Estate Planning - msu.edu...Estate planning often involves the use of a will— and that is an...

PM 993 Revised December 2000

EstatePlanningPlanning for Tomorrow

Estate PlanningPrepared by Neil E. Harl

Charles F. Curtiss Distinguished Professor inAgriculture and Professor of Economics, Iowa StateUniversity; Member of the Iowa Bar.

About This PublicationThis publication was prepared to be used inconjunction with a television and videotape seriestitled “Planning for Tomorrow.” The numberedchapters follow the sequence of the programs. Thepublication is designed for use with the series or asa single reference. In using the publication with thetelevision and videotape programs, it may behelpful to read the material before viewing theprogram and then use the material again forreference after the program.

This publication is designed to acquaint the readerwith the considerations, problems, and toolsavailable in estate planning, so that he or she mightrecognize the need for estate planning, and be ableto discuss the situation with the attorney in a moremeaningful way; and to assist the reader in devel-oping objectives and goals in estate planning thatwill provide the greatest satisfaction from propertyfor both the reader and the intended beneficiaries.

This publication is not intended to serve as acomplete text for estate planning. The subject is sobroad and complex that all details could not beincluded. The reader should observe that state-ments made in the publication apply to generalsituations; solutions to specific problems oftendepend upon the facts of each case. The author hasattempted to indicate this throughout the text. It isrecommended that the services of an attorney beobtained when dealing with the legal consider-ations of estate planning. This publication is notintended to substitute for legal counsel.

ContentsChapter Page

1 Introduction to Estate Planning 1

2 Property Ownership; Tenancy in Common 3

3 Joint Tenancy 6

4 Death Intestate—Without a Will 8

5 Testate Distribution—Where There’s a Will 10

6 The Probate Process 12

7 Considerations in Holding or Disposingof Property 14

8 Installment Sales, Private Annuities,and Self-Canceling Installment Notes 17

9 Gifts During Life: The Federal Gift Tax 20

10 Valuing Property for Federal Estate Tax 23

11 The Gross Estate 27

12 Planning to Save Federal Estate Tax 39

13 Federal Estate Tax Planning Strategies;Iowa Inheritance Tax; EstateSettlement Costs 41

14 Liquidity Planning 46

15 Tools for Estate Planning: Trusts 50

16 Implementing the Estate Plan 53

(Chapters follow the sequence of the television/videotape series Planning for Tomorrow.)

ESTATE PLANNING ❖ 1

The words estate and planning are both broad termswith many meanings. Here, the term estate plan-ning is used to mean developing a plan to transferall of one’s property from one generation to thenext or within a generation.

Estate planning often involves the use of a will—and that is an important part. A will, of course, is adocument, usually in writing, designating aperson’s wishes regarding the disposition ofproperty after death. A will becomes effective atdeath.

But a will is only one part of an estate plan. Otherfactors should be included in a comprehensive planincluding methods of owning property; insurance,its ownership and beneficiary designations; giftsand other transfers of property, both during lifeand after death.

Who Should PlanIn a sense, everyone has an estate plan. An indi-vidual may have a personal plan, evidenced by awill, that has been developed with the help of anattorney. For those who do not have a personalplan, the State of Iowa provides one. If the generallaws of the state regarding distribution of propertyat death meet your personal objectives, you needdo little else.

Chapter 4 explains how property is distributed andminor children are cared for by law when there isno will. But if you feel your objectives will not bemet by the general laws, you may want to developyour own plan. In planning, it should be under-stood how ownership of property can affect whatbecomes of property at death.

Estate planning often is considered a specialconcern of the aged, where the probability of deathis greater. But younger people, especially youngcouples with minor children, also have a great dealto gain from planning—and possibly much to loseif they don’t plan. While the probability of death isnot as great for younger people, the effect of deathmay be greater in view of the twin problems of careof minor children and management of their prop-erty in the event of death of both parents.

For those who own an interest in a family business,

the business plan should be considered along withan estate plan. Since the estate will contain theperson’s business interests, decisions should bemade so both plans fit together reasonably well.

The PlanEstate planning should be directed at three levelsof concern:

1. What to do with the property if one spouseshould die, assuming there are a husband and wife.

2. What to do with the property if both spousesshould die. Custody of minor children may be animportant question here and a guardian can benominated in the will. Also, minor children are notconsidered competent to manage property so atrust, for example, could be a helpful item toinclude in the parents’ wills.

3. What to do with the property if the entireimmediate family should die. This may be the firstlevel of concern for single persons who are bythemselves the “immediate family.” For couples, ifthere is no estate plan, the order of death maydetermine which side of the family will receive theproperty. For example, in an accident where theimmediate family is killed, but members die atdifferent times, the property goes to the heirs ofthe person who dies last. So the order of death maydetermine whether the property goes to thehusband’s side of the family or the wife’s.

Objectives of a PlanDetermining the objectives of an estate plan is themost important step. If you can identify andarticulate your objectives—what the property is tobe used for and for whose benefit—the chances arequite good that a plan can be developed to accom-plish your goals. Since there are many ways oftransferring property, much flexibility exists. Thereare a few restrictions on what one can do withproperty, but most people find these restrictions tobe reasonable. A greater concern often is thecompetition among objectives. Some examples ofsuch competition will be examined later.

Parents’ objectives often are to maintain securityand dependability of income while both are living,

Introduction to Estate Planning 1

2 ❖ IOWA STATE UNIVERSITY EXTENSION

and for the surviving spouse. Generally, the par-ents are interested in an equitable distribution ofproperty among children. Finally, most are inter-ested in minimizing estate taxes and estate settle-ment costs.

There may be some special concerns, however,such as the rights of a surviving spouse whoremarries, or management of certain types ofproperty by the survivor.

Another concern in the plan is unforeseen develop-ments, which may require flexibility in futuremanagement of property. If a living couple has achild handicapped by disease or injury, a largershare of the family’s resources may go into medicalexpenses and care of that child. Most would agreeall the children are receiving fair though unequaltreatment. But what if such an event occurs afterthe death of the parents and the estate plan rigidlycalls for equal distribution of property or incomeamong the children? Careful planning may beespecially helpful in such situations.

Objectives of OthersIn addition to the parents, other family membersmay have interests and objectives in an estate plan.Heirs or potential heirs outside the family mayhave objectives relating to their treatment if theyshould become investors in the family business byinheritance. Generally, these people have objec-tives:

• To receive income on their investment, orincrease in the value of the assets.

• To be able to sell their interest.

• To participate in management of the familybusiness, which may involve the question of howincome is divided.

In some instances, it may be difficult or impossibleto accomplish all the stated objectives. Estateplanning involves resolution of the competitiveideas advanced by the parents and possibly byother members of the family.

With a family business, it may also be an objectiveof the parents or heirs to continue the business.Linked to this may be the uncertainty faced byheirs who remain with the parents’ family business.It’s fairly common for a son to stay with the par-ents’ business 20 or 30 years with the understand-ing that he would be well taken care of at theparents’ deaths, or that he would ultimately receive

the family business. At the death of the parents, theson may find his rights are little greater than those ofbrothers or sisters who left home 20 or 30 years ago.

Again, business and estate plans should be closelytied. For family members who work and invest inthe family business, an annual determination ofownership might be planned while the parents live.

Sharp declines in land values, in the value ofmachinery and equipment, and, in some instances,in the value of corporate stock and other assets inthe 1980s altered the estate planning problem formany farm families. The effects of economicadversity also affected many nonfarm businessesthat serve farmers. For those individuals, estateplanning involves several special concerns. Risingasset values in the 1990s have provided additionalreasons for developing an estate plan or reviewingone prepared at an earlier time.

• Wills should be checked carefully to be certainthat property division remains acceptable. A willprovision leaving “all of my real property” to oneheir and “all of my personal property” to anothermay not produce acceptable results if land valueshave fallen — or risen — and the personal prop-erty is all in certificates of deposit that have main-tained their value.

• Options given, such as by will, to authorizedesignated heirs to purchase property should bereviewed for continued acceptability of the optionprice.• Special attention should be given to will and trustprovisions directing that indebtedness be paid andthe assets to pass free of the claims of creditors.Such provisions may no longer be feasible.• Individuals should consider carefully the impactof death on the ability to meet debt obligations.Liquidity for purposes of paying debts of thedeceased has taken on increased significance.• Special care should be taken to review whetherproperty should be valued at the alternate valua-tion date (up to six months after death) for federalestate tax purposes. The alternate valuation date isdiscussed in Chapter 10.• With the decline in the value of many businessassets, the percentage eligibility tests for special usevaluation of land, the family-owned businessdeduction, installment payment of federal estatetax, and corporate stock redemption after deathshould be carefully reviewed. These tests arediscussed in Chapters 10 and 15.


As indicated in the introduction, estate planningdeals with property. To deal with property effec-tively, it is important to know what property is,how it is classified, and how it may be owned.Ownership is particularly important because themethod of ownership may dictate how property istransferred and how it is taxed upon the death ofthe owner.

What Is Property?There are two broad classifications of property—real property and personal property. Real propertyincludes land and whatever is built on the land orattached to it. It includes buildings, fences, tilelines, and mineral rights, for example.

Personal property is broken down into tangibleitems and intangibles. Tangible personal propertyincludes such things as machinery, livestock,inventory items, stored grain, household goods,and automobiles. Intangible personal propertyincludes such assets as bank accounts, stocks,bonds, and insurance policies.

How Is Property Owned?There are two elements in ownership. One dealswith the degree of interest or control of the prop-erty. The other deals with relationships of ownerswhen more than one person has a present interestin the property.

If one were able to own property with total controlof it—to use it as the person pleases—the indi-vidual would have absolute ownership. But abso-lute ownership does not exist since some rights ofownership are reserved to others besides theowner.

There are three major interests in property that areretained by state or local government. The firstright retained by government is the right of emi-nent domain. For example, the state could take afarm from the owner if it were needed for a road-way, park, or some other public use. The statemust compensate the owner for the value of landtaken. The process is also known as condemnation.

A second right of the state and county is to taxyour property.

The state and county can also regulate use ofproperty through zoning or land use controls.These are examples of the “police power” overproperty. Basically, a property owner is restrictedin using property in ways that might damage aneighbor. Likewise, that property owner has theprotection from being damaged by a neighbor’s useof property through this governmental power.

In some states, these rights of the public interestare being expanded to limit or deny uses of prop-erty that damage the environment.

Thus, at least three rights to property are reservedto others. So the nearest thing to absolute owner-ship is known as a fee simple. With property heldin fee simple, the owner has the right to sell it, passit to others at death, mortgage it, lease it, manageit, and receive the income from it.

Other Ways of Owning PropertyProperty can be transferred from one person toanother with all the rights that fee simple allows.But the transfer can be made with fewer rights tothe property, where the owner voluntarily dividesthe rights of ownership. This makes propertyownership more flexible and may allow people toaccomplish the objectives of an estate plan moreeasily.

For example, a widow might own a farm in feesimple. She might decide that she would like togive her children by will something less than feesimple ownership. She may want to give the farmto her children for as long as they live and thenhave it go to someone else, perhaps to grandchil-dren or someone on her side of the family. Thechildren are “life tenants” and have a “life estate.”

Under such a plan, the children receive an interestin the farm for the rest of their lives upon the deathof the mother. They have the right to the incomefrom the farm and can collect rent or government

Property Ownership; Tenancy in Common 2


payments from it. But they cannot sell it or mort-gage it without permission of those holding otherinterests in the property. Basically, the childrenhave the right to manage the property and take theincome from it.

The life tenant or tenants also have the duty to payproperty taxes, to pay interest on any mortgage,and to keep the property in a reasonable state ofmaintenance.

At the death of the children, the property then goesto those holding the “remainder” interest desig-nated by the mother’s plan. Those with a remain-der interest generally must approve any sale ormortgage of the property while it is being used bythe person or persons with the life estate.

One variation involving use of the life estate is toestablish a life tenancy, but with no remainderinterest designated. In this instance, propertyreverts back to whomever established the lifetenancy or their heirs after death of the life tenant.

Some complications can develop when leases aremade by the life tenant. For instance, consider afarm that a man left in life tenancy to his wife. Sherents the farm out under a usual farm lease. In thepast, when the life tenant died, the farm lease wasterminated that day. That often was unfair to thefarm tenant. Initially to correct this problem, thetenant was given the right to come on the premisesand to harvest crops after death of the life tenant.

The Iowa legislature has strengthened farm tenantprotection with a law that continues farm leasesuntil the next March 1 if the life tenant dies. If thedeath of the life tenant occurs after September 1—the usual date for giving notice to terminate alease—the lease continues for the next crop yearwith the same terms and conditions except possi-bly for an adjustment to the rent if unreasonablylow.

Consequently, with farm leases involved, holdersof the remainder interest may not be able to obtaincomplete possession of property immediately uponthe death of the life tenant.

Most states have not acted to continue farm leasesbeyond the death of the life tenant, as in Iowa. Inthese states, the interests of farm tenants can beprotected from premature termination of the lease

if all interests are held in trust and the trustee signsthe lease or if holders of all interests—life estateand remainder—have signed the lease.

Co-OwnershipIf two or more people own the same piece ofproperty there is co-ownership. The propertymight be a farm, home, bank account, or automo-bile, for example. The property might be owned byhusband and wife, father and son, two brothers, oreven two or more unrelated people.

Fee simples, life estates, or remainders concernmainly the degree of rights to the property. Co-ownership involves the relationships betweenowners when more than one person holds title toproperty at the same time. Co-ownership is impor-tant in estate planning because the method of co-ownership may determine who eventually ownsthe property as well as the amount of tax due atdeath of one of the owners.

There are two widely used types of co-ownership—tenancy in common and joint tenancy.

Tenancy in CommonTenancy in common is the least used of the twoforms of co-ownership. This may be due to misun-derstandings about tenancy in common and jointtenancy.

Tenancy in common involves undivided ownershipinterests. For example, consider a 160-acre tract ofland owned in tenancy in common by A and B. It isnot correct to state that A owns one-half or 80acres, and B the other 80 acres. The two ownershold undivided interests in the entire 160 acres.

Together A and B can sell the property, mortgageit, lease it, manage it, and divide the income fromit. If one of the owners wants to terminate thearrangement, they can agree to sell the propertyand divide the proceeds. Or they can simply dividethe property into two parts so that each takes aspecified part. With the division, they exchangedeeds dividing the property and taking it out of co-ownership.

Should one owner desire to terminate the arrange-ment and the other refuses to sell or divide, theowner desiring to end the co-ownership relation-ship may, if necessary, go to court to request anorder for partition and sale. The court can require


that the property be sold and the proceeds divided,or that the property be split into parts, if that canbe done fairly.

It is not necessary that each of the parties ownsequal interests in co-ownership. One can own athree-fourths interest and the other one-fourth, forexample. If the deed or other document of titlereads “A and B,” the interest is presumed to beequal. Otherwise, the amount of interest eachowner has in the property must be specified.

Tenancy in common is not limited to husbandsand wives. It may be used by other family membersor even unrelated parties. Nor is tenancy in com-mon limited to two parties. There may be anynumber of co-owners.

In the case of tenancy in common, when oneowner dies, that person’s interest in the propertygoes to the heirs under state law if the person hasno will.

If the individual has a will, the deceased’sownership interest passes under the will todesignated beneficiaries. The heir or willbeneficiary then owns the undivided interest in theproperty with the living co-owner. The same rightsof co-ownership continue, including theavailability of partition and sale.

For purposes of figuring death taxes and estatesettlement costs, the actual percentage of interestowned is included in the deceased’s estate—one-half the value, if that is the interest of the deceased.

To determine the type of co-ownership involved, itis necessary to examine the document of title,deed, or stock certificate. Typically, the word“and” as in “John Doe and Mary Doe” createstenancy in common. For most cases, “John Doe orMary Doe” also creates tenancy in common. In afew specific instances, the word “or” creates jointtenancy.


Joint tenancy is the other system of co-ownershipin addition to tenancy in common and has been themore popular form of co-ownership. Its popularitymay have been because many people believed it tobe the best type of co-ownership. But that may notbe a correct assumption. Whether joint tenancy isbest depends on individual circumstances.

With joint tenancy, as with tenancy in common,two or more people own property together. Eachhas an undivided interest in the property. Each hasthe right to request a court order for partition andsale if he or she wants to terminate the arrange-ment.

The major difference between joint tenancy andtenancy in common becomes clear at the death ofone of the owners. With joint tenancy, there is aright of survivorship that controls disposition.When property is held in joint tenancy and one ofthe owners dies, the property goes to the otherowner. The survivor takes all. An ordinary willdoes not affect the disposition of property in jointtenancy at the death of the first joint tenant. Whenproperty is held in joint tenancy, there is a “built-in” will operating on the death of a joint tenant.

Iowa law doesn’t favor joint tenancy. All else beingequal, tenancy in common is favored. Therefore,the creation of joint tenancy requires specificlanguage. The words typically creating jointtenancy for land are: “John Doe and Mary Doe asjoint tenants with right of survivorship and not astenants in common.” Bank accounts may read“John Doe and Mary Doe or the survivor of them.”

Earlier it was indicated that the word “or” maycreate joint tenancy with right of survivorship incertain situations. One such instance is U.S.Government savings bonds. That is a specificinstance. Generally, the word “or” does not createjoint tenancy.

When using joint tenancy, you should be willing toaccept any possible order of death of the jointtenants. Usually, older people are expected to diefirst, or husbands to die before wives. When theexpected sequence of death occurs, objectives of an

estate plan using joint tenancy may be met. Butwhat if the unexpected occurs?

Consider a father-son situation, where the son hadbeen in business with the father with the businessassets held in joint tenancy. The basic intent wasthat the mother would be taken care of withinsurance, so the business would go to the son whowas employed there.

But the son, who had a wife and four children, waskilled in an automobile accident. His interest in theproperty passed to the father, which left the son’swidow and children in a difficult situation with fewassets.

Another factor, in addition to order of death, is theaccessibility of the property at death. In the case ofland, it usually isn’t critical if it’s tied up in probatefor a year or so after death. But in the case of abank account or an automobile, it may be inconve-nient for the survivor not to have access to theseitems after death. Joint tenancy assures immediateaccess for these two items. But the best arrange-ment depends on your individual situation andshould be decided by you in consultation withyour attorney.

With the bank account in joint tenancy, thesurvivor can continue to use the account after thedeath of one owner. With an automobile in jointtenancy, the survivor can take a copy of the deathcertificate, the certificate of title, and a small fee tothe county treasurer’s office and obtain title to theauto immediately after death. It is advisable toconsult your insurance agent to be certain that theauto insurance policy remains valid with thechange of title.

There is a contrary argument on placing a motorvehicle in joint tenancy. With a vehicle in jointtenancy, both owners may be liable for damages inan accident. In some situations, where one ownermay be a poor driver, or there is some type of highrisk, co-ownership might be avoided to limitliability to one person.

In most cases, owners of vehicles protect them-selves through automobile liability insurance. But

3 Joint Tenancy


owners should be aware of liability implications,especially if there are unusual circumstances.

Simplified Estate SettlementOne of the reasons joint tenancy may be so popularis that it is believed to simplify estate settlement atthe death of the first to die. And it is useful inmodest estates. But there are some problems.

First, one’s estate may be modest at the time onetakes title to property. But property values mayinflate, life insurance may be added and otherassets acquired—and the estate one day may nolonger be so modest. As estates grow larger, theadvantages of simplified estate settlement are soonovershadowed because of the tax traps of jointtenancy. The tax implications of joint tenancy arecovered in more detail in Chapter 11.

However, for those with estates of less than$675,000 (in 2001), who are relatively sure theirestates will not grow much more, and who acceptthe order of death with the survivor taking all theproperty, joint tenancy may simplify estate settle-ment and not create unacceptable death tax results.The amount of property may be as high as$700,000 in 2002 and 2003, $850,000 in 2004,$950,000 in 2005, and $1,000,000 in 2006 and later,without creating federal estate tax liability. The sizeof estate that may create state death tax concernsdepends upon the facts of the situation.

Purpose of SettlementThere is no law that requires estates to be settled.There may be a penalty for failing to pay taxes duein relation to an estate, but none for not settling theestate. Estates are settled for three reasons. If none ofthese applies, then the estate need not be settled.

• The first reason to settle an estate is to determinewho gets the property. This is one reason for theprobate process of an estate, handled under thesupervision of the court to determine formally who isentitled to the decedent’s property. However, if allproperty is in joint tenancy, disposition of theproperty is already determined, so there is no needfor settlement for this reason.

