ESTATE PLANNING FOR FAMILY BUSINESS OWNERS: SECTION 2032A, SECTION 6166, AND SECTION 303 Copyright 2003 by McGuireWoods LLP

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1 ESTATE PLANNING FOR FAMILY BUSINESS OWNERS: SECTION 2032A, SECTION 6166, AND SECTION 303 Copyright 2003 by McGuireWoods LLP Dennis I. Belcher McGuireWoods LLP One James Center Richmond, VA (804) TABLE OF CONTENTS I. SECTION 2032A - SPECIAL USE VALUATION... 1 A. In General B. Pre-Death Requirements for Special Use Valuation C. Post-Death Requirements for Special Use Valuation. 3 D. Election Filing Requirements E. Valuation under Section 2032A

2 F. Use with Business Real Property Other Than Farm Real Property G. Recapture of Estate Tax Savings H. Problems in Using Section 2032A I. Lifetime Planning for Section 2032A II. FIFTEEN-YEAR DEFERRAL OF ESTATE TAXES - Section A. In General B. The Requirements of Eligibility for the Benefits of Section C. Percentage Test D. Definition of Closely Held Business E. Trade or Business Test - In General F. Trade or Business Test - Rental of Farm Real Property G. Trade or Business Test - Rental Real Property Business H. Trade or Business Test - Activities of Agent I. Trade or Business Test - Personal Holding Company. 29 J. Numerical Tests - Attribution Rules K. Time and Manner of Election L. Judicial Review of Denial of Section 6166 Election M. Amount of Tax Deferred and Interest Rates N. Use of Section 6166 Interest Payment as a Deduction O. Acceleration of Unpaid Tax P. Acceleration of Tax and Redemptions under Section Q. Acceleration of Tax and Failure to Pay Installment of Unpaid Tax

3 R. Election in Case of Deficiency S. TPT Credit and Section T. Charitable Deduction and Section U. Lifetime Planning for Section V. Post-Mortem Planning for Section W. Miscellaneous III. REDEMPTIONS UNDER SECTION A. Corporate Distributions B. Redemptions of Stock under Section C. Redemptions to Pay Death Taxes -- Section D. Requirements of Section E. Maximum Amount of Redemption F. Timing of Redemption under Section G. Relationship of Sections 303 and I.SECTION 2032A - SPECIAL USE VALUATION A.In General. 1.The Tax Reform Act of 1976 added section 2032A and the concept of special use valuation of real property. Under section 2032A, the value of real property may be based upon the use of the property as opposed to the fair market value of the property. 1.Special use valuation is available only for real property used in a farm or other closely held business. 1.The maximum reduction in value allowed under section 2032A is $840,000 for individuals dying in 2003 (indexed for inflation, or $820,000 for individuals dying in 2002). According to the Internal Revenue Service, valuation of real property under section 2032A has produced a reduction in value ranging from 30 to 70 percent of the fair market value of the real property.

4 A.Pre-Death Requirements for Special Use Valuation. 1.The decedent must be a citizen or a resident of the United States. Section 2032A(a)(1)(A). 1.The real property must be located in the United States. Section 2032A(b)(1). 1.The real property must have been used on the date of the decedent's death in a qualified use. Section 2032A(b)(1). a.a qualified use of real property is a use as a farm for farming purposes, or a use in a trade or business other than the trade or business of farming. Section 2032A(b)(2). a.use as a farm for farming purposes is given a broad definition. Section 2032A(e)(4) and (5). It includes stock, dairy, poultry, fruit, furbearing animals, truck farms, plantations, nurseries, orchards and woodlands. 1.During the client's lifetime, it is required that the real property be used in the qualified use by the decedent or members of the decedent's family. a.a member of the decedent's family is defined (section 2032A(e)(2)) to include: (1)an ancestor of the decedent, (1)the spouse of the decedent, (1)a lineal descendant of the decedent, the decedent's spouse, or a parent of the decedent, or (1)the spouse of any lineal descendant described in subparagraph (3). a.although adopted children qualify as members of the decedent's family, an acknowledged child does not. Section 2032A(e)(2) and Rev. Rul , C.B The widow or widower of a descendant of the decedent is a member of the decedent's family. Rev. Rul , C.B During the client's lifetime, there must have been material participation by the decedent or a member of the decedent's family for five years out of the eight-year period ending on the date of the decedent's death. Section 2032A(b)(1)(C). a.material participation is defined by reference to paragraph (1) of section 1402(a) (relating to net earnings from self- employment). Section 2032A(e)(6). a.generally, the Internal Revenue Service takes the position that the decedent or the members of the decedent's family that materially participate in the operation of the farm (or other business) must pay self-employment taxes. Rev. Rul , 1983-I.R.B. 8 and Technical Advice Memorandum

5 a.a net cash rental during the decedent's lifetime to a member of his family will not disqualify the property from special use valuation. Section 2032A(b)(1)(C)(ii), Technical Advice Memorandum , and Private Letter Ruling a.a net cash rental to an unrelated party will disqualify the property from special use valuation. In this circumstance, the Internal Revenue Service holds that the real property is not being used in a qualified use. Technical Advice Memorandum a.in Schuneman v. U.S., 570 F. Supp (D. Ill rev d, rem d, & vac d, 783 F.2d 694 (7th Cir. 1986) the Seventh Circuit in reversing a District Court decision held a lease to a non-family member was substantially based upon production and the farmland could be valued under section 2032A. a.because material participation is defined by reference to the earned income test under section 1402, retired individuals had to choose between receiving social security or having their estate eligible for special use valuation. Section 2032A(b)(4) allows the material participation test (five out of eight years before death) to be met either as of the date of death, or as of the date of retirement for social security purposes. a.in Mangels v. U.S., 632 F. Supp. 1555(S.D. Iowa 1986), the Court held a crop-share lease entered into by a conservator of an incompetent did not constitute material participation. The conservator's short and infrequent consultations with the tenant were not sufficient to constitute material participation. A.Post-Death Requirements for Special Use Valuation. 1.The real property must pass or be acquired from the decedent. Section 2032A(b)(1). 1.The real property must pass to or be acquired by a qualified heir of the decedent. Section 2032A(b)(1)(A)(ii). a.a qualified heir of the decedent is defined as any member of the decedent's family. 2032A(e)(1). Section a.for this purpose, a member of the decedent's family is defined the same as for purposes of material participation. a.special use valuation is available for real property passing in trust. Trust property is considered to have passed from the decedent to a qualified heir to the extent the qualified heir receives a present interest in the property. An interest in a discretionary trust is treated as a present interest if all the beneficiaries are qualified heirs. Section 2032A(g). Private Letter Ruling ; Technical Advice Memorandum CAUTION: Contingent interests in trust may prevent real property from being eligible for special use valuation. Technical Advice Memoranda , and But see Technical Advice Memorandum where the Internal Revenue Service held