Tax ARTICLE - Special-use Valuations Help Curtail Estate Planning Disasters

If a business owner dies suddenly, his or her family may learn — too late — of a rather chilling secret: He or she had little to no working estate plan. As a result, they may find themselves on the hook for an estate tax bill so big that it leaves them no option but to sell the company.

What many families don’t know is that, when a situation like this arises, all hope isn’t necessarily lost. If a significant portion of a business owner’s estate consists of real property used in a family business or farm, the owner’s family may be able to reduce estate taxes with a special-use valuation.

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How it works

Real property’s fair market value is typically based on its “highest and best use.” For instance, a piece of prime real estate in a downtown financial district would likely be valued based on its use for an office building — even if the owner operates a parking lot on the property.

Yet a highest-and-best-use valuation can lead to harsh tax consequences for successors who wish to continue the property’s current use. So, if certain requirements are met, the tax code allows real property to be valued based on its actual use, rather than its highest and best use.

Let’s say a business owner’s estate includes a manufacturing plant on the outskirts of a growing suburb. The land’s value, based on its current use, is $1 million, but its fair market value is $1.5 million based on its highest and best use as a residential subdivision.

If the property qualifies for special-use valuation, the property’s value for estate tax purposes could be reduced by $500,000. A special-use valuation, however, cannot reduce the gross estate by more than $900,000, as indexed for 2006. (As of this writing, the 2007 amount was unavailable. Ask your tax advisor for details.)

Qualification requirements

Special-use valuations are intended to help families hold on to their small businesses and farms. Thus, to qualify to use one, strict requirements must be met:

Citizenship and location. The business owner must be a U.S. citizen or resident, and the property must be located in the United States and used for business or farming.

Length of ownership and involvement. The real property, during at least five of the eight years before the business owner’s death, must have been owned and used in a qualified manner — that is, used for farming or for the family business, or rented for such activity on a net cash basis — and the business owner or a family member must have materially participated.

In addition, as of the business owner’s death, the property must have been used by the business owner or a family member in the business or as a farm, or have been rented by the business owner’s spouse or a descendant to a family member on a net cash basis.

Adjusted value. The property’s adjusted value must account for 25% or more of the gross estate’s adjusted value. Adjusted value is the highest-and-best-use value, reduced by certain debt, such as mortgages. The adjusted value of all real and personal property used in the business must account for 50% or more of the gross estate’s adjusted value.

Allowed recipients. The property must pass to a “qualified heir,” which includes the owner’s spouse, parents, grandparents, children and grandchildren. Moreover, the qualified heir must materially participate in the business or farm operations for at least 10 years after the decedent’s death.

If the heir sells or otherwise disposes of the property or stops operating the business during the 10-year period, the IRS can collect some or all of the estate taxes that would have been owed absent the special-use election.

A dire predicament

Turning to a special-use valuation isn’t a family’s only option if estate taxes threaten to force them to sell the family business. They may also be able to defer estate tax payments for five years and then pay the tax liability in 10 annual installments. (Ask your financial advisor for details.)

Of course, ideally business owners will prevent any such dire predicament by acting today to create an estate plan that prevents unexpected estate tax consequences.

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