Be Very Careful What We Wish For
It appears that Congress and the Trump Administration want to repeal the estate tax (at least for 10 years). This is welcome news to farmers, however, the chatter that we are hearing may make it worse than the current law.
Under current law, when a person passes away, their heirs get a step-up in basis on most inherited assets. There are certain assets such as IRAs and pension plans, deferred payment contracts that do not get a step-up, but almost all other assets do (sometimes assets get stepped down too).
Let’s look at an example:
Henry and Martha Farmer own a farm operation. Farmland is worth $10 million with a cost basis of $1 million, plus they own farm equipment worth $2 million and have crop on hand worth another $2 million. Let’s assume that Henry and Martha pass away in 2018. Their combined estate of $14 is greater than the $11 million lifetime exemption amount (rounded), so the heirs will owe about $1.2 million of estate tax. However, they will inherit a new cost basis in the land of $10 million, the equipment of $2 million (depreciated over 7 years) and $2 million of grain which they can sell for $2 million and owe no taxes.
The rules on step-up basis have been around for several decades. Congress had tried to repeal these rules about 40 years ago, but it ended up being very messy to determine cost basis for assets inherited so the rules were repealed.
Now, let’s move forward to possible tax reform. Congress would like to eliminate the estate tax, but they are also discussing either eliminating step-up in basis or having a capital gains tax at death (similar to the Canadian tax system). There may be some level of assets not subject to the tax or allowance for step-up, but let’s see how this might affect our example:
The heirs of Frank and Martha will not owe any estate tax, therefore saving $1.2 million of estate tax. However, they no longer get a step-up in basis and let’s assume they decide to liquidate all the assets in 2018. They will owe capital gains tax on the land at a rate of about 30% (combined federal and state rates) and will owe about 45% on the sale of the equipment and inventory. Total income tax will be about $4.5 million ($9 million times 30% plus $4 million times 45%). They saved $1.2 million of estate tax but had to pay $4.5 million of income tax for a net cost of $3.3 million.
As you can see, eliminating estate tax can cost many farm families a lot of money if they eliminate step-up in basis or have a capital gains tax at death. Most farmers under current laws will never owe any estate tax, but almost all farm heirs benefit from the step-up in basis.