Estate Planning for Forest Landowners - Southern … · Estate Planning For Forest Landowners ... This book has been written to assist nonindustrial ... only the decedent can address

Forest Service

Southern ForestExperiment Station

New Orleans,Louisiana

General Technical Reportso-97September 1993

Estate Planning forForest LandownersWhat will Become of Your Timberland?

Harry L. Haney, Jr., and William C. Siegel

Summary

Funding f~ this book was provided by the USDA Forest Service’sCooperatii,e Forestry Staff. S:ate and Private Forestry. Dr. Karen LIU,Fmnce and Tax Specialist in the Washington, DC, Cooperative ForestryOffice, administered the project, Dr. Wil!im-~ 1,. Howe: of PurdueLniversity prwided rechnical review.

Estate Planning

For

Forest Landowners

What Will Become of Your Timberland?

Harry L. Haney, Jr., and William C. Siegel

Harry L. Haney, Jr., is professor and extension specialist, Forest Management-Economics, Departmentof Forestry, Virginia Polytechnic Institute and State University, Blacksburg, VA 24061-0324; WilliamC. Siegel is volunteer chief economist, Forest Resource Law and Economics, U.S. Department ofAgriculture, Forest Service, Southern Forest Experiment Station, New Orleans, LA 70113 and a memberof the Louisiana Bar.

CONTENTS

PARTI. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1Chapter 1. The Importance of Forestry Estate Planning ............................... 3

Forest Ownership .................................................... 3BookPolicy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Readiness Questionnaire ................................................ 4

Chapter 2. Estate Planning Considerations and Objectives ............................. 7The High Cost of Dying Unprepared ........................................ 7Estate Planning Considerations Peculiar to Forestry ............................... 8A Forest Management Plan as Part of the Estate Plan .............................. 15Specific Objectives ................................................... 16Estate Planning Team for Forest Landowners ................................... 17

Chapter 3. The Federal Estate and Gift Tax Process ................................. 19Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19UnifiedRates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19UnifiedCredit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19Determination of Gross and Taxable Estate .................................... 19

Chapter 4. Valuation of Assets for Estate and Gift Purposes ............................ 23General Considerations ................................................. 23Special Considerations ................................................. 24Forest Land and Timber ................................................ 24Discounting for Minority and Undivided Interests ................................ 29

Chapter 5. The Legal Process .............................................. 33Basis of the Law ...................................................... 33Wills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34Power of Attorney .................................................... 34Probate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

PART II. APPLICATION OF GENERAL ESTATE PLANNING TOOLS TO FORESTRY .......... 37Chapter 6. Use of the Marital Deduction in Estate Planning ............................ 39

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39Qualifying for the Marital Deduction ........................................ 39Exceptions to Terminal Interest Rule ........................................ 39Qualified Terminal Interest Property and the Marital Deduction ........................ 40To What Extent Should the Marital Deduction be Used? ............................ 40How to Make a Marital Deduction Bequest .................................... 42

Chapter 7. Disclaimers, Settlements, and Elections To Take Against the Will ................. 45General Considerations ................................................. 45Disclaimers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45Charitable Disclaimers ................................................. 46Will Settlements ..................................................... 46Election Against the Will ............................................... 46

Chapter 8. Gifts of Forestry Assets i .......................................... 47Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47Gifting Tax Considerations .............................................. 47Basic Gifting Strategies ................................................. 49GiftstoMinors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50Gifts Within 3 Years of Death ............................................ 52Charitable Gifts ..................................................... 53

i

Chapter 9. Generation-skipping Transfers ....................................... 59General Provisions ...................................................

Chapter 10. Role of Trusts ................................................zy

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61Basic Considerations .................................................. 61Tax Treatment of Trusts ................................................ 62Types of Trusts and Applications ...........................................Use of Trusts in Marital Deduction Planning ...................................

“63

Trustees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69Trust Applications for Forestry ............................................

Chapter 11. Life Insurance ................................................‘77

Role of Life Insurance ................................................. 75Types of Insurance ...................................................

Estate and Gift Tax Considerations .........................................‘77

Choice of Beneficiaries (Including Contingencies) ................................ 78Other Considerations ..................................................

How Much Insurance is Enough? ..........................................‘7;

Chapter 12. Installment Contracts ............................................ 81General Provisions ...................................................

Estate Planning Considerations ............................................“8:

Installment Obligation Dispositions at Death .................................... 83Installment Sales by the Estate ............................................ 84

PART III. APPLICATION OF FORESTRY-SPECIFIC ESTATE PLANNING TOOLS ............. 85Chapter 13. Special Use Valuation ............................................ 87

Reduction in Value ...................................................

Qualifying Conditions ..................................................f33

Election and Agreement ................................................ 91Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Postdeath Requirements ................................................ 93The Election Decision ................................................. 95

Chapter 14. Deferral and Extension of Estate Tax Payments ............................ 97Overview of the Estate Tax ..............................................

Estate Tax Option for Closely Held Business Interests ..............................!Y$

PART IV. FORM OF TIMBERLAND OWNERSHIP AND BUSINESS ORGANIZATION .......... 103Chapter 15. Sole and Joint Ownership Considerations

Sole Ownership:C_lz

. ... ........

.........................................................................

Joint Ownership Between Spouses

.........................................................................................................................................

105Chapter 16. Partnerships ..

Definition of a Partnership:(I;

Partnership Attributes 109Estate Planning with Partnerships

Chapter 17. Corporations ... ....

..................................................................................................................................................................................................................

: ii

Corporate Formation and Management 113Income Tax Implications of Incorporation 114Estate Planning Considerations

...................................................................................Chapter 18. Limited Liability Companies: :z

Overview . . . .Organization and Operation

................................................................................................................................................................................................

f;;

Tax ConsiderationsImplications for Timber Properties

t;y

ii

Chapter 19. State Death Tax Considerations ...................................... 123Types of State Death Taxes .............................................. 123Combined Federal-State Tax Ljability ........................................ 123

Appendixes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127Appendix I. Glossary ................................................. 129Appendix II. Additional Readings .......................................... 133Appendix III. State Death Tax Credit Table ................................... 135Appendix IV. Form 706. United States Estate (and Generation-Skipping Transfer) Tax Return .... 137Appendix V. Form 709. United States Gift (and Generation-Skipping Transfer) Tax Return ..... 182

. . .111

PART I

INTRODUCTION

Chapter 1

The Importance of Forestry Estate Planning

FOREST OWNERSHIP

Forests comprise one-third of the Nation’s land.Almost three-fourths of this woodland--about 350million acres--is privately owned. Most of theprivate holdings, some 283 million acres, belong tononindustrial owners. A nonindustrial private owneris one who does not have a primary wood-processingplant, that is, an owner who is not classified as aforest industry. Nonindustrial private owners control60 percent of the total commercial forest lands in theUnited States.

A Diverse Group

There are nearly 8 million nonindustrial privateforest landowners. More than 6 million hold theirforest properties either as sole proprietors or innonformal family ownerships. These two categoriesaccount for 55 percent of the nation’s private wood-land acreage. The remainder of the nonindustrialforest is owned by family corporations, family part-nerships, or various other types of ownership entities.The typical nonindustrial owner is over 50 years old.Nearly one in five is retired. Almost half of theprivate forests in the United States are in ownershipsof more than 500 acres, with an additional 31 percentin ownerships of 100 to 500 acres.

Forest land and timber values have been risingrapidly in many parts of the country in recent years.Often market values reflect factors other than com-mercial timber production. At the present time,normal estate valuation rules pose a real danger formany estates with substantial woodland holdings.Without proper estate planning, forced liquidation offamily forests or severe disruption of managementregimes is a distinct possibility.

What Can Happen?

Have you thought of retiring soon to try theprojects that you have always wanted to do on yourtree farm while you still have good health andenergy? Are the thinnings, timber stand improve-ments, hiking trails, and the cabin by the creek stillfeasible? But, can you afford to retire and still enjoya satisfactory lifestyle? Are the children educated

3

and independent? How will the retirement affect yourtimber investments?

Going one step further, if you die today, what willhappen to the timberland that you and your spouseperhaps have worked a lifetime for? Will your forestmanagement program be disrupted in order to ade-quately provide for your spouse and children in anequitable manner? Will the woodland continue tofunction efficiently and will your spouse have adequatecontrol? Are your forestry investments structured sothat they will not lose value at your death? Will thetimber management plan continue to function as aneffective tool for your spouse to follow? Have stepsbeen taken to minimize death taxes, or will timber orland or both have to be sold to pay debts?

Examples abound of forested estates that were prof-itable during the decedent’s lifetime, but had to be par-tially or entirely liquidated to settle estate debts andpay death taxes. Also, in unplanned situations, theheirs may quarrel over the settlement of the estate anddissipate valuable forest resources.

BOOK POLICY

Purpose

This book has been written to assist nonindustrialprivate landowners in addressing the considerationsenumerated above. It is designed to provide aworking knowledge of the Federal estate and gift taxlaw as it relates to estate planning for timberlandowners. The unique character of timber assets isaddressed in terms of the estate planning goals of awoodland owner. The purpose is to enhance, notreplace, communication with estate planning advisors,and to make estate planning more efficient throughunderstanding the process as an informed timberlandowner. In all cases, well-qualified professionaladvisors are essential.

Educational, Not Legal, Advice

The discussion and examples presented here shouldbe regarded as educational, not legal, advice. Thefacts and circumstances of one’s personal situation--goals, financial portfolio, land and timber inventory,

and special considerations--should be carefullyreviewed with an attorney ‘and estate planningadvisor. The applicable laws and regulations, whichare often both complex and dynamic, must be appliedin the context of a specific situation and economiccircumstances before making legal and financialdecisions. The book is written within the frameworkof Federal law, but an understanding of the applicableState law that affects the ownership, management,and transfer of timberland assets should also beincorporated into estate planning deliberations.Because State law varies widely among the 50 States,much of it is beyond the scope of this publication.

Structure

This book has four major parts plus an appendixwith a glossary, selected Internal Revenue Service(IRS) tables, selected tax forms, and a list of selectedadditional readings on estate planning. The founda-tion for estate planning is developed in part I. Estateplanning considerations and objectives, the planningprocess, and valuation principles are discussed. Inaddition, the Federal estate and gift tax process, andthe legal basis for estate planning, are addressed.

The general estate planning tools are explained inpart II and integrated with forestry examples. Theseinclude use of the marital deduction, disclaimers, andstrategies for gifting forestry assets. The role oftrusts, life insurance, and installment contracts inestate planning are also discussed.

Part III is concerned with forestry-specific estateplanning tools. The planning and requirements nec-essary to qualify for and effectively utilize special

use valuation, and the deferral and extension ofFederal estate tax provisions is covered in detail.

The various forms of timberland ownership andtheir relationship to forestry estate planning arediscussed in part IV. Alternative business structuresfor timber estates, including the advantages anddisadvantages of each, are also addressed.

In part IV, chapter 19, State death taxes are treated.The basic features of the statutes in each State arediscussed.

Forestry examples are used throughout the text toexplain the use of various estate planning tools. Thecase examples draw from several regions of the UnitedStates and incorporate combinations of strategies fromwhich to choose, depending on particular goals.

READINESS QUESTIONNAIRE.

As indicated above, effective estate planning is anongoing process consisting of three major components.The first concerns effective management of the estateassets during the decedent’s lifetime. The secondcomponent, building on the first, is concerned withensuring that the transfer of estate assets at death willbe made in accordance with the decedent’s wishes,with a minimum of problems and with minimum taxliability. The third encompasses nontax situations thatonly the decedent can address during his (her) lifetimethrough personal understanding of family circum-stances and their interaction with effective planning.At this time, take a few minutes to complete theReadiness Questionnaire on the following page (fig.1.1).

4

YtS No1. I have discussed the requirements for cash in the event of my spouse’s death. I have knowledge of the

estimated Federal and State death taxes, as welI as the debts and other costs, payable at that time.

2. Specific plans exist to satisfy immediate financial needs in the event of my spouse’s death.

3. I know what estate planning can accomplish, have set the objectives for my own estate plan, and havediscussed with my spouse a plan for continued management of the family’s timberland.

4. Both my spouse and I have complete and up-to-date wills.

5. I understand the reason for probate and how it functions.

6. I know how to use trusts as an estate-planning tool for saving taxes, lessening probate costs, andmanaging my assets.

7. My spouse and I know how to use the marital deduction for Federal estate tax saving.

8. I am aware of the tax savings available by using the gift provisions of the tax law.

9.

10.

11,

12.

13.

I understand the importance of life insurance in my estate planning.

I am aware of my spouse’s life insurance policies and how to shelter policy proceeds from Federalestate tax.

I understand the different ways to hold timber property in my estate and the advantages anddisadvantages of each.

I know how much family income will be received from retirement plans, social security, annuities, andother sources.

Both my spouse and 1 know how to contact our attorney, accountant, banking officer, and lifeinsurance agent. We both know where important documents are stored.

Check the appropriate blank to the left of each statement.

Figure 1.1 .--Estate Planning Readiness Questionnaire.

5

Chapter 2

Estate Planning Considerations and Objectives

THE HIGH COSTOF DYING UNPREPARED

Do you have an estate plan? The answer is “yes”!Even if a person has not expressed his (her) desiresby writing a will, the State in which a person islegally domiciled has a plan for disposing of his (her)property. In fact, all States have laws of descent anddistribution. If an individual has not exercised theright to specify who will receive his (her) property atdeath, State law provides a general plan of rules thatapply. The major exceptions are joint tenancieswhere property passes to the surviving tenant and lifeinsurance contracts where the proceeds pass to thenamed beneficiary. Generally, the State’s plan canbe improved upon because there are a number of con-siderations that State law does not address. Simplystated, the rules are specific as to who gets theresidue of the estate after the “transfer costs” havebeen paid.

Unexpected Heirs

When a person dies intestate (without a will), theState laws of descent and distribution determine whathappens to his (her) property. The surviving spouse,children, parents, brothers and sisters, and otherrelatives are considered in more or less that generalorder. State law does vary in this regard, however,and becomes more complicated where second andthird marriages are involved--especially when thereare minor children. State statutes rarely consider theneeds of the heirs, their contributions to the estate, orthe tax consequences of the distribution.

Unexpected Values

The fair market value (FMV) of appreciated realestate, closely held stock, jointly held property, andother low current return interests may greatly exceedthe value attributable to such property from currentcash flows. Fair market value also exceeds valu-ations based on the use value of the assets (discussedin chapter 13). The Internal Revenue Service (IRS)focuses estimates of value on the “highest and bestuse” of the property, preferring market transactions

7

evidence of value wherever possible. Therefore, IRSvaluations may be much higher than the valuesascribed to estate assets by the executor.

Transfer Costs

Transfer costs include Federal and State deathtaxes, and probate and estate administration expenses.

Federal and State D eath Taxes.- -Th e Federal deathtax law encompasses a unified transfer tax on taxablelifetime gifts, combined with property passing atdeath, in calculating tax liability. The gift and estatetax rates effectively begin at 37 percent on taxablevalues in excess of the $600,000 exemption equivalent.They increase progressively to 55 percent on amountsover $3 million (the Federal estate and gift tax processis discussed in more detail in chapter 3). Many Stateshave an estate or inheritance tax law that imposesadditional death taxes. These can amount to as muchas 20 percent of the Federal tax cost. Other Stateshave adopted what is commonly called a “pick-uptax,” which makes the State tax equal to the credit forState death taxes allowed on the Federal estate taxreturn. In this case, no additional tax is owed; thus,it is important to know State law for planning pur-poses. State death taxes are discussed more com-pletely in chapter 19.

Probate and Adm inistration Expenses.- -Th e cost ofprobate (see chapter 5) and estate administrationexpenses comprise the other so-called “transfer costs.”At least some States have statutory limits for probatecosts that are associated with small estates.Thresholds for the applicable amounts under smallestate laws vary from approximately $5,000 to$100,000. On estates exceeding the threshold, probateexpenses may amount to as much as 8 to 9 percent ofthe gross value of the estate. Generally, these costsgradually fall to approximately 5 percent of the grossestate value as estate size increases to $1 million.Wide variations within these parameters are possible,however, depending on State law and the complexityof the estate. On larger estates, the charges shoulddrop even more as a percentage of value if no undueproblems are encountered. Administration and relatedcosts incurred by the executor will be in addition tothe cost of probate. Of course, major problems can

sharply escalate legal costs--for example, a legalchallenge to the will.

On a $1 ,OOO,OOO taxable estate (gross estate minusall permitted deductions as explained on page 21)the total average settlement costs (Federal estate taxplus administration expenses equal to 5 percent ofthe estate) would be $203,000 (see table 2.1). Thisamount increases to $688,000 on a taxable estate of$2,000,000. Note that on a $10 million estate thetotal transfer cost has risen to over 54 percent of thetaxable value. State death taxes are not included inthese estimates.

Loss of Leadership and Income

The owner’s leadership and skill may be indispen-sable in successfully managing the timber property.Knowing boundary locations; having good relation-ships with neighbors, consultant foresters, loggers,and reforestation contractors; having an under-standing of silviculture; and having timber marketingexperience are all part of a knowledge base oftenbuilt up over a long period of time. This experiencemay be difficult or impossible to replace in the shortrun. At the owner’s death this leadership will belost.

Nonindustrial forest owners are typically in an agegroup where they are at the peak of their earningpower. At death these earnings will be missed.

Shrinkage Because of Liquidation

When business assets have to be sold to pay taxesand administration expenses or to retire indebtedness,shrinkage losses can often amount to 40 percent ormore of the estate. These losses can result from poormarket timing, breakup of efficient working units,premature disposition of assets and unfavorable finan-cial arrangements. Partitioning the resources of anestate among the heirs may also have unfavorableconsequences both in terms of valuation and manage-ment.

Ancillary Probate

Ancillary probate proceedings are generallyrequired when real property is held in more than oneState. The additional legal costs increase the estate’soverall administrative expenses.

ESTATE PLANNING CONSIDERATIONSPECULIAR TO FORESTRY

Estates with substantial timber values often havemany of the problems described above. They alsomay have additional problems that arise from theunique nature of the timberland asset and the economicclimate in which the timber owner operates. Thefinancial returns to timber investments are driven bythree primary factors: timber growth (site productiv-ity), timber markets (stumpage price), and the cost ofcapital (interest rate). Landowner investment andharvest decisions interact in complex ways with thesefactors which in turn are substantially influenced byFederal and State income and death tax considerations.

Illiquidity of Land and Timber Assets

Land “dedicated” to timber production is character-ized by a very long investment horizon. Timely andappropriate management decisions are important inorder to establish and maintain the necessary level oftimber growing stock to match earning potential. Thisimportance is illustrated in the value growth curves forloblolly pine shown in figure 2.1. Here land has aconstant price of $300 per acre with no inflation orreal price appreciation. Timber value growth is basedon site 60 yields (base age 25) without thinning. Site60 is an average site for much of the south. Stumpageprices are constant and are shown at three levels--high,medium and low--taken from Timber-Mart South.’Note that timber income becomes possible only afterage 15. Values then increase rapidly until approxi-mately age 30, but thereafter increase at a decliningrate.

The effects of the price level are shown by the threecurves and illustrate the importance of developing stra-tegies that make it possible to obtain the higher price.Because value is a function of price and volume, thesecurves serve as a proxy for both site quality and stock-ing level. As stocking levels fall, the value growthcurve will shift downward reflecting the reducedpotential of forestry’s financial returns over time as aresult of inadequate investment in growing stock.Similarly, poor land will result in lower positioncurves that reflect the reduced production potential.Thus, combinations of low price, poor stocking,and/or poor site serve to reduce the responsiveness

‘Timber-Mart South is a timber price reporting service for theSouthern States that is published quarterly by Timber-Mart South,Inc., P.O. 1278, Highlands, NC 28741.

Table 2.1.-- Th e high cost of dying--average settlement costs at death based on Federal estate tar after 1992, plus anaverage administration cost of 5 percent.

Taxablee s tate

Fe d e ralestate tax

Adm inistratione xpe n s e

Totalsettle m e n t

cost

--_________---______--___

100,000 0200,000 0

300,000 0

400,000 0

500,000 0

600,000 0700,000 37,000800,000 75,000900,000 114,000

1 ,ooo,ooo 153,0001,250,000 255,500

1,500,000 363,0001,750,000 475,5002,000,000 588,0002,250,ooo 710,5002,500,000 833,0003,000,000 1,098,OOO

3,500,000 1,373,ooo

4,000,000 1,648,OOO5,000,000 2,198,OOO6,000,OOO 2,748,OOO7,000,000 3,298,OOO8,000,OOO 3,848,OOO

9 ,000,000 4,398,OOO10,000,000 4,948,OOO

._DOl~~S______________

5,00010,00015,00020,00025,00030,00035,00040,00045,00050,00062,50075,00087,500

100,000112,500125,000150,000175,000200,000250,000300,000350,000400,000450,000500,000

5,00010,00015,00020,00025,00030,00072,000

115,000159,000203,000318,000438,000563,000688,000823,000958,000

1,248,OOO1,548,OOO1,848,OOO2,448,OOO3,048,OOO3,648,OOO4,248,OOO4,848,OOO5,448,OOO

9

G-T - -- - - L o w P r i c e

:“-M e d . P r i c e

j -H i g h Price

0 -04

: -3-: -0 -

:2-

0 5 10 15 2 0 2 5 3 0 3 5 4 0 4 5 5 0 5 5T I M E ( Y E A R S )

Figure 2.1.-- Land and timber values per acre for loblolfy pine plantations at constantprices on site 60, base age 25 (average site for the South). Timber valueequals volume @ieM) times price.

of timber investments by lowering revenues andlengthening the rotation, which in turn increasesilliquidity.

Uncertainty caused by long time horizons limits thepotential number of buyers in the market for timberproperty. Consequently, marketing skills, timing,and luck are usually all necessary in order to obtaintop prices when selling timberland. As tract size andvalue increase, the number of potential buyers maybe further restricted simply by the financiallimitations.

The example just discussed is for southern pinetimberland. However, the basic principles that areillustrated should apply for most species in most partsof the United States.

While the biological process of stand value growthis regular and predictable, timber stumpage pricesbehave is a much less predictable fashion, sometimeswith wide fluctuations over relatively short periods oftime. Volatile prices often follow sharp, irregularprice cycles (see fig. 2.2). For example, the averageprice of Douglas-fir rose from $169.50 per thousandboard feet (MBF) in 1975 to $432.20 per MBF in1980--an increase of 155 percent in 5 years. It thendropped precipitously by 73 percent to $118.20 perMBF in 1982. Six years later, in 1988, the price had

10

risen to $256.00 per MBF. As further evidence ofprice volatility, the stumpage price of export gradeDouglas-fir was approximately $700 per MBF duringthe summer of 1992, and some observers predict aprice of $1,000 per MBF by 1994 because of court-mandated withdrawals from the timber supply base inspotted owl habitats.

In other regions, stumpage price fluctuations havebeen less dramatic but, nevertheless, important tolandowner marketing strategies. In the South, forexample, southern pine prices increased graduallyfrom $57 per MBF in 1975 to $172 in 1981--anincrease of 202 percent over 6 years. In 1982, theprice dropped to $127.00 per MBF and ultimately to$90.70 by 1985--a decline of 47 percent in 4 years.By 1993, prices in many parts of the South hadincreased dramatically to between $250 and $300 perMBF. Of course, changes such as these do not matterunless timber is actually sold when prices are high.Generally, however, volume and quality will continueto increase throughout the investment period.

