SESSION K3 62ND ANNUAL MNCPA TAX CONFERENCE November 14-15, 2016 Minneapolis Convention Center ONLINE RESOURCES Session Handouts Most session handouts are available for download. To access: Go to www.mncpa.org/materials Log in with your MNCPA username and password Note: Your conference registration fee must be paid in full to access session handouts online. CPE Transcript (Certificate of Attendance) Your official transcript will be available on the MNCPA website. To access: Go to www.mncpa.org/transcript Log in with your MNCPA username and password Note: Tax Conference transcripts will be available Friday, Nov. 18. Minnesota Estate Tax Deduction for Farms and Small Businesses Andrew T. Howard Minneapolis, MN Andrew T. Howard, a member of the estate planning and administration section at, focuses his practice on estate planning, business succession planning, probate and trust administration, and not-for-profit law. He assists individuals and families with wills, trusts, gift and generation-skipping transfer tax issues, tax preparation, and charitable planning. Howard also provides counsel to business owners and farmers related to succession planning, entity structure, wealth transfer techniques, and the Minnesota estate tax deduction for small businesses and farms. MATERIALS DISCLAIMER These materials are provided for the exclusive, personal use of the customer. Any other reproduction, retransmission, republication or other use is expressly prohibited without prior written consent from the Minnesota Society of Certified Public Accountants (MNCPA) and/or the content author. The MNCPA makes no warranty, guarantee or representation as to the accuracy or completeness of these materials. The contents of these materials are subject to change without notice. The content authors and/or instructors are not engaged in rendering legal, accounting or professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Minneapolis, MN is co-chair of the estate planning and administration section at She specializes in estate planning, business succession planning, probate and trust administration, elder law and real estate. Lammers has lectured and written extensively in the field of estate planning and elder law for the general public as well as attorneys, accountants, insurance agents, financial planners and trust organizations. She has been recognized as a Minnesota Rising Star by Minnesota Super Lawyers Magazine and as one of the 40 Under 40 to watch by Minneapolis/St. Paul Business Journal.
62nd Annual MNCPA Tax Conference 62 nd Annual MNCPA Tax Conference MINNESOTA ESTATE TAX DEDUCTION FOR FARMS AND SMALL BUSINESSES SESSION K3 612-977-8217 jlammers@briggs.com November 15, 2016 Andrew T. Howard 612-977-8630 ahoward@briggs.com 2200 IDS Center 80 South 8 th Street Minneapolis, MN 55402-2157 Copyright, Briggs and Morgan, Professional Association, 2006-2015 Qualified Small Business/Farm Property Introduction: Changes were made to the law in the 2014 Session Laws effective retroactively for estates of decedents dying after December 31, 2013. The significant change caps the qualified small business and qualified farm property deduction at $5 million minus the Minnesota estate tax exemption amount. Year Qualified Small Business and Farm Property Deduction Amount 2014 $3.8 million 2015 $3.6 million 2016 $3.4 million 2017 $3.2 million 2018 $3 million Page 1
62nd Annual MNCPA Tax Conference Qualified Small Business Property 1. Property. SESSION K3 2. Ownership interest/ Continuous ownership. 3. The decedent must own the property. 4. Passive activity prohibition. 5. Material participation requirement. 6. The Section 469 standard. 7. Continuous Ownership after death of decedent. Qualified Farm Property 1. Compliance with Corporate Farm Statute (Minn. Stat. 500.24). File the Corporate Farm Report! The Corporate Farm Report must be completed by all business entities and Trusts (including Revocable Trusts). 2. Property classification. Class 2a property. Agricultural land that is a contiguous acreage of 10 acres or more used during the preceding year for agricultural purposes. Agricultural homestead. The property must be classified as agricultural homestead, agricultural relative homestead, or agricultural special homestead. 3. Three year continuous ownership before death. 4. Continuous ownership three years following decedent s death. Page 2
62nd Annual MNCPA Tax Conference Recapture Tax Theestateandthequalifiedheirmustelecttotreatthepropertyasqualified small business or farm property, and agree, in a form prescribed by the Commissioner of Revenue, to pay the recapture tax if applicable. SESSION K3 Three year holding requirement. If, within the earlier of three years of the date of the decedent s death or the death of the qualified heir, the qualified heir disposes of the interest an additional estate tax is imposed on the property. Disposition to family member allowed. The qualified heir can dispose of the property to a family member without triggering the recapture tax. Election. Theestateandthequalifiedheirmustelecttotreattheproperty as qualified small business or farm property, and agree, in a form prescribed by the Commissioner of Revenue, to pay the recapture tax if applicable. Sole proprietor replacement property. Inthecaseofasoleproprietor, if the qualified heir replaced small business property excluded under the qualified small business exclusion with similar property, the qualified heir will not be treated as having disposed of the interest in the property. Recapture Tax. The Minnesota statute sets the recapture tax rate at the top bracket, i.e., 16%. Thus, a failed election could end up costing more in recapture tax than the original tax would have been, if paid at the outset! Minding The Gap A list of matters to mind when a client is in-between the federal estate tax exemption amount and the Minnesota estate tax exemption amount and holds closely held entities. Page 3