• The second reason for settling an estate is to getgood or clear title to property. Usually, this is amatter of showing that creditors of the decedentwere paid and there are no claims against thedecedent or the property.

The estate settlement process gives creditors anopportunity to present their claims. If they fail tomake their claims during the allowed time, theclaims are no longer valid. Without estate settle-ment, the claims could remain against the propertyfor a period of time and the new owners may beliable for the debt.

The situation with joint tenancy property differs,however. In most states, including Iowa, creditorsof a deceased joint tenant cannot make claimsagainst the property that passes to the survivingjoint tenant unless the survivor was specificallyobligated.

Despite concerns about abuse of this situation,there have been relatively few problems. Onlyabout half a dozen states in the nation allowcreditors of a deceased joint tenant to make claimsagainst property of the surviving joint tenant.

Since Iowa does not permit that, the second reasonfor settling an estate is not applicable if all propertyis in joint tenancy. In Iowa, unsecured creditorsare cut off in joint tenancy and cannot reach theproperty to satisfy the decedent’s obligations unlessthe survivor was obligated specifically.

• The third reason to settle an estate is to paytaxes. That cannot be avoided. However, if that isthe only reason for estate settlement, all that needsto be done is to prepare and file an inventory ofproperty owned, value the property, and pay thefederal estate and state inheritance taxes, if any, orto obtain clearance from the tax agencies if no taxesare due. There’s a short form procedure to obtainnecessary tax clearances. These procedures are lesstime consuming and usually less expensive than a fullprobate of the estate. So in certain circumstances,property in joint tenancy can be a benefit.

Finally, joint tenancy assures that property willpass to the surviving joint tenant. For those with-out a will, it may assure that the surviving spousereceives the property. But placing property in jointtenancy does not substitute for a will beyond thefirst level of concern, which is death of the firstspouse or joint tenant. Joint tenancy is a helpfulsubstitute for a will in some situations up to thispoint. But joint tenancy goes no further and saysnothing about disposition of property should bothjoint owners die or should the entire immediatefamily die.


When a person dies without a will, it is said that theperson died intestate. State law specifies how theproperty is distributed among the heirs.

If you die without a will, usually a member of thefamily begins the estate settlement process. Certainindividuals have priority rights to begin estatesettlement. Usually the surviving spouse has theright for a period of time, and then the childrenhave an exclusive right following the right of thespouse to initiate estate settlement proceedings asnoted in Chapter 6.

Typically, a family member asks an attorney topetition the court to open the estate and appoint anadministrator. The person who manages the estateduring settlement when there is no will is called anadministrator.

The court usually directs the administrator to posta bond and publish a newspaper notice so creditorsand the public know the estate is open and thatclaims may be presented. Iowa law allows creditorsfour months to present their claims. Those whoowe money to the decedent also can make pay-ments to the estate.

The administrator manages the property, collectsthe assets after death, safeguards and maintains theproperty, sells the assets at the proper time, paysthe creditors during the settlement process andpays the taxes. The latter includes the final incometax return for the decedent, possibly filed with thedecedent’s spouse. There also are the income taxreturns for the estate, both state and federal; thestate inheritance tax return and the federal estatetax return; plus property taxes that may be dueduring settlement.

The administrator also prepares a final report,indicating to the court how the property has beendisposed of, what claims have been paid, and whattaxes have been paid. After approval of the finalreport, property is distributed to the heirs who areentitled to receive it under state law.

The rules on distribution of property by law canbest be illustrated by examples. These examples arebased on Iowa law that applies to permanent

residents of the state at the time of death.

First, if you die leaving no will, no spouse, and nochildren, but with a surviving mother and father,the parents share the estate equally. If one parenthad died earlier, then the surviving parent receivesthe entire estate.

If both parents had died before you, the parents areresurrected, theoretically, and the estate goesthrough their hands to their descendants, whowould be your brothers and sisters. If you were anonly child, or there were no survivors, the propertygoes back up the family tree—splitting the estatebetween your mother’s parents and your father’sparents. If all the grandparents are living, theyshare equally in the estate. If any one member ofone of the pairs is deceased, the survivor receivesthe share for the pair. If neither of the pair lives,your estate is distributed to their descendants, youruncles and aunts, or to their descendants if theuncles and aunts are not living.

If no heirs are found, the property is dividedamong your great grandparents, or distributed totheir descendants. The process continues backthrough previous generations. If no heirs can befound, the estate goes to your spouse, heirs of thespouse if deceased, or heirs of predeceasedspouses.

If all possibilities are exhausted and no heirs arefound, the property returns (escheats) to the Stateof Iowa.

A More Typical SituationA more typical situation would be where you leavea mother and father surviving and also a spouse,but no children. The surviving spouse receives anylife insurance proceeds where he or she is namedbeneficiary and any joint tenancy property if he orshe is the surviving joint tenant. In addition, thespouse in this instance receives all of the rest of thedecedent’s property.

Where There are ChildrenNow suppose you die leaving a spouse and chil-dren, and no will. If the surviving issue are all the

4 Death Intestate—Without a Will


issue (descendants) of the surviving spouse, thesurviving spouse receives all of the decedent’sproperty.

In the event some of the decedent’s issue are notthe issue of the surviving spouse, the survivingspouse receives a fixed minimum amount of theestate. A surviving spouse would receive one-halfof the real property, all personal property exemptfrom execution, and one-half of other personalproperty after debts are paid. Personal propertyexempt from execution includes items that cannotbe taken by creditors. If the total amount passingto the surviving spouse is not at least $50,000, thesurviving spouse would get enough property tototal that amount if the estate is more than$50,000. If the estate is $50,000 or less, the surviv-ing spouse would receive all the property. If theestate exceeds $50,000, the spouse would get aportion as indicated and the issue the rest. Theinterest of a wife in a husband’s estate is the sameas the interest of a husband in the wife’s estate. Theshares are divided equally among the issue. If thereare four individuals who are children of the dece-dent, for example, but one is not an issue of thesurviving spouse, each would receive 25 percent ofwhat does not pass to the surviving spouse.

Example: Grandmother died without a willleaving her husband and four children born toher and her husband. Her property, whichtotaled $300,000 in value, would pass to herhusband.

Example: Father died without a will leaving$200,000 in bank accounts. He was survived byhis second wife and by three children of thatmarriage and one child by an earlier marriage.His wife would receive $100,000 (one-half)with the remaining amount passing to the fourchildren ($25,000 each).

Example: Mother died without a will, survivedonly by her husband. Her property, valued at$500,000, would all pass to the survivingspouse.

The spouse has some other options, also. Thespouse can elect to have the homestead included inhis or her share of the property. Often the spousecan determine the exact property he or she is toreceive. The spouse also can elect to occupy the

homestead (take a life estate) instead of his or herinterest in the real property.

DisadvantagesOne of the disadvantages of death intestate is thatthe method of property distribution is rigid andinflexible. Often the distribution of property is notas the decedent would have wanted. But unless hisor her desires are reflected in a will or in someother legal way, the rules apply, regardless of theperson’s intent.

Another disadvantage, where the principal asset isa family business or farm, is that the business canbe placed in jeopardy when both husband and wifedie. For instance, if one son had remained with thefamily business with the assurance that he wouldbe taken care of at the death of his parents, theproperty is still divided among all children equallyon the death of the parents if there is no will. Afterthe death of both parents, the farm or businesswould then be owned in tenancy in common by allchildren—some of whom may be wealthy becauseof an education paid from family funds earlier. Ifone of the sons or daughters wants his or herequity for any reason, he or she can go to court andprobably obtain an order for partition and sale.Once the process is started, others may decide toask for their interest at the same time.

A child operating the business may try to borrowmoney to pay off the other owners. But the childowning only a small share of the total business maynot be in a strong position for borrowing. It may bepossible to sell enough business assets to pay offthe others, but this may drop the operation belowan efficient level. The other choice is for the childto sell his or her interest, also.

A further disadvantage of death intestate occurs ifchildren are minors. This may require that aconservator be appointed to look after their inter-ests. This involves red tape, inconvenience, andextra expense.

A final disadvantage is that an administrator maybe required to post a bond to assure that theinterests of the heirs are protected while the estateis being settled. This is an expense that can besaved if a person makes a will and asks the courtnot to require the estate representative—an execu-tor, in the case of a will—to post a bond.


A person making a will is a testator. At death, it issaid the person with a will died testate.

Who Can Make a Will?Making a will is a privilege you have to dispose ofyour property after death. It is to be a voluntaryact. The will should represent a careful and calcu-lated judgment of what you would like done withyour property after death.

To make a will, you must be of full age and ofsound mind. Full age means that you must beeither 18 or married. If you are 17 and single, youdon’t have a right to make a will. But if you are 17and married or have been married, a valid will canbe made.

A person cannot be forced to make a will. A will isnot valid if it is made while under someone’sundue influence.

Wills must be in writing in Iowa and signed by thetestator. The signature must be witnessed by atleast two disinterested witnesses. Witnesses arethere to assure that the person making the willappears to be of sound mind, appears to be of age,and isn’t being forced or influenced to make thewill.

A holographic will, written by the individual andsigned and dated, but without witnesses, is not avalid will if made in Iowa.

If a will is valid where it is written, it is generallyvalid anywhere. It is advisable to have such a willchecked, however, for it is interpreted under thelaws of the state of permanent residence at deathand the laws of other states in which real propertyis owned at death.

What Is Soundness of Mind?A person who is not of sound mind cannot make avalid will. The question of soundness of mindprobably occurs most often in the case of a secondmarriage, where a surviving spouse remarries andmakes a new will leaving all the property to thenew spouse.

Generally, a person is considered to be of soundmind if he or she knows the nature and extent ofhis or her property interests (what is owned); andif he or she knows the “natural objects of theirbounty”—spouse, children, and grandchildren, forexample.

Can You Disinherit a Spouse?Generally, a spouse cannot be disinherited unlessthe spouse is willing to abide by the share ofproperty left under the will and that interest isminimal or nonexistent. A spouse can “elect totake against” the will. A spouse electing to takeagainst the will is entitled to receive one-third ofthe real property, one-third of the personal prop-erty, and the personal property exempt fromexecution by creditors. The remainder of theproperty would be distributed as nearly as possiblein the manner specified in the will if the survivingspouse elects to take against the will.

An arrangement that can be used to avoid conflictsover estates by keeping the estates of spousesseparate is the antenuptial agreement. Such anagreement must be signed before marriage. Gener-ally, the parties agree they will not inherit from theestate of the other. Antenuptial agreements areused most often in instances of remarriage. Anten-uptial agreements are not valid in all states, but areso in Iowa.

A child can be disinherited rather easily, merely byfailing to mention the child in the will. It is notnecessary to give the child a dollar, as is commonlybelieved. However, one class of children is anexception to the disinheritance rule. These arechildren born after a will is made. If a will is madeand children are born later, these children areeligible to take a share of the estate as if there hadnever been a will. If one wishes to disinherit after-born children, it can be done by including asuitable statement in the will. Young people maywant to specify that after-born children are toinherit in the same manner as other children.

5 Testate Distribution—Where There’s a Will


These subtle rules—unknown to most people—aresome of the reasons homemade wills are oftenunwise. This is added justification for seeking legalcounsel in having a will prepared.

Are There Other Restrictions inMaking a Will?You cannot go against public policy in making awill. There must be some redeeming social oreconomic purpose served by the provisions of thewill. If there is disagreement over whether a willdistributes property in a manner that has redeem-ing social or economic value, the court makes thedecision. Wasteful disposition of funds or exorbi-tant amounts left to pets are the types of bequeststhat pose questions of redeeming value.

With these limitations on disposition of property,there still remains a great amount of latitude indisposing of property by will.

Are There Other Purposes Served by aWill?In addition to determining how property is to bedistributed, a will allows you to designate theexecutor of your estate—the person to manage it.You can ask the court not to require the executorto post a bond, which saves costs. Likewise, a willenables you to nominate the guardian of minorchildren.

You actually only nominate a guardian. The courtmakes the appointment. But in most cases thecourt follows your wishes. Generally, only in caseswhere the nominee is dead, ill, bankrupt, alcoholic,or for some other reason not suitable to serve, willthe court appoint someone else.

A person nominated as guardian may decline toserve. Therefore, it is advisable to check informallywith those you nominate before the names areincluded in the will.

Generally, only one copy of the will is executed

(signed). Unsigned copies may be kept for reference.The executed copy of the will should be stored in asecure place. The attorney who draws your will mayprovide a storage service. The will also may bestored in your safe or safe deposit box. And theClerk of the District Court in your county also has aservice of providing free storage of wills. Wills leftwith the Clerk of the Court for storage do not be-come a matter of public record until the estate isopened.

There is little problem in keeping wills in a safedeposit box in Iowa. If the will is stored there,usually the attorney for the estate and a familymember can obtain it from the bank. It is true thatneither a member of the family nor anyone else hasassured access to the safe deposit box, for access tothe box is limited at the death of any of the lessees.The bank denies access until the box has beeninventoried for tax purposes. But the bankerusually will open the box and give the will, andpossibly insurance policies, to responsible repre-sentatives of the family.

It is not advisable to place burial instructions in thesafe deposit box, however. Such instructions maynot be found until after burial. The same applies todocuments willing your body or parts of it to amedical school or donor bank.

A CautionIt generally is not effective to fill out deeds to yourproperty during life, deeding property to intendedrecipients at death with the deed retained untilyour death. This has been tried by persons whohoped to save taxes, attorney’s fees, and estatesettlement costs. But the action often is contestedand the courts generally rule that a deed cannot beused to dispose of property at death—that requiresa will. A deed may fail to meet the requirements ofa will because of an insufficient number of wit-nesses. Moreover, a deed, to be effective, must bedelivered in order to transfer ownership.


When a person dies, the estate—property, debts,and obligations—is subject to settlement or pro-bate. It is not necessary that all estates be probated.Estates go through probate only if it is necessary.

Why Probate?There are three basic reasons for probating anestate—to determine who is to receive the prop-erty; to settle the decedent’s debts; and to paytaxes, as explained in Chapter 3.

In a small estate, it may not be necessary to gothrough the full probate procedure, depending onthe type of property and how it is owned. If mostor all of the property is held in joint tenancy, itmay be possible to use “short-form” probate on thedeath of the first joint tenant. Joint tenancy alreadydetermines who gets the property—it goes to thesurviving joint tenant. And the creditors of thedeceased joint tenant may not follow the propertyinto the hands of the surviving joint tenant, unlessthe surviving tenant was bound by the obligation.This eliminates the reason for a full probate pro-ceeding. Therefore, the only step that may berequired is to value the property and pay taxes.That procedure is known as short-form probate.Short-form probate also may be possible if theproperty was held in a revocable living trust atdeath.

But short-form probate through joint tenancy maynot be an advantage in all instances. Once an estatereaches a certain size, the total taxes over bothdeaths may be greater with all property in jointtenancy, so that increased taxes may outweigh theadvantages of short-form probate.

The Probate ProcedureThe procedures of probating an estate are similarwhether or not a person dies with a will. The initialsteps are much the same. The will affects especiallythe final step in the probate process—determiningwho receives the property.

Without a WillWhen a person dies without a will, the surviving

spouse has an exclusive right for 20 days to beginestate settlement. Children have 10 more days afterthat, and then creditors and anyone with aninterest in the estate may start the process.

Usually a member of the family asks an attorney tofile a petition with the district court, asking thecourt to open the estate and appoint an administra-tor so the estate can be settled, debts paid, andproperty distributed. The administrator becomesthe manager of the estate.

After the administrator is appointed, he or shearranges publication of a legal notice in a generalcirculation newspaper indicating the estate hasbeen opened and notifying creditors that they maypresent their claims. The estate remains open for atleast four months.

With a WillIf there is a will, the first step is for an interestedperson to petition the court to open the estate andappoint the executor. There are penalties forsuppressing a will. If a will is not presented to thecourt, even though one exists, it is presumed thatthe person died without one and the property isdistributed according to law as though the persondied intestate.

Where there is a will, one of the early steps isproving the validity of the will. The usual mannerof doing this is to call the witnesses to court or askfor a sworn statement from the witnesses, if theyare alive, or show the validity of their signaturesotherwise. A will may be self-proved at the time ofits execution or later by notarized statement by thetestator and the witnesses. A self-proved will maybe admitted to probate without testimony ofwitnesses. Objections to the validity of the willmay be made and a trial may be necessary todetermine if the will is valid.

After the executor is officially appointed, a noticein a general circulation newspaper is used to notifythe public of the appointment of the executor socreditors may present claims. Again, the estate isopen for at least four months.

6 The Probate Process


Either With or Without a WillThe executor or administrator has the estateinventoried and presents a list of all property of thedecedent and an appraisal of its value. The state orfederal government may require that property suchas land that is not subject to objective valuation beappraised.

Property is listed at fair market value. Land mayeventually be listed at special use value or “use”value for federal estate tax purposes. Special usevalue is discussed in Chapter 10.

Though some property cannot be used to pay debts(that exempt from execution), it is included in theinventory, as is property held in joint tenancy.Certain property transferred before death may alsobe included in the inventory for tax purposesunder certain circumstances.

The primary task of the executor or administratoris to collect, preserve, manage, and distribute allthe property of the decedent. After setting apartexempt property to the surviving spouse, theexecutor or administrator pays expenses, debts,taxes, and any allowance made by the court to thespouse and minor children.

Claims by creditors are presented for payment.Disallowed claims may be submitted to the courtand a hearing held to consider the claim. Or theclaim, under certain circumstances, may be sub-mitted to a jury. If claims are not filed within fourmonths after notice is given, claims may be barredand hence not collectable.

Obligations of the estate are paid by the executoror administrator out of assets specified in the willor in accordance with state law.

When all debts, claims, and taxes have been paid,the executor then distributes the property topersons named in the will. If there is no will,property is distributed in accordance with statelaw.

The executor or administrator may make reports tothe court on the progress of settling the estate.When ready for final distribution of property, theestate representative makes a final report to thecourt. The report to the court shows the list ofproperty and what was done with it. Again, anyinterested person may object to the final settlementat this time. If the report is approved, distributionof any remaining property is made and the estate isclosed.

However, the file on the estate remains in thecounty courthouse and is available to anyone whomight need to consult it later. Sometimes, forincome tax purposes, it may be necessary to go tothe file to determine values placed on assets.

Special Procedurefor Small EstatesWhere the estate subject to state inheritance tax ofa person does not exceed $50,000, and a spouse orchildren or both survive, a special simplified estatesettlement procedure is available. The simplifiedprocedure is available for those with estates subjectto tax of $15,000 or less if a parent (but not aspouse or child) survives and for those with estatessubject to tax of $10,000 or less if someone sur-vives within the fourth degree of consanguinity tothe decedent. Under the simplified procedure, amember of the family agrees to be personally liablefor the decedent’s debts. An inventory still must befiled.


An important concern in estate planning iswhether assets should be held until death orwhether some or all should be sold during life.There are many factors that need to be taken intoaccount, including taxes.

Generally, income tax liability is of less concern ifassets are held until death. Certain assets, such as ahome or land, especially farm land or corporatestocks, may have large gains or profits. Conse-quently, there could be a sizable income taxliability if such items were sold during life.

Income tax liability is also a concern—but for adifferent reason—if property has a large potentialloss. The loss may disappear at death as explainedbelow.

Income tax liability on property is thus a majorfactor in the decision to hold or sell. Governmentsavings bonds, money market certificates, orcertificates of deposit, on the other hand, may havelittle, if any, gain or loss. Some bonds or invest-ments have accrued interest that could createincome tax liability if sold or redeemed, makingthis an important element.

From an income tax viewpoint, it is generally moreadvantageous to sell those assets with less gain (ora loss) and retain those with major gains if someproperty is to be disposed of during life.

Change of FormA second major factor in deciding whether to sellor retain assets is whether the change in the formof capital is desirable. For instance, if most of thefamily wealth is in land, is it preferable to sell theland and buy a different form of asset such as afixed principal obligation (government savingsbonds, for example)?

Would you feel as comfortable owning corporatestocks or bonds, as you do holding land? Confi-dence in the asset or in the pattern of variousholdings can be important and may grow moreimportant in old age.

InflationClosely related to the form of the asset is theconcern about inflation. For example, if property issold during life and invested in a fixed principalasset such as bonds, then inflation may erode thereal value of the bonds over the years. Some assets,on the other hand, may change with inflationarypressure and increase in value.