The cost of capital, or the interest rate, is a criticalinput because forestry is a capital intensive investment.Land committed to growing trees has an “opportunitycost,” because it could be sold and the income invested

- - P i n eD o u g l a s - f i rH a r d w o o d /’

I \I \

1 9 6 0 1 9 6 5 1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 8 8T I M E ( Y E A R S )

Figure 2.2.-- Stumpage price series: 1960-88 (Source: Ulrich, Alice H. 1989. U.S.h’mber production, trade, consumption andpn’ce staristics 195G87. Misc.Pub. 1471. Washington, DC U.S. Department of Agn’culture, ForestService. 77p.)

elsewhere. Similarly, a reforestation investment must land and timber. The value growth curve is identicalbe carried for the length of the rotation. Annual to the medium price curve in figure 2.1. An optimumoperating and management costs also accumulate and investment length for the assumed inputs--site prep-increase the direct burden of holding young timber aration and planting, $150 per acre; annual man-until it becomes merchantable or of holding mer- agement costs and property taxes, $5 per acre; a no-chantable trees for additional growth. Any increase thin management regime with stumpage prices of $15in the interest cost will discourage holding growing per cord for pulpwood, $35 per cord for chip-n-sawstock and shorten the rotation. This is illustrated in logs, and $135 per MBF for sawtimber--is approxi-figure 2.3 with an 8.24-percent compound interest mately 25 years at a cost of capital of 6 percent.curve--cost/income curve--that begins with the cost of There is a decision window of plus or minus approxi-reforestation in year zero and includes the mately 3 years, which causes little change in theintermediate annual expenses of property taxes and potential income to be received if the stand ismanagement costs (the cost aspect of the curve). The harvested prior to the optimum rotation curve or8.24-percent rate is the internal rate of return (IRR). carried beyond that point. The decision windowIt is found by setting the sum of dis-counted costs shows one of the key advantages of a timber invest-equal to the sum of discounted revenues for this ment (that is, trees store well and continue growing).investment and solving for the interest rate that makes First, the owner has the flexibility to take timberthem equal. An example of this calculation is shown income when it fits best with other ownership goals.in the valuation section of chapter 4. The Second, the owner can try to maximize income bycost/income curve not only represents the accum- marketing when he (she) feels that it will bring theulating cost of carrying the investment in refores- highest stumpage price. Any combination of prompttation and annual expenses, but it also shows the reforestation (to minimize costs), low interest rates,income potential of expected returns from its point of and low annual costs that hold down the cost curvetangency with the value growth (liquidation) curve of will increase the rotation length and the maximum

11

5_ _ _ . . L a n d- - - - L i q u i d a t i o n

C o s t / I n c o m e5.a4

+_______ . . . . . . . . .._.. _ ._....II “0, ’ ” I ‘I n n 1 (‘I’ I I I ‘I 1 n c 1 r 1 r I”0 5 10 1 5 2 0 2 5 30 35

T I M E ( Y E A R S )

Figure 2.3.-- Timing of timber investment and harvest decisions based on cost/incomeand liquidation values (loblolly pine on an average site with a net presentvalue at 6.00 percent and an internal rate of return at 8.24 percent).

price that can be paid for land to grow trees. Simi-larly, any combination of increased price, highervalue products, and higher yields shifts the valuegrowth curve upward, shortens the rotation, and alsoincreases the maximum price that can be bid for land.This is another way of saying that costs, prices, andland productivity are logically connected. The lowerthe costs--such as land, reforestation, taxes, andinterest charges--and the higher the returns--such astimber sale prices, hunting leases, and incentivepayments, if any--the higher will be the rate of returnon the tree farm investment and its asset value, andvice versa.

Low, Irregular Income

Low Zncome.--Low or inadequate returns on for-estry assets often result from premature harvesting,overcutting, and underinvesting in reforestation andmaintenance of timber growing stock. The result isthat the potential of the timberland is not realized.This condition has basically the same effect asshifting the value growth curve down (see fig. 2.1).Thus the rotation becomes longer, and there is lesstimber to harvest.

Irregular Income.--Irregular income occurs forsimilar reasons because most nonindustrial privatetimber properties are not managed to provide an evenflow of income. The average tenure of nonindustrialwoodland holdings is approximately 10 years, whereasa timber rotation may vary from 25 to 50 years. Thentoo, the average owner’s age is well over 50 years.This combination of age and relatively short tenuresuggests that sporadic cash flows will be the usualcase. Even in all-aged stands, excess cutting or highgrading (cutting the best trees without regard for thefuture stand) will invariably disturb the cuttingschedule and contribute to irregular income.

There are four revenue zones in even-aged foreststands that further illustrate the potential for low,irregular income (see fig. 2.4) under various circum-stances. The revenue zones vary by species, site, age,and condition of the growing stock. The followingsouthern and western management regimes illustratethe point.

1. Southern regime--even-aged loblolly pine standson average sites (site index 60, base age 25).a. The income potential for premerchantable

trees of 1 to 12 years of age, if liquidated

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b.

I II III

- - L a n d- - L i q u i d a t i o n

Cost / l ncomeN e t P r e s e n t V a l u e

0

Figu re 2.4.--

5 1 0 1 5 2 0 2 5T I M E ( Y E A R S )

Timber income liquidity Zones on a per acre basis and the decision windowfor jinal harvest based on cost/income and liquidation values (loblolbpine on an average site with a net present value at 6.00 percent and aninternal rate of return at 8.24 percent).

severed from the or land (zone I) is the unit cost for handling each productpractically zero (see fig. 2.4). Note, decreases, and as timber volumes per acrehowever, that the cost/income curve shows increase, the harvesting cost per acrethat land and timber is an appreciating asset decreases. Both situations contribute to anthat begins increasing in value from the time increase in the net value of stumpage for theof reforestation. From a practical point of landowner. However, note that a harvest inview, there is some evidence that actual zone II will result in a sacrifice in total netprices in zone I may be more heavily revenue as illustrated by the gap (verticaldiscounted by the market than the internal distance) between the liquidation curve forrate of return reflected by the cost/income land and timber and the cost/income curve forcurve in figure 2.4 would suggest.’ land and timber values (see fig. 2.4).

In zone II, the income potential improves c. An optimum financial rotation occurs in zonewith opportunities to thin for pulpwood or to III. This is the harvest timing that gives theliquidate chip-n-saw logs (small sawtimber) highest rate of return or the greatest increasein stands aged 13 to 18 years. This is a in owner wealth. It is shown in figure 2.3 asperiod of very high rates of value the point where the slope of the liquidationappreciation as trees increase in merchant- (value growth) curve equals the slope of theable size. The increase in size yields a cost/income curve. The stand value con-product mix that crosses the threshold tinues to increase, but at a decreasing rate,between pulp fiber and solid wood products whereas the cost/income curve is geometric-and contributes to the rise in value. This ally increasing. This zone includes timberpotential increase is greatest where sharp from 19 to 28 years of age, depending on sitedifferentials exist among different classes of quality, silvicultural practices, and theproducts--pulpwood, chip-n-saw, and saw- discount rate. The decision window for atimber. As individual tree volumes increase, final harvest extends to 3 or 4 years on either

13

2

side of an optimum rotation for a particularset of assumptions so that the potential forloss of income is minimized. Landownergoals, estate goals, and the market hold thekey to optimum harvest decisions forparticular sets of circumstances.

d. The final zone (zone IV) extends beyond astand’s economic maturity (30 to 40 years).Here income losses occur from a decelera-tion of the rate of value appreciation becauseof insect and disease losses and decreasedvigor. Such losses reduce the actual rate ofreturn far below the opportunity for a higherrate of return from a new stand. Manyfactors may influence a landowner’s decisionto hold onto timber until it enters this zone.For example, it is often said, “That (timber)is my insurance policy! It is like money inthe bank.” Some owners are also reluctantto pay the income tax on harvest profitsfrom highly appreciated stands, or theyvalue esthetics or let other considerationsinfluence their decisions.

Western regime--primarily Douglas-fir standson average sites. The same landowner con-siderations come into play, but other factorssuch as growth rates, scale of operations, landuse history, the influence of public timberownership, and regulations produce a vastlydifferent management environment that affectslandowner decisions. Thresholds between thezones are constantly changing as utilizationstandards, timber prices, and other inputs vary.Increased demand and the resulting higherprices have altered the economics of growingprivate timber in the West in the last decade.

a. The zone of limited income from mostlypremerchantable trees occurs from ages 1 to25 years if they have to be liquidated orsevered from the land (zone I). Valueappreciation rises at increasing rates overtime, but actual values may be heavilydiscounted by the market.

b. Limited income potential is possible forthinning in pulpwood and small sawtimberstands of 26 to 35 years of age (zone II).These stands are also in the zone of veryhigh rates of value appreciation fromingrowth as increases in timber size cross

the threshold from pulp fiber to solid woodproducts (zone II).

Excellent income potential is possible as tim-ber matures into sawlogs, peelers for ply-wood, and export material within plus orminus 5 years of an optimum rotation in therange of 36 to 50 years of age (zone III).

The rate of financial return declines as timberis held beyond its economic maturity(approximately 51 years plus) due to lossesfrom insects, diseases, decreased vigor, andthe opportunity cost of a new stand (zone IV).

Continuity of Management

Continuous long-term management under a well-defined set of goals is the most effective way to insureefficient timber production from forest holdings. Thisgoal is clearly desirable from a societal point of view.From an owner’s perspective, its primary importanceis from the standpoint of keeping timber assets produc-tive. Continuity of management, however, for all itspublic and private benefits, is often at variance with anowner’s immediate goals and personal situation. Manyvariables affect an owner’s particular management andharvest decisions that may interrupt the continuity ofmanagement associated with an optimum return asdepicted in figure 2.3. As noted above, the averagetenure of nonindustrial private timberland owners is arelatively short 10 years. Even with larger holdingsthat have longer average tenure, the holding periodrarely approaches a typical rotation cycle of 25 to 40years in the South, and longer in the North and West.Within these short time frames, Federal tax lawsfurther complicate the intergenerational transfer oftimber property, thus contributing to the liquidation ofgrowing stock and disrupting management continuity.Partitioning the estate often produces similar results.Careful planning is required to insure continuity ofmanagement and the attendant benefits.

Unitary Nature of the Forest

Economies of scale in management, harvesting, andreforestation are generally achieved only on holdingsof perhaps 1,000 acres or more. The exact size willdepend on site quality, species mix, markets, and othervariables. There is a rather well-defined inverserelationship between tract size and the unit cost of

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production. That is, as woodland size increases thecost per acre of reforestation, harvesting, andmanagement operations will decrease.

An even flow of timber and other outputs can beachieved only on holdings large enough to have adiversity of timber stands, age classes, and species.For example, if one assumes a 40-year rotation,defines the minimum operable stand size as 20 acresfor cultural treatments, and wants income every 5years, a 160 acre [(40 years/5 years) x 20 acres]minimum of operable land stocked with age classes at5 year intervals is required. If annual income isdesired, an 800 acre minimum holding would berequired (clearcut management with no thinnings isassumed). The problem, however, is that age classesare rarely uniformly distributed, and the distributionsthat do exist are upset as family changes or estateproceedings require liquidation to raise cash. Amanagement plan can help to solve some of thesedifficulties.

Fragmentation of timberland holdings is encour-aged by real estate practices and estate tax policies.Consider a 1,000 acre timber property with four par-cels of approximately equal size, which have ageclasses that differ by 10 years per parcel. In theaggregate, an even flow of income and low cost man-agement is possible. At the owner’s death, however,one parcel each passes to the surviving spouse andthree children (the values were equalized externallyto account for the different levels of growing stockon each parcel). In the absence of a family agree-ment to the contrary, the death will disrupt the flowof timber income, and the cost of management opera-tions will increase. A forest management plan willnot prevent this outcome if the respective parties donot reach an agreement that encompasses continuityof management for the entire acreage.

Example 2.1. Consider the 1,000 acre propertynoted above, which is located on four parcels ofapproximately equal size. The timber correspondsroughly to the four zones of figure 2.4. A timbermanagement plan will include an inventory of thetree farm’s timber stands by species, age, andcondition. An operational plan will project andtreat each stand based on the owner’s goals(including the estate plan, if desired). The optionsfor a 40-year rotation (investment period from seedto harvest) are illustrated by the cutting cycle:(1) harvest 25 acres per year from mature timberin zone IV for an even flow of wood products, (2)harvest 250 acres in every lo-year period when the

highest prices are expected, (3) harvest the growthfrom all merchantable timber on a 5-year cuttingcycle, (4) cut timber when the family needs money,and (5) many combinations of the above. The planwill depend on the timber market, family needs forincome, and the biological condition of the forest.A forester can transform the tree farm inventoryinto the most effective operational plan to meetowner goals and to utilize the maximum potential ofthe forest.

Diffkulty in Obtaining Credit

Forests are unimproved real estate and largelyunproductive in zones I and II (see fig. 2.4). Atimberland owner, typically over 50 years of age, withstanding in the community and with forestry experi-ence, should have excellent credit. It may be moredifficult initially for surviving spouses to obtain credit,if they do not have a proven credit record of theirown. It may be even more difficult for the children.The loss of income and family leadership exacerbatethe problem of credit worthiness when coupled withliquidity needs of the family to cope with estate trans-fer costs. This is an important issue to address in theplanning process.

A FOREST MANAGEMENT PLANAS PART OF THE ESTATE PLAN

The primary goal of estate planning is the accumu-lation and conservation of wealth, including its transferto heirs or other beneficiaries. With respect to timber-land in the estate, a forest management plan is essen-tial to both the goal of producing income and to that ofpreserving the land’s inherent productivity. The planshould have both an operational and a strategic dimen-sion. An operational plan focuses on the productionof net income over a relatively short planning horizon,typically 5 years. Beginning with the current inven-tory, all forestry operations during this period,together with their related costs and revenues, arescheduled. These would include such activities as thin-nings, harvest/reforestation decisions, timber standimprovement work, and wildlife management prac-tices. Annual budgets within this plan are developedto meet owner objectives, subject to the constraintsimposed by the timber inventory and the marketenvironment.

15

A good plan has the flexibility to make adjust-ments: (1) in revenues as owner needs and/or marketconditions fluctuate, (2) on expenditures as liquidityand the cost of capital vary, and (3) as unexpectedexternal factors such as changes in public policies andcasualty losses interject themselves.

The short-term operational plan functions logicallywithin the context of a strategic plan, which isdeveloped to meet long-term forest management goalsfor the timberland. Species selection, stocking levels,and rotations are addressed in the strategic plan, aswell as the relationships among timber, wildlife,esthetics, and other goals.

In developing a forest management plan, the scopeand sophistication will depend on the particular factsand circumstances of each situation as noted above.For limited acreage and modest timber values, a rela-tively simple plan may enable an owner to achievehis (h e r) timberland objectives. As the acreage andtimber values increase, however, the attentiondevoted to the plan should increasingly reflect theinvestment in the resource and its potential earningcapacity.

SPECIFIC OBJECTIVES

The members of the family perhaps will have some,difficulty in agreeing on the planning objectives forthe estate and its timber property. It may not be easyto do, but it is necessary for development of theestate plan. Problems arise because most estate planshave multiple objectives. Invariably, conflicts ariseamong the competing objectives that must be solvedbefore progress on the plan can be made. It is rarelypossible to satisfy all objectives completely, sopriorities have to be established for allocation of thetwo primary estate resources--income and property.Timing, equity, organization, and tax strategies areamong the more common considerations to beaddressed in the planning process. Timing deals withthe choices between current and future consumption(that is, enjoyment by this generation or the next).Equity deals with the shares of inheritance among theheirs, special needs of certain family members, andcontributions by various family members in buildingthe estate. The form of ownership or business organ-ization often must be decided in terms of who will bein control and whose philosophy of management willprevail. Tax saving strategies must be integratedwith the other goals in a way that retains a balanced

plan. Maximum tax savings may not always be themost desirable end. Finally, there is the element oftrust. If members of the immediate family and the in-laws do not have respect and trust among themselves,the planning effort becomes more difficult.

Pre- and Postretirement Security

Adequate resources should be allocated for thefinancial security and well-being of the estate ownerbefore and during retirement. Involvement in manage-ment activities and professional interests may beimportant in retirement. Planning for continuity ofbusiness activities is discussed below.

Security and Compassion for Family

The financial security, comfort, and happiness of thesurviving spouse, either husband or wife, shouldperhaps be the highest priority for most plans. Theability of the survivor to care for the children, managedaily affairs, and deal with grief due to the decedent’sdeath must be considered. With most estates, the hus-band and wife have worked together for many years toaccumulate the estate assets and often at considerablesacrifice. The death of either spouse is usually fol-lowed by a period of adjustment with respect to bothpersonal and business affairs. Arranging for the sur-vivor’s comfort and happiness during this time willdepend greatly on the amount and types of assetsreceived from the estate, and on the control that thesurvivor has over his (her) resources.

State law usually provides for a surviving spouse tohave certain minimum rights in the real and personalproperty “solely owned” by the deceased spouse,regardless of what may be stipulated in a will. Thefurther implications of property ownership will bedeveloped in part IV. Proper planning can determineif the amount to be left to the survivor in the event ofeither spouse’s death will be adequate. Specificadjustments can then be made, if necessary, by meansof a will--subject to State law. Wills are discussed inmore detail in chapter 5.

Equitable Treatment of Children

State laws of descent and distribution generallyprovide for equal distribution of property amongchildren. Although equal distribution is desirable inprinciple, it may not be satisfactory in terms of thespecific needs of disadvantaged children, nor does it

16

necessarily reflect a particular child’s contribution tobuilding the estate or caring for the parents duringtheir aging years. Other considerations include: (1)a large investment in a particular child’s education,(2) an extra investment in one child’s business orpurchase of a home, (3) a financial contribution froma child to the parents in money or in kind, (4) carefor children with physical or mental handicaps, and(5) differing contributions in managing the woodland.Equitable adjustments for these types of situations canbe specifically addressed by the will and other plan-ning techniques. A realistic assessment of workingrelationships among children and in-laws is essential.In the absence of a will, State law will control thedistribution of the decedent’s property.

Continuity of Timber Enterprise

The time required to settle an estate will generallyvary between several months and several years,depending on the complexity of the settlement. Plansshould be made for continuity of management of thewoodland, or assets and opportunities can quicklydisappear. It is essential to take advantage offavorable timber markets within the context of theforest management plan and to make timely invest-ments in reforestation and cultural practices that keepthe assets productive. Protection from timber tres-pass, theft, and natural hazards (insects, diseases, andwildfire) is also important. Proper planning willinsure that an operational timber management plancontinues in force. The will or other instrumentshould direct that business operations of the estatecontinue during the critical transition period.

The long-term plan must recognize the needs andcontributions of both spouses, as well as those of thechildren. It should also be structured to the greatestextent possible to insure continued operations afterthe death of the decedent.

Minimize Transfer Costs

Generally, one of the principal goals of estateplanning is to minimize the impact of transfer costsat death. As discussed earlier, transfer costs includeFederal and State death taxes, probate expenses, andthe costs of administering the estate.

Minimizing Ta Liabilities.--Careful attention to thetax consequences of property disposal is required.Gifts made during the decedent’s lifetime may be

subject to gift taxes. Gifts have specific advantagesand disadvantages that are discussed in chapter 8.Property given to the spouse during the decedent’s lifeor at death is shielded from tax by the maritaldeduction, but this only defers the ultimate payment ofthe tax as discussed in chapter 6. State death taxes,which vary greatly in scope among States, must alsobe considered. Careful planning is required tominimize taxes without jeopardizing other objectives.This requires that a husband and wife make a funda-mental choice: (1) minimize taxes at both deaths andpass the maximum value to the children, or (2) mini-mize taxes and other costs at the death of the firstspouse, leaving the surviving spouse with the maxi-mum possible wealth and control over estate assets.The latter approach will ultimately cost the childrenmore in estate taxes and administrative costs.

Minimizing Administrative Costs.--Certain steps canbe taken to reduce administrative costs, and even toavoid probate, but at the cost of flexibility and perhapsadditional taxes. Because all choices have advantagesand disadvantages, they should be carefully consideredin terms of the overall objectives.

Provide Flexibility and Durability of Plan

There are always tradeoffs in saving estate taxes.Rigid plans rarely work well over long periods of timebecause of changes in the law and the economy. It isgenerally best to choose an executor who can betrusted to make decisions that benefit all concerned tothe maximum extent possible and to provide the flexi-bility to do so. However, where necessary to protectthe interests of a specific heir, the desired outcomeshould take precedence over flexibility.

ESTATE PLANNING TEAMFOR FOREST LANDOWNERS

Attorney

The family attorney usually has the primary respon-sibility for coordinating the estate planning process.If he (she) lacks sufficient knowledge of the Federaland State laws affecting the transfer of real and per-sonal estate assets, an attorney specializing in estateplanning should be engaged. When particular compli-cations exist or difficulties in the business operationswarrant, expert help is well advised. The attorneyguides the formation and articulation of owner

17

objectives, supervises the inventory of personal dataand estate assets, and works with other professionalsto evaluate alternative estate planning strategies. Theattorney drafts the will and other legal documents thatare required to execute the completed estate plan,including supervision of changes in property titlesand insurance beneficiaries to conform them to theplan.

Certified Public Accountant (CPA)

A CPA understands the complex interplay amongthe estate, gift, and income tax laws, and preparesand files the appropriate tax returns and other taxdocuments. Because he (she) typically has access tothe client’s financial and tax records, the CPA candiscuss appropriate estate-planning opportunities.

Banker

A banker, who may be both lender and corporatetrustee, often has an awareness of the financial needsof the estate. The banker can help explain the finan-cial and tax aspects of alternative planning choices.He (she) has expertise in the trust department that canbe utilized during the decedent’s lifetime and alsolater by the survivors and has knowledge of howvarious types of trusts can help meet specific estateplanning objectives. The role of trusts in estateplanning is covered in chapter 10.

Chartered Life Underwriter (CLU)

A CLU can develop an insurance program that willprovide the kind and amount of life insurancerequired to meet the estate’s estimated financialneeds. The purchase of life insurance can providethe liquidity necessary to cover the estate’s transfercosts, insure protection of estate assets, and buildestate assets at critical times. In some States,insurance consultants offer professional estate plan-ning evaluations for a fee that is dependent only onthe service provided rather than on the sale of aparticular insurance package. The recommended

insurance coverage can then be purchased from thecompany of choice, with consideration being given toprice as well as to the company’s strength and rating.

Forester

A forester is not a member of the traditional estateplanning groups; nevertheless, he (she) provides aninvaluable service if there are substantial timber assetsin the estate. A forester can prepare a forest manage-ment plan that specifically addresses estate-planninggoals and functions as an integral part of the overallestate plan. The forest management plan will includeprojections of capital expenditures and managementexpenses on the cost side, and projected timber reve-nues on the income side. These projections are thenworked into operational plans that meet net revenuetargets specified by the owner’s estate plan objectives.Operational plans are typically prepared for 5-yearintervals as part of the longer range strategic manage-ment plans. The strategic plan is designed to providea long-range view of cash flow levels that are consis-tent with the amount and distribution of the timberassets. The forester routinely brings management,marketing, and harvesting skills to the planning pro-cess, but often has knowledge of timber tax issues andhow they interact with other estate considerations.

Inventory

Consultations with professional advisors should bepreceded by a personal fact-finding process thatincludes an analysis of the family situation, and cur-rent and projected lifestyle desires and financial needs.The fact-finding process also includes an inventoryencompassing the description, form of ownership, andvalue of all estate assets. Legal descriptions of all realproperty, locations of deeds and other important docu-ments, and all indebtedness should also be listed.Projected values for all assets should be made for thenext 5 years. The forest management plan will pro-vide the basis for timber volume and value projections.Insurance policies, beneficiary designations, and policyoptions need to be reviewed.

