Remember to plan for the second estate tax
South Dakotan Bob Metz farms so close to the state line, his post office box is based in Minnesota. It’s a good thing he lives on the right side of the border, however. Metz and wife Karen want ownership of the farm his ancestors homesteaded more than 125 years ago to stay in family hands. But Minnesota’s stiff estate tax adds hundreds of thousands of dollars to a modest-sized farm owner’s death tax—on top of federal estate tax obligations.
Farmland owners are rightly preoccupied with erratic tax rules at the federal level. Where Congress resets estate tax exemptions come Jan. 1, whether at $5 million, $3.5 million or even as low as $1 million per person, is still in flux. But what they may be overlooking is the tax obligation their state charges upon their death. Sixteen states charge their own estate or inheritance taxes with a maximum rate of 16 percent, on top of the federal estate tax bill.
“We have one farmer who owns 1,700 acres, not a super-huge farm, and the estate is now worth $10 million. He’s scared to death on what estate taxes will do to his family operation,” said Nick Houle, tax partner with CliftonLarsonAllen in Minneapolis.
Metz, who farms with his two sons and daughter, has a post office address across the border in Browns Valley, MN, but, luckily, all his farmland and his residence are in South Dakota. Minnesota residents are slapped with up to a 16 percent state tax on estates worth more than $1 million. South Dakota has no state estate tax.
“We still worry about estate taxes as we transition our farm to the next generation, and we have to be cognizant of the state laws. You never know when they’ll change,” said Metz. But it makes succession planning a little easier in a lower-tax state.
A farmer who owns 1,000 acres (worth $6,000 an acre) in Minnesota could potentially face a state tax bill of around $400,000 when he dies (the effective state rate for estates over $2 million averages is about 10 percent). If, however, he lived in South Dakota, North Dakota, Iowa or Wisconsin and left the farm to his children, he would pay no state estate or inheritance tax.
Two other states are particularly tough on farmland owners who must wrestle with state estate taxes: Illinois and New Jersey.
Illinois imposes a $2 million “exemption” with a top state estate tax rate of 16 percent. But it’s an extremely complicated calculation. One example of a person with a $2.5 million estate (only 373 acres at an average Illinois farmland value of $6,700 per acre), would owe $128,518 in state estate taxes in 2011.
New Jersey has a puny $675,000 exemption and a 16 percent top state estate tax rate. The average farm real estate value in New Jersey in 2012 is $12,200, according to USDA. It would take only 55 acres to knock a New Jersey farm owner against the exemption of the state estate tax there.
Strategies to deal with high tax states
One strategy is to gift the land before you die. “Most states do not have a gift tax, so we’ve seen farm clients gift land from an unfavorable estate tax state such as Minnesota to their intended heirs before they die,” explained Sarah Larson with Davenport, Evans, Hurwitz and Smith in Sioux Falls, SD.
“You give up a step-up in cost basis because the original cost basis of the land follows the gift, but the property is then not subject to the state estate tax,” Larson noted. “Or, if you are sitting on a large amount of bank CDs, you may want to gift them to reduce your estate tax li ability.”
Minnesota farm owners have also put their land in entities such as LLCs (limited liability companies) to help limit their state tax liability and protect their family succession plan, said Larson.
Different state estate taxes can be a problem if someone moves their residence from a low-tax state to a high-tax state. For example, let’s say you own property in a state with no state estate tax and then move to be close to your children, say in Minneapolis or Chicago. If you live there six months or more and die in the high-tax state, your estate plan may not be suited to the hightax state and your heirs could owe more tax than you had planned.
Iowa is one of six states with an inheritance tax. The difference between an estate tax and an inheritance tax is the estate tax is based on assets in the estate of the person who dies and is paid by the estate. An inheritance tax is based on the amount an individual heir inherits and is paid by the heir.
Iowa and Pennsylvania have exemptions for farmers giving their farm to the next generation. Pennsylvania’s exemption is for farmland bequeathed to family members. Iowa’s exemption is for any property bequeathed to direct family members, such as children or siblings, but not nieces or nephews or cousins.
Nebraska, Tennessee and Kentucky are the other states with a state inheritance tax. Indiana is phasing out of its state inheritance tax and Ohio has repealed its state estate tax after 2012.
Minnesotans had hoped for tax relief several years ago after the legislature increased its estate tax exemption to $4 million for farmers and small business owners who meet certain requirements. “However, the way the law is written now, it is so complicated and restrictive, we have found very few people who would qualify,” said Houle.
The big unknown in estate planning is what the federal government is going to do come Jan. 1. But it is also important to keep an eye on what’s happening in the state where you live. — Elizabeth Williams, DTN