62nd Annual MNCPA Tax Conference Income Tax vs. Estate Tax Minnesota estate tax rate: Tax rates begin at 9% and gradually increase to 16% as the total value of a decedent s estate increases. SESSION K3 Short-term capital gains rates for 2015: Short-term capital gains gains on shares held less than a year are taxed as normal income. The highest federal rate is 39.6%. The highest Minnesota rate is 9.85%. Long-term capital gains rate for 2015: Long-term capital gains gains on assets held more than a year are taxed based on a taxpayer s bracket. The highest federal rate is 20%. The highest Minnesota rate is 9.85%. Step-up in Basis; To Gift or Not to Gift. Carry-over basis vs. step-up in basis. If a Minnesota resident makes a gift and dies within three (3) years, the gift gets pulled back into the person s estate for Minnesota estate tax purposes WITH NO STEP-UP! Three(3)yearlook-backruleshouldbeconsideredandcash or high basis assets should be gifted to avoid the unfortunate consequence of inclusion of the asset in the estate for estate taxes purposes without a step-up in cost basis. Page 4
62nd Annual MNCPA Tax Conference Entity Valuation Valuation of entity. SESSION K3 Willing Buyer and Willing Seller Test. For gift and estate tax purposes, the fair market value of property transferred to another party is measured on the date of the transfer as the price at which the property would change hands between a [hypothetical] willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts (the willingbuyer, willing-seller test, Treas. Reg. 20.2031-1(b)). Methods for valuing closely held entities. Market method. Income method. Net asset value method. Entity Discounts Discount for lack of marketability. Discount for minority interest/lack of control. Discount for built-in gains taxes. The discount reduces the client s fair market value in the property. The discounts lowers the fair market value which reduces the estate tax liability--but the discount also reduces the client s step-up in cost basis, which can result in a greater capital gains income tax liability if the property is later sold and capital gains taxes are owing. Page 5
62nd Annual MNCPA Tax Conference Step-up in Basis and 754 Election A client that owns an interest in a business entity taxed as a partnership (this includes an LLC), the business entity can make a 754 election for the client s interest. SESSION K3 The 754 election allows the partner s cost-basis of the underlying asset (i.e. inside asset) to be stepped-up to the date of death value; however, the step-up cannot exceed the outside basis. If the entity is taking a discount, the discount reduces the step-up in cost-basis of the underlying asset. The goal of the 754 election is to achieve uniformity between the inside basis of partnership (or LLC) assets and the outside basis when there has been a transfer of a partnership interest by sale or exchange, or upon the death of a partner. Page 6
Page 7 Example of Entity Gifting with Discounts Asset FMV Entity with 30% discount Entity w/ 30% discount and gifting of 50% entity Completed gift of 1.5m bonds Homestead 200,000 200,000 200,000 200,000 Farm land 2,000,000 2,000,000 FLP/LLC 1,400,000 700,000 Checking Account 50,000 50,000 50,000 50,000 Municipal Bonds 2,000,000 2,000,000 2,000,000 500,000 Total 4,250,000 3,650,000 2,950,000 2,750,000 No planning FLP No Gifting No Sale FLP No Gifting Sale FLP Gifting No Sale FLP Gifting Sale *Gifts $1.5 million Bonds Estate taxes 306,800.00 208,866.00 208,866.00 173,000.00 173,000.00 153,000.00 Capital gains 0.00 179,100.00 89,550.00 0.00 Capital Gains 50% gifted 298,500.00 Total tax 306,800.00 208,866.00 387,966.00 173,000.00 561,050.00 153,000.00 *Client must live three (3) years after making the gift for the gift to be removed from their estate. No gifting/not Gifting/not Gifted Amount Capital Gain Taxes stepped-up stepped-up Amount not stepped-up: 600,000 300,000 1,000,000 Federal LT 20% 120,000 60,000 200,000 MN CG 9.85 59,100 29,550 98,500 Total capital gains 179,100 89,550 298,500 62nd Annual MNCPA Tax Conference SESSION K3
62nd Annual MNCPA Tax Conference Non-Minnesota situs property for Minnesota Resident If a client has Non-Minnesota sitused property, the client should be careful not to turn the property into personal property by contributing the property to a business entity such as a partnership, LLC, or corporation. The partnership interest, LLC interest, or stock becomes personal property which is subject to Minnesota estate tax. SESSION K3 If a Minnesota resident has non-minnesota sitused property with debt, consider paying-off the non-sitused property debt with personal property assets. Legislative Developments Page 8