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Chapter 3

The Federal Estate and Gift Tax Process

BACKGROUND

Since 1916, the Federal government has imposeda tax (the estate tax) on the transfer of a decedent’sestate, and since 1932, a tax (the gift tax) on theintervivos (lifetime) transfer of property byindividuals. Over the years, the two taxes haveundergone many changes; prior to 1977 they wereindependent of one another. Since that year,however, the two levies have been companion taxesthat must be considered together in the context ofestate planning.

UNIFIED RATES

Federal estate and gift tax rates were unified intoone rate schedule by the 1976 Tax Reform Act. Therate brackets for both gifts and estates becameidentical at the time. As shown in table 3.1, the ratesin the unified schedule range from a low of 18 to ahigh of 55 percent on transfers over $3 million. Anadditional 5-percent surtax was imposed through 1992on transfers in excess of $10,000,000 but notexceeding $21,040,000. After 1992, the top amountfor the 5percent surtax dropped to $18,340,000.

UNIFIED CREDIT

The 1976 Act also established a unified estate andgift tax credit to offset taxes owed. The credit hasbeen increased in steps; it reached its current maxi-mum of $192,800 in 1987. This amount effectivelyshields $600,000 (the exemption equivalent) of estateand/or gift assets from Federal taxes. As can be seenby examining the rate schedule in table 3.1, the low-est effective estate/gift tax rate is now 37 percentbecause of the fully phased in credit.

The use of the credit begins with taxable giftsmade during the decedent’s lifetime. It is mandatorythat the credit be applied to such gifts--no tax isactually paid on a taxable gift until the credit iscompletely used up. Thus, some or all of the creditmay be exhausted during a decedent’s lifetime and,therefore, not be available for use by his (her) estate.

Gifts are discussed in greater detail in chapter 8,including what does and does not constitute a taxablegift. The value of a gift for gift tax purposes is its fairmarket value on the date of the gift. .

DETERMINATION OF GROSSAND TAKABLE ESTATE

Gross Estate

The gross estate is defined as the value of allproperty, both real and personal and both tangible andintangible, owned by the decedent on the date ofdeath, or in which he (she) had an ownership intereston the date of death. Thus, the first step in the estatesettlement process is a complete inventory of the estateassets.

Valuation.- - Once property interests have been estab-lished, they must be valued. Valuation of both timberand nontimber assets is discussed in detail in the nextchapter. The general rule, however, is that propertycomprising the gross estate must be valued at fair mar-ket value either as of the date of death or as of thealternate valuation date. Special use valuation is alsopossible for timber property and certain other types ofestate assets as discussed extensively in chapter 13.Fair market value is defined as the price at which theproperty would change hands between a willing buyerand a willing seller, neither being under any compul-sion to buy or to sell and both having reasonableknowledge of all of the relevant facts.

The estate assets may be valued as of the datefalling 6 months after the decedent’s death (alternatevaluation date) if two tests are met: (1) alternatevaluation decreases the value of the gross estate, and(2) it results in a decrease in the net Federal estate taxpayable. The alternate valuation election must bemade on the first estate tax return filed and applies toall property in the gross estate. The executor may notalternately value some assets and not others. Thereturn may be filed late without invalidating the elec-tion if it is filed no later than 1 year after its due date.The election is also irrevocable--at least after the timefor filing has expired.

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Table 3.1-- Federal unzjied estate and gQi tax rate sch edule

Amount on Which TentativeTax is Computed

Tentative Tax

Not over $10,000 18 % of such amount

Over $10,000 but not over $20,000









Over $750,000 but not over $1 ,OOO,OOO

Over $l,OOO,OOO but not over $1,250,000

Over $1,250,000 but not over $1,500,000

Over $1,500,000 but not over $2,000,000

Over $2,000,000 but not over $2,500,000

Over $2,500,000 but not over $3,000,000

Over $3,000,000

$1,800 plus 20% of the excess of such amount over $10,000









$248,300 plus 39 % of the excess of such amount over $750,000

$345,800 plus 41% of the excess of such amount over $1 ,OOO,OOO

$448,300 plus 43 % of the excess of such amount over $1,250,000

$555,800 plus 45 % of the excess of such amount over $1,500,000

$780,800 plus 49% of the excess of such amount over $2,000,000

$1,025,800 plus 53 % of the excess over $2,500,000

$1,290,800 plus 55% of the excess over $3,000,000

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Taxable Estate

The definition of taxable estate is the value of thegross estate less all permitted deductions. Theseare six in number: funeral expenses, estateadministration expenses, debts, casualty and theftlosses, the charitable deduction, and the maritaldeduction.

Funeral Expenses.- -Th ese include the costs ofinterment, the burial lot or vault, grave marker,future care of the grave site, and transportation tobring the body to the burial place. Funeral expensesmust be reduced by any reimbursement from theVeterans Administration for funeral expenses and anyfuneral expense benefit payable to other than thedecedent’s spouse by the Social SecurityAdministration. The Internal Revenue Service (IRS)takes the position that, if a decedent’s estate is notprimarily liable for payment of the funeral expenses,no deduction is allowed for Federal estate taxpurposes unless the decedent’s will directs that thefuneral expenses be paid out of the decedent’s estate.

Adm inistration Expenses.- -Th ese include costsincurred for collection and preservation of estateproperty, payment of estate debts, and distribution ofestate assets. The IRS considers only thoseadministration expenses “actually and necessarily”incurred for such purposes to be deductible.

De&.--These are personal obligations of thedecedent that exist at the time of death, includinginterest accrued to the date of death. Theyencompass such obligations as mortgages, liens,unpaid income taxes on income includable on a returnof a decedent for the period prior to his (her) death,unpaid gift taxes, unpaid property taxes accrued priorto death, and unpaid medical expenses as of the dateof death. Medical expenses incurred by the decedentthat are paid within 1 year of death may be deductedeither on the estate tax return or on the decedent’sfinal income tax return. Interest expenses accruingafter death on debts incurred prior to death generallyare not allowed as a deduction. Several courts,however, have not always followed the IRS positionon this and have allowed such interest to be deductedif reasonable and necessary for administration of theestate.

Casualty and Th e ft Losses. - -Th e se may be deductedif they occur during estate settlement and prior todistribution of the asset in question to the beneficiary.The deduction is reduced to the extent that the loss is

offset by insurance or other compensation and to theextent that it is reflected in alternate valuation if suchvaluation is elected. A casualty or theft loss may bededucted on either the estate tax return or the estate’sincome tax return--but not on both.

Ch aritable D eduction.- -A deduction is allowed forestate assets that are transferred by the decedent’s willto specified public or charitable entities or uses.These include: the Federal government, a Stategovernment, and State political subdivision entities ifthe transferred assets are used exclusively for publicpurposes; corporations organized and operated (notnecessarily in the United States) exclusively forreligious, charitable, scientific, literary, or educationalpurposes; and veterans organizations incorporated byan act of Congress. There is no limitation on theamount of the charitable deduction, but it cannotexceed the net value of the property that passes tocharity as reflected in the gross estate.

Marital Deduction.- -Th e value of certain propertyinterests passing from the decedent to his (her)surviving spouse is permitted to be deducted from thedecedent’s gross estate. Treasury Regulation20:2056(e)-2(e) provides that in case of simultaneousdeath, a presumption (whether by local law, will, orotherwise) that one spouse or the other was the first todie will be recognized.

Determination of Tax Due

The next step is to compute the tentative tax on thesum of the taxable estate plus adjusted taxable gifts.Adjusted taxable gifts are defined as the total amountof taxable gifts made by the decedent after December3 1, 1976, other than those gifts includable in the grossestate. Life-time gifts that must be included in thegross estate are discussed in chapter 8. The rateschedule is then applied to this total, resulting in thetentative tax.

Once the tentative tax is determined, it is reduced bythe gift taxes (those previously paid plus those not yetpaid) on gifts made after December 31, 1976. Theresult is the gross estate tax. The tax payable on apost-1976 lifetime gift is the amount owed on that giftafter the gift tax otherwise payable is reduced by theunified credit. The estate tax reduction for gift taxespaid on such gifts is based on the rate schedule ineffect on the date of death, not on the rate schedule ineffect at the time of the gift, if the two are different.

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Credit Reductions

Once the gross estate tax is determined, it isreduced by certain credits to determine the net taxdue. There are five such credits: the unified creditdiscussed earlier, the State death tax credit, the creditfor Federal gift taxes on pre-1977 transfers, theforeign death tax credit, and the credit for Federalestate taxes on prior transfers.

Unifie d Credit.--The amount of the unified creditavailable at the decedent’s death ($192,800 minus anycredit used for lifetime gifts) will be reduced if thedecedent made a taxable gift at any time afterSeptember 8, 1976, and before January 1, 1977.Prior to unification of estate and gift taxes in 1977,a specific life-time gift exemption of $30,000 waspermitted. The unified credit must be reduced by 20percent of the exemption allowed for a gift madeduring this period. For example, if the decedent hadmade a gift on October 15, 1976, and used his (her)entire lifetime exemption of $30,000, the unifiedcredit would be reduced by $6,000 (20 percent of$30,000).

State D e ath Taxes.--A limited credit for State deathtaxes is allowed (see appendix page 134). It isdetermined by applying a rate schedule to the valueof the taxable estate reduced by $60,000.

Gift Tax Cred it.- -Th is credit is determined by firstcomputing the tax on the cumulative total of lifetimeand death taxable transfers. The tax previously paid(or payable) on the lifetime transfers is thendeducted.

Estate Tar Cred it.- -A credit is allowed for theFederal estate tax paid on transfers to the decedent ofproperty from a transferor who died within 10 yearsbefore or 2 years after the decedent’s death. Thecredit is the smaller of: (1) the amount of the Federalestate tax attributable to the transferred property inthe prior decedent’s estate or (2) the amount of theFederal estate tax attributable to the transferredproperty in the present decedent’s estate. If thetransferor dies within 2 years before or 2 years afterthe decedent’s death, full credit is allowed. If thetransferor dies more than 2 years before the decedent,

the credit is reduced by 2 percent for each 2-yearperiod.

Fore ign D e ath Tax Cred it.- -A credit is allowed forforeign death taxes paid with respect to property in thedecedent’s estate if the property is actually situated ina foreign country. The credit is the lesser of theforeign death tax or the Federal estate tax attributableto the property.

Estate Tax Computation

Example 3.1. Assume that the decedent died in1988 with a gross estate valued at $607,800. In 1979,the decedent had made a lifetime gift of propertyvalued at $253,000 to his daughter. He had filed agift tax return and paid a net gift tax of $34,800(tentative gift tax of $70,800 minus the unified creditavailable at that time of $38,000). There were noother lifetime gifts.

The decedent’s gross estate includes the gift taxespaid but not the value of the gift. The taxable portionof the gift, however, is added to the taxable estate todetermine the tentative tax, as discussed above,because the gift is not included in the gross estate.The net estate tax is computed as follows:

Gross estate

Minus debts andadministrative expenses

Taxable estate

$607,800

f107,800)

500,000

Add ad’usted taxablegifts ($$53,000 minusthe $3,000 annual exclu-sion that prevailed in1979)

Taxable amount

Tentative tax

Minus gift tax paid (orpayable)

Gross estate tax

Minus unified credit

Subtotal

Minus State death taxcredit

Net estate tax due

250,000

750,000

248,300.

( 34,800)

213,500

(192,800)

20,700

f10,000~

$ 10,700

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Chapter 4

Valuation of Assets for Estate and Gift Purposes

GENERAL CONSIDERATIONS

The unified estate and gift tax is an excise tax thatis generally levied on the fair market value (FMV)of property that is gratuitously transferred. TheTreasury regulations define FMV as:

. . .the price at which property would changehands between a willing buyer and a willingseller, neither being under any compulsion tobuy or to sell and both having reasonableknowledge of the relevant facts.

Valuation of estate and gift assets is thus a criticalcomponent of estate planning. In arriving at thetaxable base on the date of transfer, FMV is deter-mined on the basis of “highest and best use” ratherthan on the use to which the property is actuallybeing put at the time of the transfer. Although thetwo uses may be the same, often they are not. Anexception to the FMV rule permits certain propertyto sometimes be valued on the basis of actual use ifsuch value is lower than fair market value. Theapplicability of this rule to timber properties isdiscussed in chapter 13.

Establishment of FMV for certain estate assets issometimes an elusive process. The estate plannermust, therefore, anticipate disagreements over valu-ations of some types of property. If the value of anitem on the estate tax return is challenged, the lawpermits an executor to require the Internal RevenueService (IRS) to furnish, within 45 days of therequest, a statement indicating: (1) the basis for theIRS’s conflicting valuation; (2) any computationsused by the IRS in arriving at value; and (3) a copyof any expert appraisal made for the IRS.

Undervaluation

A “valuation understatement,” resulting in penal-ties, occurs if the value of any property listed on anestate or gift tax return is two-thirds or less of theamount determined to be the correct valuation. Agraduated penalty, as follows, applies:

(1) for claimed valuations between 66 2/3 and 50

percent of the correct value, 10 percent of the taxliability understatement;

(2) for claimed valuations between 50 and 40 per-cent of the correct value, 20 percent of the taxliability understatement; and

(3) for claimed valuations less than 40 percent ofthe correct value, 30 percent of the tax liabilityunderstatement.

The penalty does not apply if the understated taxliability is less than $1,000. The IRS may waive all orpart of the penalty if it can be shown that there was areasonable basis for the valuation claimed and that itwas made in good faith.

Interaction between Stepped-up Basisand Estate Tax

In some cases, undervaluation, even though it maysave estate taxes if unchallenged, could be detrimentalfrom an income tax standpoint, particularly for timberproperties. The timber (as does all other estate prop-erty) receives a stepped-up basis for income tax pur-poses equal to its valuation on the estate tax return. Inthe event the timber is subsequently sold by either theestate or the heirs, the higher the basis, the lessincome tax due. The basis is deducted from the saleproceeds to determine taxable gain. The taxpayer’scombined income tax marginal rate (State plusFederal) could, in some instances, be higher than themarginal death tax rate (Federal estate tax plus Statedeath tax). Undervaluation on the Federal return insuch a case would result in a higher total tax bill(death taxes plus income taxes) than would otherwisebe the case with no undervaluation.

State Death Tax Considerations

If the estate is not large enough to require filing aFederal estate tax return, the same caution applies.The State death tax marginal rate always will be lessthan the Federal and State combined marginal incometax rate. Undervaluation of timber on the State deathtax return in such a case will mean a higher incometax bill than would otherwise be the case, when thetimber is subsequently sold.

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SPECIAL CONSIDERATIONS

Closely Held Corporate Stock

Many nonindustrial timber ownerships are part ofclosely held family corporations. The decedent’sstock in such a business is usually an illiquid asset.For estate and gift tax purposes, it can present diffl-cult valuation problems. Because there is no estab-lished market, what valuation criteria should be used?Sales within the family are not reliable. And, as dis-cussed earlier, a penalty may be imposed if the valuereported is two-thirds or less of real value.

Factors to Consider.--Although many factorsshould be considered in valuing closely held cor-porate stock, a number are common to most situa-tions.

(1)

(2)

(3)

(4)

(5)(6)(7)

(8)

These include:the nature and history of the business--such asthe degree of risk, products produced, ser-vices provided, operating assets, and capitalstructure;the economic outlook and conditions for thespecific industry in question;the book value of the stock and the financialcondition of the business;earning capacity (usually considered the mostimportant factor);dividend-paying capacity;good will or other intangible value;prior arm’s_length (on an objective andimpersonal basis) sale of stock; andthe market price of stock of similarcorporations.

Depending on the circumstances, some of these fac-tors carry more weight than others. Generally, in afamily-owned timber corporation, the greatest weightis accorded to the underlying timber assets. Thecourts have allowed discounts of 10 to 50 percentbecause of the difficulty of selling closely held stock,especially for minority interests.

Partnership Capital Accounts

Many nonindustrial timber properties are also heldin family or nonfamily partnership form. A partner’scapital account in the partnership is initially equal tothe value of money and property that he (she) con-tributed to the partnership. It subsequently alsoreflects the partner’s share of profits minus any lossesor distributions. Under State law, unless the part-nership agreement provides otherwise, the death of a

partner terminates the partnership and requires a dis-tribution of the partnership assets in proportion to therespective capital accounts. From an estate tax pointof view, it might be argued that, on dissolution, onlythe net asset value of the decedent’s capital accountshould be valued. But the IRS also considers the valueof the business as a going concern--the price a willingbuyer would pay and a willing seller accept for theassets, goodwill, and demonstrated earning capacity.This valuation would particularly be true if the part-nership continues rather than is dissolved.

Life Insurance

The value of a life insurance policy owned by thedecedent, on the life of a person other than thedecedent, is generally the amount the company wouldcharge for a comparable policy on the date of thedecedent’s death. An insurance policy on the life ofthe decedent that is includable in his (her) gross estatehas a value equal to the proceeds payable by thepolicy. Chapter 11 discusses in more detail underwhat circumstances life insurance proceeds are includ-able in an estate and when they are not.

Future Interests

The value of property transferred by gift, whichbecomes effective at the donor’s death or at someother future time, is determined by reference togovernment valuation tables that provide the actuarialvalue of the interest The same procedure applies toa property interest transferred at death but which doesnot become effective until a designated future date.The tables apply to such things as annuities, lifeestates, term interests, remainder interests, andreversions--all of which will be discussed in moredetail later.

FOREST LAND AND TIMBER

Timberland values reflect the general state ofbusiness in the economy that affects the demand andsupply of timber products. The demand for timber isaffected by many factors such as overall incomelevels, employment, supply of mortgage funds, andinterest rates. The supply of timber in the market isaffected by such things as population changes, rate offamily formation, the building cycle, and the generalavailability of land.

24

Methods of Valuation

There are three principal methods used to valuereal estate including timberland. These are the markettransactions (comparison), income, and costapproaches. One of these methods is usually selectedas the primary procedure, but a second or even athird approach may be used as a check for accuracyif the other methods are applicable and appropriatedata are available. In practice, all methods areultimately related to the market.

Mark et Transactions.--Fair market value based ona comparison of the “subject property” to similarproperties (that is, comparable sales) is generallyregarded as the most reliable method of valuation.Value is based on the price for which similar assetswere sold under comparable conditions at or near thesame time.

The price paid for property is an expression of theproperty’s fair market value in terms of dollars at thatpoint in time. This expression of value must be veri-fied with respect to the relationship of the parties, theterms of sale, date of sale, and the effect of inflation.For price to equal value, buyers and sellers must dealon an objective and impersonal basis. Transactionsamong family members or business associates arealways suspect. When terms other than cash areinvolved (that is, mortgages, long-term contracts,etc.), they must also reflect current market conditionsfor the value-to-price relationship to hold. Favorableterms of sale may reflect hidden benefits. Forexample, a lower than market interest rate will causethe price in question to understate the property’s truevalue. Similarly, undisclosed terms that are unfavor-able could also cause the price to mask the truevalue.

The timing of a transaction is also an importantfactor in estimating an asset’s value. Here theimportant date is the actual “meeting of the minds” ofthe buyer and seller rather than the date of recordingthe deed or other paperwork for the record. The salevalue is then adjusted to reflect the interval that haselapsed between the sale date and the present. Theadjustment, of course, is to the extent possible adetermination of fact and not necessarily easy infor-mation to obtain.

Finally, the effect of inflation on the purchasingpower of the dollar is a critically important factorwith respect to transactions that occur at differenttimes. Contracts that do not adjust for inflation may

distort estimates of value, if not properly accountedfor in the appraisal process. Transfers in which theassets are encumbered by a mortgage or by contractterms that prevent the price from reflecting true valueshould be avoided for comparison purposes.

Income Approach .- -Th e income method of valuationis based on the discounted net present value of futureincome expected from the property plus the presentvalue of the property remaining at the end of theincome period. The future values are discounted tothe present using a chosen interest (discount) rate.Reasonable estimates of future revenues and futurecosts may be obtained for many business situationsbased on past experience. Future values cannot beknown with certainty, but the discounting processweighs the near term cash flows more heavily thanthose that will occur in the more distant future. Thismakes the choice of the discount rate very critical. Itshould reflect the opportunity cost of the resourcescommitted to the project as opposed to an alternativeuse. One problem is that prior experience does notaccount for future technological change.

It is essential that the components in an incomeapproach calculation of net value be expressed in thesame terms with respect to inflation, taxes, and depre-ciation.

Cost Approach .- -Th e cost approach to valuation isbased on the estimated cost of replacing an asset withan item of similar quality and utility. The cost and thevalue of an asset, however, are not necessarily thesame. Cost equals value only if the asset is new or tobe purchased. Caution must be exercised in estimatingdepreciation when adjusting for obsolescence.

Furthermore, cost equals value only when the prop-erty in question is being utilized in its “highest andbest” use. Many properties have been over-improvedor under-improved. For example, the excessive costfor bridge standards higher than necessary for efficientmanagement will not be reflected in value. Finally,cost must be economically warranted. Cost reflectsthe commitment of material and labor resources,which have an opportunity cost for other uses, butwhose value represents the right to the present valueof the future net income stream. Replacement cost islimited by the market to the cost of an item of com-parable quality to that being replaced. This is fre-quently different from reproduction cost due toimprovements in both materials and managementmethods, whether for trees or other properties.

25

Valuation of Bare Land

In valuing forest land, the market transactionsapproach is generally the most reliable. However, ifappropriate data are available, the income approachmay also be used as a check for accuracy. The costapproach, is inappropriate for bare land because noadditional supply of land can be created. Obsoles-cence, a key component of the cost approach, is avalid consideration only with respect to improvementsto property--such as bridges, fences, and buildings--but not with respect to the land itself or to trees,which are an appreciating asset. Similarly, an exces-sive cost for mechanical site preparation, versuschemical use at a lower cost and to obtain the sameresults, will not be reflected in land values.

Mark et Approach to Value.- -Th e most reliablemethod of estimating land value compares the prop-erty to sales of similar properties in comparablelocations within the same time period. This is themethod preferred by the IRS. If the market is activeand there are a sufficient number of valid comparablesales, the market approach will give a satisfactoryestimate of the land’s value.

The most important requirement with respect to themarket approach is access to current sources of landsale data. Land sale information can be found in titleinsurance company records, the local tax assessor’sand county clerk’s records, appraisers’ and consultingforesters’ tiles, and real estate brokers’ sales files.Several sources may be used to obtain a sufficientvolume of transactions to evaluate the level ofeconomic activity, price trends, and shifts in timberindustry growth patterns.

The price and terms of a sale used for valuationpurposes should be verified with either the buyer orseller or both. Sales of timberland have traditionallybeen private, and the public may not receive a truepicture of the factual circumstances of the transaction.The price paid may differ from a price paid in theopen market due to financing terms, relationship ofthe parties, or other collateral factors. The time ofthe comparable transfer should also be accuratelydetermined in order to make economic adjustmentsfor the time value of money, inflation, and otherprice influences. If these cannot be determined withconfidence for a particular transaction, the transactionshould not be included in the sample for comparativepurposes.

