March 7, 2022
My colleague Mike Dolan recently explained in a Farm Progress sister publication how federal estate tax law changes are languishing in Congress. The current federal estate tax exemption is $12,060,000, adjusted annually for inflation. This creates a window of opportunity until 2025, after which the exemption is scheduled to be cut in half.
Illinois is not so generous. Illinois taxes your estate if it exceeds $4 million and despite the dramatic increase in real estate values currently underway, there is no inflation adjustment for the Illinois exemption.
Federal income tax law also has a major impact on estate transfer planning. One proposal in the now-shelved Build Back Better legislation would have taken away one of our most effective estate transfer tools: the irrevocable grantor trust.
One danger of an article like this is that a reader concludes, “To pass my farm to my heirs tax-free, I’ll get an irrevocable grantor trust!” By analogy, you might as well say, “To farm I need to get a tractor.” The irrevocable grantor trust is a tool. It can pull a lot, but it can’t do everything. It must be driven. It requires implements, properly attached. It also requires maintenance over its lifetime. So, resist any urge to think any trust document is the magic bullet.
If your estate value exceeds your estate tax exemption, here is how you might use this tool.
Assets that you intend to pass on to heirs someday (farmland being the prime example) are transferred to a business entity such as a limited liability company. You would own that LLC initially. The governing documents of the LLC will include terms that restrict transferability of the ownership interests. The restrictions would be designed around your goals to keep the farm in the family. Unless all owners agree, for example, interests in the LLC could not be transferred to anyone other than your descendants.
You would then create the irrevocable grantor trust. The key characteristics of this trust are:
All the details you would normally include in your will or living trust for how your beneficiaries are to receive the inheritance must be included. Because of this, you need to have considered all the good that you can do for your heirs, such as lifelong asset protection, income tax minimization and long-term estate tax avoidance. A well-designed revocable living trust can serve as a rough draft of what to write in the irrevocable grantor trust.
For income tax purpose, the trust is treated as you. All income and expenses of the trust are reportable to you, individually, as if there is no trust.
For gift and estate tax purposes, what you put in the trust is no longer owned by you. You have given away whatever is held in the trust.
Next, you enter into an agreement to sell most of your interests in the LLC to the trustee of the trust. You cannot be the trustee of the trust. There is no recognition of gain on the sale. The trust has no cash, but if the agreement makes sense, the income from the LLC can be used to pay you. Where does the LLC get income? It owns what had been your land and rents it to you or whomever else you want to farm your land. The payments from the trust effectively replace the income you previously received from your land.
Down the road
There are significant complications beyond that sketch. There is often another trust involved, the ongoing cash flow management is critical, and specific rules must be followed. There are ways to revise the trust even though it is irrevocable. You pay the income tax on trust income, even though you are not a beneficiary of it.
But here is the payoff. Normally if you gave land away, you report the value as a gift, and that gift reduces your available estate tax exemption. Give away $10 million in land, report a $10 million gift, and you have used up $10 million of your federal estate tax exemption. But proper use of the irrevocable grantor trust allows you to remove the $10 million from your estate while reporting a much smaller gift — anywhere from one-half to as little as one-tenth that amount.
Whether you are concerned about the Illinois estate tax because your estate exceeds $4 million or the federal tax because your estate is over the projected $7 million exemption coming in 2026, the languishing tax law changes give you an opportunity to dramatically reduce your estate tax risk.
Ferguson is an attorney who owns The Estate Planning Center in Salem, Ill. Learn more at thefarmersestateplanningattorneys.com. The opinions of this writer are not necessarily those of Farm Progress/Informa.
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