62nd Annual MNCPA Tax Conference DOR Positions in Audit SESSION K3 Q & A Page 9
62 nd Annual MNCPA Tax Conference November 15, 2016 MINNESOTA ESTATE TAX DEDUCTION FOR FARMS AND SMALL BUSINESSES 80 South 8 th Street, Suite 2200 Minneapolis, Minnesota 55101 Tel: 612.977.8217 jlammers@briggs.com Andrew T. Howard 80 South 8 th Street, Suite 2200 Minneapolis, Minnesota 55101 Tel: 612.977.8630 ahoward@briggs.com Copyright 2016
I. QUALIFIED SMALL BUSINESS/FARM PROPERTY - Minn. Stat. 291.03 Subds. 9-10. 1. Introduction. The qualified small business and qualified farm property, found at Minn. Stat. 291.03, Subd. 1, and Subds. 8 11, was originally enacted in the Special Session of the legislature held in July, 2011. The original provision created an additional up-to-$4 million deduction for the value of "qualified small business property" and "qualified farm property" passing to qualified heirs, for purposes of computing Minnesota estate tax on estates of decedents dying after June 30, 2011. It was based very loosely upon IRC Section 2032A, with references to various federal and Minnesota statutes. Technical changes were made to the law in the 2013 Omnibus Tax Act effective retroactively for estates of decedents dying after June 30, 2011. The most significant changes expanded the definition of family member to include trusts, expanded the definition of ownership interest to include interests owned by the decedent under I.R.C. 2036, 2037, and 2038, and amended qualified heir to means a family member who acquired qualified property upon the death of the decedent opposed to from the decedent. Changes were made to the law in the 2014 Session Laws effective retroactively for estates of decedents dying after December 31, 2013. The significant change caps the qualified small business and qualified farm property deduction at $5 million minus the Minnesota estate tax exemption amount. Year Qualified Small Business and Farm Property Deduction Amount 2014 $3.8 million 2015 $3.6 million 2016 $3.4 million 2017 $3.2 million 2018 $3 million 2. Statutory language. The law is found in Minn. Stat. 291.03, Subd. 1, and Subds. 8 11. Below is the law. Subd. 8. Definitions. (a) For purposes of this section, the following terms have the meanings given in this subdivision. (b) "Family member" means a family member as defined in section 2032A(e)(2) of the Internal Revenue Code, or a trust whose present beneficiaries are all family members as defined in section 2032A(e)(2) of the Internal Revenue Code. 2 Copyright 2016
(c) "Qualified heir" means a family member who acquired qualified property upon the death of the decedent and satisfies the requirement under subdivision 9, clause (7), or subdivision 10, clause (5), for the property. (d) "Qualified property" means qualified small business property under subdivision 9 and qualified farm property under subdivision 10. Subd. 9. Qualified small business property. Property satisfying all of the following requirements is qualified small business property: (1) The value of the property was included in the federal adjusted taxable estate. (2) The property consists of the assets of a trade or business or shares of stock or other ownership interests in a corporation or other entity engaged in a trade or business. Shares of stock in a corporation or an ownership interest in another type of entity do not qualify under this subdivision if the shares or ownership interests are traded on a public stock exchange at any time during the three-year period ending on the decedent's date of death. For purposes of this subdivision, an ownership interest includes the interest the decedent is deemed to own under sections 2036, 2037, and 2038 of the Internal Revenue Code. (3) During the taxable year that ended before the decedent's death, the trade or business must not have been a passive activity within the meaning of section 469(c) of the Internal Revenue Code, and the decedent or the decedent's spouse must have materially participated in the trade or business within the meaning of section 469(h) of the Internal Revenue Code, excluding section 469(h)(3) of the Internal Revenue Code and any other provision provided by United States Treasury Department regulation that substitutes material participation in prior taxable years for material participation in the taxable year that ended before the decedent's death. (4) The gross annual sales of the trade or business were $10,000,000 or less for the last taxable year that ended before the date of the death of the decedent. (5) The property does not consist of cash, cash equivalents, publicly traded securities, or assets not used in the operation of the trade or business. For property consisting of shares of stock or other ownership interests in an entity, the value of cash, cash equivalents, publicly traded securities, or assets not used in the 3 Copyright 2016
