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“Fair or Equal: Considerations in Farm Succession”
07/01/15 | WealthCounsel Quarterly | Hannon Ford, JD, CELA
One of the biggest issues that farming families face when they begin their farm succession planning is how they can treat all their heirs fairly while accomplishing their specific goals of preserving or passing on the family farm. My clients come to me struggling with how they can leave the farm to the farming heir (or heirs) and still treat the non-farming heirs fairly. Every client’s definition of what is fair is going to be different, just as their specific estate planning or farm succession goals may be different. A counseling-oriented attorney has a great opportunity to set themselves apart from the rest by offering ways to help their clients come to a decision of what is fair.
I have often noticed the discussion of what is fair leads to the simple question, “How can we give the farming business and the assets necessary to run the business to the farming heir and not upset the other family members?” Understanding these competing planning objectives (in general, of course) can help us to guide the client to a fair compromise between the two types of heirs. Interestingly, in most families, the children’s views are mirrored in the farming parents: where the farming dad feels like the farming heir deserves to get the farm and the farming mom is looking out for the interests of the non-farming heirs.
City Mouse, Country Mouse
The farming heir has worked with their farming parents for years (typically since they were old enough to get some real work done). In later years, they take on more responsibility until the farming heir becomes the main operator of the farm and the parent farmers are now the help. Farming heirs know that without the land, machinery or other assets necessary to continue the operation of the farm, they are not going to be able to succeed in continuing to farm after the parent farmers die. With the price of land, machinery and other inputs, the idea of starting from scratch after working so many years on the farm is scary, if not impossible for that heir to imagine.
On the other hand, most of the non-farming heirs who have often left the farm soon after reaching adulthood will feel jilted if a proportionate share of the value of the estate is not given to them. Too many farming families have been acrimoniously divided by an estate where the farming heir got a larger share of the estate and the other heirs felt that it was unfair.
For most of these families an open planning process, where all heirs are included in the planning process, will lead to a more successful result than that of the norm. A counseling attorney with tools that can help the client balance these two competing interests may succeed in keeping the harmony in the family that both farming parents desire. Naturally, every client is going to be different and each client will select options that they feel is best for their estate. Some clients choose to leave everything to the farming heir and leave little or nothing to the others. Other clients leave everything equally to all the members of their family, leaving the task of preserving the farm to the unanimous agreement of the heirs. (Ufdah! As we say in Minnesota). The counselor’s job is to warn the client of the possible negative consequences of their choices and then implement the plan they choose.
Weeds In The Field
Like weeds in the field another task of the attorney is to identify the possible problems that the family farm will face and then develop a solution to overcome the issue. Each family must consider capital gains issues, estate tax consequences, nursing home costs, disability of parents or children, and distribution alternatives. Many of these issues do have an effect on the fairness of the estate plan. As the farming heir gives value to the estate by effectuating the solution, it only makes sense that the estate should give value to the farming heir for their contribution to the estate as a whole. Let me explain.
In the outdated “traditional” farm plan, the farming heir would purchase the farm from farming parents as farming parents reached retirement age. We realized that this creates an otherwise avoidable capital gains tax or recapture tax for the farming parents, diminishing the value of the estate received by the heirs. It is in most heirs’ best interests for the farming heir to purchase the farm after the death of the parents in order to take advantage of the stepped up basis and eliminate the capital gains tax. For the farming heir this means a possible increase in the price as the assets gain value with time; that heir would be better off purchasing now. For some clients the solution is to give the farming heir a set price upon death or a discounted price upon death. If the non-farming heirs are involved in the process, see the numbers, and agree that their share would be increased by waiting until death, they are less likely to complain about the deal that the farming heir had to wait for.
Additionally, without the proceeds from the sale of the farm, the farming parents will need retirement income. This income usually comes in the form of rent or share cropping. These are additional funds coming from the farming heir that most people would agree deserves some resulting benefit to the farming heir. Many clients will reduce the price the farming heir pays upon death for the real property or equipment since rent or other payments are made to farming parents during their lifetime. [Be wary to avoid creating a step-transaction contract for deed by directly linking the reductions to the payments made by farming heir].