With respect to timberland, there are many vari-ables that should be taken into account in order for

sale transfers to be comparable. These include siteproductivity, operability and accessibility of theproperty, the proportion of the tract that is productive,parcel size, location with regard to markets, and regu-latory constraints. Because land is characterized by itsunitary quality, immobility, indestructibility, and non-homogeneity, the timberland market tends to be highlylocal in character. Even the assumption of indestruc-tibility must sometimes be altered for the effects oferosion, soil compaction, and chemical pollution thatmay alter productivity and ultimately value. Mostcomparable sales include both land and timber, andmany reflect alternative uses of the land.

Incom e Approach to Value.- -W ith this method, thevalue of land is based on its income-producingcapacity (productivity) in its “highest and best use.”This approach is used when market transactions arelimited or nonexistent for comparisons with the prop-erty of interest. The income from the land during aninvestment cycle is what is left after all the costs ofproduction--labor, management, maintenance, and theopportunity cost of capital-are deducted. If thisamount is capitalized (discounted to the present) at anappropriate interest rate, the result is an estimate ofthe present value of the property. Generally, an indi-vidual investor’s interest rate is his (her) highest“alternative rate of return” if the funds were to beinvested elsewhere. Discounted revenue minus dis-counted costs for one investment period is known asnet present value. Net present value calculated for aninfinite investment horizon of timber rotations isknown as land expectation value. It is the maximumbid price for land suitablie for growing timber with theassumed cash flows.

Determining the “highest and best use” is a criticalassumption of the income approach to valuation ofbare land. Again, the unitary nature of land must beconsidered. For example, a timber property with goodroad frontage may have a higher value for the areasnear the road for strip real estate development than fortimber growing. The negative impact on the balanceof the property would have to be considered if forestmanagement operations were restricted in the highervalued areas. All such negative impacts should benetted against development revenues in determinationof the “highest and best use” for such properties.

Valuation of Merchantable Timber

Timberland in an estate is frequently valued as aunit; that is, separate valuations are not determined for

26

land and timber. This is a mistake that should not bemade. Serious income tax consequences could result,due to the lack of an identifiable timber basis, whentimber is subsequently sold.

Mark e t Transactions Approach .- -Th e market valueof merchantable timber is what the trees would sellfor under the utilization standards used in theparticular market area of the timber property. Thevalue will be influenced by many factors, such asspecies, tree size, product class, quality, total volumeon the tract, and accessibility. Timber markets, likeland markets, are highly localized. Because logs arebulky and transportation is expensive, the market areafor most products is constrained. The higher the perunit value of a timber product, the greater the scopeof its market area. For stumpage used for fiber, thatis firewood, pulpwood, and chipped wood products,the truck haul radius is usually 100 miles or less.Poles, piling, and veneer quality logs, on the otherhand, may be transported much greater distances.

If timber must be cut to realize income, it is theliquidation value today rather than the timber’spotential value that counts. This is the value shownby the liquidation curve in figure 2.3. Althoughmany comparable sales include the value of the land,the timber value alone can be readily established bya timber cruise.

Incom e Approach .- -Th e value of merchantable tim-ber below rotation age in even-aged stands can beestimated by the income method. This approachpresumes an optimum rotation cycle, or at least anassumed management regime where the expectedvalue of the future harvest and the management costscan be estimated. The expected timber revenue lessdiscounted costs and the discounted terminal value(land expectation value as discussed above) incomesare discounted to the present. This residual value isthe income value of the timber stand at the interme-diate age (see fig. 2.3). Such values are illustratedby the cost/income curve as shown in figure 2.3.The vertical distance between the cost/income curveand the liquidation curve also represents the foregoneincome that will result if timber is cut either prior toan optimum rotation or if the timber is held longerthan an optimum rotation. As has been previouslydiscussed, however, these curves are very flat oneither side of the optimum harvest (that is, there isonly a small loss of potential income within approxi-mately 3 years on either side of the best harvest age).This provides a “decision window” for schedulingharvests. They may be timed for maximum revenue

by taking advantage of price fluctuations (see fig. 2.3),smoothing income flows, or other specified landownergoals.

Cost Approach .- -To use the cost approach to obtainestimates of value, the same assumptions discussedunder the income approach will hold. In this case, theprocedure is used to compound the establishment costand the intermediate cost flows forward to the presentat an appropriate rate of interest.

The cost and the income approaches will provideestimates of value that will differ, based on the interestrate chosen, with one exception. That exception is thespecial case where the interest rate is equal to theinternal rate of return (IRR) for the assumed man-agement regime. In that situation, the cost/incomecurve showing values compounded forward and thecost/income curve showing values discounted back-ward from the harvest will be identical (see fig. 2.3).This suggests a method for determining intermediatevalues for standing timber that has been called thehybrid approach. First, an IRR is computed from allcosts and revenues for the investment cycle. Second,the IRR is used as the discount rate to calculate thecost value and/or the income value for the timberinvestment period. An example of the hybridapproach is found on page 28 under valuation of pre-merchantable timber.

The income valuation approach is the more practicalmethod for merchantable timber simply because thelength of time for the projection period (harvest valuediscounted to intermediate timber value) will normallybe shorter than the projected period for compoundingestablishment costs forward. Thus, with other thingsbeing equal, the shorter the period of uncertainty, theless the variance will be in the expected results.

Valuation of Premerchantable Timber

Satisfactory market transactions for use in valuingpremerchantable timber rarely exist. Valuations oftenmust be based on either the income or cost approach.The problems of choosing an appropriate interest ratecan be avoided by solving for the IRR for the assumedlevel of management. The IRR is the compound inter-est rate that equalizes the present values (PV) of thediscounted revenues and the discounted costs, orstated another way, the net present values (NPV) ofdiscounted costs and revenues are equal to zero. Forexample, assume that net revenue of $2,075 per acreis received in year 30. Per acre costs include $150 forsite preparation and planting in year 0 and annual

27

management expenses of $3.00 per acre. The IRR iscalculated by trial and error as follows:

Item Yeat Value PV Q 9.0% PV Q 8.5%

Site preparation 0 $-150.00 $-150.00 $-150.00Management cost l-30 -3 .OO -30.82 -32.24Harves t r evenue 30 2,075.OO 156 .40 179 .53Net present value $ -24.42 $ -2.71

PV @ 8.4% PV @ 8.45% PV @ 8.44%

Site preparation 0 $-150.00 $-150.00 $-150.00Management cost l-30 -32.54 -32.39 -32.49Harvest revenue 30 184.56 182 .03 182.53Net present value $ 2.02 $ -0.36 $ 0 . 0 4

Thus, the IRR that makes NPV equal to zero isapproximately 8.44 percent.

Income Approach.--When using the incomeapproach, only future costs and returns are con-sidered. Past costs are not included because they are“sunk” and have no bearing on future income. Withthe IRR calculated to be 8.44 percent, the incomevalue for the stand in the example above can be cal-culated. To solve for the income value at age 9, forexample, the interest calculation is as follows:

Harvest revenue =$2,075 x 0.18240 = $378.48(present value of a single sum discounted at 8.44 % for21 years)

Management cost =$3.00 x 9.68723 = -29.06(present value of a terminating annual annuityat 8.44% for 21 years)

Income value = $349.42

Cost Approach.--Again, with the IRR known, thecost approach to value works like the incomeapproach except that the establishment cost, includingintermediate costs and revenues, are compounded for-ward to the intermediate age of the premerchantabletimber. In the example, the age is 9 years and thecalculation is as follows:

Site preparation and planting =$150.00 x 2.07351 = $311.03(future value of a single sum at 8.44% for 9 years)

Management cost =$3.00 x 12.71928 = 38.16(future value of terminating annual annuity at 8.44 % for 9Yew

Cost value = $349.19

Note that both the income and the cost approachesgive the same estimate of premerchantable valueexcept for rounding error ($0.43). Note also that theopportunity cost of land is not included in thecalculation because it is common to both cases and,therefore, can be excluded.

The hybrid approach has the distinct advantage ofeliminating one of the most critical assumptions infinancial analysis, namely, that of estimating a dis-count rate. The use of the IRR for compounding anddiscounting the cash flows associated with both thecost approach and the income approach will give theidentical answer (ignoring the rounding error). This,of course, is not the case when a discount rate otherthan the IRR is used.

Court Decisions--Gift Tax

Saunders v. U.S., 81-2 U.S. Tex Gzs. (CCH)P13,419; 48 A.F.T.R. 2d (P-H) 6279 (1981).--Herethe court held that the value of gifted timberland sub-ject to a long-term lease was the present value (usinga discount rate that reflected the illiquidity of theproperty) of the anticipated annual income from theproperty for the remainder of the lease plus theresidual value of the property at the end of the con-tract period. Nevertheless, the valuation was tech-nically flawed because real cash flows (without infla-tion) and a current discount rate (with inflation) wereused in the discounting formula. This procedure isinconsistent and resulted in undervaluation of theassets.

J. A. Hipp et al. v. Commissioner of InternalRevenue 47 CCH Tax Ct Memo 623 (1983).--The TaxCourt determined the fair market value of timberlandfor gift tax purposes by relying on appraisal reportsand expert witness testimony and then adjusting thesum to reflect changed market conditions at the timeof the gift of the same acreage 1 year later. Evidencerelating to comparable sales, measurement of soil qual-ity, volume of timber (summation of assets), andaccessibility was found to be relevant and was con-sidered by the court.

Court Decisions--Estate Tax

Estate of Sturgis v. Commissioner of InternalRevenue i? C. Memo. 1987-41X--The Tax Court setthe value of 11,299 acres of timberland at an amountbetween those offered by the estate and by the govern-ment. The court considered the testimony of four

28

experts, each of whom valued the property using thesame methodology. First, the volume of timber onthe property was determined with a separate valuegiven to each species. Then, the land was valued asa separate component and added to the timber values.After considering the testimony of the four experts,the court also applied a 20-percent discount factorbecause of the estate’s minority interests in thetimberland which comprised 91 separate tracts. (Fora comprehensive discussion of discounting, see pages29-31.)

William M. Oettmeier, Jr., PersonalRepresentative of The Estate of Russell L. Carter,Deceased, v. United States, U.S. D istrict Court forth e M iddle D istrict of Georgia, No. CW 7-49 -VAL(W D O ), March 16, 19 89 .- -A so-called “commonsense” method was used by the court to value a dece-dent’s interest in leased timberlands for Federal estatetax purposes. Although the value of the reversionaryinterest was undisputed, the experts for the estate andfor the IRS differed greatly on the value of the futurelease payments. The disagreement was based on twoitems: the choice of an appropriate discount rate andthe appropriate discounting formula. The courtrejected the valuations offered by both the estate andthe IRS because it held that neither would have beenan acceptable price to both a willing buyer and awilling seller. The court determined the value usingits own approach; that is, it basically split thedifference but curiously used two discounts rates toarrive at its value.

DISCOUNTING FOR MINORITYAND UNDIVIDED INTERESTS

General Considerations

There is no authority for discounting fractionalinterests in either the Internal Revenue Code or theregulations, except the statement in Regulation 920.2031-1(b) that “all relevant facts and elements ofvalue as of the applicable valuation date shall beconsidered in every case. ” Nevertheless, anundivided fee ownership in timberland, particularly ifit is a minority ownership, is typically discountedbelow its fractional proportion of the value of thetract as a whole. Minority interests in closely heldtimber-owning corporations and partnerships aresimilarly discounted. Other situations that maycontribute to discounting are lack of marketability of

the ownership interest, transfer restrictions, expensesof partition suits, and combinations of these factors.

Expert Testimony.--Determination of the amount ofthe discount is generally more art than science. Indisagreements with the IRS, heavy reliance is oftenplaced on expert witness testimony. Among the fac-tors typically addressed by expert witnesses are thefollowing: (1) the difficulty of owners of fractionalinterests securing purchasers except at substantialdiscounts; (2) the limits of owners of fractionalinterests in their control, management, and operationof the property; (3) the inconvenience of dealing withseveral owners; (4) the possibility of complicationscaused by owners of very small fractions; and (5) thedanger of partition suits.

Corporate Stock

Among the most important considerations in valuingthe stock of a closely held company are the legal andoperating rights embodied in the stock ownership.Among the most significant of these rights is theability of certain stockholders to control a company.Conversely, the lack of control is commonly adjustedfor by applying a minority discount. The minorityinterest discount is embodied in the concept that theperceived risk is relatively less when a person has theright to control a company’s course of action. As aresult of this element of control, a minority stockinterest in a closely held corporation, owned by adecedent not related to the majority stockholders, willnormally be valued at substantially less per share thanstock that represents a controlling interest (RevenueRuling 59-60).

R elative Siz e and Ow nersh ip Concentration.- - Inaddition to control privileges, two equally importantfactors are the relative size of the block of stock beingvalued and the concentration of ownership. A 20-percent minority interest in one instance may haverelatively little to say with respect to operations whenonly one shareholder controls the other 80 percent.However, the 20-percent shareholder could exist withtwo others each holding 40 percent, with a share-holder’s agreement that at least 5 l-percent approval berequired for certain decisions. The first case wouldwarrant a higher discount.

Luck of Mark & ability.- -Th e minority discount con-cept is separate and distinct from a lack of market-ability discount. In fact, a discount for lack of mar-ketability may exist regardless of whether a controllingor minority interest is being valued. The two types of

29

discounts can exist together or one without the other.In a recently conducted study, the average discountfor a minority interest was found to be 30 percentand that for lack of marketability, 42 percent. Thelack of marketability discount recognizes that, com-pared to the broad spectrum of potential purchasersof publicly traded securities, the value of closely heldinterests is reduced due to a relatively small market.This concept can also apply to majority holdings.The IRS “Valuation Guide for Income, Estate andGift Taxes” recognizes that the absence of a readilyavailable market for closely held stock interests mayjustify a discount for lack of marketability. It statesthat such a discount is suitable for holdings of lessthan 50 percent of the voting power.

Inte rests Controlled by Mem bers of Sam e Fam ily. --In the past, the ownership of the fractional interestsother than the interest in question have had a signif-icant influence on whether a discount could beallowed. The courts in many instances have chosennot to discount the interest in question when all theother interests were owned by members of the samefamily--for example, see H orace K . Faw cett, 64 TC889 (19 75). One major exception to this judicialtrend was the Fifth Circuit Court of Appeal’sdecision in Estate of Brigh t v. U.S., 658 F2d 999(5th Cir. 1981). Here the decedent’s undividedcommunity property interest in shares of stock,together with the corresponding undivided communityproperty interests of the decedent’s surviving spouse,constituted a control block of 55 percent of the sharesof a corporation. The court held that, because thecommunity-held shares were subject to a right of par-tition, the decedent’s own interest was equivalent to27.5 percent of the outstanding shares and, therefore,should be valued as a minority interest, even thoughthe shares were to be held by the decedent’s sur-viving spouse as trustee of a testamentary trust.

Following the Brigh t decision, the IRS issuedRevenue Ruling 81-253, which held that, ordinarily,no minority shareholder discount was to be allowedwith respect to transfers of shares of stock betweenfamily members if, based on a composite of thefamily members’ interests at the time of the transfer,control (either majority voting control or de factocontrol through family relationships) of the corpo-ration exists in the family unit. The ruling also statedthat the IRS would not follow the Brigh t decision.

In early 1993, however, the IRS issued RevenueRuling 93-12, revoking Revenue Ruling 81-253, andstated that it would subsequently follow the Brigh t

and several similar decisions in not assuming that allvoting power held by family members may be aggre-gated for purposes of determining whether the trans-ferred shares should be valued as part of a controllinginterest. Stock shares transferred should henceforth bevalued without regard to the family relationship of thedonee to other shareholders.

Partnership Interests

The principles of Revenue Ruling 59-60 as dis-cussed above (on page 29 pertaining to minority dis-counts for closely held corporate stock) are applicablealso to valuation of minority partnership interests (seeRevenue Ruling 68-609). This is illustrated in theW atts decision [Estate of W atts, TC Memo 1985-595,51 TCM 60 (1985)]. Here the Tax Court agreed withthe taxpayer that a partnership operating as an activebusiness should be valued as a going business and thata partnership interest discount was appropriate. Thepartnership was engaged in the management of timber-land, manufacture of plywood, and sale of lumber.By terms of the decedent’s will, the partnership was tocontinue as a going business. The court consideredthe liquidation value, asset by asset, to be inappro-priate. It adopted the valuation method of the tax-payer’s appraisers and discounted the decedent’sminority interest by 35 percent. The decision wasaffirmed by the Fifth Circuit Court of Appeals [Estateof W atts v. Com m ission er, 87-2 USTC 13,726 (1 lthCircuit, 1987)].

In the H arw ood decision [82 TC 239, 267 (1980)],the Tax Court allowed a 50-percent discount based onliquidity and marketability factors for a minorityinterest in a limited partnership engaged in the timberbusiness.

Fee Interests

In the Sels decision [Estate of Sels v. Com m ission er(TC # 12,642(M ) (19 84)], th e Tax Court compared thein fee financial interests of the decedent to minoritycorporate and partnership interests, citing Estate ofGzm panari [(5 TC 488, (1945)] and Estate of Andrew s[79 TC 938 (1982)]. Here the value of the decedent’sundivided interests in 11 tracts of timberland wasdetermined by using the comparable sales method ofappraisal. The fractional interests ranged from 2.48 to25.00 percent. The IRS valuation was revised toreflect differences between the comparison lands andthe decedent’s properties with respect to the quality of

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timber, accessibility, and timing of the sales. In of a minority interest could expect to encounter aaddition, the IRS valuation was further reduced by a significant delay in obtaining the value of the pur-60-percent discount to reflect lack of marketability, chased interest and have little income in the mean-lack of control, and the costs of potential partitioning. time. The testimony indicated that partition would beThe estate’s expert witness testified that the purchaser expensive and take at least 6 years.

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Chapter 5The Legal Process

BASIS OF THE LAW

Statutory Basis

The Internal Revenue Code, Title 26 of the UnitedStates Code, is the primary statutory source of theFederal estate and gift tax law. Known as theInternal Revenue Code of 1986, because of the vastchanges made by the 1986 Tax Reform Act, the Codeis continually being amended by Congress. The taxcomponent of the estate and gift tax planning processis in a constant state of flux. In every year since1981, with the exception of 1985, Congress haspassed substantial changes. For example, theRevenue Act of 1987 made significant changes in theestate and financial planning area. The 1988Technical and Miscellaneous Revenue Act, the 1989Revenue Reconciliation Act, and the 1990 RevenueReconciliation Act, although billed as technicalcorrections legislation, also included many newsubstantive provisions.

Administrative Basis

Regulations. - -Th e Internal Revenue Service (IRS)is empowered to administer the Code. It does this byissuing regulations that interpret the law according toperceived Congressional intent. Other regulations arestatutory in nature, dealing with subject matter thatCongress failed to legislate in detail. The regulationsalso serve as an enforcement mechanism. Regula-tions must be issued in proposed form subject to pub-lic comment before being published by the IRS infinal form. Both statutory and interpretive regula-tions have the force of law; they may be overturnedonly by the courts.

Revenue Rulings.--Revenue rulings are interpretiverulings published by the IRS to apply the tax law tospecific factual situations. Although they sometimeshave significant general application, the rulingsgenerally have less force than do regulations becauseof their limitation to specific sets of facts. Therefore,they provide valid precedent only if a second tax-payer’s facts are substantially identical to thoseoutlined in the ruling.

Private Letter Rulings.- -Th ese comprise anotherIRS interpretive tool to apply the tax law to specific

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situations. Letter rulings are generally official repliesgiven by the IRS to taxpayer inquires concerning thetax consequences of proposed transactions. They arelimited in application to the taxpayer who made therequest; they may not be used as precedent by othertaxpayers. Letter rulings are available to the publicunder the Freedom of Information Act. Although notcomprising general precedent, they are neverthelessoften quite useful as an indication of the IRS positionon a certain point.

Tech nical Advice Mem oranda- -A technical advicememorandum (TAM) is a special after-the-fact rulingissued by the IRS upon request from either a taxpayeror the IRS auditing agent during the course of anaudit. As with letter rulings, a TAM is limited inapplication to the taxpayer who made the request; it,too, may not be used as precedent by other taxpayers.Also available under the Freedom of Information Act,TAM’s are often utilized to help interpret IRS posi-tions.

Judicial Basis

If a taxpayer disputes the IRS position in a par-ticular matter and the disagreement is unable to besettled administratively, the issue may be litigated bythe taxpayer filing suit. There are three courts oforiginal jurisdiction for estate and gift tax cases. TheTax Court conducts hearings in most large cities, withor without a formal trial. To file in the Tax Court, ataxpayer must have received a notice of tax deficiencyfrom the IRS and refused to pay. A taxpayer can alsoturn to the Federal District Court System or to theClaims Court. The latter is a single court inWashington, DC. In both cases, the disputed tax musthave first been paid. The taxpayer then files suit fora refund. The District Court is the only one of thethree courts in which a taxpayer can request a jurytrial in a tax matter. Decisions of the Tax Court andthe District Courts may be appealed by either the tax-payer or the government to the Circuit Court ofAppeals in whose jurisdiction the taxpayer resides.Appeals from the Claims Court are taken to theAppeals Court for the Federal Circuit. All appellatedecisions may be taken to the Supreme Court. As apractical matter, however, very few estate and gift taxmatters are accepted by the Supreme Court.

WILLS

A will is a legal document that directs the dis-position of a decedent’s assets. It takes effect at thedeath of the decedent through the probate process. Awill should not be confused with a letter of lastinstructions or other nonlegal written statementsrelating to the decedent’s last wishes. These are notlegal and binding documents as is a will.

Need for and Advantages of a Will

A person who dies without a will (that is, intestate)leaves the distribution of his (her) property to begoverned entirely by State law. In some cases, Statelaw will do exactly what the decedent had in mind; inother cases it will not. Under State law, all heirs ofthe same class (children, siblings, etc.) are treatedequally if there is no will. There is generally no waythe court can alter the distribution of the estate assets.

The advantages of a will are many. With a will,a person can dispose of his (her) property as he (she)wishes within the limits of the law, can name the exe-cutor of the estate, and can save probate expenses bywaiving (not requiring) bonds and sometimes otherexpenses. Guardians for minor children can also benamed in a will, and charitable bequests specified.

Will Preparation and Execution

The exact legal requirements for preparing andexecuting a will vary by State and must be followedfor the will to be valid. Even handwritten wills mustmeet certain legal specifications. Only dispositionsand other provisions in a will that are permitted bylaw are valid; the portions that do not follow the laware invalid. An attorney should always be consultedwhen writing a will. An important point to remem-ber is that, with respect to real property, the law ofthe State in which the property is located will governits disposition--not the law of the State in which theowner resides if the two are different. This is animportant consideration for those forest landownerswhose holdings are in a State or States other thantheir State of residence. The cost of a will isgenerally minimal--usually less than the cost of thebond that must be posted if there is no will.

Joint, Mutual, and Reciprocal Wills

A joint will is a single will executed by two ormore individuals. A mutual will is one made

pursuant to an agreement between two or morepersons to dispose of their property in a special way.The will in such a case may be joint, or there may beseparate wills. Reciprocal wills are those in whicheach testator names the other as his (her) beneficiary,either in a joint will or in separate wills. Even whenState law permits, it is generally undesirable forpersons to bind themselves with joint, mutual, orreciprocal wills; they run the risk of being unable todeal with changed circumstances upon the death of oneof the parties. If executed by spouses, such wills canjeopardize the marital deduction (discussed in chapter6). The safest procedure is for each spouse to executea separate will, with no provision that restricts thesurvivor’s freedom of disposition.

Changing a Will

A will may be revoked, modified, or changed at anytime before death. All changes, however, must bemade in accordance with State law. Minor changescan be made by preparing a codicil, a short attachmentto an existing will. In some States, a will may becomeinvalid if the person making it subsequently has achild, including an adopted child. In such cases, anew will would have to be written.