operation of the trade or business held by the corporation or other entity must be deducted from the value of the property qualifying under this subdivision in proportion to the decedent's share of ownership of the entity on the date of death. (6) The decedent continuously owned the property, including property the decedent is deemed to own under sections 2036, 2037, and 2038 of the Internal Revenue Code, for the three-year period ending on the date of death of the decedent. In the case of a sole proprietor, if the property replaced similar property within the three-year period, the replacement property will be treated as having been owned for the three-year period ending on the date of death of the decedent. (7) For three years following the date of death of the decedent, the trade or business is not a passive activity within the meaning of section 469(c) of the Internal Revenue Code, and a family member materially participates in the operation of the trade or business within the meaning of section 469(h) of the Internal Revenue Code, excluding section 469(h)(3) of the Internal Revenue Code and any other provision provided by United States Treasury Department regulation that substitutes material participation in prior taxable years for material participation in the three years following the date of death of the decedent. (8) The estate and the qualified heir elect to treat the property as qualified small business property and agree, in the form prescribed by the commissioner, to pay the recapture tax under subdivision 11, if applicable. Subd. 10. Qualified farm property. Property satisfying all of the following requirements is qualified farm property: (1) The value of the property was included in the federal adjusted taxable estate. (2) The property consists of agricultural land and is owned by a person or entity that is either not subject to or is in compliance with section 500.24. (3) For property taxes payable in the taxable year of the decedent's death, the property is classified as class 2a property under section 273.13, subdivision 23, and is classified as agricultural homestead, agricultural relative homestead, or special agricultural homestead under section 273.124. 4 Copyright 2016
(4) The decedent continuously owned the property, including property the decedent is deemed to own under sections 2036, 2037, and 2038 of the Internal Revenue Code, for the three-year period ending on the date of death of the decedent either by ownership of the agricultural land or pursuant to holding an interest in an entity that is not subject to or is in compliance with section 500.24. (5) The property is classified for property tax purposes as class 2a property under section 273.13, subdivision 23, for three years following the date of death of the decedent. (6) The estate and the qualified heir elect to treat the property as qualified farm property and agree, in a form prescribed by the commissioner, to pay the recapture tax under subdivision 11, if applicable. Subd. 11. Recapture tax. (a) If, within three years after the decedent's death and before the death of the qualified heir, the qualified heir disposes of any interest in the qualified property, other than by a disposition to a family member, or a family member ceases to satisfy the requirement under subdivision 9, clause (7); or 10, clause (5), an additional estate tax is imposed on the property. In the case of a sole proprietor, if the qualified heir replaces qualified small business property excluded under subdivision 9 with similar property, then the qualified heir will not be treated as having disposed of an interest in the qualified property. (b) The amount of the additional tax equals the amount of the exclusion claimed by the estate under subdivision 8, paragraph (d), multiplied by 16 percent. (c) The additional tax under this subdivision is due on the day which is six months after the date of the disposition or cessation in paragraph (a). 3. Qualified Small Business Property. 1. Property. The property must consist of assets of a trade, business, share of stock or other ownership interest in a corporation or entity engaged in a trade or business. Cash, cash equivalent, publicly traded securities, or assets not used in the trade or business must be deducted proportionate to the share of the ownership interest. 2. Ownership Interest/ Continuous Ownership. The decedent must have continuously owned the property for three years preceding the date of death of the decedent. An ownership interest includes interests the decedent is deemed to own under I.R.C. 2036, 2037, and 2038. 5 Copyright 2016
Note: If decedent is a sole proprietor, and the property replaced similar property within the three year period, the new property is treated as having been owned for the three-year period ending on decedent s death. 3. The decedent must own the property Ownership interest was expanded by the 2013 technical changes to include interests the decedent is deemed to own under I.R.C. 2036, 2037, and 2038. a) I.R.C. 2036: Value of transferred Life Estate Interest includes all interests of which decedent has made a transfer relating to: (1) Possession, enjoyment of, right to vote on matters concerning, or right to income derived from the property, or (2) Right to designate, alone or in conjunction with another, persons who may possess, use, or enjoy income derived from the property. b) I.R.C. 2037: Reversionary Value of gross estate includes value of all property held by the decedent and transferred by trust or otherwise, if: (1) Possession or enjoyment of the property through ownership can only be obtained by surviving the decedent, and (2) Decedent retains a reversionary interest in the property, valued immediately before decedent s death at more than 5% of the property value. A reversionary interest is the possibility that property transferred by the decedent may return to him or his estate, or may be subject to power of disposition by him. This does not include the possibility of income derived from the property. c) I.R.C. 2038: Value of gross estate includes value from Revocable Transfers (i.e., Revocable Trusts) when: (1) Decedent or another person, except in the case of a bona fide sale, retained the power to alter, amend, or revoke the transfer until the decedent s death, or where decedent relinquished this power in the preceding 3-year period ending on the date of decedent s death, unless the transfer occurred before 6/22/1936 and is otherwise not included in the above description. 6 Copyright 2016