Capping an EstateA final element to consider is whether it’s desirableto cap or freeze an estate. There is considerableinterest in capping or freezing an estate to preventit from continuing to grow and to increase federalestate tax or state inheritance tax liability.

An estate can be capped, for example, by sellingassets under a long-term installment contract orselling assets and buying a fixed principal invest-ment. It’s also possible to cap an estate by shifting toa corporation and taking preferred stock in exchangefor property, or forming a partnership with fixedprincipal capital interests. But there are some disad-vantages. If the estate is capped and inflation contin-ues, you may find after 10 to 20 years that there isinsufficient capital to support the owners of theestate in later years.

Also, if an estate were capped and deflation occurs,you could end up with a larger relative estate thanhad the asset values changed with the economy.There are reasons to be cautious in capping anestate in times of economic uncertainty. In addi-tion, depending on how it is accomplished, cap-ping or freezing an estate may create problems ofeligibility for special use valuation of land, install-ment payment of federal estate tax, and, possibly,the family-owned business deduction.

Federal legislation enacted in 1990 repealed afederal estate tax rule limiting freezes, but imposeddetailed federal gift tax rules on property subjectedto the freeze.

Income Tax BasisTo understand the income tax liability on the sale

7 Considerations in Holding or Disposing of Property


of assets, one must understand the concept of basis.Simply, basis is that portion of the asset value thathas been accounted for in previous tax handling.Often, basis is the cost, but in some instances, basismay differ from cost. There are three rules that helpdetermine how much of the income from the sale ofan asset will be subject to income tax liability.

Purchased AssetsThe first rule of basis relates to assets that havebeen purchased during life. For purchased assets,you take the purchase price of the asset, add to thatthe cost of any improvements made during life andsubtract any depreciation claimed. Thus, if prop-erty was purchased in 1940 for $10,000, improve-ments totalling $4,000 were made, and $2,000worth of depreciation was claimed, the income taxbasis would be $12,000.

If the asset is sold, any amount received greaterthan the $12,000 basis is a gain. Except for sales toa related party, any amount received less than the$12,000 basis would be a loss. For capital losses,the deductibility may be limited to offsettingcapital gains plus up to $3,000 of other income peryear (for individuals). The income tax basis issubtracted from the selling price to determine gainor loss.

The basis indicates how much of the selling pricewill be taxable gain.

Assets Acquired by GiftThe second rule applies to assets acquired by gift.For that type of property, you go back to the giver’sor donor’s basis. That provides the starting pointfor your income tax basis. To the donor’s basis,you add improvements since the date of the gift,and subtract depreciation taken. You may, in someinstances, add part of any gift tax paid to the basis.

Again consider that property was bought in 1940for $10,000, improved by $4,000, with $2,000 indepreciation claimed prior to the gift. Let’s assumethat the property at the time of the gift is reallyworth $100,000. The federal gift tax would bebased on the $100,000 fair market value, but the$12,000 figure still carries over to the new owneras the income tax basis.

If the person receiving the property by gift should

sell it a few years later for $110,000, the income taxliability would be based on the $110,000 sellingprice, minus the basis. The basis would be $12,000(donor’s basis), plus the cost of improvementssince the date of the gift, and any gift tax paidattributable to the net appreciation in the property,less depreciation claimed. In effect, the personreceiving the property as a gift shoulders thepotential income tax liability of the donor.

If the basis is less than the fair market value at thetime of the gift, the basis to the donee is the fairmarket value.

Inherited PropertyThe third basis rule applies to inherited property.Using the same example, the property with anincome tax basis of $12,000, but worth $100,000,is held by the owner until death. The differencebetween the $12,000 basis and the $100,000 valueis not considered. The new basis becomes$100,000 for the new owner who inherits theproperty.

While the federal estate tax and state inheritancetax will likely be based on the $100,000 fair marketvalue of the property, elimination of income tax onthe $88,000 of gain is a major advantage.

If fair market value at death is less than the basis,the decedent’s estate receives a step down (ratherthan a step up) in basis. Thus, if property acquiredfor $200,000 (no improvements and no deprecia-tion) had dropped to $120,000 at death, thepotential $80,000 loss is eliminated.

There are two exceptions to the general rule of anew income tax basis at death. If appreciatedproperty is given away within one year of deathand then inherited back by the donor or the spouseof the donor, or the property is sold and theproceeds are inherited by the donor or spouse ofthe donor, the property does not receive a newincome tax basis at death. The other exception, forproperty producing income in respect of decedent, isdiscussed below.

Advantages to Holding AssetsOne of the major advantages of holding propertyuntil death has just been shown. For those withgains in assets, the advantage of receiving a new


income tax basis may overshadow the potentialestate or inheritance tax liability, or at least asignificant part of it.

If the property is land, the land held until deathmay be valued under the special use valuationrules. That is a second major advantage. Specialuse valuation is discussed in detail in Chapter 10.But special use valuation does not apply to transac-tions by sale or gift.

Third, business assets held until death may beeligible for the family-owned business deductionfor federal estate tax purposes. Thus, part or all ofthe business assets may be deducted from the grossestate for federal estate tax purposes. Cash or non-business investments from a sale of business assetsbefore death would not be eligible for the deduc-tion. The family-owned business deduction isdiscussed in Chapter 11.

One type of asset does not receive a new incometax basis at death, however. These are assets thatproduce “income in respect of decedent.” This is acategory of income that is so close to being earnedincome that a new basis is not permitted for theassets involved.

If the decedent has been renting out farmlandunder a non-material participation crop sharelease, the stored crops and growing crops areincome in respect of decedent and the gain is noteliminated. Accrued interest on Series E U.S.Savings Bonds is another example that continues tobe taxable after death.

Installment sales, or installment contracts for thesale of assets such as land, produce income inrespect of decedent, also. Qualified retirementplans including Individual Retirement Accountsand Keogh Plans (for those self-employed) also

produce income in respect of decedent with thebenefits subject to income tax to the heirs orbeneficiaries.

Sale of ResidenceThere are some special tax treatments available onthe sale of a residence. These treatments apply tourban residences, or to the sale of the farm resi-dence either as part of the farm or if sold indepen-dently.

One provision available to ease the income taxburden on sale of the residence was repealed in1997; another was modified substantially. Theprovision that was repealed permitted a home-owner to sell the principal residence, reinvest theproceeds in another principal residence within twoyears, and postpone paying income tax on the gain.If the new residence cost as much or more thanwas received on sale of the old residence, all of thegain was transferred into the new residence.

The other provision, which was substantiallymodified, enables the owner of a principal resi-dence to exclude up to $500,000 on each sale afterMay 6, 1997, if married filing a joint return($250,000 for a separate return). Gain is recog-nized to the extent of depreciation claimed forbusiness use or rental of the principal residence forperiods after May 6, 1997. The exclusion can beused no more frequently than once every twoyears. To be eligible, the residence must have beenowned and occupied as the principal residence forat least two of the last five years before sale. Aresidence in trust is not eligible for the exclusion ifheld in a trust where the beneficiary has only a lifeestate in the trust and thus in the residence.


If the decision were made to sell assets during life,there are several options open. One would be a salefor cash. A second possibility is the installmentsale. Third, one could make use of the privateannuity. Fourth, the assets could be sold using aself-canceling installment note at death. And fifth,it might be desired to use a part gift, part saletransaction, especially if family members areinvolved.

The major income tax considerations for cashtransactions were discussed in the precedingchapter, examining the income tax basis, theamount of gain or loss involved, the reinvestmentproblems, and the effects of inflation.

Installment SaleThe installment sale has a number of advantagesand disadvantages. The first advantage is that theseller’s gain can be spread over the life of thecontract. This can ease the income tax burden thatthe seller may have if there is substantial gain inthe property sold. For the buyer, the down pay-ment is typically fairly low.

A third point to consider and one that favors theseller is that if the buyer is unable to make pay-ments, the seller can recover the property aftergiving notice—often as little as 30 days. The sellercan recover the property much faster than wouldbe the case with a mortgage foreclosure.

The installment sale produces income for theseller. That income changes over the life of thecontract if the payment is a fixed amount ofprincipal with a decreasing amount of interest.With that arrangement, the total payment declinesover the life of the contract. Or the payment maybe fixed, but with a decreasing amount of interestand increasing amount of principal each year of thecontract. In this instance, the amount of incomedoes not change, but the nature of the incomechanges.

But with either system, the seller knows how mucheach year’s payment will be. The only real risk to

the seller is the risk that the buyer might be unable tomake the payments.

The income received under a contract is partly in theform of return of basis, which is not taxable; partlyin the form of gain; and partly in the form of interest.These three components do not reduce social secu-rity benefits in retirement, regardless of amountreceived.

One drawback is that if land is sold under installmentsale, the contract is an asset in the seller’s estate andis not eligible for special use valuation of land forfederal estate tax purposes and usually will not beeligible for the family-owned business deduction. Ifthe land were held until death, it might be eligible forspecial use valuation. Land or other business assetsheld until death perhaps would qualify for thefamily-owned business deduction.

Also, inflation can be a problem with the installmentsale since it’s a fixed principal obligation. If inflationcontinues, the fixed principal amount can reduce thereal value or purchasing power of the income streamto the seller.

Income Tax Aspectsof Installment SaleOne of the desirable features of the installment saleis the possibility for spreading the income amountover the life of the contract. But there are someconstraints.

First, a minimum interest rate is specified. Youcannot set whatever interest rate you might wishon the contract. From a seller’s point of view, itmay be desirable to reduce the interest rate andincrease the selling price. The increased sellingprice produces capital gain, which receives pre-ferred income tax treatment, while the interest isalways taxable as ordinary income. For sales orexchanges after May 6, 1997, the maximum in-come tax rate on net long-term capital gains for anindividual was reduced from 28 percent to 20percent. For those in the 15 percent income tax

Installment Sales, Private Annuities,and Self-Canceling Installment Notes 8


bracket, the long-term capital gains rate has beenreduced to 10 percent. On the sale of depreciablereal property, such as buildings, gain to the extentof depreciation claimed is taxed at a maximum of25 percent.

Beginning in 2001, an 18 percent rate will be im-posed on long-term capital gains on assets held morethan five years, 8 percent for those in the 15 percenttax bracket. That provision, however, is effective forthose above the 15 percent tax bracket only for assetsfor which the holding period begins after December31, 2000.

For long-term capital gain treatment, the general rulehas been that eligible assets had to be held more thanone year. That requirement was increased to morethan 18 months for sales after July 28, 1997. Theholding period for livestock (24 months or more forcattle and horses, 12 months or more for otherlivestock) was left unchanged. The general rule forthe holding period was changed back to more thanone year after 1997.

The maximum tax rate on “collectibles” remains at28 percent.

For a number of years, the Internal RevenueService has specified a minimum interest rate forinstallment sales. At present, the minimum rate isthe lesser of 9 percent or the “Applicable FederalRate” (which is published monthly) for transac-tions up to $4,085,900 (for 2001) of seller financ-ing. Where the amount of seller financing is morethan $4,085,900 (for 2001), the minimum rate isthe applicable federal rate. The Applicable FederalRate varies by length of contract. The AFR isseparately quoted for short-term contracts (threeyears or less), midterm contracts (more than threebut not more than nine years), and long-termcontracts (more than nine years).

For large transactions (more than $2,918,500 in2001) the minimum interest rate rules are morecomplex.

For sales of land up to $500,000 in a calendar yearbetween family members (brothers, sisters, spouse,ancestors and lineal descendants), the interest rate is6 percent.

Here’s an example of how the seller calculates theincome tax liability when the gain is spread overthe life of the contract. Let’s assume that we have a

tract of land with a fair market value of $100,000.Let’s further assume that there’s a mortgage on thatland of $40,000 and that the land has an incometax basis of $60,000.

First, we must determine the amount of gross profit.Gross profit is the selling price less the income taxbasis in the property, or $100,000 minus the $60,000basis. The gross profit is $40,000.

The second calculation is total contract price. That isthe total amount of principal to be paid by the buyerto the seller. In addition, the buyer will eventuallypay off any mortgage assumed. In our example, thetotal contract price is calculated by taking the sellingprice of $100,000, minus the $40,000 mortgagetaken over by the buyer. So the total contract price is$60,000. The gain on sale is reported as the pay-ments on the total contract price are received by theseller.

Next we calculate the gross profit percentage bydividing gross profit by the total contract price, or$40,000 divided by $60,000, or two-thirds. So two-thirds of every principal payment would be capitalgain. One-third of every principal payment isreturn of basis. The return of basis is not subject toincome tax. The capital gains amount is usuallytaxable as long term capital gain if the propertyhad been held for more than one year (other than foreligible livestock), which is relatively more attractivethan reporting it as ordinary income.

The seller, of course, receives interest payments thatare taxable each year as ordinary income. In addi-tion, there may be recapture of depreciation on aninstallment sale of property.

There are other problems with the installment sale.One is if the mortgage on the property to be takenover by the buyer exceeds the income tax basis,that excess is gain. Such excess would generally begain in the year of the takeover of the mortgage —a point to watch. Disposal of the contract otherthan at death may produce a taxable event — ataxable disposition. So sale or gift of the contractcan trigger tax liability.

If property is sold to a related party with gainreported on the installment method, disposition ofthe property by the purchaser within two yearsmay cause taxable gain to the original seller. Thereare exceptions if the second sale involved aninvoluntary conversion (such as a fire), it was


because of the death of the seller or buyer, it was notmotivated by tax avoidance motives, or it involvedsale of stock of the issuing corporation. For sales ofdepreciable property to an entity as a related party,installment reporting is not available. For installmentobligations held until death of the seller, to the extentthe obligation passes to the obligor under the con-tract, the gain on the contract is taxed to the seller’sestate.

Cancellation or forgiveness of installment paymentsby the seller as the payments come due is usuallytreated as a taxable disposition to the seller.

The Private AnnuityAnother option for the disposition of assets duringlife is the private annuity. It is similar to its firstcousin, the commercial annuity. A commercialannuity involves a payment of cash to an insurancecompany in exchange for a promise to pay anamount to that annuitant for the rest of theannuitant’s life or to the annuitant and the surviv-ing spouse. The private annuity differs in severalrespects from the commercial annuity.

First, the private annuity usually does not involvecash—it typically involves an asset like land orsome other family asset. Second, it doesn’t involvean insurance company—it involves someone else,often a member of the family, as obligor.

In the usual situation the parent is the annuitantand a family member is the obligor. The familymember makes payments to the parent as long asthe parent lives. The annuitant is taking a risk thatsomething may happen financially to the obligor so

the obligor can’t make payments. The annuitant isnot permitted to retain a security interest in theproperty involved. If that is done, the transaction islikely to be treated as a sale.

Also, there may be a windfall involved. If theannuitant—the parent in our example—diesprematurely, that’s a windfall gain to the obligor. Ifthe parent lives a longer than normal life, that’s adifferent matter. The obligor then may pay morethan the property is worth. Also, there’s no interestdeduction for the obligor with the private annuity.The private annuity can be a useful technique, butit has problems.

The Self-CancelingInstallment NoteThe Self-Canceling Installment Note (or SCIN) is arelatively recent development. It resembles aninstallment sale with the seller able to retain asecurity interest in the asset involved. However,payments cease at the death of the seller. Thatfeature resembles a private annuity. Because thebuyer may not be required to make all of thepayments, a premium must be built into the sellingprice or interest rate.

The major tax disadvantage of a SCIN is thatincome tax on payments remaining at death mustbe paid by the decedent’s estate even though thepayments are not received. In general, no part ofthe value of the property is included in the seller’sestate for federal estate tax purposes.

The part gift, part sale is discussed along with thegift tax aspects in the next chapter.


The estate planning process often involves thequestion: “Should gifts be made during life?” Thereare both advantages and disadvantages in makinggifts. It’s an option, however, that many may wantto consider.

The federal gift tax rules are important in estateplanning because they establish how much prop-erty can be given during life without paying the gifttax. The federal gift tax is levied on outright giftsmade during life and is imposed on the donor—theone who makes the gift. Some states, but not Iowa,have a state gift tax, also.

You can give away a considerable amount ofproperty without incurring any liability under thefederal gift tax.

The federal gift tax is integrated with the federalestate tax in that both use the same tax scheduleand the single unified credit applies to both taxes.Use of part or all of the unified credit during life istaken into account by including taxable giftsduring life in the taxable estate at death andallowing the full unified credit at death.

For federal gift tax purposes, property is valued atits fair market value. That applies even to land,which if held until death might be valued forfederal estate tax purposes at special use value.Special use value is often considerably less than fairmarket value. Thus, there may be a heavier taxburden on gifts during life than if the propertywere held until death.

Three key deductions and a credit influence thecalculation of the federal gift tax: the annualexclusion, the gift tax marital deduction, thecharitable deduction, and the unified credit.

Annual ExclusionEach person (donor) can give up to $10,000 ofproperty each year to each of as many people as heor she would like with no federal gift tax liability.The persons to whom the property is given neednot be related to the donor for the annual exclu-sion to be available. A husband and wife could give$20,000 to each person each year even though the

property is owned by only one of them. The$10,000 and $20,000 amounts are indexed forinflation.

To be eligible for the annual exclusion, the giftmust be of a present interest. It must not be a giftof something like a remainder interest, which doesnot carry a right to current income. If the personreceiving the gift would have the right to theincome from the gift and possession of it now, itwould generally be a present interest and would beeligible for the annual exclusion. If the personreceiving the gift is to receive the property andincome later, such as after expiration of a lifeestate, then the gift would not be eligible for theannual exclusion.

Gifts to CharityIn addition to the annual exclusion, an unlimiteddeduction is available for gifts to a qualified char-ity. Other than for gifts to a subdivision of govern-ment or a church, a charity should have an exemp-tion letter from the Internal Revenue Serviceindicating that gifts are eligible for the gift taxcharitable deduction if it is planned for the gift tobe deductible.

Marital DeductionUnder the federal gift tax marital deduction, 100percent of the value of gifts from one spouse toanother is deductible. That permits a couple toarrange property ownership in any desired patternwith no federal gift tax concern.

The federal gift tax marital deduction can also beclaimed for a life estate left to the surviving spouse.The executor of the first spouse to die can elect totreat a life estate left to the surviving spouse as“qualified terminable interest property.” In thatevent, the entire value of the property—and notmerely the value of the surviving spouse’s lifeestate—qualifies for the marital deduction.

Later, if the surviving spouse disposes of his or herinterest by gift, the entire value of the property issubject to federal gift tax. Similarly, if retained

9 Gifts During Life: The Federal Gift Tax


until death, the entire value of the property issubject to federal estate tax at the survivingspouse’s death. Any gift tax or estate tax attribut-able to the remainder interest may be recoverablefrom those holding the remainder interest.

Gifts to the spouse can be used to help balance theestates of husband and wife, which may be anadvantage in some estate plans. With balancedestates, use of the federal estate tax marital deduc-tion may not be as crucial.

As an example of how these deductions andexclusions may be used, a husband and wife withfive children in any year could give away $100,000each year— $20,000 to each of the five children.That annual exclusion could be continued eachyear for as long as desired and, as noted, is indexedfor inflation.

There is no limit to the number of years the annualexclusion can be used nor is there a limit on theamount of property in the aggregate that can passunder the annual exclusion. In addition, onespouse could give the other an unlimited amountunder the gift tax marital deduction withoutencountering federal gift tax problems.

For gifts beyond those amounts, the single unifiedcredit is available. The unified credit is discussedin detail in Chapter 12.

Under the unified gift and estate tax rules the sametax schedule applies to gifts during life and toproperty transfers at death.

Gift Tax ReturnIf a gift of more than $10,000 is made to anyperson (other than spouse) in any year, a federalgift tax return must be filed, even if no gift taxwould be due. Any size gift of a future interestrequires that a federal gift tax return be filed. Thegift tax return is to be filed on an annual basis;however a gift tax return is not required unlessgifts exceed the annual exclusion for that year. Ifgifts exceed $10,000 for at least one person, areturn should be filed.

Federal gift tax returns are filed on an annual,calendar year basis. The gift tax return is to be filedon or before April 15, except for the year of death,and that year the gift tax return is due with thefederal estate tax return.

Gifts are reported to the Internal Revenue Serviceon Federal Form 709. Again, gifts of more than

$10,000 to any one person (other than to a spouse) inany year are to be reported if they are gifts of apresent interest. A gift of a future interest, such asa remainder, should be reported on a gift taxreturn regardless of the size of the gift. Form 709Amay be used to report gifts by husband and wifewishing to split the gift to take advantage of thecombined federal gift tax annual exclusion.