POWER OF ATTORNEY

A power of attorney is a legal document preparedunder State law by which the grantor transfers theright to legally act for him (her) to another person. Apower of attorney can be limited to only certain actsor may be a general power of attorney covering allactions permitted by State law. Powers of attorneymay be revoked at any time by the persons grantingthem by executing a written revocation in the formatprovided by State law. They are usually automaticallyrevoked by death or incompetency of the grantor.Therefore, revocable trusts (see page 60) aresometimes used instead of powers of attorney. Undera revocable trust, the trustee can act even if he (she)is unable to ascertain whether the grantor is still aliveand even if the grantor becomes incompetent.

Durable Power of Attorney

Many States now permit durable powers of attorney,which survive the incompetency of the grantor. For

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example, New York law allows a principal toexpressly provide that his (her) subsequent disabilityor incompetency shall not automatically revoke orterminate the authority of an attorney-in-fact who actsunder a power of attorney.

PROBATE

Probate is the legal process designed to protect,administer, and distribute a decedent’s estate. Itincludes proving the validity of a will. Probatecourts exist for the purpose of protecting the rights ofthe heirs and/or legatees, supervising the assemblingof the estate assets, and assuring proper and orderlydistribution of the assets, either by terms of the willor in accordance with State statutes in the absence ofa will. Basically, the probate court performs thesame function in all States although its name mayvary from one State to another.

Probate Administration and Costs

The existence of a will does not necessarily avoidprobate. It is still necessary for the court in mostcircumstances to supervise distribution of the estateassets. Under some circumstances, depending on the

type of property ownership involved and State law, allassets of an estate need not go through probate. Inmany States, for example, property owned jointlybetween husband and wife automatically passes to thesurvivor upon the death of the other (see chapter 15for a discussion of joint ownership).

Probate administration includes such matters as theassembling of estate assets, payment of debts, clearingtitle to estate property, payment of taxes, and distri-bution of the assets to the heirs/legatees. In mostcases, a final income tax return will have to be filedfor the decedent. During administration of the estate,one or more fiduciary (estate) income tax returns mayalso have to be filed. In most cases, the executornamed in the will or the administrator appointed by thecourt if there is no will--together with the attorney forthe estate--actually handles these details, but alwaysunder the court’s supervision.

Probate costs vary among States. They depend onthe attorney’s fee schedule, and on the size and com-plexity of the estate. In addition to the attorney’s fee,there will be court costs, the administrator’s or exe-cutor’s fee unless waived, and the cost of the adminis-trator’s or executor’s bond unless waived. Althoughit is difficult to generalize, costs typically rangebetween 2 and 6 percent of estate value.

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PART II

APPLICATION OF GENERAL ESTATE PLANNING TOOLS TO FORESTRY

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Chapter 6

Use of the Marital Deduction in Estate Planning

OVERVIEW

The marital deduction is a deduction from theadjusted gross estate for property passing to thesurviving spouse. It is considered by many to be themost important estate tax saving device available toa decedent’s estate. Since 1948, individuals havebeen eligible for tax-saving opportunities related toproperty passing to a surviving spouse that werepreviously available only in community propertyStates. The law has been liberalized several timessince then. Finally, the 1981 Economic RecoveryTax Act (ERTA) made deductions for both lifetimeand testamentary transfers to spouses “unlimited.”Thus, the marital deduction now recognizes the roleof both spouses’ contributions to building the family’sassets. Wills written before 1982 that contain amarital deduction clause based on pre-ERTA lawshould be reviewed and amended if the clause willproduce an unsatisfactory result based on current law.Bequests to spouses who are not U.S. citizens do notqualify for the estate tax marital deduction unlessthey are in a qualified domestic trust. In order to beconsidered a qualified domestic trust, the trustinstrument must provide that at least one of thetrustees be a U.S. citizen or domestic corporation andthat any distribution from the trust principal besubject to the U.S. trustee’s right to withhold theestate tax due on the distribution.

QUALIEYING FOR THEMARITAL DEDUCTION

The decedent’s estate can claim a deduction--themarital deduction--for qualifying lifetime and testa-mentary (by will at death) transfers of property to asurviving spouse. The deduction for both lifetimeand testamentary transfers is unlimited. However,the property must actually pass from the decedent tohis (her) spouse. The marital deduction is notavailable to the estate of a widow, a widower, or anunmarried person.

Transfer of Property Interests

To be eligible for the marital deduction thedecedent must have been a citizen or resident of the

United States at his (her) death. The decedent must besurvived by a spouse, and the property must be passedfrom the decedent to the surviving spouse. Not onlymust the value of the property interest be included inthe decedent’s gross estate, but it must also be of atype that will be included in the surviving spouse’sgross estate to the extent that it is not consumed orgiven away during the surviving spouse’s lifetime.

Generally, no marital deduction is allowed forproperty interests that are terminal interests. Aterminal interest is an interest in property that willterminate or fail on the lapse of time or on theoccurrence, or failure to occur, of some event orcontingency. Examples include life estates andannuities. Another example is property given to asurviving spouse that would revert to the children ifthe surviving spouse remarries. The purpose of thisrule is to require that, if property is transferred to thesurviving spouse, it will be included in the survivingspouse’s estate unless disposed of during the survivingspouse’s lifetime. Thus, whenever trust betweenspouses is lacking and conditions are attached to giftsor bequests, the use of the marital deduction is onshaky ground. As explained later, there are, however,certain exceptions to the terminal interest rule.

Examples of eligible property transfers to thesurviving spouse include: an outright bequest by will;a power of appointment; life insurance proceeds; jointtenancy survivorship; transfers by annuity, insurance,or other contract; and transfers by State laws ofintestate distribution. In summary, any property leftwith no strings attached is an absolute interest andqualifies for the marital deduction.

Property interests passing to a surviving spouse thatare not included in the decedent’s gross estate do notqualify for the marital deduction. Expenses, indebted-ness, taxes, and losses chargeable against propertypassing to the surviving spouse will reduce the maritaldeduction.

EXCEPTIONS TOTERMINAL INTEREST RULE

Basically, each spouse must trust the otherimplicitly for the marital deduction to work effec-tively . However, there are five exceptions to the

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terminal interest rule, which generally stipulate thatthe property interests in question will qualify for themarital deduction if certain requirements are met.They will, however, also be taxable in the survivingspouse’s estate if not consumed or given away beforehis (her) death.

Qualified Terminal Interest Property

Property under a qualified terminal interest prop-erty (QTIP) election is eligible for the Federal estatetax marital deduction. Under this election, the valueof the property is included in the surviving spouse’sestate at his (her) death. A more detailed discussionfollows.

The General Power of Appointment

This is the right to determine the ultimate dis-position of certain designated property. The survivormust have a life interest that entitles him (her) to allthe income (payable at least annually) and must havethe power to appoint the property to himself (herself)or his (her) estate.

Survivorship Condition

A bequest to a spouse may be conditioned on his(her) survival for a period up to 6 months after thedeath of the decedent; or on his (her) survival of acommon disaster, providing the spouse does, in fact,survive.

Right to the Payment

The surviving spouse must have a right to thepayment of life insurance, endowment, or annuityproceeds, coupled with a power of appointment forthe survivor or the survivor’s estate. Annuitiespayable from a trust and commercial annuitiesqualify.

An Income Interest

The survivor must have an income interest in acharitable remainder unitrust or annuity trust (seechapter 8) where he (she) is the only noncharitablebeneficiary. These conditions apply automatically;however, the executor can elect for these provisionsnot to apply.

QUALIFIED TERMINAL INTERESTPROPERTY AND THE MARITAL DEDUCTION

A QTIP is a special form of life estate interestgiven to a surviving spouse that qualifies for themarital deduction. With a QTIP, the estate owner cancontrol the disposition of the remainder interest afterthe surviving spouse’s death. The remainder interestwill, however, be included in the surviving spouse’sestate. For example, timber property may be put intoa QTIP, with the value qualifying for the maritaldeduction. The surviving spouse receives the incomefrom the timber property for life, with the remainderinterest passing to the children or other designatedbeneficiaries at his (her) death.

The amount of the marital deduction resulting fromthe QTIP election is the net value of the propertyinvolved, after reduction of indebtedness chargedagainst it. The debt to be reduced from the propertyvalue includes any estate taxes charged against theproperty.

Qualification for the QTIP

The QTIP interest must be specifically elected bythe executor of the estate on the estate tax return.Once made, it is irrevocable. To qualify, thefollowing conditions must be met: (1) the survivingspouse must be entitled to all of the income from theproperty payable at least annually for his (her) life, (2)a QTIP interest in property not placed in trust mustprovide the survivor with rights to income that aresufficient to satisfy the rules applicable to maritaldeduction trusts, and (3) there must be no power ofappointment in anyone to appoint any part of theproperty to any person other than the spouse duringthe spouse’s life. The fact that a marital deductionformula (as discussed later in this chapter) is used todetermine the amount of property passing to a QTIPdoes not jeopardize the QTIP election (Letter Ruling8814002).

TO WHAT EXTENT SHOULDTHE MARITAL DEDUCTION BE USED?

Because the unlimited marital deduction is such apowerful planning tool, it should be used carefully inorder to meet both the forest landowner’s objectivesand legal constraints on the transfer of property. Thesurvivor’s estate, his (her) general state of health, and

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his (her) ability to manage the additional resourcesefficiently are also factors to be considered.

Legal Rights

Legal rights of the surviving spouse to take ashare of the real property and, in some States, ashare of the personal property in the estate must betaken into account in deciding how much and in whatform property should pass if it is to qualify for themarital deduction. This, of course, is governed byState law. These decisions are affected by the pre-sence of children from the current and perhapsformer marriages of either spouse.

Nontax factors

Nontax factors that may affect the maritaldeduction’s use include the couple’s personalrelationship, health and age (life expectancy), anddegree of confidence in the spouse’s business abilitybecause there is always a tradeoff between controland tax savings. Spousal trust permits equalization ofthe estate’s resources and freedom to use all theplanning tools that are available to save taxes. Alack of trust, fear of a spouse’s remarriage, andperhaps fear of divorce may force an owner tomaintain maximum control, which complicates theplanning process.

The surviving spouse’s resources and thepossibility of inheritances from other sources shouldalso be taken into account in projecting tax outcomes.The needs of young children have to be included hereas well. The current value of both spouses’ estatesand the effects on each other’s estate tax returnshould be considered.

Marital Deduction Deferral

If the goal is simply to save the maximum estatetax at the death of the first to die, the maritaldeduction should be used to the fullest extent. A willthat states, “I leave everything to my spouse,” resultsin the deferral of all estate tax on the death of thefirst to die. This may create a hugh tax problem forthe estate of the second to die, especially if thatperson already has a substantial estate of his (her)own. The marital deduction defers the tax until thesurviving spouse’s death; therefore, the aggregateestate taxes of both spouses should be considered. Ifthe survivor’s health is good and normal lifeexpectancy is long, the deferral gives time for the

survivor to use the additional resources wisely throughadditional planning or consumption. A number of taxfactors, as follows, should be considered.

Maxim iz e Credit.--Maximization of the unifiedcredit in each spouse’s estate is the key to use of themarital deduction. The $192,800 credit permits eachspouse to transfer $600,000 in net taxable estate valueto persons other than the other spouse without estatetax. Thus, together, they can pass $1,200,000 in nettaxable value to the children without estate tax cost.

Example 6.1. Assume a forest landowner hus-band owns 1,200 homogeneous acres of timberlandwith a net value of $1,200,000 after payment ofestate debts and administrative costs. His wife iswithout assets. (The analysis works the same withhusband and wife roles reversed.) If he wills herthe entire estate with a marital deduction bequest,his estate will pay no tax. When the wife dies,with income earned used to pay funeral expensesand administrative costs, her estate will face aFederal estate tax of $235,000 on the value of thetimberland. This equals a 20-percent reduction inestate value. It may have to be paid by selling partof the property or utilizing Section 6166 (see chap-ter 14) and paying the tax from timber sale incomeover time. In addition, there is considerable riskfrom concentrating the assets in one or the otherspouse’s estates because the spouse without assetsmight die first, and the unified credit would bewasted. This result would be similar to the situa-tion where the survivor inherits all the assets.Balancing th e Marital Deduction.- -Th e goal is to

balance the expected values in each estate with adjust-ments for life expectancy, earning power, and abilityto manage the assets.

Example 6.2. Assume the same facts as in exam-ple 6.1, but now the husband makes an outrightbequest of $600,000 in timberland value (600acres) to the children, which is protected fromestate tax by the unified credit. He wills thebalance to his wife with a marital deductionbequest, and his estate also pays no estate tax onthat portion (600 acres). When the wife dies, herestate has a $600,000 exemption equivalent so thatno estate tax is owed and the children have saved$235,000. The disadvantage here, however, is thatthe wife did not have control of half of the timber-land estate that she had helped the family accumu-late and that she may need to maintain the lifestyleto which she had grown accustomed.Survivor’s ability.- -Th e survivor’s ability and

willingness to reduce the size of his (her) estate is a

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key factor. The spouses’ goals with respect to thewelfare of the children must be compatible.

Example 6.3. Assume the same facts as before,but now the $600,000 bequest to the children isput into a nonmarital trust from which the wifehas the income for life. She has access to thesame level of income as before. If desired, aclause can be included for invasion of trustprincipal subject to an ascertainable standard ofliving (see chapter 10 on “The Role of Trusts”).The spouse’s ability and willingness to adjust the

size of his (her) estate must be considered. In exam-ple 6.1, the wife’s credit will be lost if she dies first,because she owns no assets. This situation can beremedied easily with a gift of $600,000, which bal-ances the two estates, permits use of both credits, andsaves $235,000 in taxes after each transfer. Thisremedy works if the credit is used by the first spouseto die by putting the assets in a nonmarital trust, orby giving it outright to the children. Spousal trust isessential--as discussed above--for this procedure towork.

To summarize the optimum marital deductionstrategy: (1) it must be used in conjunction with theavailable unified credits, (2) it must be used withregard to the survivor’s estate, and (3) considerationmust be given to the survivor’s ability, health, andwillingness to reduce the remaining estate to mini-mize estate tax liability. Generally, the maritaldeduction is used to defer the tax at the first spouse’sdeath so that additional planning can be done by thesurviving spouse.

HOW TO MAKEA MARITAL DEDUCTION BEQUEST

Basic Patterns

A bequest that qualifies for the marital deductionmay be made as an outright gift, a direct transfer tothe surviving spouse, or by trust for his (her) benefit(see chapter 10). In any case, the transfer willusually fall into one of the following patterns.

Property.- -An outright bequest of specific propertymay be made in these terms: “I give my wife the600 acres of timberland that I own in LaidbackCounty, State (legal description).”

Example 6.4. Assuming the same facts as inexample 6.1, but specifing that the bequestincludes zone IV mature timber and zone III

maturing timber (see chapter 2, for a discussion oftimber zones), will provide liquidity for the sur-viving spouse’s immediate needs. Alternatively, ifthe surviving spouse’s needs for liquidity can bemet from his (her) own resources, the bequest canbe of zone I premerchantable timber and zone IIyoung timber, both of which are rapidly appre-ciating assets.Money.--This is known as a “pecuniary bequest,”

or a gift of money: “I give my husband $600,000.”That statement alone does not necessarily make it so,however. The resources have to be in the estate togenerate the cash.

Example 6.5. Assume the same acreage as inexample 6.4, but now the land and timber stands inzones I through IV are assumed to be distributed asfollows: bare land equals $300,000, which isequally distributed among the zones; zone I--premerchantable timber only, $90,000; zone II--young growth of 30 cords per acre, $210,000; zoneIII--young sawtimber, $600,000; and zone IV--mature sawtimber, $900,000; for a total of$1,800,000 in timber and $2,100,000 total value.This situation lets the total value increase reflectthe potential value for the property. The acreageis equally divided into 250 acres per zone (whichare handled as management units). The timberstands are as follows: the 8- to lo-year-old pineplantations in zone I are valued at $360 per acre;pine pulpwood in zone II is valued at $840 per acre($28 per cord); the small sawtimber in zone III isvalued at $2,400 per acre and is predominatelychip-n-saw saw-logs; and the mature sawtimber inzone IV is valued at $3,600 per acre because it isprimarily high quality sawtimber. The bequest caninclude the acreage in zone IV, which will providesufficient timber that can be sold relatively soon togenerate the necessary cash.Fractional sh are .- -Th e owner can give a straight

fractional share; that is, “I give one-half of myresidual estate, outright, to my wife.” The “netestate, ” technically known as the residual estate, iswhat remains after payment of debts, administrativeexpenses, specific bequests, and other charges.

Example 6.6. Assume the same facts as in exam-ple 6.5. The timberland portion of the bequestwould thus amount to $1,050,000, if the expenses,other bequests, and charges are paid from otherliquid resources. This creates an immediate tax billof $173,500, which could have been deferred.

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Formula Marital Deduction Bequests

Other things being equal, the preferable approachwould be to use a formula marital deduction bequestthat sets aside the largest amount that can pass free ofthe Federal estate tax by way of the unified credit.This circumvents the problems generated when thebequest amounts have appreciated (depreciated insome cases, but rarely for timber) into an unantici-pated tax situation. There are three basic formulaclauses that are normally used.

Pecuniary. - -Th e pecuniary marital deduction form-ula is easy to express and may offer greater oppor-tunity for post mortem planning. The bequest can bemade outright or in a marital deduction trust (seechapter 10). It directs that the amount to the maritalshare for the surviving spouse be the sum that mini-mizes the Federal estate tax payable. The bequestcan be made outright or in trust. The residual sharecorresponding to the exemption equivalent andFederal credit for State death taxes can be disposedof outright or in a nonmarital trust (see chapter 10).

Example 6.7. Assume the same facts as in exam-ple 6.4. The pecuniary marital deduction sharecan include the timber from zones III and IV inorder to provide liquidity. The residual share caninclude timber in zones I and II. This placesgrowth and value appreciation in that portion ofthe first spouse’s estate that will not be taxedagain at the second spouse’s death. Amounts inexcess of $600,000 in the marital share can beconsumed or gifted to reduce the second spouse’sestate value.Unified Credit. - -Th e pecuniary unified credit for-

mula (see chapter 10) is similar to the pecuniarymarital deduction formula. It directs that an amountequal to the exemption equivalent, plus Federal creditfor State death taxes, if appropriate, be given outrightor in trust. The residual estate in this case willconstitute the marital deduction amount that can alsobe outright or in trust. The results are similar toexample 6.7 with respect to appreciation andliquidity.

Fractional Res iduary Marital Deduction Form ula.--This directs to the survivor the smallest fraction thatminimizes the Federal estate tax payable. Althoughit is harder to calculate than the pecuniary formula--shares can only be determined after a final accountingby the executor--appreciation of estate assets is sharedby the spouse and other beneficiaries, and this maybe a desirable outcome in terms of family relation-ships even if it costs some additional tax.

The Choice of Marital Deduction Formula

The choice as to which marital deduction formulato use depends on the gain (or loss) potential of estateassets, the preferences as to whether spouse or chil-dren or both should benefit from the appreciation (ordepreciation) in the estate’s timber assets, estate taxesthat may be due at the spouse‘s death, and family rela-tionships. The choice should be made only after ananalysis of the financial and tax considerations, withemphasis on the personal preferences of the individualsinvolved.

7Iimber Assets. - -Th e treatment should be dictated bythe landowner’s goals as expressed in the timber man-agement plan. These include continuity of manage-ment, keeping the forest property intact as a manage-ment unit, financial targets, and nonmonetary consid-erations of the family. Integrating the timber man-agement plan into the overall estate plan can be facil-itated if the timber plan has an estimate of currentvalue by stand or management unit, a projection of netcash flows over the immediate planning horizon (oper-ational plans are usually for 5 years, but sometimes upto 10 years), and a projection of the timber value atthe end of the planning period.

Timber assets are dynamic in that they are appreci-ating assets that respond to weather and markets.Their current value depends on the distribution of tim-ber stands as affected by volume of merchantable tim-ber and product classes (see chapter 4). Timber assetsusually appreciate but present particular challenges dueto their unitary nature, the fact that only periodicincome is usually available, and illiquidity. Theappreciation, moreover, will vary with market fluctua-tions and the stage of the growth cycle that stands arein at a particular time.

Life Insurance.--Life insurance proceeds may qua-lify for the marital deduction in numerous ways, buta life insurance specialist should be consulted to insureboth marital deduction qualification and the best finan-cial choice for the heirs. It is imperative that thepolicies be carefully coordinated with the overall estateplan with respect to policy ownership, beneficiaries,and settlement options. Otherwise the financial advan-tages of insurance may be dissipated, and the needs ofthe beneficiaries left unmet or only partially served(see chapter 11).

Personal E& k ts. --Special attention should be givento their treatment, including value, when using themarital deduction formulas. Many family heirloomsare difficult to value and difficult to divide. Thedecedent and heirs often have particular attachments to

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certain effects that should not be ignored but shouldbe handled separately.

D isclaim er. --In making a marital deductionbequest, it may be desirable to provide in the willthat the surviving spouse can refuse to accept anypart of the marital bequest. The opportunity for adisclaimer provides a second look at the outcomes(see chapter 7).

State D eath Taxes.- -Th e applicable State deathtaxes, if any, should be reviewed and included indrafting the marital deduction formulas and in otheranalyses. State death taxes often do not conform tothe Federal estate tax model, and they can upset plansif not incorporated (see chapter 19).

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Chapter 7

Disclaimers, Settlements, and Elections To Take Against the Will

GENERAL CONSIDERATIONS

Sometimes a decedent’s best laid plans do notmaterialize. Assets may appreciate or depreciate invalue, an unexpected gift may be received, or a lossmay occur. Adjustments may not have kept pacewith fast-moving events. Sometimes the decedentwas merely careless or neglectful, and at death it’stoo late to change his (her) plan for disposing ofproperty. Nevertheless, the heirs or legatees canoften make certain changes in the plan of dispositionthrough disclaimers, settlements, and the election totake against the will.

DISCLAIMERS

No one is forced to take what is due to him (her)under another person’s will or by virtue of the lawsof inheritance in the absence of a will. The bequestor legacy can be disclaimed. A disclaimer is definedas the irrevocable and unqualified refusal by a bene-ficiary to accept property during probate underauthority of Section 2518 of the Internal RevenueCode (IRC). Disclaimers can be effectively utilizedto realize certain post mortem estate planning benefitsthat were not established prior to the decedent’sdeath. If a qualified disclaimer is made by someonewho does not wish to accept an interest in property,the interest disclaimed will be treated for Federal taxpurposes as if it had never been transferred to thatperson. Additionally, the disclaimant will not betreated as having made a gift, for either estate or gifttax purposes, to the person to whom the interestpasses by reason of the disclaimer.

Disclaimer Requirements

Section 2518 of the IRC provides a single set ofdefinitive rules for disclaimers for purposes of theestate, gift, and generation-skipping transfer taxes.To be effective, a disclaimer must be qualified.

Four basic requirements must be met:(1) The refusal must be in writing.(2) The written refusal must be received by the

transferor, his (her) legal representative, theestate representative, or the holder of legal

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title to the property not later than 9 monthsafter the day on which the transfer is made, or9 months after the beneficiary becomes 21years old.

(3) The disclaiming party must not have acceptedthe property, any interest in it, or any of itsbenefits before making the disclaimer.