(2) The power to alter, amend, revoke, or terminate shall be considered to exist on the date of decedent s death, even when the exercise of power is subject to notice not given, or when the power shall not take effect until after a term of years which has not yet expired. 4. Passive Activity Prohibition. In the taxable year preceding the decedent s death, the business cannot be engaged in Passive Activity. Passive Activity is defined in I.R.C. 469(c) as any activity which: a) Involves the conduct of any trade or business in which the taxpayer does not materially participate. b) Any rental activity (except for taxpayers in the real property business to whom over ½ of all services performed are real property trades, and said taxpayer performs over 750 hours of services during the taxable year in property trades or for a business in which the taxpayer materially participates). 5. Material Participation Requirement. The material participation requirement for Minnesota qualified small business property adopts the standards of 469 of the Internal Revenue Code, for determining whether there was material participation or not. 1 Section 469 of the Internal Revenue Code contains provisions on passive activity losses and credits allowed. It is not clear why, but the Minnesota legislature chose to use a definition of "material participation" which is used to govern passive losses, and not refer to 1402(a)(1) which is the section dealing with self-employment taxes and is the section referred to for determining material participation under 2032A. 6. The Section 469 Standard. Section 469(h)(1) of the Internal Revenue Code defines "material participation" by stating: A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is (A) regular, (B) continuous, and (C) substantial. Treasury Regulations interpreting section 469 provide that a taxpayer is considered to have "materially participated" if his or her activities satisfy at least one of seven specific tests. According to Treasury Regulation 1.469-5T, "an individual shall be treated, for purposes of section 469 and the regulations thereunder, as materially participating in an activity for the taxable year, if and only if: 1 Minn. Stat. 291.03, subd. 9(2) (2011) 7 Copyright 2016
1. The individual participates in the activity for more than 500 hours during such year, and the taxpayer owns an interest in the activity while performing the work. 2. The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year. This permits a small operation to qualify, when it could not under test (1) above. 3. The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year; 4. The activity is a significant participation activity (within the meaning of paragraph (c) [of Regs. 1.469-5T] for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours; 5. The individual materially participated in the activity (determined without regard to this paragraph (a)(5) [of Regs. 1.469-5T] for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year; 6. The activity is a personal service activity (within the meaning of paragraph (d) [of Regs. 1.469-5T], and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or 7. Based on all of the facts and circumstances (taking into account the rules in paragraph (b) [of Regs. 1.469-5T], the individual participates in the activity on a regular, continuous, and substantial basis during such year. 2 This test requires at least 100 hours of activity during the year. Management activity cannot be taken into account unless no other person is compensated for management services and no other individual performs management services for more hours than the taxpayer. There is no definition of "management services." Note on Passive Activity and Martial Participation. A client reports business profits and losses on the client s individual Form 1040. The client checks a box 2 Regs. 1.469-5T 8 Copyright 2016
