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Recently, I had the opportunity to work on an estate project involving special use valuation of a farm. According to the CPA who referred the client, the farm was placed in a C corporation many years ago (before the 1986 repeal of the General Utilities doctrine). The shares were split among the decedent and family members.  Fortunately, we were able to use §2032A special use valuation (but after wrapping up this particular work, it occurred to me that special use valuation can prove to be a highly useful estate planning tool while the individual is alive (instead of simply the posthumous estate tax reduction tool we typically think about while working on estate tax issues). Under certain circumstances, some planning ahead of time to ensure special use valuation remains an advantageous option may prove to be highly worthwhile.

 Under IRC §2032A, the special use valuation rules (often referred to as the “special valuation” rules) can be used to further leverage use of the lifetime estate exemption ($5.43 million in 2015, indexed to $5.45 million for 2016) and/or reduce estate tax liability. Generally, the special use valuation rules may be applied to “qualified real property” (land and buildings) used in a family-owned farm or closely held business.[1] The rules allow a reduction in value of the real property of up to $1,100,000 in 2015[2] (indexed to $1,110,000 for 2016).[3] While the special valuation rules are most frequently viewed as a posthumous estate tax reduction mechanism, tax practitioners should view these rules as yet another estate planning tool for owners of farms, or businesses with a high-value real estate component where it is known that there will be a large difference between the real estate’s “highest and best use” and its value used in farming or within the business. Together with other estate planning tools that the Code and current estate and gift tax rules provide, including portability, special valuation can be used as an effective estate planning tool. The farmer or business owner may be considering use of (or already using) a business entity that holds the real estate.  Owning the real estate “indirectly” through an entity ownership interest may still make special use valuation a viable option just as it is used for direct ownership interests in the special use property.  However, certain guidelines for the entity and entity interest owned by the farmer or business owner must be met.

 Why Special Use Valuation?

Generally, for estate purposes, property is valued on a “highest and best use” basis. However, under the special use valuation rules, the executor may value the property based on its special use as a farm or business property, which may result in a substantially lower value than the “highest and best use” value for estate purposes. Such a lower value may result in a lower estate tax liability, or require a smaller amount of the decedent’s lifetime estate exemption to be allocated to the real property to eliminate estate tax.

 Qualifying to Use Special Valuation

There are certain prerequisites that must be met in order for the property to qualify for application of the special use valuation rules.

 The decedent must have been a U.S. citizen or lawful resident at the time of death.[4]  In addition, the real property must be within the U.S. and have been held by the decedent (or in a business in which the decedent had an interest).[5]

 Moreover, the property must pass to a “qualified heir” of the decedent. A qualified heir is broadly defined to include the decedent’s surviving spouse, parent, any ancestor of the decedent, or a lineal descendant of the decedent or decedent’s spouse.[6]

 In addition, at the time of death, the property must have been used by the decedent as a special use property (ie. used within farming or other trade or business).[7] Under some circumstances, it is possible for this requirement to be met if the decedent meets either the retirement or disabled exceptions, and had a family member continue the special use of the property.[8]

 This special use must have existed for at least 5 of the 8 years preceding death, but that 5 year required period need not have been continuous.[9] In addition, the value of the special use real and personal property must comprise at least half of the decedent’s total gross estate value (after having made required §2053(a)(4) unpaid mortgage adjustments to both the real property and the estate).[10]

Lastly, the value of the special use real estate must comprise at least 25% of the total gross estate value (after similar §2053(a)(4) adjustments).

 Continuity of Ownership

Only property that is actually owned by a combination of the decedent, members of the decedent’s family and qualified closely held businesses for periods that total at least 5 years in the aggregate during the last 8 years before the decedent’s date of death may qualify for special use valuation.[11] Regard to the impact of other tax rules on ownership must be given due regard under this rule. For example, if a like-kind exchange occurs prior to the decedent’s death, the acquired property is considered to be owned only from the date of acquisition.  On the other hand, if the property is transferred from the decedent’s direct ownership into a closely-held corporation or partnership, the property is considered to be continuously owned if the property transfer into the corporation or partnership met the requirements of §351 or §721.[12] In addition, property transferred to a trust is considered continuously owned if the trust arrangement is such that if the trust were considered to be a corporation, and the beneficiaries, if considered shareholders of that corporation, would qualify under the closely-held test of IRC §6166(b)(1).