Gifts that exceed the annual exclusion, the maritaldeduction, and the charitable deduction are taxablegifts. Taxable gifts are brought back into thetaxable estate at death for federal estate tax pur-poses if they were given after 1976. IRS after deathcan challenge the date of gift valuation of propertygiven away as a taxable gift unless properly re-ported to the IRS.

Inadvertent GiftsGifts may occur on transfer of insurance policies orother property—land, stocks, bonds, inventoryitems, for example—and are valued for gift taxpurposes at fair market values as of the date of thegift.

The IRS position is that a gift may also occur ifproperty is sold with payment over a period ofyears at an interest rate different from a market rateof interest. This may occur, for example, on salesof land to family members where a special interestrate of 6 percent is allowed up to $500,000 of salesof land each year.

Example: Parents sell farmland to their two daugh-ters for $400,000 with payment over 20 years at 6percent interest. IRS determines that a market rateof interest at the time would be 11 percent. At thatinterest rate, the contract is valued at $250,000.The difference, $150,000, is a gift from parents tothe daughters.

The IRS position has been upheld by the Tax Courtand by the Eighth and Tenth Circuit Courts ofAppeal but not by the Seventh Circuit Court ofAppeals. The Seventh Circuit decision generallyprevails in Illinois, Indiana and Wisconsin.

Taxable gifts may also occur in transfers to or fromco-ownership. As a general rule, a transfer of cashor other property from one person to that personand another as co-owner would constitute a gift ofan appropriate fraction of the value involved.


Hence, purchase of $100,000 of corporate stock by Afrom A’s funds would involve a gift of $50,000 to Bif title to the stock were taken by A and B as tenantsin common or joint tenants. The gift occurs at thetime the property is acquired.

But there are two current exceptions to the generalrule. (1) Deposits of funds in a joint bank orbrokerage account by one owner alone do notconstitute a gift—until the co-owner not providingthe funds withdraws from the account without anyresponsibility to account to the one who depositedthe funds. (2) Purchase of U.S. Governmentsavings bonds by an individual with title taken injoint tenancy with another is not a gift—until theone not providing the funds redeems the bondswhile both are living without any responsibility toaccount to the one who provided funds for thebonds.

Acquisition of land, by a husband and wife, in jointtenancy between December 31, 1954, and January1, 1982, even though only one of them providedthe money, was not a gift at the time of acquisitionunless expressly declared to be a gift on a timelyfiled federal gift tax return.

For acquisitions of land by a husband and wife injoint tenancy after 1981, if initial contributions arenot equal, a gift is involved (and would be coveredby the federal gift tax marital deduction). Thus,such a joint tenancy could be later severed intotenancy in common without a gift.

Gifts from Value FreezesAs noted in Chapter 7, some individuals cap or“freeze” their estates or specific items of propertyby converting the assets into a form that does notchange in value over time. An installment sale ofland is a type of freeze for the seller. The value ofthe contract in the seller’s hands does not changeas land values change. All fluctuations in value ofthe land are felt by the purchaser, not by the seller.

In 1990, federal legislation repealed an attack onsuch freezes enacted in 1986 that involved federalestate tax rules. The 1990 law imposed detailedrules governing the valuation of interests retainedand transferred as a result of a freeze for federal gifttax purposes.

Gifts to MinorsAnother tool for estate planning is gifts to minors.Because minors are not competent to manageproperty from a legal standpoint, there is a prob-lem of making transfers of property to those underthe age of majority. Until recently it was oftennecessary to set up a trust if property was to betransferred to minors in Iowa. But the trust may besomewhat cumbersome, particularly for small gifts.

The Iowa General Assembly has authorized the useof a simpler device than the trust for making giftsto minor children—the “Transfers to Minors Act”custodianship.

Under this act, property can be given to a custo-dian who acts for the minor. The custodian man-ages the property until the time control over theproperty is relinquished to the individual. Unlike atrust, property cannot be held beyond that age. Thecustodian could be one of the parents, anotheradult, or a bank or trust company.

The Transfers to Minors Act provides a relativelysimple and convenient device for making gifts ofproperty to minors without a great deal of com-plexity. It can be used for gifts of cash, stocks, lifeinsurance policies, or securities, as well as for giftsof tangible property.

Tax reasons suggest the same person should not bethe donor of the property and also the custodianunder a Transfers to Minors Act arrangement. Forexample, if a father makes the gift and is alsocustodian and the father dies before the childreaches the age for distribution, the propertymanaged could be included in the father’s estatefor tax purposes. The matter of control of propertyis again the influencing factor.

Also, it may be preferable that a parent legallyobligated to support the child not act as custodian.Another adult or a bank or trust company might beused as custodian.

The custodianship can be activated simply byputting title on the stock, security, or bank accountin the name of “Mrs. John Doe as custodian forJohn Doe, Jr., under the Iowa Uniform Transfers toMinors Act.”

Though more complex, the trust also is an optionfor making gifts to an adult or minor. Trusts arediscussed in Chapter 16.


Tax aspects of estate planning typically concern asmany as five different taxes. There’s the federal gifttax, the state and federal income tax, the stateinheritance tax, and the federal estate tax. Here,our focus is on the federal estate tax with particularemphasis on when property is valued and how it isvalued for that tax.

When Property Is ValuedIn general, property is valued as of the date ofdeath. However, there is an alternate valuationdate. If the requirements are met, the property canbe valued up to six months after death if thatwould be more advantageous. A later valuationmight be advantageous if property values had gonedown after the date of death. If property in exist-ence at death is disposed of during the six-monthperiod, you would use the date of disposition forvaluation. Property not in existence at death—suchas crops planted after death—is usually not subjectto the alternate valuation rule.

To be eligible to use the alternate valuation date,the value of all property in the estate and thefederal estate tax liability of the estate must bereduced by making the election.

Valuing the Property: General RuleThe general rule is that property included in theestate is valued at its fair market value. That’s thevalue at which property would change handsbetween a willing buyer and a willing seller,neither being under any compulsion to buy or sell.

Special Use ValuationHowever, the executor may elect to value realproperty devoted to farming or other businesses atits special use value, rather than fair market value.

If the real property eligible for special use valuationis used for farming, its value can be determined intwo ways. One involves capitalization of the cashrent for comparable farm land in the locality.Specifically, the formula involves dividing theaverage annual gross cash rental for comparablefarm land in the locality less property taxes for

Valuing Property for Federal Estate Tax 10

comparable land by the average annual effectiveinterest rate for all new Federal Land Bank loans.The calculations are to use the five most recentcalendar years ending before the deceased’s death.For the Federal Land Bank interest rate, a districtrate is to be used. The rate in the Omaha district,which includes Iowa, is shown in Table 1. The ratevaries by Federal Land Bank District. The interestrate used is the rate for the Federal Land BankDistrict where the land is located.

Table 1. Interest rate for special use valuationcalculations in Omaha Farm Credit District.

Death in Rate (percent)

1977 8.701978 8.921979 9.051980 9.251981 9.591982 10.171983 11.521984 11.861985 12.451986 12.991987 12.501988 12.561989 12.071990 11.591991 10.871992 10.101993 9.541994 9.151995 8.631996 8.381997 8.091998 8.171999 8.072000 8.10

As an example of this method of valuation, assumeaverage annual gross cash rental of $90 per acrewith property taxes at $9 per acre leaving anamount of $81 to be capitalized. If the averageannual Federal Land Bank loan rate is 8.10 percent,dividing $81 by 8.10 percent would produce avalue of $1,000 per acre.


If there are no cash rented tracts of comparableland in the locality, use can be made of “averagenet share rentals” from crop share leases. The term“net share rentals” means the landowner’s portionof the crop share return from the land minus the“cash operating expenses which, under the lease,are paid by the lessor.” The rent capitalizationapproach is not to be used if there is no compa-rable land for determining average rentals or if theexecutor elects to value the real property using thefollowing factors (this is the procedure also fornon-farm land): (1) capitalization of income theproperty could be expected to yield over a reason-able period under prudent management; (2)capitalization of the fair rental value; (3) assessedvalue for property tax purposes based on currentuse; (4) comparable sales in the same geographicalarea but without significant influence from metro-politan or resort areas; and (5) any other factorthat would fairly value the real property.

To qualify for special use valuation, several condi-tions must be met: (1) the value of the farm orother business real or personal property must be atleast 50 percent of the deceased’s gross estate lessindebtedness attributable to the property and thatamount or more must pass to a qualified heir orheirs (by inheritance or by purchase); (2) at least25 percent of the deceased’s gross estate lessindebtedness attributable to the property must bequalified farm or other business real property; (3)during five or more years in the eight-year periodending with the deceased’s death, the real propertymust have been owned by the deceased or a mem-ber of the deceased’s family and held for use as afarm or other business; and (4) the deceased or amember of the deceased’s family must have “mate-rially participated” in the operation of the farm orother business for five or more of the last eightyears before the earlier of the date of disability,retirement, or death. For this purpose, “disability”is defined as the inability to engage in materialparticipation; “retirement” means receiving socialsecurity benefits. For a surviving spouse whoinherits qualified real property from a deceasedspouse, “active management” substitutes formaterial participation.

In addition, the “qualified use” test must be met.The decedent or a member of the family must have

had an “equity interest” in the farm operation at thetime of death and for five or more of the last eightyears before death. Each qualified heir must meet thesame test during the recapture period after death. Ingeneral, that means no cash renting of land afterdeath except for the two-year grace period immedi-ately following death and except that survivingspouses can cash rent to a member of the survivingspouse’s family and lineal descendants of the dece-dent may cash rent to a member of the linealdescendant’s family so long as the lessees or tenantsare “at risk.”

Crop share leases give the decedent (or qualifiedheir) the necessary equity interest. Cash rent leasesbetween family members are acceptable in the pre-death period. In general, cash rent leases to non-family members do not meet the test before death.

In the period after death, a cash rent lease triggersrecapture of special use valuation benefits even ifthe lease is to a family member, except for a two-year grace period immediately after death when thequalified use test need not be met and except for acash rent lease by a surviving spouse to a memberof the surviving spouse’s family and by a linealdescendant of the decedent to a member of thelineal descendant’s family. To the extent that use ismade of the two-year grace period, however, therecapture period after death is extended for a liketime.

As noted, at least 50 percent of the deceased’s grossestate must pass to qualified heirs. Qualified heirsinclude the decedent’s ascendants and descendants(children, grandchildren, and great grandchildren).It also includes the descendants of the parents ofthe decedent, which would include brothers,sisters, nieces and nephews, and spouses of allthose persons, the spouse of the decedent and thedescendants of the spouse of the decedent.

If special use value property is purchased from theestate by a qualified heir, the purchaser does notreceive an income tax basis for the property equalto the purchase price, as is usually the case. Rather,the purchaser’s income tax basis is generally thespecial use valuation for the property in the handsof the estate. The estate does not have income taxliability on the sale except to the extent the fairmarket value of the property on sale exceeds thefair market on the date of death.


Example: Farmland with a fair market value of$2,000 per acre is valued under the special usevaluation rules at $850 per acre. If the on-farmheir purchases the land for $2,000 per acre at atime when fair market value is $2,000 per acre,the estate would recognize no gain. Thepurchaser’s basis would be $850 per acre. In theevent of later sale of the property by the pur-chasing heir at $2,000 per acre, the seller wouldhave $2,000 minus $850 or $1,150 per acre ofgain subject to income tax.

If farmland is distributed to all of the heirs with theinterests of off-farm heirs then sold to the on-farmheirs, the gain on sale above special use valuation(up to the selling price) would be taxable to thesellers. Thus, there is a substantial difference inincome tax treatment between purchase of landfrom the estate and purchase of land from the otherqualified heirs.

If the property is disposed of within the recaptureperiod after the death of the deceased to non-family members or ceases to be used for farming orother closely-held business purposes, the taxbenefits must be repaid. For deaths after 1981, therecapture period is 10 years. For deaths before1982, the recapture period was 15 years.

Absence of material participation by the qualifiedheir or a family member for more than three yearsduring any eight-year period ending after thedeceased’s death also causes repayment of the taxbenefits. However, for a qualified heir who is asurviving spouse, person under age 21, full timestudent or disabled person, “active management”by the qualified heir substitutes for materialparticipation. For those under age 21 and disabledpersons, a fiduciary (such as a conservator) canprovide the involvement for meeting the activemanagement test.

Each qualified heir must meet the “qualified use”test for the recapture period after death. Thatmeans, in general, no cash rent leases during theperiod, except during the two-year grace periodimmediately after death and except for a cash rentlease by a surviving spouse to a member of thesurviving spouse’s family and a cash rent lease by alineal descendant of the decedent to a member ofthe lineal descendant’s family (so long as thelessees or tenants are “at risk”).

If land is taken by eminent domain or condemnationafter special use valuation, there is no recapture if theproceeds are reinvested in property with the sameuse. That is considered to be an involuntary conver-sion and does not affect the special use valuationstatus. Similarly, if land is exchanged in a tax-freetrade, there is no recapture if the replacement prop-erty is in the same use—farmland for farmland. It isbelieved that bankruptcy filing does not causerecapture of special use valuation benefits buttransfers in bankruptcy other than to a member of thequalified heir’s family could cause recapture tooccur.

Death of the qualified heir does not trigger repay-ment or “recapture” as to the property interest ofthat qualified heir.

To be eligible for special use valuation, all interestsin the land must be held by qualified heirs. Aspecial problem arises if interests in land couldpass to someone other than a member of thedecedent’s family.

Example: At the mother’s death in 2000, landwas left to the husband for life, then to thechildren living at the father’s death. Because ofthe contingency, it is not known who will holdinterests in the property until the father’s death.Therefore, the property may not be eligible forspecial use valuation. Court cases have allowedspecial use valuation if the probabilities wereslight that the property might pass to non-family members.

Remainder or other “future” interests in landcannot be valued under special use valuationunless a present interest in the land is also beingvalued.

Example: At father’s death in 1970, land wasleft to mother for life, then to children. If onechild were to die before the mother, the child’sremainder interest would not be eligible forspecial use valuation.

The special use valuation procedure is applicableto real property interests held in a partnership,corporation, or trust.

For a trust, care should be exercised that a quali-fied heir has a “present interest” in the property.That means all of the income should go to familymembers. Any discretion in the trustee to pay


income or principal should be limited to familymembers.

For land held in a partnership or corporation to beeligible for use valuation, the entity must be aclosely held business. At least 20 percent of thecorporate voting stock or partnership interest, asthe case may be, must be included in the deceased’sgross estate or the entity must have 15 or fewerowners. The entity itself is then apparently disre-garded with an examination of the amount offarmland and farm personal property held by theentity. Remember, at least 50 percent of thedecedent’s estate, directly or indirectly throughownership of an entity, must be farmland or farmpersonal property. Non-farm investments or cashbeyond the reasonable needs of the business don’tappear to count toward the 50 percent test. Simi-larly, at least 25 percent of the decedent’s estate,directly or indirectly through ownership of anentity, must be farmland.

The special use valuation procedure cannot beused to reduce the deceased’s gross estate by morethan $800,000 for 2001. That figure is indexed forinflation.

LeasesLeases take on special importance in planning ifone expects to take advantage of special usevaluation. Since a typical retirement step is to leaseout farmland, the type of lease becomes ratherimportant at this stage in order to meet the mate-rial participation and qualified use tests for specialuse valuation.

A cash rent lease to a tenant who farms the land andwho is a member of the family should meet both thequalified use and the material participation tests.Both tests would be met by a family member astenant.

If the decedent rents the land to a tenant who is not amember of the family, a cash lease would violate thequalified use test. If the landowner were retired ordisabled and had accrued five or more years ofmaterial participation before retirement or disability,the material participation requirement would be metuntil death, so long as the landowner remainedretired or disabled, as the case may be. Thus, theminimum lease for a retired or disabled landownerrenting to an unrelated tenant is generally a nonmate-rial participation crop share lease.

If the decedent rents to an unrelated farm tenantbefore retirement or disability, a material participa-tion crop share lease would be the minimum requiredto meet the tests.

If the decedent operates the land until death, thereshould be no problem of eligibility in the pre-deathperiod. If a family partnership or corporation totallyowned, controlled, and managed by family membersleases the land as the tenant, a cash rent lease shouldordinarily meet the requirements.

Leases should be checked carefully with a taxadviser if one plans to take advantage of special usevaluation.


Taxes are an expense at death and thus play a rolein planning for the distribution of property.Knowledge of the federal and state taxes that applymay be helpful in minimizing taxes and in assuringthat objectives will be met in an estate plan.

There are two types of taxes on property trans-ferred at death, the federal estate tax and the Iowainheritance tax. Closely related is a third tax, thefederal gift tax, imposed on gifts during life.

The federal estate tax is levied on the value ofproperty owned by the decedent at death, on otherproperty transferred during life over which theperson retained some interest or control, and,under certain circumstances, on property givenaway within three years of death. The total value ofsuch property is the gross estate.

What Is Includedin the Gross Estate?The gross estate includes land, inventory items,machinery, bank accounts—all the real and per-sonal property of the decedent.

The gross estate also includes the decedent’sproportional ownership of property held in ten-ancy in common. That’s usually half. However, itcould be any fractional share if it is clearly spelledout on the title that the decedent owned other thanhalf. Otherwise it is presumed that half the valuewould be included in the gross estate for twoperson tenancies in common.

Joint Tenancy PropertyWhen a person dies owning property in jointtenancy, one of two rules is applied to determinethe portion of value subject to federal estate tax.Under the “consideration furnished” rule, appli-cable to all joint tenancies except those involvingonly husbands and wives, the full value of theproperty is included in the estate of the first personto die for federal estate tax purposes (and the fullvalue receives a new income tax basis), except tothe extent the survivor can prove he or she pro-

vided the money when the property was acquired orthe mortgage was paid off.

The survivor bears the burden of proving he or sheprovided part of the money. This burden might bemet by showing that an inheritance, gift or incomefrom employment had been used to acquire theproperty. The basic question is the source ofmoney when the property was acquired.

The “fractional interest” rule makes one-half thevalue of joint tenancy property held by a husbandand wife subject to federal estate tax at the firstdeath. Each is considered to own half the propertyfor federal estate tax purposes. Proof of contribu-tion is not important. The rule operates arbitrarily:one-half is taxed if the husband dies first; one-halfis taxed if the wife dies first. Moreover, only one-half the total property value receives a new incometax basis at the first death.

Six cases have allowed the “consideration fur-nished” rule to be applied in a husband-wifesituation when property was acquired before 1977.Because the husband provided all of the funds forthe purchase initially in those cases, the result wasa new basis for all of the property at the husband’sdeath at no federal estate tax cost because of the100 percent marital deduction for the amountpassing to the surviving spouse.

A major problem with joint tenancy is that it cancreate a heavy tax burden at the survivor’s death.Since property is transferred outright to the survi-vor, the entire value of the property frequently isincluded in the estate of the survivor. Joint tenancyproperty ownership is, therefore, inconsistent withthe major tax saving techniques designed to reducefederal estate tax liability at the death of thesurviving spouse.

For those concerned with federal estate taxes, thebest strategy, therefore, might be to get out of jointtenancy.

Certain Transfers During LifeProperty transferred by gift within three years of

The Gross Estate 11


death is not included in the estate at death for federalestate tax purposes. There are, however, two catego-ries of exceptions to that general rule: (1) transfers ofproperty are included in the decedent’s gross estate ifthe decedent retained a life estate in the property, thetransfer was to take effect at death, the transferinvolved a revocable transfer, or the transfer in-volved a life insurance policy; and (2) for purposesof determining eligibility for special use valuation ofland, installment payment of federal estate tax andredemptions of corporate stock to pay death taxesand estate settlement costs, property transfers by giftwithin three years of death are included in the grossestate for the limited purpose of determining whetherthe eligibility requirements have been met.

Any increase in value of the property after the dateof the gift is excluded from estate and gift taxation.The value of the gift is already taken into accountin reducing the unified credit or incurring a gift tax(or both). In addition, property transferred by giftdoes not receive a new income tax basis at deathand, if land, is not eligible for special use valuation.

Because life insurance policies come within theexception, a transfer of insurance policies by giftwithin three years of death makes the proceeds (orthe value of the policy if on another’s life) includ-ible in the insured’s gross estate.