indicating whether the client materially participated in the business during the tax year. Generally, a client is eligible to claim material participation if the client participated in a business on a regular, continuous, and substantial basis as discussed above. If the client checks no, to material participation on the box, the business counts as a passive activity. According to the IRS, a trade or business is considered a passive activity unless the taxpayer materially participates. Passive income generally refers to the proceeds from a financial investment that does not require significant time or effort to manage after the investment is made, such as a business or rental property. For businesses that engage in rental activities, it can difficult for the client to claim material participation. According to the IRS, the long-term leasing or rental of real estate is considered a passive activity even if you materially participated in the activity unless you materially participated in a rental activity as a real estate professional. To qualify as a real estate professional, more than half of the work you perform in trades or businesses during the taxable year must be in real property activity in which you materially participate. Additionally, you must work more than 750 hours a year in these trades/businesses. 7. Continuous Ownership after death of decedent. In the three-year period following the decedent s death, the business must refrain from passive activity and a family member of the decedent must materially participate in the business or trade. 4. Qualified farm property. 1. Compliance with Corporate Farm Statute (Minn. Stat. 500.24) a) File the Corporate Farm Report! See attached form. 2) The Corporate Farm Report must be completed by all business entities and Trusts (including Revocable Trusts). 2. Property classification. The property must be classified for property tax purposes as Class 2a property under Section 273.13 Subd. (23) in the year of the decedent s death AND as agricultural homestead, agricultural relative homestead, or special agricultural homestead under 273.124 in the year of the decedent s death. a) Class 2a property under Section 273.13 Subd. 23. The property must be classified as 2a property which is agricultural land. In essence, parcels or portions thereof of property consisting of agricultural land and buildings, including Class 2b property interspersed with Class 2a property. 9 Copyright 2016
(1) Class 2a property. Agricultural land that is a contiguous acreage of 10 acres or more used during the preceding year for agricultural purposes. a. Agricultural purposes means the raising, cultivation, drying, and storage of agricultural products. (2) Class 2b property. Rural vacant land that consists of parcels of properly that are not used for agricultural purposes, unplatted real estate, rural in character, not improved with a structure. Typically class 2b property does not qualify for the deduction, however, there are exceptions where class 2b property is linked or classified as 2a property. a. Class 2b rural vacant land that is contiguous to and under the same ownership as class 2a land may be eligible for 2a agricultural homestead treatment. b. Real estate that is impractical to separate may be eligible for 2a classification. (3) Agricultural homestead. The property must be classified as agricultural homestead, agricultural relative homestead, or agricultural special homestead. (See attached agricultural homestead determination chart.). a. Agricultural Homestead. To qualify as Agricultural homestead, the client must: (1) Own the property. (2) Occupy the property as a residential homestead. (3) Only have one homestead. (4) Be a Minnesota resident. b. Relative Agricultural Homestead. Residential real estate that is occupied and used for purposes of a homestead by a relative of the owner. (1) Relative of the owner means: grandchild, child, sibling, or parent of the owner or the spouse of the owner. 10 Copyright 2016
(2) Owner and relative must be Minnesota residents. (3) Owner cannot homestead any other property. c. Special Agricultural Homestead. Certain property qualifies as special agricultural homestead which various exemptions and special rules. (1) Linked property. (2) Non-contiguous land: four cities and four townships. (3) Over 50% of the agricultural land must be actively farmed. (4) Owner cannot homestead any other property. d. Homestead classification for owner in a care facility: Under Minnesota Statute 273.124 Subd. 1(f), the assessor cannot deny homestead treatment if the owner or the owner s spouse is absent due to residence in a nursing home, boarding care facility, or an elderly assisted facility property and the property is not otherwise occupied. 3. Continuous ownership. The decedent must have continuously owned the property for three years preceding the date of death of the decedent. An ownership interest includes interests the decedent is deemed to own under I.R.C. 2036, 2037, and 2038. (See paragraph (C)(3) for discussion on I.R.C. 2036, 2037, and 2038) 4. Continuous Ownership three years following decedent s death. Three years following the death of the decedent, the qualified heir must continually own the property as class Class 2A Property under Section 273.13 Subd. (23). Note: the property does not have to be homestead. 5. Recapture Tax. The estate and the qualified heir must elect to treat the property as qualified small business or farm property, and agree, in a form prescribed by the Commissioner of Revenue, to pay the recapture tax if applicable. 1. Three year holding requirement. If, within the earlier of three years of the date of the decedent s death or the death of the qualified heir, the qualified heir disposes of the interest an additional estate tax is imposed on the property. 11 Copyright 2016