In some states like Minnesota, and under federal laws (IRC §2032(a), for instance) the farming heir will qualify the entire estate for an additional exemption or a reduction in valuation that reduces the amount of estate tax the family would otherwise owe. When the other heirs understand that the active farming status (or other qualifiers) saves the estate money, they may agree to the distribution of additional assets to the farming heirs share.
Sweat equity is another reason the farming parents will give the farming heir a reduced price or greater share of the farm. The farming heir has improved the land through tiling, rock picking, leveling and other valuable work. Sometimes the farming heir has built or improved buildings with his or her own funds. As the farming heir typically lives nearest to the farm parents, that heir is the one relied upon for assistance as parents age. If parents become disabled, it is the closest children who care for them and support them in their needs. That support is a valuable contribution to the welfare of the estate and the aging parents.
Where the Rubber Meets the Road
After discussions clients and their families, the time comes to make some decisions. Do they give the inheritance in specific devises, with the farming heir receiving a larger portion? For example, they may give the Southwest Quarter (160 acres) to Johnny and the South Half of the Northwest Quarter (80 acres) to Jane. (I advise clients to not make children co-owners of any piece of land in order to avoid the division problem later.)
Or, do they give Johnny the right to buy the real estate or farm assets at a discounted price reflective of his contributions to the estate (my personal favorite)? Or is it a combination of the two where Johnny receives a piece and then receives the right to buy Jane’s piece (or at the very least a right of first refusal on Jane’s piece).
The clients should understand that any discount in purchase price given to the farming heir will reduce the share received by the non-farming heirs. Once client understand that concept, they can easily determine and change the discount. I have had clients with discounts across the board (5%, 10%, 25%, 60% and up). I have even had clients give no discount in order to be “exactly equal..
Another solution is to give the individual pieces out relatively equally (or in some cases equal undivided interests in all pieces of real property) and then give the farming heir the right to rent for his lifetime or for another specific time period. It can be helpful to specifically state the rental rates so that there is less opportunity for the family to fight in negotiation. Consider tying the rate to the average for the county (plus or minus a percentage) as published by a local University Extension program or other reputable source in order to keep the rates flexible with the times. Specificity will go a long way in preserving family relationships and avoiding ambiguity.
Last But Not Least
The first and last question the farming heir and farming parents will ask is, “How can I afford this?” The farming heir knows that even with a discounted price, they will often need millions of dollars to buy out their family (especially with a large Minnesota farm family). This can be a great opportunity to work with local insurance and financial advisors. In the old regime, at the time of farming parent’s retirement, the farming heir would be putting money into their parent’s hands. Under the new estate planning model, the farming heir would use that same money to buy insurance on the farming parents’ lives. This is by far the best way to fund the purchase of the family farm. Sometimes, the farming parents will fund this policy by setting up an ILIT for the farming heir and at the same time making gifts to other heirs from their surplus income. And sometimes it is a combination of the two parties putting this policy into place.
What if the policy is unattainable because of health, lack of funds or believe it or not the farmer hates insurance? Unfortunately, too often a loathing of a fantastic tool like insurance can be passed from generation to generation as easily as the John Deere. In those situations, a larger discount may be appropriate to allow the farming heir to obtain a mortgage on the property to pay off the siblings. In a family with three children, a 25-50% discount on the price will allow the farming heir 50-60% equity in the land which will qualify them for the funds they need to pay off the non-farming siblings.
Another frequently used option will be a right for the purchaser to pay on a contract for deed. The terms should specify the length of time, the interest rates, and any balloon payment or amortization rules in order to keep the heirs from negotiations. Many clients like that the farm income can then pay for the farm over time. The heirs receive a fair rate of interest on their inheritance and the farming heir will not have to worry about high bank interest rates like the industry experienced in the 1930’s, 1950’s and 1980’s.
Conclusion
Not every client is going to be ready to make these decisions. Not every client is going to want to make these decisions. But for each client we lead through this valuable counseling issue, their farm and family will benefit greatly. Make sure to point out to clients who struggle with these options that there are resources to help with the farm succession process. In Minnesota, we have a fantastic University Extension program that can help them set and prioritize goals within the family and then merge those goals with the other generations to create an outline for this type of planning. Those families who follow carefully outlined recommendations and processes will enjoy much more family cohesiveness during and after the planning comes to fruition. For most of my clients that is really what fair or equal is about.
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