Under a different rule, retaining control overproperty that is transferred may also make theproperty subject to tax. The general rule is that togive away property to save taxes at death, allconnections must be severed with the property.For example, a couple cannot save taxes by deed-ing a farm to the children while retaining the rightto collect the income. Retention of income or otherinterests subjects the full value of the property tothe federal estate tax at the death of the personretaining powers or control over the property.

Thus, the gross estate contains all property ownedoutright by the individual, property transferredwith retained powers, and some property givenwithin three years prior to death.

Insurance ProceedsProceeds of life insurance policies may be subjectto the federal estate tax, depending on the circum-stances. Two factors determine whether proceedsare taxable: policy ownership and beneficiary

designation. If the person who dies and whose lifewas insured is also the owner of the policy, theproceeds are subject to the federal estate tax.

If the beneficiary is the estate of the insured, theinsurance proceeds are subject to tax. Thus, twoconditions must be met for insurance proceeds notto be taxed. First, the owner of the policy must besomeone other than the insured, and second, thebeneficiary must be someone other than theinsured’s estate.

The owner of a life insurance policy is the one whohas the right to change the beneficiary, borrow onthe policy, take paid up insurance, or collect thecash value.

Typically, when a husband takes out a policy onhis life, he makes his wife the beneficiary and he isthe owner. Under these circumstances, the pro-ceeds are subject to tax but are covered by themarital deduction.

If the wife is the owner of the policy on thehusband’s life, the proceeds are not subject tofederal estate tax. Thus, the husband is the insured,but the wife is the owner and beneficiary. Thehusband should recognize that the policy may be avaluable piece of property and that the policywould then belong to his wife. Also, if the wife diesbefore the husband, the cash value (not the facevalue) of the policy would be included in herestate. If the wife has a large estate, ownership ofthe policy by her might be undesirable. Again, itdepends on the circumstances. If the wife doesbecome the owner of insurance policies on thehusband’s life and then she dies first, it is impor-tant how she disposes of the policies. If she givesthem to the surviving husband by will, for ex-ample, at his death later the proceeds would besubject to federal estate tax. Hence, it is commonfor policy ownership to be specified for a stepbeyond the wife’s life, perhaps to a trust or an adultchild.

Ownership of a policy can be changed by assign-ment. For a whole life or ordinary life policy, thismay create a gift, and, depending on the value ofthe gift, may be subject to the federal gift tax.Remember, gifts to a spouse are eligible for thefederal gift tax marital deduction.


Your insurance company can give you the preciseamount of the gift, but for a rough estimate in yourplanning, the cash value of the policy will bereasonably close.

Retirement BenefitsIn general, the value of a retirement plan is in-cluded in an estate. If you are involved in a quali-fied employee plan or retirement plan, your planadministrator can indicate the amount that wouldbe included in the gross estate.

DeductionsIn computing the federal estate tax, the first stepafter determining the amount of the gross estate isto identify deductions. Deductible items includedebts of the decedent, the attorney’s fee, theexecutor’s fee, court costs, and costs of last illness,death, and burial. The costs involved in sellingproperty, if claimed as a federal estate tax deduc-tion, cannot also be used to offset gain for incometax purposes. (An estimate of estate settlementcosts appears in Chapter 13.)

Family-Owned Business DeductionOne of the most dramatic features of the TaxpayerRelief Act of 1997 was the creation of the “family-owned business exclusion” or FOBE. That exclu-sion was enacted to cover part or all of the value ofa qualified family-owned business interest. Legisla-tion enacted in 1998 converted the exclusion to adeduction from the gross estate for federal estatetax purposes. That technical change was made forseveral reasons but among other consequences ofthe shift was an assurance of a new income taxbasis at death for assets covered by the deduction.The 1998 legislation also addressed other problemswith the provision as originally enacted. Manyfarm and ranch operations with asset valuesexceeding what can be covered by the unifiedestate and gift tax credit should be able to qualifyfor the deduction.

In several respects, the pre-death and post-deathrequirements parallel those for special use valua-tion. Unfortunately, the two provisions, both ofwhich are likely to be important in farm and ranchestate and business planning, do not have identicalrequirements even though the rules are similar.This will likely lead to some confusion over use ofthe two provisions. It is important to approachspecial use valuation and the family-owned busi-

ness deduction as separate and distinct concepts,each with unique pre-death requirements foreligibility and post-death requirements to avoidrepayment or recapture of the benefits involved.

One major difference between special use valuationand the family-owned business deduction is thatspecial use valuation applies only to land andcontains detailed rules on how eligible land is to bevalued for federal estate tax purposes. The family-owned business deduction, by contrast, is appli-cable to all assets used in the farm or other closelyheld business. Thus, machinery, equipment,livestock, stored grain and cash needed in thebusiness are eligible for the deduction. The assetsinvolved are valued at fair market value in thetraditional manner. Up to the available amount forthe year of death, the assets are deducted from thefederal estate tax gross estate.

Amount of the family-owned business deduction.The amount of the family-owned business deduc-tion (FOBD) has been referred to as being $1.3million in amount. However, the unified credit“applicable exclusion” amount is subtracted fromthe $1.3 million. Therefore, for deaths in 1998, theapplicable exclusion amount from the unifiedcredit was $625,000. The FOBE was $1,300,000minus $625,000 or $675,000. As the applicableexclusion amount increased (through 2006) to the$1,000,000 level, the FOBE dropped from $675,000to $300,000. Unless amended further, the $300,000amount would have continued to be available after2006.

Figure 1 (next page) shows the relationship of theapplicable exclusion amount and the family-ownedbusiness exclusion (FOBE) from 1998 through2006, as originally enacted.

When the exclusion was converted to a deduction,in 1998, effective for deaths after 1997, the appli-cable exclusion amount from the unified credit wasset at $625,000 (the amount for deaths in 1998)and continues at that level as shown in Figure 2(next page). Thus, the combined amount was$1,300,000 for 1998 and thereafter. The applicableexclusion amount, for this purpose, does not phaseup from $625,000 to $1,000,000 as scheduled.

If an estate includes less than $675,000 of qualifiedfamily-owned business interests, the unified creditapplicable exclusion amount is increased on a


dollar-for-dollar basis but only up to the applicableexclusion amount otherwise available for the yearof death.

Requirements for eligibility. Several requirementsmust be met for estates to be eligible for the FOBD.These requirements are expected to be scrutinizedas carefully as have the requirements for specialuse valuation over the past 20 years.

• First, the decedent must have been a U.S. citizen orresident at the time of death and the principal placeof business must be in the United States.

• Second, the executor or personal representativemust elect to use the FOBD and file an agreementof personal liability for possible “recapture” orrepayment of the tax benefits.

1998

$625,000

1999

$650,000

2000

$675,000

2001

$675,000

2002

$700,000

2003

$700,000

2004

$850,000

2005

$950,000

2006and later

$1,000,000

$1,300,000

Family-Owned Business Exclusion

Unified Credit

Year:

Figure 1. Unified credit and family-owned business exclusion (as originally enacted)

Figure 2. Family-owned business deduction (as currently in effect)

1998

$625,000

1999 2000 2001 2002 2003 2004 2005 2006and later

$1,300,000

Family-Owned Business Deduction$675,000

Aplicable Exclusion Amount

Year:

$625,000 $625,000 $625,000 $625,000 $625,000 $625,000 $625,000 $625,000


• Third, the aggregate value of the decedent’squalified family-owned business interests mustexceed 50 percent of the adjusted gross estate(gross estate less allowable deductions).

To ascertain whether the decedent’s “qualifiedfamily-owned business interests” make up morethan 50 percent of the decedent’s adjusted grossestate, a calculation is used involving a numeratorand a denominator.

➤ The numerator is the aggregate of all qualifiedfamily-owned business interests that areincludible in the decedent’s gross estate and arepassed from the decedent to a qualified heir,plus any lifetime transfers of such interests bythe decedent to members of the decedent’sfamily (other than the decedent’s spouse), ifthose interests have been held continuously bymembers of the family and were not otherwiseincludible in the gross estate. For this purpose,transferred interests are valued as of the date ofthe transfer. That amount is reduced by thevalue of claims and mortgages less that on aqualified residence, indebtedness incurred topay educational or medical expenses of thedecedent, spouse or dependents and any otherindebtedness up to $10,000.

➤ The denominator is the gross estate of thedecedent reduced by estate indebtedness andincreased by lifetime transfers of qualifiedbusiness interests made by the decedent tomembers of the decedent’s family (other thanthe spouse) if the interests were held continu-ously by members of the family, plus transfers(other than de minimis transfers) from thedecedent to the spouse within 10 years of deathplus any other transfers made by the decedentwithin three years of death except for nontaxable transfers made to members of thedecedent’s family.

• The qualified family-owned business interests,which must make up more than 50 percent of thedecedent’s adjusted gross estate as noted above,must pass to or be acquired by qualified heirs tothe extent of that 50 percent figure. This is a criticalrequirement and means that any post-death sale ofbusiness assets should be considered carefully withan eye to whether a sale would jeopardize eligibilityfor the family-owned business deduction.

• There is no “qualified use” test as such as underspecial use valuation. That test requires, in the pre-death period, that the decedent or member of thedecedent’s family be “at risk.” It is pointed out thatthe qualified use test emerged in IRS regulationsfour years after enactment of special use valuationbased upon language in the statute requiring theproperty to be devoted to “use as a farm for farm-ing purposes or use in a trade or business offarming.” The inclusion in the statute of the term“...trade or business of farming” gave rise to thequalified use test.

It is noted that the family-owned business deductionalso requires the existence of a “trade or business.”Under the statute, it appears that several categoriesof assets are considered passive assets and are notincluded in the value of a qualified business—(1)assets producing interest, dividends, rents, royalties,annuities and personal holding company income; (2)assets that are interests in a trust, partnership or realestate mortgage investment conduit (REMIC); (3)assets producing no income; (4) assets giving use toincome from commodities transactions or foreigncurrency gains; (5) assets producing income equiva-lent to interest; and (6) assets producing income fromnotional principal contracts or payments in lieu ofdividends. Thus, as originally enacted, a cash rentlease of assets by the decedent (or by the qualifiedheirs) was not considered a “trade or business.”Likewise, a non-material participation share leasewith a low level of involvement by the decedent ora member of the family was unlikely to be consid-ered a trade or business.

The definition of “rent” in the statute and regulationswas not very helpful but a 1957 court case hadconsidered income received under crop share leaseswith a high level of involvement in managementunder the lease by a farm manager to be businessincome, not rent.

The 1998 legislation, to remedy the problem,adopted two amendments which allow cash rentingin the pre-death period to a member of the familyor a family-owned entity as tenant. Thus, forpurposes of eligibility the following types of rentalarrangements should meet the pre-death tests:

➤ Single entity structuring of the business shouldmeet the requirements.

➤ Material participation share leases should beeligible.


➤ Non-material participation share leases withactive involvement in management under thelease should be eligible in retirement, assumingthe material participation requirement was metuntil retirement.

➤ Non-material participation share leases withnominal involvement under the lease shouldmeet the test if to a member of the family orfamily-owned entity as tenant.

➤ Cash rent leases should meet the requirementonly if to a member of the family or family-owned entity as tenant.

• The decedent or a member of the decedent’s familymust have owned and materially participated in thetrade or business for at least five of the eight yearspreceding the decedent’s retirement, disability ordeath.

The “material participation” requirement wasspecifically made similar to the special use valua-tion material participation test. It is important tonote that material participation cannot be achievedthrough an agent under the special use valuationrules for those producing agricultural or horticul-tural commodities. The same limitation applies tothe family-owned business deduction. For pur-poses of FOBD, material participation is requiredby the decedent or member of the decedent’sfamily for five or more of the last eight yearspreceding the decedent’s retirement, disability ordeath. The meaning given the term for purposes ofFOBD is the same as for special use valuation. TheSenate Finance Committee report states that “...anindividual generally is considered to be materiallyparticipating in the business if he or she personallymanages the business fully, regardless of thenumber of hours worked, as long as any necessaryfunctions are performed.” It is noted that thiscommittee report language is substantially lessdemanding than is required for material participa-tion under special use valuation as the FOBDstatute states is to be used as the guide on whatconstitutes material participation. A question israised as to whether the committee report languagecan be relied upon.

The Senate Finance Committee report states that “ifa qualified heir rents qualifying property to a mem-ber of the qualified heir’s family on a net cash basis,

and that family member material participates in thebusiness, the material participation requirement willbe considered to have been met with respect to thequalified heir for purposes of this provision.” Thatlanguage seems to support the position that thepresence of a cash rent lease does not preclude afinding of pre-death material participation. However,as noted above, cash rent leasing may be inconsistentwith the “trade or business” requirement, both pre-death and post-death. Indeed, it is puzzling why thecommittee report speaks so favorably of a cash rentlease.

Remember, the FOBD rules do not contain a “quali-fied use” test or “at risk” requirement as such.However, the provision does specify that the two-year “grace period” rules under special use valuationare to apply to the FOBD. In the context of specialuse valuation, the two-year grace period only appliesto the qualified use test. This puzzling feature ofFOBD is discussed below.

Meaning of “qualified family-owned businessinterest.” This is an important term in FOBD andone of the “gates” to keep mere investors fromtrying to gain eligibility.

A “qualified family-owned business interest”includes an interest as a proprietor in a businesscarried on as a proprietorship or an interest in anentity carrying on a business if at least 50 percentof the entity is owned, directly or indirectly, by thedecedent or a member of the decedent’s family.Also, an interest in a business qualifies if 70percent of the entity is owned by members of twofamilies (and at least 30 percent is owned by thedecedent or members of the decedent’s family).Similarly, an interest in a business qualifies if 90percent of the entity is owned by members of threefamilies (and at least 30 percent is owned by thedecedent or members of the decedent’s family).

In applying the ownership test in a corporation,the decedent and members of the decedent’s familymust own the required percentage of the totalcombined voting power of all classes of stockentitled to vote and the required percentage of thetotal value of all shares of stock of the corporation.For a partnership, the decedent and members ofthe decedent’s family must own the requiredpercentage of the capital interest in the partnership


(the Senate Finance Committee report indicates thatthe required percentage of ownership interest appliesalso to the profits interest).

In the case of entities in which a trade or businessowns an interest in another trade or business, a“look-through” test is employed with each trade orbusiness owned by the decedent and members ofthe decedent’s family separately tested to determinewhether that trade or business meets the require-ments of a qualified family-owned business inter-est. Any interest that a trade or business owns inanother trade or business is disregarded in deter-mining whether the first trade or business is aqualified family-owned business interest. The valueof any qualified family-owned business interestheld by an entity is treated as owned proportion-ately by or for the entity’s partners, shareholders orbeneficiaries.

A trade or business does not qualify for FOBD ifthe stock or securities of the business were publiclytraded at any time within three years of thedecedent’s death. Other than for banks and domes-tic building and loan associations, an interest in atrade or business does not qualify if more than 35percent of the adjusted gross income of the busi-ness for the year of the decedent’s death waspersonal holding company income—rents, interestand dividends, for example.

Excess cash. The value of a trade or business forpurposes of FOBD is reduced to the extent thebusiness holds passive assets or excess cash ormarketable securities. The value of a qualifiedfamily-owned business interest does not includeany cash or marketable securities in excess of thereasonably expected day-to-day working capitalneeds of the trade or business

Member of family. The term “member of family” isused throughout the FOBD statute and has thesame meaning as for purposes of special usevaluation. That definition includes the individual’sspouse; lineal ancestors; lineal descendants of theindividual, the individual’s spouse and theindividual’s parents; and the spouse of lineal descen-dants.

Qualified heir. The term “qualified heir” defines thegroup of eligible individuals to receive interests in aqualified family-owned business. The term is defined

as under special use valuation and includes membersof the decedent’s family who acquired the property(or to whom the property passed) from the decedent.In addition, for purposes of FOBD, the term “quali-fied heir” includes an “active employee of the tradeor business to which the qualified family-ownedbusiness interest relates if such employee has beenemployed by such trade or business” for at least 10years before the decedent’s death.

Recapture rules. Establishing eligibility for thefamily-owned business deduction is only half ofthe battle. There’s also a set of requirements in theafter-death period to avoid repayment or “recap-ture” of the benefits from the provision.

The family-owned business deduction rules levy arecapture tax if, within 10 years of heir’s death andbefore the qualified heir’s death, a recapture eventoccurs. Recapture is triggered by any one of severalevents:

• Absence of material participation by the qualifiedheir or a member of the qualified heir’s family formore than three years in any eight-year periodending after death causes recapture.

The rules specify that the provisions applicable tospecial use valuation which allow active manage-ment to substitute for material participation forsome qualified heirs apply also to FOBD. Thatincludes surviving spouses, full-time students,those under age 21 and those who are disabled.Members of that group can get by with “activemanagement” which requires less involvementthan material participation.

The meaning given the term “material participa-tion” for purposes of the family-owned businessdeduction is the same as for special use valuation.As noted above, the Senate Finance Committeereport states:

“...an individual generally is considered to bematerially participating in the business if heor she personally manages the business fully,regardless of the number of hours worked, aslong as any necessary functions are per-formed.”

That language is hardly consistent with the statu-tory mandate to use the special use valuationdefinition of the term. Where committee report


language and the statute are in conflict, the commit-tee report language usually is disregarded.

• As noted above, the legislation incorporates thetwo-year “grace period” from special use valuation.For special use valuation purposes, the two-yeargrace period immediately following death appliesonly to excuse the estate or qualified heirs frommeeting the “qualified use” or “at risk” test. It hasno application to material participation. Thefamily-owned business exclusion rules did notexplicitly include a qualified use or at risk test asoriginally enacted. But the widespread use of theterm “business” throughout the statute and thereference to passive assets being ineligible for theexclusion clearly indicated that Congress contem-plated that a business be carried on. That is onepossible interpretation of the incorporation of thetwo-year grace period into FOBE. With thatinterpretation, the requirement of a “business” iswaived during the two-year period after death andthe 10-year recapture period is extended for a liketime. This interpretation harmonizes with thestatute and was believed to be the correct interpre-tation.

Although the family-owned business exclusionstatute did not define “trade or business” or referto a code provision where the term is defined, theterm generally requires continuity and regularity ofactivity and that the owner or owners be bearingthe risks of production and the risks of pricechange. If, indeed, the term has that meaning inthe FOBD statute, and the exclusion from eligibil-ity of passive assets supports that interpretation, arental of assets for cash would almost certainly notmeet the test and has not met the test in a similarsetting under special use valuation. In the event acash rent lease would be considered to create atrade or business relationship, as was intimated bythe Senate Finance Committee report, mere inves-tors could take advantage of the family-ownedbusiness exclusion (which is now a deduction).

Although the Joint Committee on Taxation of theU.S. Congress in 1997 indicated that “…farmlandthat originally qualified for the family-ownedbusiness exclusion will not be subject to recaptureif the heirs cash lease the farmland to a member ofthe decedent’s family who operates the land, thatconclusion seemed inconsistent with the statute

itself. In 1998, Congress enacted an amendment toclarify that land under the family-owned businessdeduction could be rented to a family member ofthe qualified heir or to an entity owned by mem-bers of the family of the qualified heir withoutrecapture. The amendment states that—

“A qualified heir shall not be treated as dispos-ing of an interest …by reason of ceasing to beengaged in a trade or business so long as theproperty to which such interest relates is usedin a trade or business by any member of suchindividual’s family.”

That language, although not completely clear,permits cash rent leasing to a member of the familyof the qualified heir or an entity owned by mem-bers of the family. In addition, that amendmentallows gift, sale or death-time transfer of businessinterests or assets from a qualified heir to anymember of the qualified heir’s family when theassets continue to be used in the business.

• Recapture is triggered if the qualified heir disposesof a portion of a qualified family-owned businessinterest other than to a member of the qualified heir’sfamily (not the decedent’s family) or through aqualified conservation contribution.

As drafted, the family-owned business deductionrules do not contain an exception to post-deathrecapture for sales or exchanges of crops or livestockheld for sale or for property used in the business(such as machinery, equipment, dairy animals orbreeding stock). Thus, as the statute is now worded,a sale of a corn crop or of cull cows would triggerrecapture consequences. Similarly, a sale or trade ofmachinery or equipment would cause recapture. Thesame outcome would be expected from the sale ofinventory of a nonfarm sole proprietorship. It isunclear how a sale of all or a substantial part of theassets of a business held by an entity would behandled.