(4) The property disclaimed must pass to some-one other than the person making the dis-claimer without any direction on the part ofthe disclaimant. However, a valid disclaimermay be made by a surviving spouse eventhough the interest passes to a trust in whichhe (she) has an income interest.

D isclaim er Provisions in th e W ill.- - In th e absenceof a contrary provision in the will, disclaimed assetsgo to those persons who would have received them ifthe disclaiming party had predeceased the estateowner. However, if there is a possibility that a dis-claimer might be a useful post mortem tool, it wouldbe advisable to make provision for disclaimers in thewill. These could include the requirement that awritten statement be delivered to the executor withinthe requisite time limits, stipulations for disposition ofdisclaimed bequests, and details as to what is requiredto assure the effectiveness of a disclaimer for Federaland State tax purposes (various States have furtherrequirements of their own in addition to the Federalrequirements listed above). The provision in the willthat disposes of a disclaimed bequest is extremelyimportant to the one who is going to disclaim. Asnoted above, the disclaimant cannot disclaim in favorof anyone of his (her) choice; all that can be done isa refusal to accept the bequest and allow it to passunder the alternate provision in the will.

Disclaimers by the Surviving Spouse

If the surviving spouse’s marital deduction bequestprovides more than he (she) may need or consume, theadditional amount will be includable in his (her) estate.This could result in the beneficiaries of the survivingspouse receiving somewhat less than they might other-wise receive. In such a situation, the surviving spousemight wish to disclaim all or part of the bequest. Ifthe disclaimer will result in the disclaimed propertypassing to those whom it is desired to benefit (that is,

the children), the property in question would never beincluded in the surviving spouse’s taxable estate. Itwould pass to the intended beneficiaries without gifttax liability and without any added transfer expenses.A point to consider is that a disclaimer of a maritaldeduction bequest may serve to increase the estate taxliability of the decedent’s estate unless it is made infavor of a charity or the unified credit is available tooffset liability. But even if additional estate taxresults for the decedent’s estate, the disclaimer couldpossibly reduce the estate tax and administration costsof the disclaimant’s estate. These factors would allhave to be considered.

Disclaimer in Favor of a Surviving Spouse

If a surviving spouse is to receive a maritaldeduction bequest considered to be less than adequatefor his (her) needs and there are bequests to others,the other beneficiaries may wish to disclaim theirbequests in whole or in part. The effect of thisstrategy would be to increase the marital deductionand thus reduce estate taxes. Internal Revenue CodeSection 2056(a) permits an estate tax marital deduc-tion for property disclaimed by a third person thatpasses in favor of the surviving spouse. If the dis-claimed assets are not necessary for the survivingspouse’s needs, gifts in the amount of the disclaimedbequests could later be made to the original benefi-ciaries in installments that would minimize or elim-inate gift taxes.

CHARITABLE DISCLAIMERS

Internal Revenue Code Section 2055(a) allows adeduction for a charitable transfer resulting from adisclaimer. For example, if a decedent’s will pro-vides that a charity would receive a disclaimedbequest, a disclaimer may reduce estate taxes and, atthe same time, take the bequest out of the disclaim-ant’s estate. In this situation, however, there areincome tax considerations to be taken into account. Ifthe bequest is accepted and then given to charity, thelegatee-donor will get an income tax deduction. Thevalue of that deduction must be weighed against anyhigher estate taxes resulting from acceptance of thebequest.

WILL SETTLEMENTS

A will contest or settlement can result in a shift ofproperty interests from one beneficiary to another orfrom a beneficiary named in the will to a person notnamed. If the contest or settlement is bona fide and atarm’s length, the courts have held that no gift results.

If ascribed

will does not give a surviving spouse a pre-share of the testator’s estate, many States

permit the surviving spouse “to take against the will.”If the surviving spouse makes this election, he (she)will get a larger share of the estate. At the same time,the election may increase the marital deduction, there-by reducing the estate tax.

ELECTION AGAINST THE WILL

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Chapter 8Gifts of Forestry Assets

OVERVIEW

Estate planning frequently focuses on the transferof property at death; however, gifts also offer apowerful tool to achieve planning objectives. With aprogram of giving, the “ability to afford the gift”should be the first consideration. Stated another way,do not give away money or timberland that somedaymight be needed. Many gifting objectives are per-sonal and do not involve tax saving, but they are justas, or perhaps more important than tax and financialconsiderations. However, careful attention to the taxrules permits the donor to stretch the benefits of his(her) gifting program.

Some Reasons for Gifts

The foremost reason for a program of gifting is tobenefit family members. When most of the assets areowned by one spouse, a substantial gift equalizing thefamily assets is a statement of trust. Other beneficialeffects that follow as a result of gifting are discussedin chapters 6 (“Use of the Marital Deduction inEstate Planning”) and 10 (“Role of Trusts”). Gifts tothe adult children, especially of timberland, may helppromote a sense of financial maturity in the doneesand may provide the motivation for them to learn thebusiness of managing the tree farm. Thus, the donorcan see the responsibilities for managing a going con-cern transferred to the next generation with efficiencyand effectiveness. It follows that the donor will gaina general feeling of satisfaction in seeing the timber-land used and enjoyed. The process can assist thedonees’ personal growth and, properly done, influ-ence their behavior in favorable directions.

Gifts from senior family members who are inhigher income tax brackets can improve the totalfamily income tax burden by moving income-producing property into the hands of family memberswho are in lower tax brackets. Charitable giftsprovide an income tax benefit while at the same timebenefiting organizations that are personally importantto the donor--churches, colleges, museums, andothers. Gifting reduces (thins) the size of the donor’sgross estate and, in so doing, reduces both Federaland State death taxes. This also lowers estate settle-ment costs and avoids the delays and fees of theprobate process with respect to the property gifted.

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In some cases, the transfers can put the property outof reach of creditors.

Because of the power of gifting to reshape thedonor’s estate, a program of gifting should be pursuedcautiously because there are also disadvantages. Per-haps the most important is the loss of control. Thus,important business entities and key parcels of timber-land may not be the best candidates for a gift. Giftsof income-producing assets reduce the donor’s income.A gift also transfers the donor’s basis to the donee,with possibly adverse income tax implications thatwould not be the case with testamentary transfers.Additionally, special use valuation (see chapter 13) isnot available for lifetime gifts. Most of these pointswill be discussed more fully in the following sectionsof this chapter.

GIFTING TAX CONSIDERATIONS

Any transfer of property or an interest in property,without adequate and full consideration in money or inkind, may involve a gift. The goal of gift and estatetax minimization has been made more difficult byrecent changes in the tax laws. For example, Cliffordand spousal remainder trusts can no longer be used aseffective income-splitting devices. These short-termtrusts with reversionary interests of income or prin-cipal were formerly used to shift income from thegrantor to beneficiaries in lower tax brackets. Suchincome is now taxed to the grantor, effectively nulli-fying the benefit of these types of trusts. The so-called “kiddie tax” affects gifts to children under age14 because their unearned income over $1,100 peryear is taxed at the parent’s top rate. Children 14years and older with unearned income of $550 or moreare taxed at their own rate. This provides a con-siderable incentive to increase an older child’s incomewith income-producing gifts.

Incomplete Gifts

If a donor retains an interest in or power over theproperty gifted, it results in the gift being incomplete.A complete gift requires: a competent donor anddonee, a clear intent to make a gift, an irrevocabletransfer of legal title, the delivery of the gift to thedonee, and the donee’s acceptance.

Gifts with no strings attached are complete gifts.Incomplete gifts are more likely to occur in transfersto trusts than in outright transfers (see chapter 10 ontrusts). If provisions are included in a deed to theeffect that “If I outlive you, the property will becomemine again,” the gift is called “the possibility of areverter . ” The gift is considered complete, but therestriction reduces its value. Along similar lines, aparent who gives the family tree farm to the children,but tells them, “I plan to live here and hunt and fishuntil I die,” has made a gift of a remainder (future)interest. Again, the gift is considered as being com-plete, but its value has been reduced, and it is noteligible for the annual $10,000 exclusion.

Gifts of property are valued as of the date of thegift. Any appreciation of the property while in thedonee’s hands is excluded from the donor’s estate.In addition, gift taxes on property transferred morethan 3 years before the donor’s death are excludedfrom the donor’s gross estate, probate administrationexpenses will be avoided on the value of the giftproperty and the gift taxes paid, income from thegifted property will be excluded from the donor’sestate, and State death taxes may be reduced in someStates.

Gifts of Land and i’k ber R igh ts.- -Th e InternalRevenue Service (IRS) will treat the gift of under-lying land with retention of the timber rights by thedonor as an incomplete gift. This means that thevalue of the land will be included in the donor’sestate. Revenue Ruling 78-26 held that the entirevalue of forest land given to an individual by a donorwho reserved for 10 years all timber rights, whichconstituted personal property under the law of theState in which the timber was located, with the donordying during the lo-year period without havingremoved any timber, was included in the decedent’sgross estate. The U.S. Fourth Circuit Court ofAppeals has upheld the IRS position. The court heldthat under South Carolina law, when the decedenttransferred her land to a corporation in exchange forshares of its stock, reserving timber rights on a por-tion of the land for 2 years, she also reserved aninterest in the soil necessary to nourish the timbergrowing on it. The court ruled that to the extent thatthe transfer to the corporation was not for an ade-quate and full consideration, the timberland wasincludable in her gross estate as a gift with a retainedlife estate (Estate of Grah am v. United States, U.SCourt of Appeals, Fourth Circuit, No. 83-1068, Sept.30, 1983).

Gift Tax Rates, Credits, and Exclusions

The unified gift and estate tax transfer scheduleapplies to all gifts. As discussed in chapter 3, a singlerate schedule exists with respect to both lifetime giftsand estates of decedents. The marginal tax rate beginsat 37 percent of the taxable amount in excess of$600,000. The top rate following the passage of theRevenue Reconciliation Act of 1993 is 55 percent ongifts and estates in excess of $3 million (see table 3.1).The amount of gift tax payable in any calendar year iscalculated by taking the cumulative lifetime taxabletransfers and applying the unified transfer taxschedule. The tax on previous transfers is thensubtracted from this amount, as is whatever has notpreviously been used of the $192,800 unified gift andestate tax credit.

Internal Revenue Code (IRC) Section 2504(c) setsa 3-year statute of limitations for revaluation of life-time gifts for gift tax purposes. It does not, however,bar the revaluation of lifetime gifts for estate tax pur-poses. Thus, a gift of timberland that does not havea readily determinable market value should be sup-ported by a qualified appraisal to establish its fairmarket value (see chapter 4 for a detailed discussion oftimberland valuation).

Annual Exclusion. --The annual exclusion permitsthe first $10,000 in gifts, based on fair market value,to each donee (other than the donor’s spouse) duringeach calendar year to be transferred tax free. The giftmust be of a present interest; that is, it cannot com-prise property or a right that cannot be utilized untilsome future date by the donee.

Example 8.1. Parents have four adult, marriedchildren. One parent, in this case the father, owns2,000 acres of timberland in fee simple, which hasan average value of $1,000 per acre. The father(donor) can give each child (donee) $10,000 invalue each year. That is, he could give each childeither 10 acres or a fractional, undivided jointinterest in the timberland (see chapter 15) worth$10,000 each, for a total of $40,000 per year forthe family. He could also give each child’s spousea similar 10 acres or $10,000 interest in the timber-land each year. This could be transferred as 20acres or $20,000 in joint family ownership to eachchild and spouse for a total annual family transferof $80,000.As long as the donor makes the gift outright, the

annual exclusion should not present a problem. How-ever, with timberland, a qualified appraisal is neces-sary to verify the fair market value of the transfer.

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In addition to the annual gift tax exclusion of$10,000, there is an unlimited gift tax exclusion forqualifying payments of tuition and medical care. Thededuction for tuition is limited to direct tuition costs,and the payment must be paid directly to the institu-tion. The deduction for medical costs is for thoseunreimbursed by insurance as defined in IRC Section213(d).

Marital Deduction . --The marital gift tax deductionis unlimited. For gift transfers to a spouse to qualify,the following requirements must be satisfied: theman and woman must be married at the time the giftis made, the donor spouse must be a U.S. citizen orresident, the donee spouse must be a U.S. citizen,and the gift cannot be a “nondeductible” terminalinterest except for QTIP’s (see chapter 6 for adiscussion of QTIP’s and terminal interests).

Although an effective planning tool in the rightsituation, the question remains as to what extentshould the unlimited gift tax marital deduction beused? A lifetime transfer saves estate administrativeexpenses and probate costs for the donor spouse whodies first and it may permit full utilization of theunified credit if the other spouse were to die first.The QTIP election (see chapter 6) can be utilized ifthe donor feels that it is necessary to insure that thechildren ultimately receive the property. Thesedecisions should be carefully analyzed with expertcounsel and with the family’s goals fully in mind.

Reportin g Proce du re s .- - A Form 709 gift taxreturn (see appendix) is required for transfers ofproperty greater than $10,000 in fair market valueand for split gifts (see below), regardless of value.Returns are due on April 15 with the Federal incometax returns for the tax year, or as extended.

O th e r Considerations. --Approximately one-fourthof the States have a gift tax on the transfer ofproperty (see chapter 19). These provisions, ifapplicable, should be considered.

Split Gifts

A married person who makes a gift to a child orany other person can treat that transfer as thoughone-half had been made by him (her) and one-half byhis (her) spouse, if the spouse agrees. The gift issplit for the purposes of computing the gift tax.Thus, the gift is taxed at a lower rate than if thetransfer had been a single gift by one spouse. The$10,000 annual exclusion and unified credit areapplied jointly, but the actual donor must file the gifttax return.

Example 8.2. Assume the same facts as in exam-ple 8.1, but now the mother (assetless spouse)agrees to make a split gift to the children. Eachchild will now receive a split gift of either $20,000in undivided value or 20 acres. This can beincreased to $40,000 or 40 acres by making splitgifts to the child and his (her) spouse. In that case,the total transfer for four children and their spouseswould be $160,000. A practical way to make thetransfer would simply be to draft a deed for eachfamily member for 40 acres in joint ownership.Split spousal gifts are allowed only if: (1) each

spouse is a citizen of the United States at the time thegift is made, (2) the parties are married at the time,and (3) both spouses agree to split all their gifts forthe calendar year.

BASIC GIFI-ING STRATEGIES

In this section, attention is focused on the questionof the economic impact of giving an asset; the effec-tive use of the unified credit, annual exclusion, maritaldeduction, and gift-splitting; and whether cash, or itsequivalent should be the gift property. Timberland isemphasized, but other assets usually found in timberedestates are included.

What Type of Property to Give

Choosing the right property for a gift is an impor-tant part of the gift plan. A gift may be of personalproperty--art, cash, business interests, securities(stock), personal effects, cars, and other tangibleassets. It could be real estate--rental property, tim-berland, timber and hunting leases, personal resi-dences, easements, or other rights in real property.Or, the gift could be of life insurance--cash value,cash refunds, or other benefits associated with thepolicy. Considerations in selecting gifts should, ofcourse, be meshed with the overall estate planninggoals.

There are some basic considerations to bear inmind in choosing gift property.

Low Gift Value.--For lifetime gifts, it makes senseto give property that has a low gift tax cost but a highpotential estate tax cost. Appreciating assets, such astimberland in zones I and II, fit this category (seefigure 2.4 and the trust example in chapter 10). Tim-berland with high growth potential is a good candidatefor gifts because it is likely to become an estate taxproblem for the donor if held.

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Appreciated Property. --Timberland often fits intothe appreciated property category. Assume that adonor is in the 32-percent marginal income taxbracket--28 percent Federal and 4 percent State. Ifhe (she) sells a property for $10,000 net gain, theincome tax will be $3,200. However, if the donorgives the property to a son or daughter (older than14) who is in the 15-percent marginal income taxbracket, the tax on the sale of the same property bythe donee would be only $1,500. This transfershould also be compared with a gift of cash whilecarrying the timberland through the estate for astepped-up basis.

H igh - yield Assets. --Senior family members in thenew 36.0- or 39.6-percent brackets may considertransferring high income-producing assets to children(over age 14) who are just getting started in theircareers and who are currently in a low marginal taxbracket. Alternatively, a retired parent in the 15- or28-percent bracket should consider gifts to children oflow income-producing assets with good growth poten-tial, such as rapidly appreciating young timberstands.

Keeper Assets. --Timberland is often low-basisproperty that will remain in the family. Many timessenior family members who worry about control oftheir tree farm will consider taking the timber incomeand parting with the land. If it will cause futureestate problems, the donor could harvest the maturetimber and transfer the cutover, bare land to thechildren. This transfer can be coupled with gifts ofsome of the liquid assets to cover the cost of refor-estation. In such a case, it is important to make surethat the donees have the resources to handle the man-agement costs and carrying charges associated withthe property while it is unproductive.

Problem Property.- - If timber property will causeproblems for the owner’s estate executor because it ishard to divide, value, or sell, the owner could givethe property during his (her) lifetime. Sometimes thefamily home, the lake property, or the shore cottagewill fit into this category. Art, antique guns andclocks, and jewelry also fit into this mold.

Jointly H eld Property.- - If timberland is heldjointly, it may be advantageous to retitle the propertyto make it easier to handle for testamentary disposi-tion. For example, if a parent and child hold timber-land jointly, the parent may wish to gift his (her)interest to the child. This avoids the problem ofhaving the property fully valued in the estate of thefirst to die due to inadequate records for proof ofproportionate contributions.

Life Insurance.--In order to keep life insuranceproceeds out of the decedent’s estate, it may be bene-ficial to transfer ownership of the policy to a juniorfamily member or to a life insurance trust (see chapter11). The gift tax cost is based on the value of thepolicy, but it is likely to be lower than for other assetswith approximately the same expected value at thedecedent’s death because of insurance’s “tax-favored”status.

Income Tax Basis

The donee’s basis in gifted property is the donor’sbasis plus any gift tax paid on the net appreciatedvalue of the gift while in the donor’s hands. For thisreason, highly appreciated property should often beheld in order to receive a stepped-up basis on thedeath of the owner. This strategy, however, must bebalanced with the further appreciation potential of theproperty.

Installment Sales and Gifting of Installment Notes

A strategy of selling property to a son, daughter, orother related person with installment reporting of gainand periodic forgiveness of all or part of the paymentsas they come due should be used with considerablecaution. This runs the risk of having the salerecharacterized as a gift. Because the payments underthe installment contract are treated as income to theseller, a possible solution is to treat the payment asincome and make gifts of cash to the children whothen make the payments from an entirely separateaccount (see chapter 12).

GIFI’S TO MINORS

Gifts within families are the most common type oflifetime gifts, such as from parents to children andfrom grandparents to grandchildren. Many are gifts tominors that are made without much thought beinggiven to the legal or tax consequences. As long assuch gifts are small, there is generally no seriousproblem.

As gifts increase in value, however, the so-called“kiddie tax” has a major impact on minors under theage of 14 (see page 47). On the other hand, State lawis often more concerned about protection of theminors’ rights and the minors’ legal capacity to own,manage, and sell property. Many States requireguardians for minors who own real property, place

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restrictions on a minor’s power to make contracts,and otherwise restrict a minor’s ability to conductbusiness on his (her) own behalf. These constraintscomplicate gifting to minor children, especially ofreal property, such as timberland. Vehicles, such astrusts, custodianships, and guardianships, are utilizedfor protecting minors’ interests. These differ in anumber of important respects and their advantagesand disadvantages should be understood beforeembarking on a substantial gifting program involvingminors.

Two pieces of legislation have been widelyadopted that make the process of gifting to minorsmore uniform across State boundaries. The UniformGift to Minors Act (UGMA) and more recently theUniform Transfer to Minors Act (UTMA) have madeit easier and legally safer to make gifts of all types ofproperty to minors.

When making gifts to minors, the legal, tax, andpractical management aspects of the transfer all needto be considered, especially where timberland is con-cerned. The Revenue Reconciliation Act of 1993increased the spread between the lowest and highestnoncorporate income tax bracket by more than 50percent. This in turn has increased the motivation fortax shifting. State income taxes also have to be con-sidered.

Example 8.3. Assume that a parent who is in the36-percent income tax bracket gives a child (overage 14) an interest in timberland that is under along-term lease to a forest products company.The interest transferred provides an income of$10,000 per year. The lease payment is treated asordinary income for income tax purposes. If it isassumed that the child has enough additionalunearned income from other sources to utilize his(her) $550 standard deduction, the family hassaved $2,100 in income taxes [($lO,OOO x .36)versus ($10,000 X .15)].However, the issue of parental obligations for

legal support must be taken into account. A legalobligation of support makes the child’s incomeattributable to support taxable at the parent’s rate. Inaddition, trust income actually applied to the supportof a beneficiary whom the grantor is legally obligatedto support is taxable to the grantor (IRC Section677). The IRS treats custodial accounts similarly,and many State laws treat a guardianship as a trust,which would subject it to treatment under Section677. State law should be carefully considered withrespect to the definition of support because expensesfor private schools, a college education and, in some

cases, a graduate education may be considered asrequired for support.

Custodianship

Under the UGMA and UTMA laws for transferringproperty to minors, custodians have the same powerover the property that an unmarried adult could exer-cise over his (her) own property. These laws permitall types of property to be transferred, includingtimberland. The custodian can enter into businesstransactions that are required for managing the prop-erty. Such actions, however, are subject to the lawsgoverning fiduciary obligations.

State statutes should be checked for the specificrequirements concerning transfers, for the exactresponsibilities of the custodian and for the age ofmajority. The custodial control of a minor’s propertyis usually given over to the full control of the donee atthe age of majority, but the applicable State law shouldbe reviewed.

Estate Tax.--If the minor child dies before the cus-todial account is transferred to his (her) control, theproperty is includable in his (her) estate. It may beincluded in the donor’s estate if the donor is the cus-todian and dies before the child reaches the age ofmajority. Therefore, it is not a good idea for thedonor to also serve as custodian and risk having theassets included in his (her) estate, especially if thevalue is large. Similar problems exist with regard tothe donor’s spouse serving as custodian. These prob-lems suggests that a reliable aunt, uncle, or cousinwould be a safer choice.

Gijl Tax.--Gifts under the UGMA and UTMA qua-lify for the annual gift tax exclusion of $10,000($20,000 for split gifts). However, the parent-donorsshould not be custodians because there is a risk thatthe transfer to the child-donee at majority could betreated as a release of a general power of appointmentand, therefore, taxable to the parents.

Guardianships

A legal guardian takes custody of and manages aminor’s property. He (she) has fiduciary responsi-bilities similar to those of a trustee; however, theguardian does not hold legal title to the property. Theguardian can be the recipient of gifts to a minor.

Example 8.4. Assume the same facts as in exam-ple 8.3. The parent is appointed as the child’sguardian and, in addition, is also legally obligatedfor his (her) support. The $10,000 annual leaseincome would continue to be taxed at the parent’s

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36-percent marginal tax rate, even though it isnow the property of the child, if used for thechild’s support. The portion (if any) not used forthe child’s support, but rather for his (her) bene-fit, is taxable to the child. The guardian files theincome tax return for the child.For estate purposes, the property that is given to

the child is removed from the donor’s estate, subjectto the provisions for gifts within 3 years of death thatare discussed below on pages 52 and 53.

A guardianship provides the greatest protection forthe child’s property rights. This includes bonding,accounting, and court supervision. The price for thisextra measure of security for the child often meansadded operating costs and constraints on the flexi-bility of operations, as compared to a custodial ortrust arrangement. Potential disadvantages includeterminations at majority, which may be earlier thanwhat is in the best interests of the child’s welfare,and adverse estate tax consequences if the child dieswithin the term of the guardianship.