2. Disposition to family member allowed. The qualified heir can dispose of the property to a family member without triggering the recapture tax. 3. Election. The estate and the qualified heir must elect to treat the property as qualified small business or farm property, and agree, in a form prescribed by the Commissioner of Revenue, to pay the recapture tax if applicable. 4. Sole proprietor replacement property. In the case of a sole proprietor, if the qualified heir replaced small business property excluded under the qualified small business exclusion with similar property, the qualified heir will not be treated as having disposed of the interest in the property. 5. Recapture Tax. The Minnesota statute sets the recapture tax rate at the top bracket, i.e., 16%. Thus, a failed election could end up costing more in recapture tax than the original tax would have been, if paid at the outset! II. MINDING THE GAP A list of matters to mind when a client is in-between the federal estate tax exemption amount and the Minnesota estate tax exemption amount and they hold farm property, small business property, or property held in an entity such a partnership or LLC. 1. Income Tax vs. Estate Tax. Going forward, estate planning will need to incorporate the importance of income tax planning and the step-up in basis with estate tax planning. If a client is in the gap, future income tax liabilities may be greater than Minnesota estate tax savings due to the income tax rates being greater than the estate tax rates. a. Estate tax rates vs. capital gains (income tax rates). 12 Copyright 2016
Minnesota estate tax rate: Tax rates begin at 9% and gradually increase to 16% as the total value of a decedent s estate increases. Short-term capital gains rates for 2015: Short-term capital gains -- gains on shares held less than a year -- are taxed as normal income. The highest federal rate is 39.6%. The highest Minnesota rate is 9.85%. Long-term capital gains rate for 2015: Long-term capital gains gains on assets held more than a year -- are taxed based on a taxpayer s bracket. The highest federal rate is 20%. The highest Minnesota rate is 9.85%. 2. Step-up in Basis; To Gift or Not to Gift. When property is gifted, the donee (the person receiving the gift) takes the property at the cost-basis of the donor (person making the gift). I.R.C. 1015. This is called carry-over cost basis. On the other hand, when a person dies, the person s property gets a step-up in basis to the property s fair market value at the time of the person s death and the beneficiary takes the property with a stepped-up basis at fair market value. ). I.R.C. 1014. As stated earlier in this outline, Minnesota has repealed the Minnesota gift tax. If a person makes a gift of assets and is a Minnesota resident, no gift tax will be owed to Minnesota. However, if a Minnesota resident makes a gift and dies within three (3) years, the gift gets pulled back into the person s estate for Minnesota estate tax purposes with no step-up! When gifting assets, it is very important to review the client s carry-over cost basis and determine if the best option is to gift or hold the asset until death and pay the Minnesota estate tax but receives a step-up in cost basis. With the long-term capital gains rates greater than the Minnesota estate tax rate, great care should be given to evaluating the cost basis of the asset and gifting only high basis assets to minimize income taxes if no step-up in achieved. Furthermore, the three (3) year look-back rule should be considered and cash or high basis assets should be gifted to avoid the unfortunate consequence of inclusion of the asset in the estate for estate taxes purposes without a step-up in cost basis. 3. Entity Discounts. When dealing with small businesses and real estate many clients hold the property in entity form such a partnership or limited liability company (LLC). These entities are typically valued with a discount for lack of marketability and lack of minority interest (for partnerships). The discount reduces the client s fair market value in the property. The discounts lowers the fair market value which reduces the estate tax liability--but the discount also reduces the client s step-up in cost basis, which can result in a greater capital gains income tax liability if the property is later sold and capital gains taxes are owing. Since the capital gains tax rates are typically higher than the Minnesota estate tax rates, careful consideration needs to be made when taking discounts for the business interests. 13 Copyright 2016
If the client was married at death and there will no estate tax owned due to the marital deduction, discounts should be carefully considered for income tax planning- especially if the surviving spouse will be gifting assets or selling assets. a. Step-up in basis and 754 election. A client that owns an interest in a business entity taxed as a partnership (this includes an LLC), the business entity can make a 754 election for the client s interest. The 754 election allows the partner s cost-basis of the underlying asset (i.e. inside asset) to be stepped-up to the date of death value; however, the step-up cannot exceed the outside basis. Therefore, if the entity is taking a discount, the discount reduces the step-up in cost-basis of the underlying asset. The goal of the 754 election is to achieve uniformity between the inside basis of partnership (or LLC) assets and the outside basis when there has been a transfer of a partnership interest by sale or exchange, or upon the death of a partner. Again, careful consideration should be made when taking a 754 election to determine if the discount provides an effective overall tax position if any of the underlying assets will be sold or exchanged before the death of the new partner. 