Language in the conference committee report (whichwas added at the last minute when this problem wascalled to the attention of committee staff members)supports the view that sales or exchanges of grain orlivestock in inventory and sales or exchanges ofassets used in the business (other than land) in thecourse of business should not lead to recapture:


“The conferees clarify that a sale or disposition,in the ordinary course of business, of assets suchas inventory or a piece of equipment used in thebusiness (e.g., the sale of crops or a tractor)would not result in recapture of the benefits ofthe qualified family-owned business exclusion.”

With no statutory provision providing support forthat statement, however, a question is raised whetherlanguage in the conference committee report will besufficient. An amendment to the statute will likely benecessary to resolve the matter.

The FOBD provision likewise does not specificallyaddress other possible post-death events:

• Transfers of interests in an entity by sale during lifeto other than family members (such as corporatestock or partnership shares).

• Transfers of an interest in an entity by gift duringlife to other than family members.

• Mortgages of property after death.

• Declaring dividends or making other distribu-tions from an entity.

• Changing the organizational structure of anentity (including liquidation) during the recaptureperiod.

• Filing bankruptcy.

• Partitioning assets.

• Granting of an easement or other interest in land(other than a qualified conservation contribution).

The FOBD statute includes three provisions drawnfrom the 15-year installment payment of federalestate tax:

• “Section 303” stock redemptions apparently do notcause recapture.

• Some types of corporate reorganizations areapparently allowed.

• Transfers at death to a member of the family areapparently not a recapture event.

Under the family-owned business deduction rules,recapture is apparently calculated on a proportionatebasis in the event of a partial disposition.

The FOBD statute contains rules drawn from specialuse valuation allowing tax-free exchanges (withouttriggering recapture) and allowing reinvestment of

proceeds received in an involuntary conversionwithout recapture.

• Recapture is also caused if the qualified heir losesU.S. citizenship or the principal place of businessof the family-owned business interest ceases to belocated in the United States.

The recapture rules for the family-owned businessexclusion phase down the recapture tax based onthe number of years of material participation.

Recapture eventoccurring in following

year of material Percentage ofparticipation recapture tax due

1 through 6 1007 808 609 4010 20

It is pointed out that the provision is ambiguous inthat it uses “year of material participation” to calcu-late the recapture tax. Lapses in material participa-tion in the post-death period are allowed withoutrecapture for up to three years (absence of materialparticipation for more than three years in any eightyear period ending after death triggers recapture).

Form 706-D is to be used for reporting recaptureevents after death, transfers to members of thefamily, exchanges, involuntary conversions and lossof U.S. citizenship.

Election. The FOBD statute contains rules drawnfrom special use valuation for purposes of makingthe election and filing an agreement of personalliability. Schedule T of Form 706 is used in makingthe election to use the family-owned businessdeduction.

Several other provisions including authority for aspecial lien for the additional estate tax are alsoincluded.

Other considerations. The enactment of the family-owned business deduction raises several questions ina planning context. A few are discussed below;others will almost certainly arise.

For those with assets exceeding $1,300,000, can partor all of the land be “removed” from the businessand valued under special use valuation with the


remaining assets passing under the family-ownedbusiness deduction? Or will it be necessary to keepthe land (for which special use valuation is desired)outside of the business and rent the land to thebusiness? It appears that the land is eligible forspecial use valuation even though part of the busi-ness.

Can part of the overall business (say a fractionalamount or specific assets) be subjected to thefamily-owned business deduction election? Theanswer appears to be yes.

One effect of the family-owned business deductionis to discourage farmers and others in small busi-ness from building up savings. Savings beyond thereasonable needs of the business aren’t eligible forthe tax break involved. That provision, especiallyfor older farmers, will encourage individuals toremain fully invested in land and other assets. Saleof land before death will be discouraged. Landsales on contract is unlikely to be considered abusiness asset, at least in a sole partnership.

The family-owned business deduction will beviewed widely as an attractive way to shelter assets.Because of the ready availability of tenants tooperate farms under crop share leases in almost allareas of the country, investments in farmland arelikely to be viewed with particular favor. Thiscould mean increased investment in farmland byolder taxpayers and higher farmland prices.

As with many parts of the Taxpayer Relief Act of1997, the family-owned business deduction isalmost unbelievably complex. At the moment, thestatute needs additional repairs.

The provision is effective for deaths after December31, 1997.

Permanent Conservation EasementExclusionThe 1997 legislation allows the exclusion from thetaxable estate of up to 40 percent of the value ofland subject to a qualified conservation easementmeeting the following requirements: (1) the landmust be located within 25 miles of a metropolitanarea or a national park or wilderness area or iswithin 10 miles of an Urban National Forest; (2)the land has been owned by the decedent or amember of the decedent’s family during the three

year period ending on the date of the decedent’sdeath; and (3) a “qualified conservation easement”of a qualified real property interest was granted bythe decedent or member of the decedent’s family.To the extent the value of land is excluded fromthe estate, the basis is not adjusted at death.

The exclusion (of up to 40 percent) may be takenonly to the extent that the total exclusion for thequalified conservation easement plus the exclusionfor the family-owned business does not exceed thefollowing limits:

2000 $300,0002001 $400,0002002 $500,000

and thereafter

In the event the value of the conservation easementis less than 30 percent of the value of the landwithout the easement, reduced by the value of anyretained development rights, the exclusion per-centage is reduced. The reduction in percentage isequal to two percentage points for each point thatthe ratio falls below 30 percent. Thus, the exclu-sion percentage is zero if the value of the easementis 10 percent or less of the value of the land beforethe easement less the value of retained develop-ment rights.

The granting of a qualified conservation easementis not treated as a disposition for purposes ofspecial use valuation recapture and the existence ofa qualified conservation easement does not preventthe property from subsequently qualifying forspecial use valuation.

The provision further allows a charitable deductionfor a permanent conservation easement on propertywhere a mineral interest has been retained andsurface mining is possible but its probability is “soremote as to be negligible.”

The provision is effective for deaths after December31, 1997 and easements granted after December31, 1997.

Marital DeductionA marital deduction may be claimed for propertypassing to a surviving spouse. Since the maritaldeduction is 100 percent of the qualifying propertypassing to a surviving spouse, the marital deductionis a major factor in planning for estate tax saving.


The marital deduction can never exceed the value ofthe property passing to the surviving spouse andqualifying for the marital deduction. Historically,property passing outright has qualified, whetherpassing to the surviving spouse under the will,under state law of distribution, to the survivingjoint tenant, or as life insurance proceeds subjectto federal estate tax.

The least interest that could qualify for the maritaldeduction has been a life estate to the survivingspouse plus a general power of appointment—thepower to designate who ultimately receives theproperty. Those rules were retained in the majorchanges in the federal estate tax marital deductioneffective in 1982. In addition, “qualified terminableinterest property” was made eligible for the maritaldeduction.

Under that concept, a mere life estate passing to asurviving spouse may permit a marital deductionto be claimed for the property involved if theexecutor of the estate so elects. If that is done, anytransfer of the life estate by the surviving spousesubjects the entire value of the property to federalgift tax. In the event of such a transfer, any addi-tional federal gift tax paid on the remainder inter-est may be recovered from the holders of theremainder interest. Moreover, the entire value ofthe property is included in the surviving spouse’sestate if the property is retained until death.

Again, the additional federal estate tax may berecovered from the person receiving the propertyunless provided otherwise by will.

The major advantage of qualified terminable interestproperty (QTIP) is that the property owner cancontrol the ultimate disposition of the property.Thus, a husband could leave property to a secondspouse for life with the property to pass at her deathto children of the first marriage, for example.

Charitable DeductionEarlier, the federal gift tax charitable deduction forgifts during life was discussed. There is also afederal estate tax charitable deduction. To qualifyfor that deduction, again, the gift must be made toa qualified charity. A qualified charity is a church,a division of government, or an organization that hasbeen approved by the IRS as authorized to give acharitable deduction.

To qualify for the federal estate tax charitablededuction, property may be passed directly to thecharity. There are limited possibilities for leavingthe charity less than complete ownership of prop-erty.

Thus, a farm or personal residence could be left toa surviving spouse or someone else for life, withthe remainder interest passing to charity. The valueof the remainder interest would be eligible for thefederal estate tax charitable deduction.

For assets other than a farm or personal residence,for tax deductibility, it is necessary to set up a trustin order for the property to pass to someone for aperiod of years or for their life and then to thecharity. Corporate stock, for instance, could beplaced in a charitable remainder annuity trust, acharitable remainder unitrust, or a pooled incomefund. Income could go to a designated person, saya surviving spouse, with the remainder interestpassing to a charity. Again, the value of the remain-der interest would be deductible.

There are important differences in the types oftrusts for passing property to charities. With thecharitable remainder annuity trust, property isvalued at the time it goes into the trust with at leastfive percent of the value paid as income to whom-ever is designated.

With the unitrust, the property is revalued everyyear, so the amount of income changes as theproperty value changes.

Another possibility for benefiting a charity with alimited interest is the charitable lead trust. With thistype of trust, corporate stock or other property couldbe left for the benefit of a charity for a period ofyears, with the property then passing ultimately tofamily members.

The charitable lead trust can reduce federal estatetaxes because the income interest to the charityreduces the taxable value of the remainder interestthe family holds. This arrangement benefits thecharity, reduces the estate tax and still placesultimate control of the property with the family.

Calculating the Estate TaxOnce the gross value of the estate is established,the deductions just covered are subtracted—theestate settlement costs and the marital and charitabledeductions. The remaining amount of property isthen subject to tax. Also any taxable gifts made


during life after 1976 are added back into the taxableestate. IRS cannot reexamine after death the value ofgifts made earlier to see if the value placed on theproperty was reasonable at that time once the periodfor assessing federal gift tax has passed. If a gift isrequired to be reported on a federal gift tax return,and it isn’t, the gift tax can be assessed at any time.

Next, the federal estate tax rates are applied. Thefederal estate tax rates begin at 18 percent of thefirst $10,000 of taxable estate. The maximum taxrate is 55 percent. The tax table is on page 55. Thesame rate structure applies to taxable gifts madeduring life. Once the amount of tax has beencalculated, there are credits available to reduce theamount actually paid.

Unified CreditThe unified credit is called that because it isavailable for gifts during life, or for propertypassing at death. It reduces the calculated taxdollar for dollar. The unified credit can be usedonly once, either during life to offset gifts or atdeath to offset the calculated federal estate tax.

The unified estate and gift tax credit of $192,800 for1997 was equivalent to a deduction or exemption of$600,000—for someone with that size estate.

The unified credit, expressed as the “applicableexclusion amount,” has been scheduled to increaseas follows:

Year of Gift Applicableor Death Exclusion Amount

1998 625,0001999 650,0002000 675,0002001 675,0002002 700,0002003 700,0002004 850,0002005 950,000

2006 and thereafter 1,000,000

As a rule of thumb, no federal estate tax would bedue on an estate of that size or smaller if theunified credit had not been used during life, since thecredit would cover the estate. The estate could be asmuch larger than that as the amount of the estatesettlement costs and other deductions and still not besubject to federal estate tax. The largest tax burdennearly always falls on the estate of the survivor.Ways to minimize tax at the two deaths are discussedbelow and in Chapter 13.

Other CreditsThree other credits may be subtracted from thecalculated tax. There is a credit for state inheritancetax based on the taxable estate for federal estate taxpurposes. The amount of the credit is based on aformula that involves subtracting $60,000 from thetaxable estate to produce the “adjusted taxableestate.” The amount of the credit is determined froma table on a graduated basis. (See table, page 55.)

The other credits allowed to reduce the calculatedfederal estate tax include death taxes paid to aforeign government and part or all of the federalestate tax paid on the same property included in anestate within the previous 10 years.


Planning can be done to ease the estate tax liabil-ity, particularly at the second death of a husbandand wife. Careful use of the unified credit is oneway not only to reduce estate tax liability, but to“inflation-proof” the second estate. “Inflation-proofing” can be used in certain instances to allowthe second estate to grow in later years withoutencountering increased estate taxes.

Here’s an example of how planning can reducefederal estate taxes. Take a gross estate of$1,000,000, as shown in table 2, all in thehusband’s name. Assume that the deductions are$50,000, leaving an adjusted gross estate of$950,000. Assume that the maximum maritaldeduction is used and the property is left to thesurviving spouse outright. The taxable estatewould be zero and the computed tax would bezero.

Assume that the husband dies and his wife dies 10years later with an assumed 8 percent per yearincrease in property value. The wife’s estate wouldtotal $2,050,978. Deductions (at an assumed rateof five percent of the gross estate) would total$102,549 with no marital deduction available. Thetaxable estate would total $1,948,429 and thetentative tax would be $757,593. After subtractinga unified credit of $345,800 and a state death taxcredit of $95,887, the federal estate tax due wouldtotal $315,906.

Using the same facts except that the first spouse todie leaves the property to the surviving spouse forlife rather than outright, except as to the maritaldeduction portion which would be left outright, asshown in table 3, there would be no federal estatetax due at either death. The savings would total$315,906 compared to leaving the property to thesurviving spouse outright as shown in table 2.

Basic Planning StrategiesGiven a specific size of estate, two basic systems(and one variation) can be used to reduce sharplythe federal estate tax that would otherwise be dueat the death of the surviving spouse if the property

had been left to the surviving spouse outright at thedeath of the first to die. For the larger estates, thesavings are the most dramatic, of course.

Table 2. Death of property-owning spouse in 2001with all property left to surviving spouse outrightwith death of surviving spouse 10 years later.

Estate of Estate ofProperty- Surviving

Owning Spouse Spouse

Gross estate $1,000,000 $2,050,978

Deductions – 50,000 – 102,549

950,000 1,948,429

Marital deduction 950,000 0

Taxable estate 0 1,948,429

Tentative tax 0 757,593

Unified credit 220,550 345,800

Federal estate tax 0 411,793

Credit for state death tax 0 95,887

Federal estate tax due 0 $315,906

Table 3. Death of property-owning spouse in2001 with use of life estate and with death ofsurviving spouse 10 years later.

Estate of Estate ofProperty- Surviving

Owning Spouse Spouse

Gross estate $1,000,000 $593,704

Deductions – 50,000 – 29,685

950,000 564,019

Marital deduction 275,000 0

Taxable estate 675,000 564,019

Tentative tax 220,550 179,487

Unified credit 220,550 345,800

Federal estate tax 0 0

Credit for state death tax 0 0

Federal estate tax due 0 0

Depending upon the way the property is owned, as

Planning to Save Federal Estate Tax 12


well as a number of other variables, the optimalestate planning strategy may or may not involveclaiming a full marital deduction. Estate planningstrategies vary, depending upon whether it isdesired to minimize the tax for the two deaths—that of the husband and that of the wife—orwhether the desired strategy is to minimize the taxat the death of the first spouse to die with littleattention given to the tax burden at the death ofthe survivor.

The strategies outlined in this section—referred toas Model I, Model II, and Modified Model II—arebased on the premise that it is desired to minimizetax at both deaths. More precisely the assumptionis made that an objective is to maximize wealthpassing from the second estate.

Zones for PlanningIf it were known (1) when death would occur and(2) the amount of property that would be owned atdeath, the best planning strategy for saving taxcould be readily determined. The answers to thosequestions are not, of course, known with certaintyin most situations. The following “zones” ofproperty value may provide helpful guidelines forplanning.

Zone I—If the combined wealth of husband andwife is expected to be no greater than the equiva-lent deduction amount from the available unifiedcredit at the death of the surviving spouse($675,000 in 2001), the optimal strategy may be toleave the property outright to the survivor at the

death of the first to die. Leaving the property intrust would be helpful if management assistancewere needed. For individuals in this category, statedeath tax and income tax considerations may bemore important than federal estate tax concerns.

Zone II—If the combined wealth of husband andwife is expected to be no greater than twice theequivalent deduction from the available unifiedcredit at the death of the surviving spouse($1,350,000 in 2001), the optimal strategy may beto (1) divide the property between the spousesequally during life and (2) each leave the other alife estate in the property owned with no maritaldeduction claimed at the first death. The planoutlined below as Model II is designed to accom-plish that result.

In making transfers to equalize property ownershipbetween the spouses, the 100 percent federal gifttax marital deduction would normally cover anygift involved.

Zone III—If the combined wealth of husband andwife is expected to be more than twice the equiva-lent deduction from the available unified credit atthe death of the surviving spouse ($1,350,000 in2001), the optimal strategy may be to (1) dividethe property between the spouses equally duringlife, (2) create a partial marital deduction at thedeath of the first spouse to die and (3) leave theremaining property of the first spouse to die in alife estate for the other spouse.


Planning Strategies

Model IThe first method of saving estate taxes we’ll callModel I. This approach to federal estate tax savinghas been in use for years and was popular in pastyears. Many wills in existence are based upon thisapproach to leaving property for the survivor’s use.This model involves two assumptions for it towork properly: The husband must die first, and thehusband must own the property in his name alone.

Figure 2. Model I

A

B

H W

Children

(life estate)

(marital deduction amount)

Through his will, the husband leaves his propertyto his wife in two packages, as shown in Figure 2.The first package (A) is generally designed toqualify for the marital deduction. A marital deduc-tion is available for up to 100 percent of theamount of property included in package A. Thepackage A amount is given to the wife outright orin a manner that would qualify for the maritaldeduction. As noted earlier, the least interest thatwould qualify for the marital deduction would be alife estate plus a general power of appointment todispose of the property, except for the specialarrangement (referred to as QTIP) involving a lifeestate only as discussed in Chapter 12. In mostinstances, the remainder of the estate (package B)goes to the children or a favorite charitable organi-zation but with a life estate to the wife, so that shehas the use and income from it for as long as shelives.

For practical purposes, the wife has the incomefrom the entire estate. But there are some limita-tions on her use of the principal. Acting alone, shecannot sell or dispose of the life estate property.She cannot live on the principal, only the income,of the property in package B. An independenttrustee over package B could, if necessary, dip intothe principal of the property in package B for thewife’s care, support and maintenance.

She may be able to sell or reduce the principal ofthe property in package A, however, with fewerrestrictions. In fact, it would be desirable to use theprincipal of package A first, since it is this propertythat will be taxable at the death of the wife.

Upon the death of the wife, package B propertygoes to the children immediately with no furtherfederal estate tax. Estate taxes were covered in theestate of the husband when the package B propertywas given to the children with the life estate to thewife. The wife’s estate then contains the remainingamount in package A, plus what other property shemay have at the time.

Model I is designed to take advantage of themarital deduction and allows the rest of thehusband’s estate to go directly to the children, or afavorite charity, subject to the wife’s life estate.Model I usually reserves the income from theentire estate for the surviving wife, but does notrequire that all the property be taxed in both thehusband’s estate and the wife’s estate. If the prop-erty is owned largely in the husband’s name,approximately half the family wealth is taxed in thehusband’s estate and the other half in the wife’sestate. Thus, the tax liabilities in the husband’sestate should about equal the tax liabilities later inthe wife’s estate.

Model I doesn’t save tax if the wife dies first.Actually if the wife dies first, the tax burden wouldbe much greater, for the husband is left with all theproperty in his own name and without a maritaldeduction.

Federal Estate Tax Planning Strategies; IowaInheritance Tax; Estate Settlement Costs 13


A variation of the traditional Model I is shown infigure 3.

Figure 3. Model IA

A

B

C

H W

Children orfavorite charity

Life estate

Marital deduction amount(including QTIP)

Credit shelter amount(wife for life)

Children orfavorite charity

An amount representing the maximum amountthat can be covered by the unified credit is setaside in package A. Usually, that amount would beleft to the surviving spouse for life, then to thechildren or a favorite charity. All or part of theremaining property is left in package B, which isset to qualify for the marital deduction. Thepackage C amount could be qualified for themarital deduction under the rules for qualifiedterminable interest property (QTIP).

Thus, in some instances, it may be desirable toleave some property in a life estate with a remain-der interest to the children or a favorite charity.This provides flexibility in acting after death tocreate a marital deduction under the specialarrangement discussed earlier for life estates andqualify additional property for the marital deduc-tion.

Model IIThe second model is based upon equal propertyownership, as shown in figures 4 and 5. Here theamounts of property owned by the husband andwife are balanced to keep them as equal as pos-sible. This can be done through separate ownershipof different items, or through tenancy in common.With Model II, it makes no difference, tax-wise,who dies first.