Trusts for Minors

Trusts can provide a very flexible means ofmaking larger gifts. The general applicability oftrusts as an estate planning tool is addressed inchapter 10. Certain specific issues related to gifts tominors will be discussed here. The grantor has con-siderable freedom to design a trust instrument thatmeets his (her) objectives. It can be established todistribute income to a minor during its term, accumu-late income for the minor, or both. The grantor canestablish the term of the trust, select the trustee (andsuccessor), specify when and how the principal willbe distributed, and fulfill other functions discussed inchapter 10. If substantial gifts are involved, this isprobably the most effective method of handling a gifttransfer to minors, assuming that the size of the giftwarrants the expense of setting up and operating atrust.

Two basic types of trusts are in most common useas instruments for making gifts to minors. Trustswritten to conform to the provisions of IRC Section2503(b) make the annual gift tax exclusion possiblebecause the transfer will be a gift of a presentinterest. This type of trust requires the currentdistribution of income to the minor but does notrequire distribution of the principal when the minorreaches majority. Trusts written in accordance withIRC Section 2503(c) also insure the availability of theannual gift tax exclusion on gift transfers for the

benefit of minors. Current distribution of income isnot required, but the distribution of the principal andincome is required when the minor reaches majority--or sooner if specified in the trust instrument. Theannual exclusion will additionally be available if theincome “may” be used by the beneficiary before he(she) reaches age 2 1, with the remaining principal paidto him (her) at age 21. If the minor dies beforereaching age 21, it will be paid to his (her) estate(GuU, CA-5 75-USTC 7 13,107, 521 F2d (1975),aff’g DC Tex., 75-l USTC 1 13,067). With thesetypes of trusts, the income portion is considered as agift of a present interest and the principal portion as agift of a future interest. The income tax treatment forthe beneficiary is as discussed above.

A trust written under the provisions of IRC Section2503(c) is a separate taxable entity. The income taxtreatment of trusts is discussed in chapter JO. Thetrust property will generally not be included in thedonor’s estate.

Trusts have considerable flexibility as tools formaking gifts to minors, but they require careful atten-tion to draftsmanship in order to qualify for the annualgift tax exclusion and also to make practical sense formanagement of property such as timberland. A quali-fied estate planner should be consulted.

GIFTS WITHIN 3 YEARS OF DEATH

The value of gifts made within 3 years of thedonor’s death is generally not includable in his (her)gross estate. Such gifts are valued on the effectivedate of transfer, and the appreciation in value after thatdate is not subject to the estate transfer tax.

There are certain exceptions to this rule, however,which apply whether a gift tax return is required ornot. The value of a life insurance policy transferredby the decedent within 3 years of death will beincluded in the gross estate. In addition, all gifttransfers within 3 years of death will be included inthe calculation of estate value for purposes of deter-mining the estate’s qualification for special use val-uation under IRC Section 2032A (see chapter 13),deferral and extension of tax payments under IRCSection 6166 (see chapter 14), and qualifications forspecial stock redemption (IRC Section 303). Such gifttransfers made within 3 years of death are not effectivefor meeting the statutory percentage requirementsunder these statutes. In addition, gift taxes paid ongifts within 3 years of death are includable in thedonor’s estate.

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In spite of these few restrictions, there are stillgood reasons for proceeding with a gifting programwithin 3 years of death. As noted above, the appreci-ation after the gift’s transfer is not taxable to thedonor; therefore, properties with high appreciationpotential, such as young plantations in zones I and II(see discussion of timber zones in chapter 2), aregood candidates for gifts. Similarly, subsequentincome generated from the gift is not includable inthe donor’s estate although the gift tax paid on thetransfer is included. For spouses the unlimited maritaldeduction may be used without incurring a gift tax.Gifts to donees in lower income tax brackets maysave on income taxes if not subject to the “kiddietax. ” In States with a gift tax, the State gift taxespaid are deductible on the Federal estate tax return.

Certain negative factors must be considered inmaking gifts within 3 years of death. One is thegross-up provision, which takes all previous taxabletransfers into account when computing the transfertax. Also, as discussed earlier, the gift does not geta stepped-up basis as does a testamentary transfer.This is particularly disadvantageous for timberlandbecause timber is a long-term investment. The basisfor most timber assets held for long periods of timeis low.

CHARITABLE GIFTS

Overview

With the peace of mind that comes from knowingthat one’s spouse and children will be adequately pro-vided for, a plan for charitable giving of additionalassets may bring great personal satisfaction. A donorcan benefit both his (her) family and the charity in avariety of ways. The affordability of the gift dependson its after-tax cost, which is affected by the donor’sfiling status, taxable income, and overall tax rate(that is, the sum of Federal, State, and local marginalrates, as adjusted).

FuZ jiZ Z s D ream s. --Charitable gifts can help fulfilldreams of things that the donor would like to havedone to help others, given different circumstances.For example, a scholarship could be provided for atalented young person to help him (her) achievethings not able to be done directly.

Sets Exam ple. --Giving sets a powerful example ofgenerosity and humanitarian concern for others--amessage of incentive and motivation to a generationwith sufficient wealth for survival. It also refutes themind set that implies, “I have mine and I don’t careabout you! ”

Uses Resources Eflciently. --Gifts permit efficientuses of resources. For example, churches and scholar-ships provide large benefits for the community and forsociety by combining voluntary labor and a rapid turn-over of resources. The gift enables the charity toleverage its resources.

Perm its Ch oice . --Gifts permit a choice of charitableopportunities, such as churches, forestry research,youth programs and community efforts. These may becombined in a number of ways that meet the donor’sobjectives.

Satisfaction. --Gifts should be viewed as a source ofsatisfaction rather than a cost. The donor should feelgood because he (she) has contributed to the better-ment of one or more persons or organizations thatbenefit the community.

Charitable Income Tax Deduction

Taxpayers can deduct amounts contributed to religi-ous, charitable, educational, scientific, and otherorganizations for income tax purposes. The tax effectsdepend on w h en assets are given, h ow th ey are given,h ow m uch is given, and to w h om they are given. Forsubstantial gifts, the donor should understand the dif-ferent categories of charitable giving and their effectson deductions. These categories include: (1) publiccharities--such as churches, universities, hospitals, andfoundations that have received considerable public sup-port; (2) semipublic charities--such as veterans organi-zations, nonprofit cemetery associations, and othersthat do not fit into the public charity category; (3)private charities--such as private, nonoperating, or dis-tributing foundations; (4) contributions for the use ofa charity (rather than “to” a charity); and (5) capitalgain property--that is, highly appreciated property.

Churches and subdivisions of government are auto-matically viewed as charitable, but private charitableorganizations must meet the requirements of Section501(c)(3) of the IRC and have an exemption letterfrom the IRS to prove their status in order to assure atax deductible contribution.

The percentage limitations on charitable contribu-tion deductions are based on the charitable category ofthe organization and the nature of the gift. Thecharitable contribution deduction for the tax year islimited to a percentage of the donor’s “contributionbase.” The donor’s contribution base is defined as his(her) adjusted gross income without regard to any netoperating loss carryback.

A 50-percent limitation on charitable contributiondeductions applies jointly to so-called “50-percent”

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charities, which include a number of organizationalcategories, both public and private. It is applied topublic charities first, then to private charities, andany contributions in excess are carried over for 5succeeding taxable years. There is a 30-percent limi-tation on deduction of contributions to private char-ities classified as so-called “30-percent” charities, aswell as contributions “for the use of” charities.Examples of the former include fraternal orders andveterans organizations. Deductions for contributionsof capital gain property to semipublic and privatecharities is limited to 20 percent of the donor’s con-tribution base. There is also a special 30-percentlimit on certain capital gain property given to a pub-lic charity, and there are further limitations based onthe ratios among these various categories.

Valuation of the Contributions.--A deduction fordonated property is measured by its fair marketvalue, subject to certain reductions for appreciatedproperty as discussed below. No problems exist forsecurities that are publicly traded. However, forlarge gifts of real estate or timber property a qualifiedappraisal must be obtained and a summary must beattached to the tax return (Section B, Form 8283) ifthe value of the property exceeds $5,000 ($10,000for nonpublicly traded property). The appraisal mustbe made within 60 days prior to the date of the gifts.The appraiser must be qualified to make appraisals ofthe type of property being gifted. For example, tim-berland should be appraised by a person who meetsthe federal appraisal standards. The appraiser mustsign the appraisal form, must not be related to thedonor, and must not work on a percentage basis.

There are penalties for overvaluation of property.If an audit determines the reported value to be 200percent more than the correct value, a 20-percentpenalty can be imposed. Additional penalties can belevied for more blatant overvaluation.

Appreciated Proper& --The charitable deductiondepends on the property’s fair market value, the typeof property (real or personal), the holding period, thecharacter of the charity, and the use of the property.Capital gains property and ordinary income propertyretain their different characters for charitable pur-poses.

Capital gain property held by the donor for morethan 1 year is given favorable tax treatment. That is,the donor gets a deduction of fair market value anddoes not have to pay tax on the appreciation, subjectto the alternative minimum tax. For real estate,including timberland, the donor is entitled to adeduction based on the property’s fair market value

on the date of the contribution. The deduction isgenerally limited to 30 percent of the donor’s con-tribution base, as noted above, if made to a publiccharity, such as a church or university. If the con-tribution is to a semipublic charity the limitation dropsto 20 percent. Contributions of capital gain propertyto certain private foundations that do not make distri-butions may be limited to the property’s basis.

However, there is also a special rule on contribu-tions of appreciated property that permit the donor todeduct up to 50 percent of his (her) contribution baseif an election is made to reduce the value of the con-tribution by the amount of the appreciation. The elec-tion decision should be based on the amount of theappreciation (timberland often has a very low or zerobasis and may not be a good choice), the importanceof a deduction greater than the 30-percent limit, andthe donor’s exposure to the alternative minimum tax(AMT) provision of the Federal income tax. Theappreciation is a preference item that is included in thebase of AMT taxable income.

Charitable Estate Tax Deduction

Lifetime charitable contributions generate not onlyan income tax deduction but also an estate tax deduc-tion. In addition to the income tax deduction dis-cussed above, the estate tax deduction depends on themarginal tax rate. At the estate’s taxable threshold(that is, just over $600,000 in taxable estate value) thesaving would be 37 percent of the value of the char-itable contribution. When the value of the taxableestate exceeds $3 million, the donor saves 55 percentof the value of the contribution. If the transfer is atestamentary bequest or includable in the donor’sestate by virtue of a retained interest, only the estatetax deduction will be available.

Gifts with Retained Interests--Charitable Remainders

A timberland owner may be thinking of giving aparticular property to a charity, but he (she) may feelthat the income from the property is needed for thepresent time. The transfer could take effect at death,but there may be a spouse or other family memberwho would need the benefit of the income value afterthe donor is gone. For example, there are manyparents who own woodlands in rural, often remoteareas of the country with children who are profes-sionals and live in distant cities, and who often havelittle interest in the tree farm. However, the children

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may feel that they need the income for educatingtheir children or for some other reason.

Such a landowner can make a present gift to acharity of a future interest. This is known as acharitable remainder. If the gift is money or liquidassets, the transfer should be in trust. For realproperty, however, the remainder interest can becreated without using a trust. The remainder can beconstructed to take effect at the end of a set term ofyears, at the donor’s death, on the death of the sur-viving spouse, or perhaps on the death of other per-sons as well. The donor of the gift gets a currentincome tax deduction based on the present value ofthe remainder interest. There are, of course, somestrict limitations.

The value of the remainder interest is deductiblefor Federal gift tax and income tax purposes, if givento a qualified charity. The amount of the gift is thefair market value of the property less the value of theretained “life interest,” determined from actuarialtables.

Ch aritable R em ainder Trusts.- -Th e donor can getan income, estate, or gift tax deduction for a char-itable contribution to a charitable remainder trust thathas one or more noncharitable beneficiaries only ifthe trust qualifies as an annuity trust or a unitrustunder the IRC. The annuity trust provides a “fixedannuity payment” to the income beneficiaries. A uni-trust provides a “variable annuity payment” based ona percentage of the trust’s earnings. Both trusts canbe established during a donor’s lifetime or by thedonor’s will. The donor is required to set aside cer-tain assets with payments--either fixed or variable--made for either a fixed term (not to exceed 20 years)or for the life of the donor-grantor, his (her) spouse,or other named persons with the remainder to go toa qualified charity. Distributions to the beneficiariesmust be made at least annually, and the principalmust not be used for the beneficiaries’ benefit exceptin accordance with specific payout requirements inthe trust.

Both the annuity trust and the unitrust require apayment rate of at least 5 percent. The paymentunder an annuity trust is calculated on the basis of theinitial fair market value of the trust assets, updatedannually. With a unitrust, the beneficiaries have avariable annuity. For example, if the assets aretimberland, the payments may fluctuate with thecyclical nature of the market. With a unitrust, theinstrument may, but is not required, to have a pro-vision permitting use of the principal if the annualincome is insufficient. Furthermore, additional

contributions can be made to a unitrust during thegrantor’s life or by terms of the grantor’s will underspecified terms and conditions [Treasury Regulation Q1.664-3(b)] and (Revenue Ruling 74- 149). On theother hand, with an annuity trust, once the paymentschedule is established, the annual payments are madefrom principal, if current earnings are insufficient andno additions to the trust are accepted. In fact, if thepayment rate is set too high for an annuity trust, theremainderman-the charity--may get a smaller gift thanexpected or none at all. This situation has been notedas an opportunity that invites abuse and thus meritsCongressional attention.

The unitrust may be created with an income-only ormakeup option. Under this arrangement, the trusteepays the beneficiary only the current income, but asearnings increase in future years the deficit in previouspayment amounts is made up DRC Section 664(d)(3)].

Tax Conse quences. - -Th e remainder interest underan annuity trust for tax purposes is the net fair marketvalue of the trust property less the present value of theannuity. If two or more beneficiaries are involved,the computations are based on the life expectancies ofeach individual. The present values are computedusing the IRS tables in IRC Section 7520 and arebased on a floating interest rate--120 percent of themidterm applicable Federal rate. Examples of the pro-cedure can be found in IRS publication 1458.

The annuity trust and the unitrust are exempt fromFederal income taxes except for unrelated business tax-able income. The distributions to trust beneficiariesare taxed as ordinary income first, and then as capitalgains to the extent of the trust’s undistributed capitalgains.

For estate tax purposes, the trust property’s valuewill be includable in the grantor’s estate if he (she) isthe sole beneficiary.

Pooled Incom e Fund.--This is an IRS-designedvehicle for charitable contributions that meets adonor’s needs and provides him (her) with a taxdeduction. It operates within safe guidelines for valua-tion of the contributions and for the protection of thegovernment and the charity. Whereas the annuity trustand unitrust are private endeavors, pooled incomefunds pull together several contributors to benefit boththe charity and the individual contributors. In a word,a pooled income fund is a public trust that is con-trolled by the charity. Most of the provisions aresimilar to the annuity trust and the unitrust; however,with pooled income funds, the property of all donorsare commingled. The pooled income trust cannotreceive or invest in tax-exempt securities. The income

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tax deduction is based on the present value of theremainder interest to the charity.

A Ch aritable Lead Trust.--This is the reverse ofthe charitable remainder annuity trust. Property isleft to create income for the charity, with theremainder interests passing to the family. It reducesdeath tax liability; however, there is a gift tax on thepresent value of the remainder interest when the trustis created.

Ch aritable R em ainder in a Personal Res id ence orFarm.--Generally, a donor can obtain a charitablecontribution deduction for a gift of a future interest inproperty only through a charitable remainder trust ora pooled income fund. However, the IRC makes anexception for the gift of a personal residence or farm[IRC Section 170(f)(3)(B)]. Under these circum-stances, a donor can contribute the property tocharity but reserve the right to live on it or use it forthe rest of his (her) life and for that of the survivingspouse, if applicable. The gift must be irrevocable.The personal residence can be a second home orcooperative apartment. A “farm” means land andimprovements used by the donor or tenant to producecrops, fruits, or other agricultural products orlivestock or poultry [Regulation 8 l.l70A-7(f)(4)].The regulation does not explicitly include or excludea tree farm. But if a taxpayer is considering usingthis provision of the IRC for a tree farm, it would beprudent to obtain a letter ruling (see page 33) fromthe IRS. If this fails, other alternatives should beconsidered. For example, this type of asset can betransferred by deed during life or by will at death,with the surviving spouse having income and right ofpossession for life, and the property then passing tothe charitable organization at his (her) death.

Qualified Conservation Contribution

A charitable contribution of any interest in prop-erty that is less than the donor’s entire interest doesnot qualify for a deduction unless it is an undividedpart of the donor’s entire interest, or a gift of apartial interest in property that would have beendeducted if it had been in trust.

A charitable contribution of an open space ease-ment in gross and in perpetuity is treated as a con-tribution of an undivided portion of the entire interestof the donor in the property [Regulation 8 l.l70A-7(b)(l)(ii)]. An easement in gross is defined as apersonal interest in, or right to use, the land ofanother. A deduction is allowed for the value of arestrictive easement gratuitously conveyed to the

United States in perpetuity. Special rules apply toeasements and remainder interests granted for conser-vation purposes.

Gifts of partial interests in real estate generally donot qualify for a charitable contribution deduction;however, a qualified conservation contribution is anexception [IRC Section 170(f)(3)(B)(iii)]. A qualifiedconservation contribution is defined as a qualified realproperty interest donated to a qualified conservationorganization exclusively for conservation purposes[IRC Section 170(h)]. A qualified real property inter-est is defined as the entire interest of the donor otherthan a qualified mineral interest, a remainder interest,or a restriction granted in perpetuity on the use thatmay be made of real property. The term “conserva-tion purpose” is defined to include any one (or more)of four objectives: (1) the preservation of land areasfor outdoor recreation by the general public or for theeducation of the general public; (2) the protection ofa relatively natural habitat of fish, wildlife, or plants,or similar ecosystem; (3) the preservation of openspace, including farmland and forest land, where suchpreservation (a) is for the scenic enjoyment of the gen-eral public and will yield a significant public benefit or(b) is pursuant to a clearly delineated Federal, State orlocal conservation policy and will yield a significantpublic benefit, and (4) the preservation of a historic-ally important land area or certified historic structure.

The conservation purpose must be protected in per-petuity. Qualified organizations are limited to govern-ment and publicly supported charities or organizationsthat they control. The value of the conservation ease-ment is based on the sales of similar easements to thegovernment if such records exist. If such records donot exist, the conservation easement is based on thedifference between the fair market value of the prop-erty before and after the easement [Regulation 8l.l70A-14(h)(3)]. After the conservation easement ismade, the donor must reduce the basis of the retainedproperty by the proportional part of the basis allowableto the easement.

Example 8.5. Talloak owns a 200-acre parcel oftimberland in the path of a suburban leap frogdevelopment. The property has been in the familysince the original land grant from the King, and itis the owner’s objective to keep the property in thefamily and in timber production. The market valueof the property for timberland is $300,000,including the current growing stock which has beenwell managed for timber and wildlife. The fairmarket value in the “highest and best use” in 1993had risen to $900,000. Talloak gave the USDA

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Forest Service a permanent conservation easementsubject to the restrictions that the property wouldbe managed on a sustained-yield basis, that nomore than 20 percent of the forest could be har-vested in a S-year period, and that it would bepromptly regenerated within 2 years. The$400,000 charitable deduction is limited by theincome tax contribution rules discussed above.The income tax deduction is limited to 30 percentof adjusted gross income because it is appreciatedproperty given to a public charity. SinceTalloak’s adjusted gross income is $200,000, thecurrent income tax deduction is $60,000($200,000 X 30 percent). With a 5year carry-over for excess contributions, Talloak’s adjustedgross income is expected to increase sufficiently tofully absorb the deduction over this period. Theestate’s value is also reduced by $400,000 due tothe restriction. The appraisal was made by a qua-lified consulting forestry company that specializesin forest appraisals.

Examples of Charitable Giving

The following are recent actual case examples,with the persons’ names changed.’

Example 8.6. Case l--A Gift of Timber.Mr. Plen T. Trees, a bachelor in his mid-50’s,

was interested in a plan that would save taxes andpay him income for life.

He owned a stand of timber, deeded to him byhis parents 20 years earlier, and now worth$300,000 to $350,000. He owned only the tim-ber, not the land.

Working with his CPA and Linfield’s develop-ment office, he established a charitable remaindertrust with the timber. This made it possible forhim: (1) to avoid the capital gain on the sale ofthe timber,(2) to obtain a charitable income taxdeduction in the year of the gift, (3) receive anincome for life, and (4) to save on estate taxes byreducing his taxable estate.

A unitrust was chosen because Mr. Treeswanted a vehicle that would keep up with infla-tion. A unitrust pays a fluctuating income basedon the value of the assets in trust, revaluedannually. As the trust assets increase/decrease invalue, Mr. Trees receives a higher/lower income.

‘Prepared by Ms. Elizabeth Holden, Director ofPlanned Giving, Linfield College, McMinnville, OR, andused with permission.

The specific unitrust is an “income only with makeupprovisions” instrument. In periods when the trustassets do not earn enough to pay the agreed uponpercentage, Mr. Trees receives the actual incomeearned. The balance will be “made up” and paid tohim later in years when the trust earns more than theagreed upon percentage

The results are that the trust sold the timber for$330,000, neither Mr. Trees nor the trust had torecognize a capital gain on the sale, he was allowed acharitable income tax deduction in the year of the giftof $34,000, and he began receiving an annual incomeequal to 12 percent (when the trust was established in1988 interest rates were higher than currently) of thevalue of the trust, which will continue throughout hislifetime. At Mr. Tree’s death, Linfield College willreceive the trust principal that remains as a charitablegift and will set up an endowed scholarship fund in hisname.

Example 8.7. Case 2--A Gift of Land and Timber.Mr. Well D. Zerved, a recently retired busi-

nessman who had developed a very successful com-pany, wanted to make a major contribution to theeducational programs of Linfield College. He andhis wife, ages 68 and 70, had several children andmany grandchildren for whom they wished to pro-vide in their estate plan. They had sufficientfinancial wealth from his work to leave substantialamounts for their heirs as well as their charitableinterests.

Working with his attorney to determine whichassets to use and the best way to make the contri-bution, Mr. Zerved established a charitable remain-der unitrust and named Linfield College as thecharitable remainderman. He funded the trust witha large tract of land, timber, and mineral rights thathe had held for many years. The property wouldhave been subject to a considerable capital gain ifsold directly.

Since Mr. Zerved wanted to make sure that hiswife was well provided for if he should predeceaseher, he chose a two-life trust that would make pay-ments throughout both their lifetimes. Specifically,it is a unitrust with a “net income with makeupprovision. ” The payout rate is set at 10 percent ofthe assets of the trust, revalued each year.

The results were that the property, appraised at$550,000, was sold by the trust for a much higherprice with no tax obligation. Mr. Zerved wasallowed a charitable gift deduction of $96,700 inthe year of the gift, he avoided income tax on thesale of the appreciated value of the property, and

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he reduced the taxable value of the estate. Mr.and Mrs. Zerved are receiving an annual income,set at a payout rate of 10 percent, until the deathof the survivor beneficiary. At that time, LinfieldCollege will receive the proceeds of the trust andestablish a named endowment as requested by Mr.Zerved at the time the trust was created.Example 8.8. CASE 3--A Gift of Timber withTimberland Retained.