4. Minnesota QTIP Planning. With federal portability, the Minnesota QTIP election has limited application for tax planning purposes. If a married client is in the gap, one planning option to minimize estate taxes without having to QTIP the property is to fund the Credit Trust (Family Trust) to the client s available Minnesota exclusion amount with the remaining assets passing to the surviving spouse outright. The spouse then makes a subsequent gift of assets to the Credit Trust. If the spouse survives three (3) years, the gift escapes Minnesota estate taxation. The Credit Trust should be drafted to with an independent Trustee. Additionally, and importantly, income and principal distributions should only be made in the Independent Trustee discretion with an ascertainable standard. If there are mandatory income or principal distributions there are potential 2036 concerns. The fund-to-minnesota-and-gift strategy has some risk. If the surviving spouse does not survive three (3) years, the gift gets brought back into the surviving spouse s estate for estate tax purposes. If possible and practical, the surviving spouse should gift cash in which case the surviving spouse s estate is no worse-off. The Minnesota QTIP election continues to have application for a client that wants the assets in Trust for the surviving spouse for purposes of a blended family or other considerations such as control and management of assets and distributions. The tax planning may be less important than ensuring control and ultimate distribution of the assets. 14 Copyright 2016
5. Disclaimer Planning. If a client s plan includes disclaimer planning and a Disclaimer Trust is created by the surviving spouse with the possibility that a subsequent gift to the Disclaimer Trust can be made, the Disclaimer Trust s provisions should be carefully drafted. An Independent Trustee should be acting and income and principal distributions with an ascertainable standard should be available only in the discretion of the Independent Trustee. If there are mandatory income or principal distributions there are potential 2036 concerns. 6. Non-Minnesota situs property for Minnesota Resident. If a client has Non- Minnesota sitused property, the client should be careful not to turn the property into personal property by contributing the property to a business entity such as a partnership, LLC, or corporation. The partnership interest, LLC interest, or stock becomes personal property which is subject to Minnesota estate tax. If a Minnesota resident has non-minnesota sitused property with debt, consider paying-off the non-sitused property debt with personal property assets.. III. DOR Positions in Audit. 1. General Positions a) Who signs if a trust receives the qualified property? b) Specific description of asset on M706Q (1) No fractional language/no formula language (2) Ideally the property is separately stated on the Federal 706 c) Attachments for M706Q (1) Decedent s tax returns for previous three years (2) Documentation showing continuous ownership of property a. Assignment of business interests. b. Deed to property. (3) Property tax statements for previous three years 2. DOR positions regarding Small Business Deduction a) Tax-free spin offs and holding period b) Passive activity 15 Copyright 2016
3. DOR positions regarding Farm Deduction a) Issues with jointly held property and holding period b) Property held in revocable trust and holding period c) Incorrect property tax classification 4. DOR position regarding recapture tax a) Property taken by eminent domain triggers total recapture b) Partial sale of property will trigger total recapture c) Sales to family members IV. Legislative Developments 1. Pending and proposed legislation a) Exempt revocable trusts from compliance with the Corporate Farm Act b) AG Homestead Rules when property is owned by spouses and trusts c) Exempt property taken via eminent domain from the recapture tax d) Treat spouses as one economic unit for purposes of calculating the holding period 16 Copyright 2016
62ND ANNUAL MNCPA TAX CONFERENCE November 14-15, 2016 Minneapolis Convention Center, Minneapolis, MN Please rate the following using the scale below: 5=Excellent, 4=Very Good, 3=Average, 2=Fair, 1=Poor K3. Minnesota Estate Tax Deduction for Farms and Small Businesses Excellent Poor Relevancy of Topic 5 4 3 2 1 Stated Objectives Met 5 4 3 2 1 Overall Satisfaction 5 4 3 2 1 Andrew T. Howard Knowledge of Subject 5 4 3 2 1 Presentation Skills 5 4 3 2 1 Quality of Materials 5 4 3 2 1 Engagement of Participants 5 4 3 2 1 Knowledge of Subject 5 4 3 2 1 Presentation Skills 5 4 3 2 1 Quality of Materials 5 4 3 2 1 Engagement of Participants 5 4 3 2 1 Do you have any additional feedback regarding the instructors and/or materials? If so, please share it with us. What would you like to learn at the 2017 conference? Who would you like to hear speak at the 2017 conference? Thank you for your feedback and suggestions. We appreciate your input. Minnesota Society of Certified Public Accountants www.mncpa.org 952-831-2707