Four Farm Families, Four Ways to Hand the Land to the Next Generation

Every family business has an awkward moment, and on a farm it comes at Thanksgiving. The turkey is carved, the pie is out, and somebody at the table asks the question that nobody wants to answer: "So what happens to the farm?" Forks stop. The dog leaves the room. One son-in-law suddenly needs to check on something in the truck.

Most families put that conversation off for twenty years, and then a funeral answers it for them, in a lawyer's office, with everybody hurt and nobody ready. I want to spare you that. The trick to passing on a farm is that taxes are only half of it. The other half is fairness, and fairness on a farm is a stranger beast than it looks, because the farm is one thing that cannot be cut into equal slices without ruining it.

To make this concrete, I have invented four households. They are hypothetical. The names, acres and dollar figures are made up, rounded, and chosen to make the arithmetic easy, and none of them describes a real family. The tax figures use a hypothetical 20 percent federal capital gains rate and a 40 percent top estate tax rate, which are simplifications. Your numbers, your state's rules and the law in the year that matters will differ, so this is a map of the trade-offs, not advice. Use a lawyer.

First, two ideas that run through everything

Basis. For income-tax purposes, "basis" is roughly what you paid for an asset. When you sell, you pay tax on the gain, which is the sale price minus the basis. If you give someone an asset during your life, they generally take your old basis, which is called carryover basis. If they inherit it at your death, their basis generally resets to the market value at the date of death, which is called a stepped-up basis. The gap between those two rules is the engine behind many of the decisions below.

Fair is not equal. If three children inherit one farm, an equal split of the land is not necessarily fair. The child who has worked the ground for twenty years has put in labor and, often, equity of her own. The children who moved away have a legitimate claim, too. A good plan names that tension aloud and chooses on purpose.

Family one: the Harlans, one child farms and two do not

Our hypothetical Harlans have three grown children. Daughter Maria farms with them every day. The other two, a son in the city and a daughter in another state, do not. The estate:

• Farmland, 560 acres at $7,500 per acre: 560 × $7,500 = $4,200,000
• Machinery: $600,000
• Everything else (house in town, accounts, retirement savings): $1,200,000
• Total: $4,200,000 + $600,000 + $1,200,000 = $6,000,000

An equal split gives each child $6,000,000 ÷ 3 = $2,000,000. The trouble is that the farm assets, land plus machinery, are $4,800,000. If Maria takes the whole farm, she gets $2,800,000 more than an equal share, and the other two get only the $1,200,000 of "everything else," which is $600,000 each. They would each be $1,400,000 short of an equal share. Nobody can pay that gap in cash, and a farm that must sell land to cash out two siblings is a farm in trouble.

Here are three ways the Harlans might handle it.

1. Leave Maria the farm and accept an unequal split. It is simple, and it keeps the farm whole. But two children get $600,000 each while one gets $4,800,000. That may be fair if the parents think Maria earned it, and it may light a fuse in the family.
2. Split ownership three ways, keep the operation with Maria. Put the land in an LLC or trust owned equally. Each child holds one-third of the land: $4,200,000 ÷ 3 = $1,400,000. Maria takes the machinery, $600,000, and the other two split the other $1,200,000, which is $600,000 each. Now each child has $1,400,000 + $600,000 = $2,000,000. Equal on paper, and the farm stays in one piece. Maria then rents the land at, say, $300 an acre: 560 × $300 = $168,000 a year, which is 4 percent of $4,200,000. Each sibling's one-third share of the rent is $56,000. The trade-off is that Maria is farming ground two-thirds owned by siblings who may someday want out, or who may die and leave their shares to their spouses and kids.
3. Give Maria an option to buy. Pair the shared ownership with a written buy-sell agreement that lets Maria buy the siblings' shares at a formula price, over time. This gives her a path to full ownership and gives the siblings a way out.

The lesson of the Harlans: the way to avoid selling the farm to be fair is to make the non-farm assets do the equalizing, and to write down who can buy whom, at what price, on what terms.

Family two: the Whitfields, a couple with no children

Our hypothetical Whitfields have no children, 400 acres worth $3,000,000, and a basis of only $300,000 because they bought it long ago. They love the land and do not want it to become a subdivision. Their options:

• Leave it to a nephew who has helped for years. At their deaths the land receives a stepped-up basis to $3,000,000. The nephew could farm it or sell it with no income tax on the gain that built up before death. The estate tax, if any, depends on the exemption in force.
• Sell during life. The gain would be $3,000,000 − $300,000 = $2,700,000. At a hypothetical 20 percent federal rate that is $540,000 of tax, before state tax and before any other adjustment. By contrast, if the land passes at death, that income-tax bill disappears.
• Sell on an installment contract to a young farmer. Say the buyer pays $3,000,000 over ten years, $300,000 a year in principal. Because the gain is $2,700,000 out of $3,000,000, or 90 percent, each $300,000 payment carries $270,000 of gain, taxed as it comes in. At 20 percent that is $54,000 a year, or $540,000 over ten years, the same total, spread out, and possibly at lower rates in a given year. The Whitfields get an income stream, and a young farmer gets a start without a bank loan for the whole price.
• Leave it to a conservation group or charity. The land is protected, and the estate gets a charitable deduction, but nobody in the family keeps farming it.

The lesson of the Whitfields: with no children, the question is not who gets the land but what do we want the land to become. The tax consequences follow the answer. And the step-up at death is the reason an older couple should think hard before selling in their last years.

