Passing Down the Family Farm or Ranch
Compliments of The Litherland, Kennedy & Associates, APC, Attorneys at Law
Written By: The American Academy of Estate Planning Attorneys
Family-owned farms and ranches were once the backbone of the American economy. Just a century ago those farms and ranches were still going strong throughout the U.S. Over the last few decades of the 20th century, however, most family-owned farms and ranches struggled to survive, much less compete with corporate farming and ranching. However, in recent years, small farming and ranching operations have begun to make a comeback across the U.S. as consumers become more health-conscious and more skeptical of corporate America. If you own a family farm or ranch that you hope to pass on to future generations, a well-thought-out estate plan is the key to ensuring that your loved ones are provided for and your family business remains intact.
In general, small businesses, especially family farms and ranches, face unique issues when attempting to pass the legacy from one generation to the next. You might have heard the less-than-optimistic figures – only 20% of all small businesses successfully make the transition to the next generation. When a farm or ranch is involved, the two most common obstacles are lack of liquidity and failure to plan for tax liabilities.
Estate liquidity refers to the amount of cash and/or assets that can readily be converted into cash, in a person’s estate at the time he or she dies. Family-owned farms and ranches are often “asset-rich and cash-poor,” which means they have valuable assets in the form of land, machinery, livestock, and/or crops, but they have very little available cash. Moreover, those assets are often tied up as security for loans taken out during lean years or to expand operations. The end result is a lack of estate liquidity.
Why is estate liquidity important? Liquidity greatly reduces the impact of the second obstacle – taxes. When you die, the value of all the assets you own at the time of your death, combined with the value of all taxable gifts made during your lifetime, is potentially subject to federal gift and estate tax at the rate of 40%. Every taxpayer is entitled to exempt up to the lifetime exemption amount (set at $5 million and adjusted annually for inflation) before estate taxes are levied; however, a hefty tax obligation could still be due from the estate. Furthermore, your beneficiaries only receive the net amount after reduction for any estate taxes. If sufficient cash isn’t available to pay the taxes, estate assets may need to be sold to raise the needed funds, potentially crippling the farming or ranching operation before the next generation can acquire it.
By way of illustration, imagine that Bob and Sally own a ranching operation that has been in the family for generations. As such, the ranch covers hundreds of acres of rich grazing land, currently valued at $13 million. Bob and Sally’s residence includes a second, smaller home for the ranch foreman and several outbuildings collectively valued at $3 million. Livestock owned by the ranch is worth $2 million; machinery and equipment are valued at $1 million, and Bob and Sally have $1 million in various checking and savings accounts. Altogether, the ranch assets total $20 million. Like many ranches, however, the operation has seen some lean years caused by outside factors such as the weather, the economy, etc. In addition, the ranch has been forced to try and keep up with big corporations which required Bob and Sally to modernize their operation. In the end, the ranch also had debts totaling $5 million. Bob and Sally are fortunate that their debts do not exceed their net worth, which is often the case with many family farms and ranches.
In life, as we all might have experienced, situations occur which derail everything. In this case, Sally and Bob are both tragically killed in a car accident. Their estates must go through the probate process before the ranch can be passed down to their daughter, Mary, who has always been part of the operation. Their combined gross estates of $20 million is offset by the $5 million debt for a net estate of $15 million. This can be further reduced by $2.22 million (2 x $1.11 million in 2016) due to “special use valuation” of the ranch. In other words, we can value the ranch as a ranch, even though it may be worth more for development. This leaves them with $12.78 million. Between them, Bob and Sally can exempt $10.9 million before federal gift taxes are levied (The current lifetime exemption limit for 2016 is $5.45 million per taxpayer). That leaves $1.88 million subject to taxation at the 40% tax rate, meaning Bob and Sally’s ranch would owe $752,000 in estate taxes. The ranch, however, only has about $1 million in liquid assets. If they use all the money for taxes they won’t have funds for debt repayment and cash flow. The executor of the estate might be able to borrow from the IRS. The only other option is to start selling estate assets in order to meet cash flow, including “Uncle Sam.” By the time creditors are paid, the ranch may not have enough assets left to continue day-to-day operations.
Comprehensive estate planning could likely have saved Bob and Sally’s ranch by incorporating a number of asset protections, incapacity planning, and business succession tools and strategies into the plan. Utilizing life insurance to insure the owners of the business, for example, might have produced enough estate liquidity to pay the creditors. The annual exclusion could also have enabled Bob and Sally to gift shares in the business to Mary each year, tax-free, thereby limiting the value of the ranch when they passed away.
Hopefully, this cautionary tale of Bob and Sally’s beloved family farm can help you better understand how to pass a legacy in the way you want. If you own a family farm or ranch, be sure to consult with an experienced estate planning attorney to prepare your assets and make sure your farm or ranch is left behind for future generations.