Material Participation

Regulatory guidance regarding special valuation provides important insights on the material participation requirement. With respect to material participation, the special valuation concept of material participation should not be considered to precisely coincide with the material participation concept that exists under the passive activities rules governed under IRC §469 and the corresponding seven tests for material participation under Treas. Reg. §1.469-5T.  The concept of material participation for purposes of special valuation evolved before the passive loss limitation rules of §469, and occupies its own definition under the special valuation rules, with guidance provided by IRC §2032A(e)(6) and Treas. Reg. §20.2032A-3.[13]  IRC §2032A(e)(6) indicates that material participation under the special valuation rules is determined in a manner “similar to the manner used” for determining net earnings from self-employment under IRC §1402(a).

 In order for special valuation to apply, the decedent and/or a family member must materially participate in the operation of the farm or business, and whether material participation exists is a question of fact.[14]  Because material participation is a factual determination, the IRS will not issue any advance ruling on the subject of material participation.[15]  There is a material participation requirement for a period before the decedent’s death and after death.  In order for the property to qualify for special valuation, material participation must exist for periods aggregating at least 5 years during the 8 year period immediately preceding the date of death.  Material participation must also continue through continued special use by one or more family members for periods amounting to at least 5 years during any 8 year post-death period that exists within 15 years of the date of death.[16] If family member(s) do not continue to operate the farm (or other trade or business) for this requisite time with material participation, there will generally be a “claw back” ( or “recapture”) of the estate tax savings that resulted from the use of the special valuation rules (subject to some limits and special rules discussed later).

 Passively collecting rental income, or drawing a salary or dividend from a business do not suffice to create material participation.  For a farming business, material participation will not be attained by providing the farm operation with additional capital, reviewing a crop plan or other business proposal or financial reports each season or year without more involvement.[17] 

 In addition, if two or more family members materially participate at the same time, each family member’s material participation time is not counted separately for purposes of meeting the material participation time requirements.[18] Moreover, payment of self-employment tax itself is not conclusive of material participation, and the activity of each participant is viewed separately from the activities of other participants.  At any given time, at least one participant must engage in the activity in a manner that meets the material participation requirement. Brief periods of 30 days or less in which no material participation exists will be disregarded if preceded and followed by substantial periods in which material participation exists.^[19]Activities of a family member are also only considered if a family relationship existed at the time the activities occurred.[20]

 Further, regulatory guidance on special valuation indicates that actual employment of the decedent, or a family member, on a 35 hour (or more) per week basis constitutes material participation.[21]  However, a lesser extent of involvement will also suffice if less time is actually needed to manage the farm or business in which the special valuation property is used.  The fact that a farm only requires seasonal activity will not preclude material participation from existing in that farm.  In fact, “material participation is present as long as all necessary functions are performed even though little or no activity occurs during nonproducing seasons.”

 Trade or Business

Special valuation may be applied to real property used in a farming business or other trade or business.[22] Just as the §2032A special valuation rules encompass their own brand of “material participation”, special valuation regulatory guidance indicates that the term “business” is “not as broad under section 2032A as under section 162.”[23] However, in keeping with the §162 concept of “trade or business”, only an activity engaged in for profit may qualify as a trade or business.[24]

 Business Entity Interests and Special Valuation

Property may still qualify for special valuation even if that special use property was “indirectly” owned by the decedent through a partnership, corporation, or trust arrangement.[25] However, in addition to meeting all of the qualifying prerequisites mentioned previously, the decedent’s interest in the entity holding that property must qualify as a closely-held business interest under IRC §6166(b)(1). The decedent’s ownership interest in the entity must meet the §6166(b)(1) requirement at both the date of death and for at least 5 of the 8 year period preceding the date of death.[26] To meet this 5 year requirement, time periods of direct and indirect ownership by the decedent may be aggregated. Family member ownership in the entity is also permissible, as long as the limitations of §6166 are met along with the §6166 requirements placed on the decedent’s interest.[27]

 Under the terms of §6166(b)(1), a “closely held business interest” of the decedent includes an interest in a business the decedent operated as a sole proprietorship.  It also includes a partnership (or corporation) interest of the decedent if the partnership has no more than 45 partners (or the corporation has no more than 45 shareholders) and the decedent’s interest that is included in the gross estate comprises at least 20% of the capital interest in the partnership (or at least 20% of the value of voting stock in a corporation).[28]

 Accordingly, within an estate planning context, it may be helpful to keep the §6166(b)(1) “closely held business interest” requirements in mind. Depending upon the estate planning objectives of the farm or business owner, allocation or exhaustion of the $5.45 million lifetime exemption and use of various specialized trust arrangements or other tools to leverage that exemption, if special valuation is seen as an important estate tax reduction tool, use of an entity should bear in mind these closely held business interest rules so that the decedent’s interest will qualify.