Family three: the Ostranders, gift now or leave it at death

The hypothetical Ostranders have 800 acres they expect to pass to their son, who farms. The land is worth $3,000,000 today with a basis of $400,000, and they guess it might be worth $5,000,000 by the time the second of them dies. Should they give it now or leave it?

If they gift the land now. Their son takes a carryover basis of $400,000. The gift uses part of their lifetime exemption, and they file a gift tax return. Any appreciation after the gift, the $2,000,000 from $3,000,000 to $5,000,000, is out of their estate. If the estate would otherwise be taxable, that saves up to 40 percent of $2,000,000, which is $800,000. If the son never sells, the low basis never matters, because there is no sale and no gain.

If they leave it at death. The son gets a stepped-up basis of $5,000,000. If he sold the day after, he would owe nothing on the gain. But the land counts in the estate at $5,000,000, and if the Ostranders' estate is above the exemption, the full value is exposed to the estate tax.

Now flip it. If the son sold the gifted land for $5,000,000, his gain would be $5,000,000 − $400,000 = $4,600,000, and at 20 percent that is $920,000 of income tax. If he inherited it instead, the gain would be zero.

So the answer depends on two questions: Will the family keep farming the land, or sell? and Will the estate be over the exemption? If they will keep farming and the estate is large, gifting tends to win. If the land may be sold and the estate is under the exemption, leaving it at death tends to win. Two other warnings belong here. First, a gift is final. The Ostranders give up control and security, and if the son divorces or is sued, the land is exposed. Second, if either parent might need long-term nursing care paid for by Medicaid, the program looks back five years at gifts, and a large gift can delay eligibility. Ask a lawyer who handles elder law.

Family four: the Prescotts, an LLC and a conservation easement

The hypothetical Prescotts have 640 acres valued at $5,000,000, two children who both want to farm, and a lot of advice from neighbors. Their lawyer suggests two tools.

The LLC. They put the land and equipment into a limited liability company and gift shares to the children gradually. Suppose, as a round placeholder, the yearly tax-free gift allowance per recipient is $20,000 (the real figure is published by the IRS and changes). Say the Prescotts give that much to each of three recipients, perhaps the two children and one child's spouse: 3 × $20,000 = $60,000 a year. At that pace, moving $5,000,000 would take $5,000,000 ÷ $60,000 = about 83 years. The point is not that they will take 83 years. It is that the annual allowance alone is too small for a farm, so larger gifts will use part of the lifetime exemption, and the IRS closely examines any discount claimed for minority or non-marketable interests. An LLC is a useful container, with voting and non-voting shares, a written operating agreement and buy-sell rules, but it is not a magic tax eraser.

The conservation easement. The Prescotts agree with a land trust to give up the right to develop the land. An appraiser says the restriction lowers the land's value from $5,000,000 to $3,500,000. The $1,500,000 difference can be a charitable donation for income-tax purposes, subject to limits. For qualified farmers and ranchers, federal law allows a larger deduction than for most donors and a long carryforward of unused amounts, 15 years. To use the whole deduction in that period, they would need to take about $1,500,000 ÷ 15 = $100,000 of deduction per year, which may be more income than a modest farm earns. The easement also lowers the land's value for the estate tax: if the estate is taxable, a $1,500,000 lower value saves up to 40 percent of that amount, $600,000. A separate federal provision can exclude a further share of the value of land under an easement from the estate, up to a dollar cap.

The costs are real. The easement is permanent. It binds every future owner, it can lower the land's value as collateral at the bank, and it is only as good as the paperwork. Conservation-easement transactions have also drawn IRS scrutiny when appraisals were inflated, so work with a reputable land trust and an independent appraiser. If you hold minerals, check how they interact with the easement; Who Owns the Oil Under Your Farm, and Why America Answers Differently explains why the answer can surprise you.

Four lessons the families share

1. Talk before the funeral. The cheapest estate plan is a conversation that happens while everyone is alive and civil.
2. Decide who farms and who owns. Those are different jobs. Separate them on purpose with leases, LLCs and buy-sell agreements.
3. Use non-farm assets to equalize. Life insurance, off-farm investments and other assets can square the account without chopping the farm.
4. Write it down. A buy-sell agreement should state the price formula, the payment terms, who may buy, what happens on death, disability or divorce, and how it is funded. A handshake does not survive the third generation.

Where to go next

Run the numbers on your own place with Does Your Farm Owe Estate Tax? A Worksheet You Can Run at the Kitchen Table, which walks through the estate tax, special-use valuation and installment payments. For the history of why land and debt can turn on a family so fast, read Embargo, Volcker and Foreclosure Is What Really Caused the 1980s Farm Crisis. If you are weighing how much of your income depends on government programs, Eight Myths About Farm Subsidies That Both Parties Keep Repeating is useful background, and seven tax myths that scare working families and cost them money clears up several ideas that keep families from planning. If water is part of the value, read First in Time, First in Right, and How Western Water Law Really Works before you divide anything.

The bottom line

• Fair is not the same as equal. Decide what you consider fair among your children, say it out loud, and plan around it, because the farm cannot be cut into slices.
• Basis is the hidden number. Giving land during life passes on your old, low basis; leaving it at death resets it to market value. Which is better depends on whether the family will sell and whether the estate is over the exemption.
• Separate who farms from who owns. Leases, LLCs and written buy-sell agreements let one heir run the operation while others share ownership without a fight.
• Put the agreement on paper. Price, payment terms, triggers and funding belong in a signed document, not in anyone's memory.
• Hire an estate lawyer who knows agriculture, and check your state's law. These four stories are hypothetical; yours is real, and so are the deadlines.