example 3

Assume Ed and Florence own farm equipment, livestock and harvested crops. They have talked to Thomas, their attorney, and Mike, the gift planner at their favorite charity, about transferring these assets to the charitable remainder unitrust they have already funded with the farmland. The farm equipment, livestock and harvested crops are valued at $1,200,000. Thomas and Mike have recommended that Ed and Florence set up two trusts: a "farmland" trust for the farmland and a "rawhide" trust for the equipment, crops and livestock. Thomas has told them that the rawhide trust would bypass ordinary income when the equipment, crops and livestock are sold inside the trust. In addition, the deduction would not be determined until those assets were sold. Thomas also told Ed and Florence that setting up two separate trusts allows them to receive a deduction when the farmland is transferred to the farmland trust. Most of the payouts from the farmland trust will also come from tier two, thus being taxed at preferential capital gains rates.

Ed and Florence transfer the farmland and the $1,200,000 of tangible personal property farm assets to the two separate trusts. Because of the intervening interest rule, their deduction for the rawhide unitrust will not be determined until the trust sells the tangible personal property. Furthermore, the deduction for the property contributed to the rawhide trust will be small because under Sec. 170(e) there is no deduction for the ordinary value in each asset. For tangible personal property, the deduction is the cost basis in the assets times the remainder factor. However, Ed and Florence are able to bypass ordinary income upon the eventual sale of the farm equipment, livestock and crops. Ed and Florence are very pleased with this plan and excited by the prospect of receiving income from both trusts.

Unitrust and Insurance Trust


Many farm donors are “land rich and cash poor.” The primary asset they have to pass on is the family farm. Such donors may have concerns that a charitable remainder trust arrangement may take away their ability to provide an inheritance for family. These donors may find the combination of a unitrust and insurance trust to be an attractive option.

Under the unitrust and insurance trust plan, the donors transfer the farmland to a unitrust. At the same time the donors establish an irrevocable life insurance trust (ILIT). The ILIT is the owner and beneficiary of a life insurance policy. The insured will be the donor or donor couple. Each year the donors contribute a portion of their annual unitrust payout to the ILIT to pay the insurance premium. Upon the donor’s passing, the ILIT will receive the insurance proceeds, which may be distributed to family members as an inheritance according to the trust’s terms.

An ILIT provides a number of advantages. First, the internal rate of return on the policy could be in the range of 3% to 4%. Second, the insurance proceeds are income-tax and estate tax free. The proceeds are estate-tax free because the donor or donor couple do not have incidents of ownership with respect to the insurance policy. The ILIT will be the only owner and beneficiary of the policy.

While the ILIT will be income and estate tax free, the donor’s attorney will need to ensure the trust is gift-tax free as well. Normally, individuals can take advantage of the gift tax annual exclusion when making gifts to children and others. However, the gift tax annual exclusion is only available for completed and present interest gifts. While the transfer of the premium amount to the ILIT is automatically considered a completed gift, it is only considered a present interest gift if a Crummey Power is included in the trust document. With the Crummey Power, the ILIT trustee sends a letter to the ILIT beneficiaries each time a premium payment contribution is made to the trust. This letter gives the beneficiaries thirty days to withdraw the money. If the thirty days passes without them doing so, then their power to withdraw the money lapses. Because of this thirty day right to withdraw the money, the Crummey Power converts an otherwise future interest gift into a present interest gift. As such, contributions to the ILIT qualify for the gift tax annual exclusion, allowing the trust to be gift tax free as well.

Example 4

Ed and Florence are happy with the charitable plans they have already discussed with their attorney, Thomas. However, Ed and Florence explained to their attorney and the gift planner at their favorite charity that they originally hoped their kids would inherit some portion of the farm. Thomas explained to Ed and Florence that the farm could still be used to provide an inheritance to their children. He explained how one-half of their annual unitrust payout could be contributed to an ILIT, which would use the money to pay the premiums on a $500,000 second-to-die life insurance policy. The ILIT would pay premiums of $12,500 for fifteen years. In addition, the ILIT would contain a Crummey Power giving Ed and Florence’s three children the power to withdraw each contribution within thirty days. After thirty days, the power would lapse and the trustee could then use the money to pay the premiums. Thomas explained to Ed and Florence how the life insurance proceeds would then be paid from the ILIT to their three children income, gift and estate tax free. Ed and Florence liked this plan and decided to establish an ILIT along with the unitrust.

Fulfilling the Objectives of Ed and Florence


The example of Ed and Florence helps illustrate how planned gifts can be used to help donors and clients achieve personal, estate and charitable planning objectives. Because Ed and Florence have multiple objectives, it may be helpful to provide an overview of how professional advisors can combine planned gifts as part of an overall plan to sell the farm assets.

First, the sale and unitrust plan allowed Ed and Florence to sell their farm with a zero-tax result while also providing them with retirement income. Second, Ed and Florence used the life estate to receive an income tax deduction while also allowing them the ability to continue living in their home. If Ed and Florence set up the life estate at the same time as the sale and unitrust, they could use the deduction to further increase their cash portion. Third, Ed and Florence established a Rawhide unitrust funded with farm equipment, livestock and harvested crops. The deduction from this trust was small, but it provided them with additional income and allowed them to avoid paying ordinary income upon sale of the tangible personal property assets. Finally, Ed and Florence planned to use some of the income from the unitrusts to fund an ILIT with a $500,000 life insurance policy. Upon their passing, the ILIT will benefit Ed and Florence’s three children.

The overall benefits of Ed and Florence’s plan are listed in the table below.

GiftDeductionInitial IncomeTotal
Income/Cash
to Ed, Florence and
Children
Projected Charity
Benefit
Sale and Unitrust$1,001,567$112,291$4,213,150$2,737,612
Life Estate $82,263 N/A N/A $307,635
Rawhide Trust $44,597 $60,000$1,313,892$1,462,778
ILIT* N/A N/A $500,000 N/A
Total $1,128,427$172,291$6,027,042$4,508,025

*Note: The total income/cash for the sale and unitrust includes projected lifetime income of $2,458,968 plus cash received of $1,754,182. The ILIT only lists a cash benefit of $500,000 because the other unitrust benefits are recorded under the Sale and Unitrust and Rawhide Unitrust.

Conclusion


Gifts using farms can be a wonderful way for donors to fund planned gifts. The variety of farm assets can create challenges in structuring gifts, but with proper planning farm assets can be used to help both donors and charity. Some options donors can consider include the sale and unitrust, the life estate, the rawhide trust and the unitrust and insurance trust. Each farm donor’s goals and objectives are unique, but it is important that gift planners and advisors be aware of the various gift options and how they can be used to help farm donors achieve their goals.

Published May 1, 2015

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Donating Real Estate Part II

Donating Real Estate

2015 Charitable Tax Planning

Gifts of Pass-Through Business Interests

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