 Recapture of Estate Tax Savings

Generally, if qualified heirs discontinue the qualifying use of the special valuation property within 10 years of the decedent’s date of death, the reduction in tax savings is recaptured. Qualified heirs must generally continue qualified use of the special use property The 10 year period after death is the recapture period, and liability for recaptured estate tax ends with the conclusion of this 10 year period, or at the death of the qualified heir, whichever occurs first.[29] However, there is a two-year “grace period” immediately following the decedent’s date of death in which a qualified heir may take time before commencing qualified use of the special use property. Use of some or all of this two year grace period will not trigger estate tax recapture.  However, the 10 year recapture period is extended by any amount of this two year grace period used by the qualified heir before starting to use the special use property in farming or the trade or business.[30]  While the grace period rule applies to qualified use, it is unclear whether it applies to periods of qualified use (but with lack of material participation).

 In order to preserve the estate tax savings benefit of special valuation, qualified heirs generally have a qualified use requirement[31] and a material participation requirement[32]after the decedent’s death. Surviving spouses benefit from a more lenient “active management” test that may be used to satisfy the material participation requirement.[33]

 Selling the special use property to a non-family member or ceasing to use the special use property in farming or a trade or business within the recapture period constitutes a triggering event for recapture.[34] Special rules allow the additional tax recapture to be prorated in instances where there is a partial disposition of the special use property.^[35]

 As a starting point, the amount of recapture is the difference between the amount of regular estate tax that would have been paid without use of the special valuation rules, and the amount that was paid after their application.  However, if the special use property is disposed of in an arm’s length transaction for a price that is lower than that appraised for estate tax purposes, this lower sales price serves as an overall ceiling on the amount of additional estate tax that is recaptured. Interest is also payable on the recaptured estate tax, calculated from the date that is 9 months from the date of death to the payment date.[36]

 In the event of any recapture, a qualified heir can elect to increase the basis of the property by the difference between the date of death FMV (or FMV as of an alternate valuation date, if such date was used) and the special use value.  This will serve to increase basis to what the basis would have been in the special use property had the special valuation rules not been used to begin with. This election is made by attaching an appropriate statement to Form 706-A, United States Additional Estate Tax Return.[37] The due date for such an election is six months after the recapture triggering event, and the election to increase basis is irrevocable.[38]

 Payment Extension and Special Use Property Lien

IRC §6166 provides the operable definition of “closely held business interest” that is used to determine whether the decedent’s business interest qualifies for the application of the special valuation rules. However, this code section primarily addresses the extension of payment time for estate taxes for estates that involve closely held businesses, and this Code provision can provide some advantages. A special lien is available that may be used to obtain a §6166 extension for payment of estate tax. This generally releases the executor from liability for the estate tax. The special lien is provided under IRC §6324A.

 In addition, IRC §6324B imposes a lien on the special use property for the duration of the qualified use and material participation requirements to which the qualified heir must adhere. The amount of this lien is essentially the difference in regular estate tax (without use of the special valuation rules) and the estate tax amount with use of special valuation.

 Conclusion

Along with the other tools estate planners use to maximize use of the lifetime exemption and increase the deceased spouse’s unused exemption (DSUE), the special valuation rules should be considered as yet another tool available to accomplish the estate planning objectives of moderate or high net worth individuals with a strong farm real estate value or business real estate value component within their portfolio. For farmland, there is specific guidance on special valuation procedures[39] that can be used to estimate the current difference between a “highest and best use” value obtained from an appraisal and a special use valuation.  For business real estate, preliminary appraisals can be used to determine the potential value of using the special valuation rules. Understanding the rules associated with indirect ownership of special use property through an entity allows for planning that may provide for use of an appropriate entity for creditor proof protection and other estate planning objectives (while keeping the door open to the potential later advantages of using special use valuation after the taxpayer’s death) as long as the entity is structured to meet the required prerequisites.

 While special use valuation can prove to be a strong estate planning tool to reduce estate taxes and accomplish client estate objectives, clients must be advised of the necessary posthumous qualified use and material participation requirements expected of qualified heirs needed to preserve the tax advantages of the special valuation election (and the consequences of not adhering to these requirements).