In Model II, the husband provides by will for thewife to receive a life estate in the property owned

Figure 4. Model II: Husband dies first

Childrenforlife

y

x = y

x} }

Will

WH

Figure 5: Model II: wife dies first

Children forlife

y

x = y

x} }

Will

WH

in the husband’s name. Thus, if the husband diesfirst, property in his name goes to the children butwith a life estate to his wife. She has income fromall the property, but as to the life estate portionpreviously owned by her husband she is limited toonly the income.

Conversely, the wife, by will, leaves her property tothe children but with a life estate for the husband.If she dies first, her husband may receive theincome from the property previously owned by thewife, but is limited in using the principal of thatportion.

In a sense, this system creates a marital deductionresult during life by the way in which property isheld. Though the usual marital deduction is notused, tax savings occur because half the totalproperty goes through one estate, the other halfthrough the other estate, rather than all propertygoing through both estates.

Model II does not put the property all in the nameof one spouse as is done with Model I. Some likethe Model II approach because it recognizes thecontribution of each spouse in property acquisitionor otherwise in the marital relationship.


Modified Model IIBecause there is economic merit in legitimatelydelaying the payment of the federal estate tax aslong as possible, it may be desirable for the estatesto be balanced during life—to lessen the adverseconsequences of placing all the property in onespouse’s name with that spouse surviving theother—with the estate of the survivor to be some-what larger than the estate of the first to die. Thiscan be accomplished, as shown in figure 6, byproviding for a partial marital deduction at thedeath of the first to die. The marital deductionreduces the estate of the first to die and increasesthe estate of the survivor. The result is a smallertax in the first estate and a larger tax in the second.The economic advantage in reducing the tax at thefirst death is that the postponed tax dollars may beused interest-free during the period of time be-tween the two deaths. This can be an especiallyimportant advantage in a time of high interestrates.

Figure 6. Modified Model II: husband dies first

Children

maritaldeduction

yx = y

x}}

Will

WH

forlife

}}

}

B

A

Will

The size of the marital deduction, for optimal taxsaving in both estates, depends upon five factors:(1) life expectancy of the surviving spouse; (2) thestate of health of the surviving spouse (disregardedif normal for age, but it would overrule life expect-ancy if it appeared that health was poorer thanexpected for age); (3) the return expected ondeferred tax dollars; (4) expectations about rates ofinflation (or deflation); and (5) expected changesin tax rates, exemptions, and credits.

The older the surviving spouse, the smaller theoptimal marital deduction because there’s less time

to gain interest on tax savings. The Modified ModelII plan is based on gaining interest earnings tooffset larger taxes later.

The same principle applies if the surviving spouseis in poor health. Again the marital deductionshould be reduced.

If inflation is anticipated, that would increase thesize of the survivor’s estate in all probability.Therefore, the higher the rate of inflation, thesmaller the optimal marital deduction to allowgrowth in the second estate.

Regarding interest rates, generally the higher therate of return on those dollars that are saved fromtaxes at the first death, the larger the optimalmarital deduction. In other words, the more thesavings earn, the more we want to invest.

If tax rates are expected to rise, the marital deduc-tion might be smaller with more of the estate taxednow rather than later at higher rates. Or, if adecrease in death taxes is expected, the maritaldeduction might be increased at the death of thefirst spouse with a larger estate later under thelower rates.

Making the ChoiceFor most couples personal preference as to prop-erty ownership is a major factor in determiningwhich of the three tax saving techniques should beused. With the 100 percent federal gift tax maritaldeduction, changes in property ownership betweenspouses may be made without concern aboutfederal gift tax consequences.

Desired changes in property ownership patternsshould not be delayed. An unexpected death couldpreclude use of the tax saving features of any of theplans designed to reduce federal estate tax liabilityat the second death.

Iowa Inheritance TaxThe Iowa inheritance tax is the second death taxand differs from the federal estate tax in a numberof important respects.

Philosophically, the inheritance tax differs fromthe federal estate tax. The estate tax is imposed onthe estate—the property held by the decedent atdeath. The estate tax is actually paid by the estate.

The inheritance tax is imposed on those who


inherit the property. Thus, the amount of propertyeach individual inherits and the degree of relation-ship to the decedent influence the rate of tax.

There is no marital deduction under the stateinheritance tax. However, a series of varyingexemptions and tax rates ease the tax burden whenproperty is transferred within the immediatefamily. Also, the state inheritance tax handlesinsurance proceeds in a different manner.

Under the state inheritance tax, life insuranceproceeds are taxed only if the proceeds are payableto the estate of the deceased insured. If the pro-ceeds are payable to someone other than theinsured, the proceeds are not subject to tax, nomatter who owns the policy.

For joint tenancy property owned by a husbandand wife, no more than one-half of the value issubject to state inheritance tax at the death of thefirst to die. And, to the extent the survivor canprove contribution to acquisition of the jointtenancy assets in money or other property to anextent greater than one-half, even more of thevalue may escape tax at the death of the first to die.

Property subject to the Iowa inheritance tax is thebasis used to determine such costs as the executor’sfee and the attorney’s fee. Therefore, it is doublyimportant to know what property is subject to thetax.

The Iowa inheritance tax reaches most of theproperty held by the decedent. It includes propertyheld in the decedent’s name, that in tenancy incommon to the extent of his or her portion of it,and joint tenancy and life insurance proceeds asindicated. The special use valuation concept hasbeen extended to Iowa farmland for inheritance taxpurposes. The special use valuation method forvaluing farmland is similar to the federal rules onspecial use valuation discussed in Chapter 10.

To determine the Iowa inheritance tax, the estatesettlement costs, attorney’s fee, executor’s fee,debts due at death, funeral expenses, and a tempo-rary allowance for the surviving spouse and chil-dren during estate settlement may be subtractedfrom the gross estate.

At this point, it is necessary to determine who isgoing to receive the property. The relationship

between the recipient of the property and the dece-dent determines the tax rate. The more closelyrelated the recipient is to the decedent, the less thetax.

For deaths after June 30, 1997, Iowa does notimpose a state inheritance tax (except for the stateestate tax) on property passing to a child (includ-ing adopted children and “biological” children),stepchild, grandchild, other lineal descendants,parent, grandparent or other lineal ascendant.Property passing to a spouse has not been subjectto Iowa inheritance tax in recent years. Stateinheritance tax is imposed on property passing toothers (except for charities qualifying for thecharitable deduction).

The Iowa inheritance tax return is due ninemonths after death. The federal estate tax return isdue nine months after death, also.

State Estate TaxThere is also an Iowa estate tax. It is rarely im-posed except for amounts passing to individualswho are exempt from paying Iowa inheritance tax.It is only levied where it is necessary to impose anadditional tax to fully utilize the amount of creditavailable against the federal estate tax for stateinheritance tax paid. Thus, if the credit for stateinheritance tax allowed on the federal return is$2,000, for example, and the actual tax levied isonly $1,200, the Iowa estate tax is imposed tocollect an additional $800. This results in no moretax being paid by the estate. But it keeps theadditional $800 in tax in Iowa instead of going tothe federal government.

Estate Settlement CostsAs for specific estate settlement costs, court costsusually claim a relatively small share of the es-tate—usually less than $500. Fees for the adminis-trator or executor can be substantial. These fees areset by Iowa law for ordinary services at six percentof the first $1,000 of probate inventory (propertysubject to Iowa inheritance tax), four percent onthe next $4,000, and two percent on all over$5,000. On a $100,000 estate the administrator’s orexecutor’s fee would be $2,120. If the estaterepresentative supplies extraordinary services, thecourt might be asked to approve an additional fee.In many situations, especially where a member of


the family serves as administrator or executor, thesefees may be partially or totally waived.

For those who serve as administrators or executorsand waive fees, there is a caution. In some in-stances, the Internal Revenue Service requirespayment of income taxes on waived fees. The ruleis that a fee, once earned, is taxable income eventhough never actually paid. Generally, however, ifthe fee is waived within the first six months afterservice begins as an estate representative, there isno income tax due. If the fee is waived later,income tax might be levied, unless the facts indi-cate a continuing intention to serve gratuitously.

What about Attorney’s Fees?The attorney’s fee is based on the same percentageas the administrator’s and executor’s fees. Again,these are ordinary fees for ordinary services. Ifthere are extraordinary services, the attorneywould be entitled to additional fees as allowed bythe court. Such extra service might include extra

work involving disagreements among heirs, con-tested debts, land title problems, or unusual taxmatters.

Bond CostsAnother expense may be the bond required for theadministrator, or an executor serving under bond.As noted in Chapter 5, the testator can request inthe will that the named executor serve withoutbond. This eliminates the expense of a bond.However, unless the executor is nominated in awill or those to receive the property all agree, abond is required to cover the value of personalproperty of the estate plus the estimated annualincome from the estate. Bond costs usually run $5or so per $1,000 worth of coverage up to $100,000.

Other CostsMedical expenses of the last illness and funeralcosts also are paid by the estate. These costs, ofcourse, can vary greatly.

Table 4. State Inheritance Tax*

4. Rate of tax on1. Taxable amount 2. Taxable amount 3. Tax on amount excess over amount

equaling not exceeding in column 1 in column 1

0 12,500 0 5 percent12,500 25,000 625 6 percent25,000 75,000 1,375 7 percent75,000 100,000 4,875 8 percent100,000 150,000 6,875 9 percent150,000 — 11,375 10 percent

* For property passing to the deceased’s brother or sister, son-in-law or daughter-in-law.


One of the important elements in estate planning isplanning for liquidity. By that we mean planning tohave the cash available or a way assured to pay thefederal estate tax, the state inheritance tax, and theestate settlement costs. Those amounts can add upto a fairly large sum, especially for those withsizable estates. The amount of indebtedness forwhich the decedent is responsible at death maypose a serious liquidity problem, particularly if theassets are not readily salable.

Liquidity may be even more important for thosewho have a family business. If the family businessis to continue beyond the generation of its found-ing into the next generation, it may be desirable toprovide cash for those heirs who are not affiliatedwith the family business. If the business is tocontinue, it may be a handicap to have to sellessential business property, or to mortgage itheavily to compensate other heirs or to pay settle-ment costs.

The Liquidity PlanThough liquidity needed may vary with circum-stances, the problem is serious enough to justifycreating a liquidity plan as part of the estate plan.The liquidity plan should have four components.

Assess Need—The first step in planning is arealistic assessment of liquidity needs. That in-volves taking a look at the amount of property attoday’s values and also on a projected basis lookingfive to ten years into the future.

The liquidity need is influenced heavily by thegoals for the family business operation. If there isno family business to continue, inventory propertycan be sold, or land can be sold or mortgaged.

However, if the family business is to continue, saleof such items may be painful economically. Itcould reduce the scale of operation to the pointthat it may be difficult to continue.

Review the Alternatives—Once the liquidity needis thoroughly assessed, you should examine thechoices to solve the problem. There are two basic

classes of alternatives—pre-death and post-death.Life insurance is in the pre-death category. Extrainvestment in the family business may be planned,so the business could be reduced in scale to createfunds to pay taxes and settlement costs at death.Or funds to cover these needs could simply beaccumulated in a savings account.

There also are post-death options that can bearranged after death either to pay off death taxesand settlement costs, or to ease those payments.The latter include the 15-year installment paymentprovision on federal estate tax, or corporate stockredemption, if there is a corporation. Each of theseis discussed in detail in this chapter. And survivorsmay simply obtain a loan to cover after-death costsand repay it later.

Select the Best Choices—After all the liquiditychoices are examined, the one or ones that appearto be the most advantageous are selected. These aregenerally the ones that will produce the largestamount of wealth after all taxes and costs are paid.

Meeting Requirements—The fourth element of theliquidity plan is to list all the requirements thatmust be met in order to have liquidity alternativeswe want available for use. Certain pre-deathactions can influence which choices are availableafter death. For example, the kind of lease used torent land to a tenant before death can affect use ofcertain alternatives. Whether gifts of property weremade to the children during life, and how much,can have an influence, as can the sale of propertyto children during life.

Deferring Paymentof Federal Estate TaxThere are two ways payment may be delayed onfederal estate taxes, which may help liquidityproblems where a family business is involved.Requirements for the two methods vary, so indi-vidual circumstances may dictate which may beused.

For reasonable cause, the payment of federal estatetax on the due date may be extended for one-year

14 Liquidity Planning


periods with interest on the unpaid balance. Up to 10one-year extensions may be granted.

15-Year Installment Payment

Under the “15-year” installment payment provision,the portion of federal estate tax attributable to aclosely held business may be totally deferred until 69months after death with the tax payable in up to 10equal annual installments thereafter. The last pay-ment is due 177 months after death (which is threemonths short of 15 years).

Interest on the deferred tax commences nine monthsafter death with interest payments due during thefirst five years. Interest is due on the unpaid balanceuntil the deferred tax is fully paid. A special 2percent interest rate (compounded daily) is allowedon the unpaid tax attributable to the first $1,060,000of taxable estate involving farm or other closely heldbusiness property (for 2001). The first $1,060,000 oftaxable estate (for 2001) is in excess of the amountcovered by the applicable exclusion amount and anyexclusions. The $1,060,000 figure is inflationadjusted.

The interest rate imposed on the amount of deferredfederal estate tax attributable to the taxable value ofa closely-held business in excess of $1,060,000(inflation-adjusted) is reduced to 45 percent of therate applicable to underpayments of federal tax.

The regular interest rate on underpayments of tax isthe federal short-term rate plus 3 percentage points.The federal short-term interest rate is based on theaverage market yield on outstanding marketableobligations of the United States with remainingperiods to maturity of three years or less. Changes inthe regular rate of interest are made quarterly.

For deaths after 1997, interest paid on deferredfederal estate tax under the 15-year installmentpayment option is not deductible for either federalestate tax or federal income tax purposes.

Under a special transitional rule, estates involvingdeaths before 1998 that had elected the 4 percentinterest rate could elect before 1999 to use the 2percent rate on the amount originally eligible, noton the increased eligibility amount under the 1997legislation, and to forego the interest deduction forinstallments due after the date of the election touse the 2 percent rate.

To be eligible for 15-year installment payment offederal estate tax, the decedent must have an “inter-est in a closely held business.”

• For a corporation, at least 20 percent of the votingstock must be in the deceased’s estate or there mustbe 15 or fewer shareholders.

• For a partnership, 20 percent or more of the part-nership capital must be included in the deceased’sestate or there must be 15 or fewer partners.

• For a sole proprietorship, the interest of the soleproprietor counts as an interest in a closely heldbusiness.

• Some types of leases qualify the property as aninterest in a closely held business. In a farmoperation, a crop share or livestock share lease,where the landowner receives a portion of the crop(and a portion of the livestock produced, in thecase of a livestock share lease) and pays part of theexpenses, qualifies as an interest in a closely heldbusiness if the landowner or an agent or employeeis involved in management under the lease.

A cash rent farm lease generally does not qualifythe property involved for installment payment offederal estate tax. However, rental of residentialrental units has, in some instances, qualified as aclosely held business where the necessary level ofmanagement was present.

Eligibility for 15-year installment payment alsorequires that the interest in the closely held busi-ness must represent a significant part of the totalestate. The interest in the closely held businessmust exceed 35 percent of the adjusted gross estateto be eligible. The adjusted gross estate is the grossestate less allowable costs and debts.

The 35 percent requirement may be difficult tomeet if substantial amounts of business propertyhave been sold during life. An installment contractheld at death is considered an investment asset andnot an interest in a closely held business. Gifts ofbusiness property during life may also jeopardizeeligibility for installment payment of federal estatetax by reducing the amount of business property inthe estate at death. Retaining non-business or invest-ment assets until death and making gifts of businessproperty could preclude eligibility for installmentpayment of federal estate tax.


The farm residence is considered an interest in thebusiness if occupied by the owner, employee of theowner, tenant or employee of the tenant for pur-poses of operating or maintaining the farm. If theresidence is rented to others, it is not an interest inthe business.

Thus, it can be seen that actions during life interms of lease used and in terms of decisions to sellor make gifts of property can affect eligibility forinstallment payment of federal estate tax.

Disposal of one-half or more of the decedent’sinterest in the business during the 15-year deferralprogram terminates the installment paymentprovision. Transfers at the death of an heir ortransferee do not cause acceleration of payment ifthe transfers are to family members. In general,mere changes in organizational form do not resultin termination of installment payment. Likewise,tax-free exchanges of property do not acceleratetax payments. However, some transfers do consti-tute dispositions or withdrawals (and acceleratethe payment of federal estate tax if making up one-half or more of the decedent’s interest in thebusiness). These include sales or gifts, even tofamily members, and interruption of the businessuse of the property. The cash renting of farm landis treated as such a disposition. It is believed thatbankruptcy filing does not cause acceleration ofinstallment payment of federal estate tax buttransfers in bankruptcy could trigger accelerationof payment.

There is relatively little authority as to whetherproperty can be mortgaged during the 15-yearperiod. One ruling allowed refinancing of anexisting mortgage and another permitted the saleof property to pay off indebtedness existing atdeath.

Late payments made up to six months after the duedate do not terminate installment reporting but doincur a payment penalty.

There may be a lien to secure payment of thedeferred taxes. The lien generally takes priorityover other borrowing after death except for someborrowing in a special category of “super priorities.”

Corporate Stock RedemptionFor those who have their business organized as acorporation, stock redemption may be a liquidity

alternative. In the period after death, the corporationmay buy some of the stock held by the estate, withfunds from the corporation paid to the estate. Thesefunds can then be used to pay death taxes andsettlement costs.

Generally, if you try to redeem part of ashareholder’s corporate stock in a family or closelyheld corporation, the redemption is treated asordinary dividend income. With estates, however,stock may be redeemed with only capital gain paidon any profits involved, if certain rules are fol-lowed.

This type of procedure is known as Section 303stock redemption. Section 303 is the section of theInternal Revenue Code that prescribes the rules.

For Section 303 stock redemption, the corporatestock must represent more than 35 percent of theadjusted gross estate. Again, that’s the gross estate,less estate settlement costs. And again, that qualifi-cation may be a difficult one to meet, particularly ifa family corporation was formed and the decedentkept some of the major assets, such as land, out-side the corporation.

Use of debt securities in formation of the corpora-tion reduces the amount of corporate stock andmay make meeting the 35 percent requirementdifficult, also. These factors illustrate the impor-tance of careful planning in forming corporations.

Stock from two corporations can be countedtoward the 35 percent requirement in Section 303redemptions if the decedent owned 20 percent ormore of each corporation.

If all the requirements for a Section 303 redemp-tion are met, stock can be redeemed for 48 monthsafter death to pay death taxes and estate settlementcosts. If the 15-year installment payment is used,you can continue to redeem stock over that periodto generate cash to meet the payments.

“Flower Bonds”Flower Bonds are a special series of U.S. Govern-ment Bonds that may be used to produce liquidityfor payment of the federal estate tax. The bonds arebought during life at their traded value, and areredeemed at death.

If a flower bond is purchased at $94, it would beredeemed at $100 (par value) to pay the federalestate tax. This would yield a profit from the bonds.When interest rates rise, bond values generally fall,


so that might be a good time to purchase bonds ifyou use this option.

The profit in flower bonds is not subject to incometax but it is subject to federal estate tax and somestates levy a state inheritance tax against the fullredemption value including the profits. Iowa doesnot tax flower bond profits in that manner, however,with only the traded value at death subject to inherit-ance tax.

Congress discontinued the flower bond program asof March 3,1971, so no new bonds are being issued.However, bonds then issued were left in circulation.Be certain bonds you purchase were issued prior tothis date and also recognize that there is a steadilyshrinking supply with no new issues.

Generally, you should purchase only as many bondsas you need. Tax problems can arise if excess bondswere purchased and a tax deficiency develops later.Also, it is best to purchase bonds yourself. Someattempts to have the bonds purchased by someoneelse through a power of attorney have been chal-lenged.

Special care is needed if flower bonds are purchasedand held by a trust at death. For the bonds to beeligible for redemption, the trust must terminate infavor of the decedent’s estate or the trustee must be

required to pay the decedent’s federal estate tax. Theonly other instance in which flower bonds held by atrust could be redeemed to pay federal estate taxwould be if the debts of the decedent’s estate ex-ceeded estate assets without regard to the assets inthe trust.

Life InsuranceAnother estate planning device is life insurance.Briefly, life insurance can be used to build up anestate, cover estate settlement costs, provideincome to parents, preserve a family business, orpay the decedent’s debts.

For example, life insurance can be used to providean annuity that would continue to provide incometo the parents for as long as they live. Insurancecan be used to fund passage of the family businessor farm to certain children. Thus, if you want topass the family farm or business to a son, youcould do that in a will. Then life insurance couldbe used to provide an equal amount of cash tononfarm heirs or to provide income for a survivingspouse.

