Freeze Your Estate Size

“Inflation created this problem for me,” said Bill. Mary nodded. “What do we do now that our farm ground has appreciated so much? There seems to be no end in sight!” Another challenge faced by a couple with a high net worth is the increasing value of their estate.

Snowball effect

Like a dog chasing a car, sometimes we don’t know what to do with what we’ve caught. Many a farm family started decades ago with not much, worked hard, lived frugally, and saved by reinvesting every spare dollar in mortgage reduction. Then, if everything went reasonably well, they rather suddenly found themselves sitting on hundreds of acres of debt-free and rapidly appreciating real estate.

With land prices around the state nearly doubling in the last few years and commodity prices continuing to climb, is there nothing that can be done? Using the $12,000 per year gift tax exclusion, Bill and Mary could each give a couple of acres annually to each of their children. But with 1,500 acres worth $5,000 per acre appreciating at 7 – 10% per year, their estate is growing by over half a million dollars per year. They cannot give it away fast enough to make a dent. At this rate, their estate will be worth $15,000,000 in 10 years.

Discounting Strategies

Bill and Mary implement some “discounting” strategies. They give a charitable foundation a perpetual conservation easement on 500 acres, prohibiting commercial development. This reduces the market value of that land to $1,875,000. Then they form a limited partnership and deed their 1,500 farm acres to the partnership. The terms of the partnership prohibit transfer of the assets outside of the family. Although the partnership now owns farm ground appraised at $6,875,000, a professional appraiser determines that each 1% of the partnership would only be worth $45,000.

Sale to a trust

Bill now creates a special type of trust for his children. He makes a cash gift of $500,000 to the trust. The trust will never be included in Bill or Mary’s estate, nor the estates of their descendants. Bill sells 98% of the limited partnership interests in exchange for $500,000, plus a promissory note of $3,910,000. The note bears interest at 4.5%. The trust, owning 98% of the partnership, has to pay $250,000 per year to Bill & Mary for about 26 years. If they die before it is paid off, the note will remain payable to their living trusts, which will pass to their children.

The net income of the farm is typically about 3.5%, or $262,500. Of that income, 98% goes to the trust…which uses the money to pay the note. Because of the way the trust and note are established, there is no capital gain on the sale or income tax on the interest. The farm income remains taxable to Bill & Mary much as it was before this transaction. To the extent the farm income is more, it will stay in the trust where it remains with the rest of the partnership, insulated from estate and gift taxes forever. More land could be bought. The terms of the trust may permit distributions of income and principal to their descendants in the discretion of the trustee, as needed. The trust can be divided among the children now or in the future, and each child can be given broad control over his or her share.

Fast forward a few years…

In ten years, instead of Bill and Mary having a taxable estate worth $15,000,000, they own only 2% of the partnership and the remaining balance of the promissory note, which is less than $3,000,000. They probably still own their home outside of the partnership, and to the extent they haven’t been spending all of the $250,000 annual payments, they might be growing a savings account!

By looking ahead and attacking their “growing” problem, they effectively discounted and froze the value of their estate at around $4,500,000, and limited the growth to the 4.5% they receive in interest. Even if land prices had gone flat, instead of a $7,500,000 estate, their taxable estate is under $4,000,000 and all of the land is protected in the perpetually-tax-free trust.

As is so often the case, this is an overly-simplified illustration. The true complexities underlying estate freeze planning are mind boggling. You should embark on such planning only with experienced professional advisor, taking into account the specific asset and income situation and, most importantly, the unique family goals, challenges and issues.

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Article authored by Curt W. Ferguson and originally published in the Prairie Farmer magazine, February 2008 issue