With the many types of insurance policies and thelack of restrictions on the use of this option, lifeinsurance is one of the more flexible methods ofobtaining liquidity in an estate.


The trust is one of the most useful and flexible toolsof estate planning. Yet it is probably the mostunderused estate management technique.

A trust is an artificial being, something like acorporation, created by a document or instrument.The trust instrument specifies the rules of opera-tion of the trust, the powers of the trustee, and thebeneficiaries to share in the income and principalfrom the trust.

A trust requires three basic elements—a trustee,property for the trustee to manage, and beneficia-ries to receive income generated by the trust andthe principal remaining at the time for ultimatedistribution of the property.

The person or firm managing the trust, the trustee,receives the property, invests capital if necessary,collects the income, handles the accounting, paystaxes, and reinvests or distributes income accord-ing to the rules laid down by the trust. Finally, thetrustee distributes the principal in accordance withthe trust instrument.

A high degree of “fiduciary” care or responsibilityis imposed upon the trustee. For example, a trusteecannot make high-risk speculative investmentsbeyond the authority found in the trust or what areasonable and prudent person would do under thecircumstances. If the trustee does make imprudentinvestments, the trustee may have to repay thetrust from the trustee’s own funds. This assures adegree of protection for the beneficiaries of a trust.

A trustee can be an adult person or a bank or trustcompany having trust powers. Fees vary accordingto the type of property being managed. A typicalfee for managing a trust made up of corporatestock would be about one-half of one percent ofthe property in the trust annually. If a trust had$300,000 worth of this type of property, the annualfee would generally run from $1,500 to $3,000 formanagement. If the trust owns bonds, the feemight be a bit less. If the trust owned a farm, thetrustee usually claims a farm manager’s standardfee, often 10 percent of the landlord’s share of the

gross income. Again, family members serving astrustees may waive the fees, though most non-family members and banks and trust companiesnormally claim a fee.

Two Types of TrustsThere are basically two types of trusts. One type isa living trust or inter-vivos trust. This type of trustis established by a living person and property istransferred into the trust at that time.

Living trusts are generally of two types—revocableand irrevocable. Under a revocable trust, the poweris retained to alter, amend, or revoke the trust.This permits a person to change his or her mindafter the trust is established. Frequently, under therevocable trust the person establishing it receivespart or all of the income for that person’s remain-ing life. Part of the income might go to a wife,children, or grandchildren, or the income might beaccumulated and added to the principal.

A revocable trust does not save death taxes. Reten-tion of control over the trust subjects the propertyto the federal estate and state inheritance tax. Sincethe revocable trust is subject to state inheritancetax, the property becomes part of the estate for thepurpose of figuring attorney’s and executor’s fees ifprobate of the estate is necessary. If all or most ofthe property is included in a revocable living trustat death, short-form probate (involving propertyvaluation and payment of taxes only) may befeasible with some possible reduction of estatesettlement costs.

In transferring property to a revocable trust,several points should be kept in mind.

• Transferring the residence does not make theresidence ineligible for tax-free sale up to $250,000of gain ($500,000 on a joint return). Apparently,most revocable trusts could claim the exclusion,enacted in 1997, but a trust over which the benefi-ciary held only a life estate does not qualify.

• Expense method depreciation does not apply totrusts (but that rule may not apply to “grantor”trusts).

15 Tools for Estate Planning: Trusts


• Flower bonds require special handling as explainedin Chapter 14.

• Series E government savings bonds may be trans-ferred without causing the accrued interest to be-come taxable. The election to report the accruedinterest on the decedent’s final income tax return isstill available.

• Installment sale obligations may be transferredwithout causing the gain to become immediatelytaxable unless the obligor under the obligation is atrust beneficiary.

• For encumbered property, check to see if thetransfer would cause the mortgage or other indebt-edness to become due and payable.

• A grantor trust can own S corporation stock upto the grantor’s death and for two years after death.“Subchapter S” trusts, “small business” trusts, andtrusts with another than the grantor considered tobe the owner may also own S corporation stock.

• The ordinary loss deduction on loss from corpo-rate stock under the special provision for “Section1244 stock” does not apply if the stock is disposedof by a trust. Again, that provision may not applyto “grantor” trusts.

• Transfer of closely held business assets couldterminate installment payment of federal estate taxunless it is a mere change in organizational form.

• Recapture of special use valuation benefits couldoccur unless all beneficiaries are qualified heirsand consent to personal liability for any recapture.

To have an effective living trust, the propertyactually must be transferred to the trust. Thatincludes land, bank accounts, stocks, bonds, andother assets.

So long as the person setting up the living trust isalso a trustee, no additional tax returns need befiled. The person establishing the trust reports allincome on that person’s income tax return. How-ever, once the person setting up the trust is not atrustee, the trust must begin filing state and federalincome tax returns and obtain a taxpayer identificationnumber.

Although there are reasons for establishing “joint”trusts for a husband and wife, in general it isbelieved that it is better for each spouse to have his

or her own trust. Exercising the right to revoke thetrust is more certain with separate trusts.

An irrevocable trust cannot be altered, amended, orrevoked by the person who sets it up. The propertyis transferred as completely as if by gift to anindividual. No powers are ordinarily retained overthe trust or its property. A completed transfer ofproperty is made, subject to gift tax, and the valueof the irrevocable trust is not subject to federalestate tax, attorney’s fees, or executor’s fees.

If property was transferred to an irrevocable trustwithin three years of death, the value would besubject to state inheritance tax. In general, prop-erty transferred by gift is not included in the grossestate for federal estate tax purposes even thoughthe gift occurred within three years of death. That’sthe outcome unless powers, rights or controls wereretained over the property or the transfer involvedlife insurance policies.

However, the irrevocable trust is used only rarely.Few people are willing to give up complete controlover their property during life. This accounts forthe lack of popularity of the irrevocable trust.

Testamentary TrustA testamentary trust is the type of trust set up tobecome effective at death and is usually found inthe will. This type of trust frequently is used as avehicle for property management if both parentsshould die leaving minor children surviving. Thetestamentary trust for minors is a useful device formanaging the property for the children’s benefituntil each attains a stated age. The trustee could bethe same person named as guardian for the chil-dren, or it could be a different person or a bank ortrust company providing further control overexpenditure of funds. Typically, a testamentarytrust for minors distributes income as needed tothe minors while growing up or in college, withthe principal distributed to the children at the agespecified in the trust.

One of the practical problems facing many trusteesof such trusts is how money is to be used foreducation. Guidelines can be provided for thetrustee to use in deciding the type of institution (interms of cost) for which the child would be eli-gible, level of support he or she could receive andthe maximum time over which educational support


could be paid. Otherwise, disagreements over thesepoints could arise between a child and the trustee.Another important question is the age at whichchildren should receive the principal from thetrust.

A second use of the testamentary trust is to handlemanagement of property passing to the survivingspouse, particularly property passing to the spousefor life. Life estate portions are more easily admin-istered if in trust than if held in a “legal life estate.”Arrangements for leaving property to a survivingspouse for life are discussed in Chapter 13.

Generation SkippingA trust may also be used for “generation skipping.”Successive life estates may be created for familymembers in succeeding generations. Property heldin a granted life estate is not taxable in the estate ofthe deceased life tenant for federal estate taxpurposes.

In general, for generation-skipping transfers, ageneration skipping transfer tax is imposed at thehighest federal estate and gift tax rate (55 percent).

However, an exemption is provided for generation-skipping transfers of $1 million per transferor.

Special use valuation for land is available in calcu-lating the generation-skipping tax for direct skips.

Family Estate Trusts“Family estate” trusts, “pure” trusts or “constitu-tional” trusts that purport to be irrevocable andinvolve the assignment of lifetime services to thetrust should be approached with caution. TheInternal Revenue Service has indicated that suchtrusts will be challenged on several grounds. Courtcases and rulings to date have bolstered the IRSposition that (l) assignment of “lifetime services” tothe trust is ineffective to shift the income tax liabilityto the trust, (2) the value of the property involved istaxed in the estate of the person who established thetrust and who usually retains control over the trust,(3) the trust may be taxed as a corporation for incometax purposes, and (4) in general, creation of such atrust does not involve a taxable gift.

The use of “off-shore” trusts has been promoted inrecent years with IRS challenging such trustssuccessfully.


Even the best of estate planning efforts means littleunless we actually implement the plan in the formof a will, change in property ownership, or modifi-cation of the insurance plan. It’s not easy to put anestate plan into place. Most of us prefer not to talkor think about death. But we owe it to those whoare close to us and who are dependent upon us totake that step.

We suggest you begin by giving serious thought toobjectives. What do you want to accomplish? Whatdo you want to have happen to your property, orthe family’s property, over the next 10,15, or 20years? Try to review that scene without yourselfbeing present. Who would be in charge? Whowould make the decisions? Who would need theincome? Who could authorize sale of property anddistribution or reinvestment of proceeds?

After you have determined your objectives, youmay want to consider objectives of yourself andspouse together. Some objectives may be obtainedfrom family members. Especially if you want thefamily business to continue into the next genera-tion, children should be consulted.

A family conference may be helpful to shareconcerns about the estate planning process, prop-erty disposition, estate settlement, and some ideaof the governing objectives.

The next step is probably a visit with your attor-ney. Your attorney may advise you of other ways toaccomplish your objectives. You may want tospend some time thinking and reflecting upon howyou want to go about your plan. Another familyconference may be helpful to discuss possibleoptions.

After you and the family are certain of objectives,you’ll want to work closely with your attorney andothers on the estate planning team to implementthe plan.

Business PlanningFor those involved with the family business oranother business relationship, business planning

may be an important part of estate planning. This isbecause many business decisions made prior to deathcould influence and affect estate planning decisions.

For example, availability of installment payment forfederal estate taxes can be affected by the way thebusiness is structured. Similarly, eligibility forspecial use valuation of land or the family-ownedbusiness deduction can be affected. For those in acorporation, eligibility for stock redemption alsocan be influenced by how the business entities arestructured.

How Many Entities?One of the more fundamental questions is the wayto structure the business. Specifically, how manyentities should you have in organizing the busi-ness? Should you have a single entity that holds allthe business assets—inventory, machinery, live-stock, and land? Or should you have two entities?One might carry on the production. Another entitymight hold the land with the land leased to theproduction entity. The latter is a common practice.However, a 1995 case, a 1996 ruling, and three TaxCourt cases in 1999 have imposed self-employmenttax on rents (which normally are treated as invest-ment income, not subject to self-employment tax) ifinvolvement in the business as lessor and aspartner, employee or otherwise reached the level of“material participation.” A late 2000 Court ofAppeals case reversed the three Tax Court casesdecided in 1999 and indicated that rents consistentwith market rental rates “very strongly suggest” thatthe rental arrangement stands on its own as anindependent transaction and would not produce“rents” subject to self-employment tax just becausethe lessor is involved in the business as an employeeor partner.

The choice of organizational pattern can have muchto do with the estate planning strategy. Let’s look ata multiple-entity approach.

Consider a farm operation where one entity holds theland and leases it to the production entity. With thisarrangement, parents who own the land receive rent.

Implementing the Estate Plan 16


Rent is usually certain, secure, and it won’t reducesocial security benefits.

The separate land entity also is a way to continue theownership in land for the heirs who are not affiliatedwith the family business. Those heirs can continue tohold ownership interests in land as a major asset inthe business without becoming involved in day-to-day management. Further, the heirs affiliated withthe business do not need as much investment tocontrol the production entity if land is left out of theproduction entity.

Usually those heirs affiliated with the business wantto control the production entity no later than the timeof death of the surviving parent. They tend to fearthat a coalition of heirs not affiliated with the busi-ness might dissolve the operation to obtain theirassets.

DisadvantagesThere are some negative estate planning aspects tomultiple entities, however.

One concern is eligibility for installment paymentof federal estate tax. As you recall, where there isan interest in a closely held business and it is morethan 35 percent of the adjusted gross estate,payment of the portion of federal estate tax attrib-utable to the business may be deferred.

Eligibility requirements for 15-year installmentpayment are discussed in Chapter 14. A key pointis that assets cash rented to the production entitygenerally are not considered an interest in a closelyheld business for purposes of installment paymentof federal estate tax.

In addition to structure of the organization, thetype of lease used can influence eligibility forspecial use valuation of land. Special use valuationrequirements are discussed in Chapter 10. Eligibil-ity for the family-owned business deduction mayalso be affected by leasing as discussed in Chapter11.

There are, in addition, questions regarding whetherto use a general partnership, limited partnership,limited liability company, limited liability partner-ship, or corporation for part or all of the assets, orwhether you should use a trust or individualownership of land. The organizational problems ofthe farm business are discussed in a companion

videotape series. The reference publication for thatseries is PM 878, Organizing the Farm Business,available from Iowa State University Extension.

Steps in ImplementingYour PlanYour plan may be implemented by a will to disposeof property, to designate an executor, and possiblyto nominate a guardian for minor children. Youmay want to look at how property is owned. Achange in property ownership patterns may bedesirable. You may want to shift from joint tenancyon some assets, possibly to tenancy in common, orinto individual ownership. A careful review ofproperty ownership is part of the implementationprocess.

Also at this stage, you should examine your insur-ance plan for any needed changes. Beneficiarydesignations should be compatible with the estateplan and your desires. You may want to considerchanges in the ownership of the policy, also.Ownership changes may reduce federal estate taxon life insurance proceeds.

Your estate plan may suggest a gift program, or thesale of some assets. All are properly part of theimplementation process.

CharitiesYou may want to consider benefiting a favoritecharity. A gift to a charity either at or before deathis a way of extending yourself. It may be a way toaccomplish some of those things you had plannedto do during life, but for various reasons could not.

A charity can provide a productive use of re-sources. For example, scholarship funds are oftenturned over year after year with the income usedproductively. Charities also often make efficientuse of funds because they operate with a great dealof volunteer effort for low overhead costs.

Giving to a charitable cause at death conveys aspecial legacy to family members—the idea ofsupport for humanitarian causes. That may beworth more to the family in terms of their develop-ment than leaving them all of the property.

Giving to a qualified charity may provide incometax advantages, estate tax deductions, and possiblya gift tax deduction as well.


InventoryIn implementing your plan, an inventory of assetsshould be made. It can be helpful to family mem-bers trying to settle an estate and continue manage-ment of your property after death. The task issimpler if they know what property is owned,where it is located, and the details associated withit.

Although you rely upon your attorney and othermembers of the estate planning team, don’t turnyour estate planning problems over to them andforget it. Be sure you understand your plan—whatis in the will, and what it will do for you. If youknow the provisions, you are in a better position toknow when a will or trust needs to be changed.

Remember that if you have a great deal of propertyin joint tenancy and the value of your estate isgrowing, there may be tax concerns. If your estateis at the $675,000 level and still increasing, thereare likely to be good reasons for considering a shiftout of joint tenancy.

Employee BenefitsFor those of you who are employees, consider youremployee benefits. Check with the employer—there may be death or retirement plan benefits. Besure that beneficiary designations are compatiblewith your plan and wishes.

These benefits may be subject to death tax. Thereare typically a number of choices to be made interms of how benefits should be paid, also. Oftenthere are provisions for a surviving spouse or otherdependents in retirement programs. Be sure youunderstand the death, retirement, and otherbenefits in the employee package.

A Team ApproachDeveloping the total plan—including tax aspectsand property disposition—suggests a need for ateam approach. A key person, of course, is yourattorney, who can help you in developing anintegrated plan to accomplish your objectives. Anaccountant, who can help on tax and financialmatters, also may be part of the team. A life insur-ance representative and a trust officer, if you arethinking of a trust, also could be useful membersof the estate planning team. If your plan involvesone or more charitable organizations, a full-time

charitable giving officer may be a useful teammember.

ChangesIn the process of developing an estate plan, oneshould study all possible arrangements, discuss theplan with the family, and obtain competent advice.Services of an attorney are essential.

Once the plan is developed, it is advisable toreview the plan periodically to be sure it continuesto accomplish current objectives. Your degree ofwealth, marital status, or objectives might change,any one of which might call for a review of theplan. Or laws may change as they have in recentyears.

A will can be changed or amended with a codicil—an amending document executed with the sameformality as the will itself. It is not necessary toredraft the old will completely to make minorchanges. The codicil must be in writing, signed bythe testator and witnessed by at least two disinter-ested parties. You cannot amend the will simply bywriting in the margin or by crossing out particularprovisions.

A will may be revoked by making out a new willthat expressly revokes the former one, or bydestroying the original will completely.

Finally, this publication was designed to reviewsome of the relevant points to consider, the prob-lems involved and the tools available in estateplanning. Emphasis has been placed on the need toexamine alternatives and the consequences offailing to plan. The series was not intended tomake participants “instant experts” in estateplanning. Because of the breadth of the area andthe complexities, it was necessary to omit somedetails and to summarize.

In brief, this series was designed to identify themajor points to consider in planning an estate forthe greatest benefit of the person and his or herloved ones. It has indicated the major tools avail-able, some of the pitfalls, and some of the com-plexities. With this knowledge, you should be ableto discuss estate management more competentlywith your legal adviser. The fundamental objective,of course, is the development of a plan designed toaccomplish your goals now and for the foreseeablefuture.


Unified Rate Schedules for Federal Estate and Gift Tax*Amount from which tentative tax is computed Tentative tax

Not over $10,000 18 percent of such amountOver $10,000 but not over $20,000 $1,800 plus 20 percent of the excess of such

amount over $10,000Over $20,000 but not over $40,000 $3,800 plus 22 percent of the excess of such








amount over $500,000Over $750,000 but not over $1,000,000 $248,300 plus 39 percent of the excess of such

amount over $750,000Over $1,000,000 but not over $1,250,000 $345,800 plus 41 percent of the excess of such

amount over $1,000,000Over $1,250,000 but not over $1,500,000 $448,300 plus 43 percent of the excess of such

amount over $1,250,000Over $1,500,000 but not over $2,000,000 $555,800 plus 45 percent of the excess of such

amount over $1,500,000(The rate continues upward on a graduated scale to 55 percent above $3,000,000)

*Before allowance of credits

Credit for State Death Taxes Paid

Adjusted taxable estate* Maximum tax credit

Not over $90,000 8/10ths of 1 percent of the amount by which thetaxable estate exceeds $40,000

Over $90,000 but not over $140,000 $400 plus 1.6 percent of the excess over $90,000

Over $140,000 but not over $240,000 $1,200 plus 2.4 percent of the excess over $140,000


Over $440,000 but not over $640,000 $10,000 plus 4 percent of the excess over $440,000


Over $840,000 but not over $1,040,000 $27,600 plus 5.6 percent of the excess over $840,000

(The credit amount continues upward to $10,040,000 on a graduated scale.)

*Federal estate tax taxable estate minus $60,000.

Other Legal Affairs Programs

In addition to the series on estate planning, threeother videotape programs are available throughoffices of Iowa State University Extension. Theseprograms, featuring Neil E. Harl, include:

Organizing the Farm Business—A series of 12programs designed to help you understand thelegal aspects of organization of the farm business.A reference publication by the same title is avail-able.

Civil Liabilities—Twelve programs looking atlegal rights and responsibilities of both farmers andurban dwellers. Reference publication also avail-able.

Publications

The following ISU Extension publications on legalaffairs are available through your county extensionoffice.

PM 782 Civil Liabilities: Legal Considerations forIndividuals, Families and Firms

NCR 11 The Farm Corporation

PM 878 Organizing the Farm Business

CRD 112 Township Trustee and Clerk Orientation

E FILE: Economics 3-1

. . . and justice for all

The U.S. Department of Agriculture (USDA) prohibits discrimi-nation in all its programs and activities on the basis of race,color, national origin, gender, religion, age, disability, politicalbeliefs, sexual orientation, and marital or family status. (Not allprohibited bases apply to all programs.) Many materials can bemade available in alternative formats for ADA clients. To file acomplaint of discrimination, write USDA, Office of Civil Rights,

Room 326-W, Whitten Building, 14th and Independence Avenue,SW, Washington, DC 20250-9410 or call 202-720-5964.Issued in furtherance of Cooperative Extension work, Acts of May8 and June 30, 1914, in cooperation with the U.S. Department ofAgriculture. Stanley R. Johnson, director, Cooperative ExtensionService, Iowa State University of Science and Technology,Ames, Iowa.

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