Mr. and Mrs. Juan A. Travel, farmersapproaching retirement (ages 55 and 53), wereinterested in freeing themselves from some oftheir farm responsibilities. They wanted to retire,have their son take over the responsibility ofrunning the farm, and have as much income aspossible to do a little traveling.

They owned a tract of timber valued atapproximately $150,000 together with the landthey farmed. It had such a low basis that theywould have had to pay what seemed like an

enormous amount of capital gains tax if they soldit. Mr. Travel had heard about charitable trusts, sothey came to Linfield College to find out moreabout this life income arrangement. Because theywanted to pass the land to their children when theydied, they decided to retain the land, but give thetimber to establish a charitable remainder trust.

The results were that in 1990 the trust sold thetimber tax free to a buyer who logged andreplanted the tract. The Travel’s have a lifetimeincome from the two-life unitrust with an annualpayout rate of 7.5 percent of the trust’s assets,revalued annually. Because they avoided a capitalgain tax, they had $45,000 more invested forincome than they would have had if they had soldthe timber themselves. Their children will receivethe reforested land with growing timber when theydie. Linfield College will receive the principal inthe trust to establish a scholarship fund in theTravel’s memory.

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Chapter 9Generation-skipping Transfers

A detailed discussion of generation-skippingtransfers and the associated generation-skipping taximposed by chapter 13 of the Internal Revenue Code(IRC) is beyond the scope of this book. The proce-dures involved are complex in nature and oftenhazardous to implement.

Nevertheless, generation-skipping transfers, ifproperly planned, can be used to provide income freeof Federal estate and gift taxes to one or moregenerations of direct heirs. The property itselfeventually passes to a person or persons two or moregenerations down the line. The forest estate plannershould therefore be alert to the benefits of generation-skipping transfers while at the same time under-standing the disadvantages.

GENERAL PROVISIONS

Every individual has a $1 million generation-skipping transfer exemption which he (she) can allo-cate during life by gift or at death by will to anynumber of generation-skipping transfers. An alloca-tion, once made, is irrevocable. Married couples canelect to split the use of the exemptions, thus raisingthe amount to $2 million, much like the case of splitgifts discussed in chapter 8.

The generation-skipping transfer tax is imposed atthe time the property is eventually transferred.Unlike the estate and gift tax, which has a progres-sive rate structure, the generation-skipping tax isimposed at a flat rate equal to the maximum Federalestate tax rate in effect at the time of the eventualtransfer--currently 55 percent plus a possible surtax.

A generation-skipping transfer involves use of agranted life estate that can either be held in trust orcreated outside of a trust. Life estates not held intrust are referred to as legal life estates. The dis-claimer provisions of Federal law discussed inchapter 7 apply for generation-skipping transfer pur-poses (see IRS Letter Rulings 8815034 and 8907028).

Advantages

If the family goal is to preserve the woodlandoperation intact through more than one generation,

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minimization of the estate tax in the estates of thechildren of the current generation is critical. Pre-serving the operating property for the lifetime of thechildren is consistent with such a family goal, and thusa generation-skipping transfer may be an ideal arrange-ment.

Example 9.1. A grandparent (A) might leave bywill a tract of timber property valued at $500,000to his child (C) for life, with a remainder interestto a grandchild (G). C, the life tenant, would beentitled to the income from the property for life.At C’s death, title to the property would pass to G.Under current law, an exemption from Federal taxof $1 million per transferor, as discussed above, isprovided. This means that the property in questionwould be subject to Federal estate tax in the estateof A but not again until the death of G. At G’sdeath, the transfer would be subject to a flat rate of55 percent under current law. The same rule.would apply if the transfer by A had been made bydeed during his lifetime rather than by will at hisdeath, with the normal $1 million exemption.Strategic use of the $1 million exemption will per-

mit particularly large sums to escape taxation. Assetswith the greatest potential for appreciation should beused to fund generation-skipping transfers.

Disadvantages

A number of disadvantages apply to generation-skipping transfers. In specific instances, these mayoffset the potential benefits. A careful analysis of eachparticular situation is critical in order to avoid costlymistakes.

Special use valution as discussed in chapter 13applies only to generation-skipping transfer property asincluded in the transferor’s gross estate, not to theproperty as included in the eventual transferee’s estate.The same rule applies to the installment payment ofestate tax under Section 6166 of the IRC as discussedin chapter 14. As mentioned above, the property willbe taxed in the transferee’s estate at the maximum ratethen in effect, and without benefit of the unifiedcredit. The credit for previously taxed property (seepage 22) also is not allowed. With respect to life-timegeneration-skipping transfers, the $10,000 gift tax

annual exclusion is not available if the transfer is notof a present interest. (See chapter 8 for a discussionof the annual exclusion.)

Special Problems with Timber Properties

Problems may arise with legal life estates over thequestion of how far the life tenant can go withrespect to certain actions involving the property inquestion. This is particularly important with timber-land.

For example, what constitutes income from a tim-ber property? Will harvesting be restricted to cuttingonly timber volumes equal to the growth that occurs

after creation of the life estate? Or can additionalharvesting be done if part of a professional forestmanagement plan? What rights do the life tenant havewith respect to making changes on the property wherean expenditure of funds would be needed to return theland to its previous condition? What about minerals?State law in many instances controls the answers tothese questions. In some cases, however, dependingon the State in question, there are no clear guidelines.For these reasons and more, a trust with carefullydrafted powers for the trustee can provide a moreflexible management structure than could a transferoutside of trust. (See chapter 10 for a more detaileddiscussion of trusts.)

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Chapter 10

Role of Trusts

OVERVIEW

A trust is an arrangement by which a person orentity called a trustee holds legal title to designatedproperty in trust. The property in the trust is calledthe corpus, and it is managed by the trustee for thebenefit of one or more beneficiaries. The rulesgoverning trust administration come from Federallaw, State law, and the provisions of the trust instru-ment itself. Federal law primarily concerns theFederal tax treatment of income, estate, and gifttransfers associated with trusts. State law generallygoverns the conduct and rights of the trustee, controlson trustee action, and State tax aspects. The trustinstrument contains the rules of operation within theoptions permitted by State law.

A trust may be established to do almost anythingthe person creating it, called the grantor, might dofor himself (herself) and some things that he (she)cannot do because of lack of skill, sickness, dis-ability, distance from the timberland, or death. Theability of the trust to bridge the gap between life anddeath is one of its remarkable characteristics. A trustis recognized as a separate legal entity under bothState and Federal law.

BASIC CONSIDERATIONS

The discussion that follows concerns trusts gen-erally; however, the principles are illustrated inseveral examples concerning timberland.

Trust Provisions

Trust law is complex and, as noted above, is basedon both Federal and State law. Because the States donot have a uniform law of trusts, it is imperative tohave the trust instrument drafted by an attorney whoknows not only the Federal tax rules but also theapplicable State law. The provisions generallyincluded in a trust are as follows:

Property.- -Th e property transferred to the trust tobe managed--the corpus--is described. If timberlandis being put in trust, the applicable deeds and legaldescriptions should be included.

Trustee.--This is the person or entity who holds

title to the property and signs the trust agreement.The trustee may be either an individual or aninstitution such as a bank and may include cotrusteesas necessary or desired.

Bene$ciaties.--Both primary and contingent bene-ficiaries may be named. The conditions under whichincome and principal will be distributed are spelledout. With respect to timber, it is particularly impor-tant to distinguish between the principal (timber mer-chantable volume and young growth present at creationof the trust) and the income (subsequent growth); andbetween the trustee’s powers and the beneficiaries’rights with respect to both.

Pow ers.- -Th e administrative powers and flexibilityaccorded the trustee are enumerated. Flexibility isespecially important as concerns timberland because ofsometimes rapid changes in markets, new technology,and environmental regulations.

Spendth rift Provision.- -Th is bars transfer of abeneficiary’s interest and stipulates that it is notsubject to a creditor’s claims, subject to the provisionsof State trust law.

Term - -Th e length of the trust is the term. If ashorter period is not specified, a saving clause againstperpetuities can provide that the trust will end no laterthan the period allowed by State law. State law gen-erally limits a trust term to no more than 21 yearslonger than the death of the last surviving beneficiarynamed in the trust.

Bond.- -Th e trust may specify that the trustee post abond, but most trusts normally exempt the trusteefrom this requirement and address the conditions forexemption of successor trustees.

Successor.- -Th e trust instrument should provide forappointment of a successor trustee in the event thenamed trustee dies, becomes incapable, or declines toserve.

Fees.--Payment of reasonable fees to the trustee isprovided for, or alternatively the trustee serves withouta fee. Institutional trustees always serve for a feebecause that is their business.

Nontax Benefits

Nontax benefits can include professional manage-ment of financial and real property assets, includingtimberland. A trust can be designed to assure a timber

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owner or beneficiaries designated by the owner ofboth income and protection from creditors. Trustsare frequently designed to benefit family members--such as spouses, minor children and grandchildren,and aged parents--during either the life of the grantor(living trusts) or after the grantor’s death (testa-mentary trusts). Th e trust supplies the missingmanagement and experience elements for the bene-ficiaries, who may lack ability and training, be inpoor health, be involved in school or a profession, orbe incompetent. It can provide the opportunity totravel by insuring professional management of tim-berland and other assets and by freeing the grantorand/or beneficiaries from management details. Atrust assures continuity of management, provides pri-vacy, and can save probate expenses. In fact, trustcreativity is limited only by the grantor’s imaginationand the applicable law.

TAX TREATMENT OF TRUSTS

Trusts can provide savings in three major taxareas: income, estate, and gift. These are discussedhere, in general terms. Specific tax considerationsassociated with particular types of trusts areaddressed later.

Income Taxes

A trust can either be a separate taxable entity or aconduit for passing income to beneficiaries, who thenreport the income on their own returns, or both.Moreover, a trust can be set up to accumulateincome, distribute income, or a combination of both.Thus, the trust income can be split in one more waythan there are beneficiaries. The grantor is taxed ontrust income only to the extent of income actuallyreceived, or income actually used for the support ofsomeone that the grantor is legally obligated tosupport.

The Federal income tax saving benefits associatedwith trusts have been severely limited by recent taxreform changes. Th e rules with respect to short-term, income-splitting trusts--such as Clifford andspousal remainder trusts (see chapter 8)--have beenchanged so that the income from such trusts is nowtaxable to the grantor, thus removing them as aneffective income-splitting device between grantor andbeneficiary. Income from other types of trustsreceived by children under age 14 who are eligible to

be claimed as dependents on their parents’ returns istaxed at the parents’ rate on income in excess of$1,100 per year. Both trust and estate Federal incometax rate schedules have been revised to lower thebracket thresholds far below those of other noncorpo-rate taxpayers. Trusts must also now make estimatedpayments on income. The current income tax rulesregarding estimated payments and distributions tobeneficiaries may serve to increase the cost of trustadministration. Generally, trusts must use a calendaryear as their tax year. There still remain a number ofways for the grantor to retain favorable income taxtreatment, but they require careful analysis by aspecialist in order to conform to all the rules and arebeyond the scope of this book.

fie Trust Tax Return.- -A trust is taxed like an indi-vidual with certain important exceptions. A limitedexemption--equivalent to a personal exemption--of$300 for trusts required to distribute all income cur-rently and $100 for others, is allowed. For the 1993tax year, undistributed income is taxed at 15 percenton the first $1,500, at 28 percent on amounts from$1,500 to $3,500, at 31 percent on income from$3,500 to $5,500, and at 36 percent on amounts over$5,500. A lo-percent surtax produces an effective39.6-percent rate on taxable income above $7,500.These rate thresholds are indexed for inflation.

Deductions and credits for trusts are similar to thosefor individuals, with some important differences fortimber. For example, trusts are not eligible for thereforestation amortization and investment tax credit.These expenditures must be capitalized and recoveredwhen the timber is sold or otherwise disposed of. Theopportunity to immediately deduct certain depreciablecosts under Section 179 of the IRC also is not avail-able to trusts. Other differences are covered inSection 642.

Generally, the conduit principle applies to incomedistributed under a simple trust. The income isreported by the trust on its tax return and is thenallowed as a deduction to the extent distributed orrequired to be distributed. Beneficiaries are taxed onthe income required to be distributed to them whetherreceived or not. Thus, the trust works as a conduitfor income passed through to the beneficiaries. Thedistributable net income (DNI) concept limits thedistribution deduction allowed the trustee. It alsolimits the amount includable in the beneficiaries’ grossincome. Distributable net income is defined in IRCSection 643(a).

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Example 10.1. A simple timber trust requires thatall income be distributed currently to the lifebeneficiary. The trust has ordinary income in1993 of $18,000 from crop and hunting leases,expenses of $750 chargeable to income, long-termcapital gains of $6,000 from timber sales, and$2,250 in expenses chargeable to corpus.

The beneficiary would receive $17,250 ($18,000minus $750). The trust’s DNI would be $15,000[$18,000 - ($750 + $2,250)], which is the taxableamount to the beneficiary (capital gains areexcludable from DNI). The trust’s taxable incomeis $5,700 ([$18,000 ordinary income + $6,000capital gain] - [($300 exemption + $3,000expenses + $15,000 DNI]). The result is that thetrust beneficiary gets deductions that wouldordinarily be charged to trust principal.Example 10.1 is for a simple trust. Complex

trusts, which may accumulate income or distributeprincipal, in addition to distributing income, aremuch more intricate and beyond the scope of thisdiscussion.

The income tax basis for property transferred to atrust by lifetime gift is the donor’s basis increased bythe gift tax on the unrealized appreciation. On theother hand, property transferred to a trust from adecedent that is includable in his (her) estate receivesa stepped-up basis equal to its value for estate taxpurposes. This is an important consideration indealing with highly appreciated assets such as is oftenthe case with timberland. The stepped-up income taxbasis for timber property that is valued in its currentuse under IRC Section 2032A (see chapter 13) is itsspecial use value.

Accum ulated incom e.- -Th e re may be many reasonsfor accumulating income in a trust. For example, ifthe beneficiary does not need all of the trust incomecurrently, or if he (she) could not use it wisely, itcould be accumulated if the trust instrument so per-mits. If the beneficiary’s tax bracket is higher thanthat of the trust, the accumulation of income willproduce an immediate tax saving. However, becausethe 28-percent tax bracket for trusts begins at $1,500,the opportunity for this type of savings is limited.

When the trust accumulates income for highincome beneficiaries, certain so-called “throwbackrules” apply to the ultimate distributions. The basicpremise is that distributions will be taxed as theywould have been in the years the income was earnedby the trust. A “short cut” method is now used forcomputing the tax, which is still quite complicated.

Estate Taxes

When establishing a trust, the grantor must decideif he (she) wants the trust corpus included in his (her)estate. If the situation is such that the estate will besubject to tax, substantial estate tax benefits willaccrue from exclusion of the property from the estate.The penalty is loss of control of the property duringthe grantor’s lifetime. There are also advantages to begained from keeping the property out of probate, suchas continuity of management and probate cost savings,which will vary by State.

If the grantor is willing to relinquish control of trustproperty forever, the property’s value will not beincluded in his (her) estate. However, if the propertyis an insurance policy on the life of the grantor, he(she) must transfer it to the trust more than 3 yearsbefore death in order to be excluded from the estate.Most grantors are reluctant to give up control even ifit means large estate tax savings. Furthermore, taxproblems are often associated with living trusts whenit is not clear how much control or benefit has beenretained by the grantor. There are a number of guide-lines in several sections of the IRC that should beobserved if the desired outcome is to prevail for theheirs.

Power-.--The power to revoke, alter, amend, or ter-minate a trust should be given up. If such powers areretained, they will result in the trust assets beingincluded in the grantor’s estate. Furthermore, thechanges should be made more than 3 years before theexpected date of death (IRC Sections 2035 and 2038).

Life Interest.- - If a life interest in the possession,enjoyment, or right to income from the trust propertyor the power to dictate who will enjoy the property isretained, it will result in the property being includedin the grantor’s estate. For example, reserving theright to hunt and fish or the right to hunting leaseincome from timberland will have the effect ofincluding the entire property in the decedent’s estate.This rule also applies to voting rights associated withstock in a “controlled corporation” (see chapter 17),which may own timberland in a trust.

R eversionary Interest.--Keeping a reversionaryinterest increases the possibility that property willreturn to the grantor’s estate. If the reversionaryinterest is worth more than 5 percent of the totalproperty value when the decedent dies, it may beincluded in his (her) estate (IRC Section 2036).

General Pow er of Appointm ent.- - R e tention of con-trol to dispose of trust property in the grantor’s favor,

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or in favor of his (her) estate or creditors, will resultin the inclusion of the property in the estate (IRCSection 204 1).

Insurance Policy .--If an insurance policy is to bepart of the trust corpus, the estate should not be thebeneficiary, and if someone else is the beneficiary,the insured should not retain “incidents of ownershipin the policy” (IRC Section 2042) (see chapter 11).Transfers of any powers with respect to an insurancepolicy, within 3 years of death, will result ininclusion of the policy in the estate.

Gift Taxes

A transfer of property to a trust involves a gift.The trust beneficiaries are the donees rather than thetrustee. This fact has special significance in applyingthe annual gift tax exclusion. That is, there are asmany exclusions available as there are beneficiariesfor either the $10,000 annual exclusion or the$20,000 split gift tax exclusion (see chapter 8 and thetrust example on page 66).

Transfers of nonincome-producing property to atrust can also pose a problem in connection with theannual exclusion. Timberland is generally treated asbeing nonproductive when it does not produce currentincome. This problem can be overcome by showingthat the timber is an appreciating asset and that it isproducing unrealized income in terms of volume andvalue growth. It may be advisable to incorporategrowth projections and recommendations for pro-ducing periodic income by thinning and final harvestsinto the management plan. The information in theplan can be refined at anytime to show current annualincrements and a schedule of accumulating values.

Trust benefits can be costly. The advantagesoutlined here must be balanced against the costs suchas legal fees, the trustee’s fees, and ongoing timber-land management costs.

TYPES OF TRUSTS AND APPLICATIONS

Trusts are flexible tools in estate planning thatgenerally provide one or more otherwise unavailablebenefits. These include shielding the trust’s assetsfrom creditor’s claims, accumulating funds for col-lege tuition, and providing necessary financialsupport for children or retired parents. Income orestate tax savings, or both, may also be a goal, aswell as the desire to avoid probate.

Living Trusts

A living trust is created during the grantor’slifetime. It can be either revocable or irrevocabledepending on the goals of the grantor.

Irrevocable Living Trust.- -Th e grantor gives up thetrust property permanently, but in return gains super-vised management and investment of the assets, andavoids probate. He (she) may pay gift tax upon estab-lishment (see chapters 3 and S), but the trust corpus isnot includable in his (her) estate, and income is taxableto the beneficiaries as it is distributed annually. Otheradvantages of an irrevocable living trust include thepossible saving of estate taxes in the grantor’s estateand those of the life beneficiaries, providing protectionfor family assets, and perhaps saving income taxes forthe family. Avoiding probate prevents public dis-closure of the decedent’s financial affairs, the size ofthe assets of the estate, and the listing of the bene-ficiaries and the property each received. With respectto timber, it eliminates the necessity of operating thetree farm as part of an estate while the estate is beingsettled. Probate fees and expenses are saved. Estatetax savings are achieved by keeping the trust assets,which may have appreciated considerably since thetrust was established, out of the grantor’s estate. Thisis accomplished by not retaining a life interest in theproperty (IRC Section 2036); not keeping a reversion-ary interest worth more than 5 percent of the propertyvalue on the date of death (IRC Section 2037); notkeeping the power to alter, terminate, or revoke thetrust (IRC Section 2038); not having a general powerof appointment as defined in chapter 6 (IRC Section2041); not possessing an incidence of ownership of alife insurance policy on his (her) life that names thetrust as beneficiary, or not transferring ownership ofthe insurance policy on his (her) life within 3 years ofdeath (IRC Sections 2042 and 2035)--all as discussedearlier.

The primary disadvantages of an irrevocable livingtrust are giving up control of the timber property andother assets placed in trust, and keeping a hands offposture forever. There are also, of course, the costsof distributing the trust corpus upon termination. Gifttaxes will also be due if the transfer to a trust exceedsthe $10,000 ($20,000 for split gifts) annual gift taxexclusion per beneficiary (donee) plus whatever uni-fied credit equivalent is available.

R evocable Living Trust.- -A revocable living trustmay be changed or terminated by the grantor at anytime. It may be funded or unfunded; it provides an

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opportunity for the grantor to try certain provisionsand make changes as needed to meet his (her) goals.Because it is revocable, there are essentially no taxsavings associated with this type of trust. Theincome is taxable to the grantor. The fair marketvalue of the trust assets are taxable in the grantor’sestate. There is no gift tax, however.

The advantages of a revocable living trust include:(1) avoiding probate; (2) avoiding interruption offamily income upon either the grantor’s death orupon his (her) becoming incompetent; (3) providinga trial period for trust operation and the power tomake subsequent changes based on experience; (4)consolidating scattered real estate, such as timberproperties, in two or more States by putting the titlein trust and avoiding ancillary probate; (5) enablinga business or other enterprise, such as a tree farm, tocontinue operating; (6) relieving the grantor of anadministrative burden, such as timber management;(7) having generally less accounting and administra-tion requirements than a testamentary trust; (8) beingpossibly less vulnerable to judicial challenge of thegrantor’s capacity as compared to a testamentarytrust; (9) depending on State law, possibly serving tobar the statutory rights of a surviving spouse to ashare of the decedent’s property and putting theproperty beyond the reach of the grantor’s creditors;and (10) serving as an instrument to accept deathbenefits from employee plans and life insuranceproceeds on the grantor’s life. Thus, the revocableliving trust has many advantages, but it is veryimportant to have the instrument carefully drafted andcoordinated with the grantor’s will.

The disadvantages, as noted above, are that theincome is taxable to the grantor and the trust’s assetsare includable in the grantor’s estate. However, thetrust becomes irrevocable on the grantor’s death(unless terminated at that time) and then becomeseligible for tax advantages associated with irrevocabletrusts. The trust may be established to avoid deathtaxes upon the death of the beneficiaries, althoughthis procedure is subject to the generation-skippingtax (see chapter 9). The trust incurs the costs ofestablishment and operation during the grantor’s lifeand may incur additional costs at death, such as thoseassociated with filing Federal estate and State deathtax returns.

Standby Trust.- -Th e standby trust is generally revo-cable but may be established to become irrevocableupon the grantor’s disability. It provides supervisedcontrol and investment management if the grantor is

disabled or absent, but the income is taxable to thegrantor, and the fair market value of the estate prop-erty is includable in his (her) estate. There is no gifttax liability. The standby trust is essentially designedfor the contingency of the grantor becoming mentallyor physically disabled, or having the inability to man-age his (her) affairs for any reason. Its primary advan-tage is prevention of incompetency proceedings underState law, while at the same time protecting thegrantor’s assets and providing for his (her) financialneeds. The disadvantages are that there are no incomeor estate tax savings and it may not be available underthe law in some States.

Pourover Trust.- -Th e pourover trust is a living trustthat may be either revocable or irrevocable, funded orunfunded. Its purpose is to receive and accumulatepayouts and proceeds from various sources as theseoccur over time--such as insurance payments, annuitychecks, and similar receipts. The tax treatment is thesame as for other living trusts discussed above,depending on revocability. The pourover trust can bevery useful as a means of collecting funds from dis-parate sources such as individual retirement accounts,Keogh plans, insurance policies, qualified employeebenefit plans, and assets from estates and other trusts.

The pourover trust can be established to give theprime beneficiary of a life insurance policy a lifeinterest in the insurance proceeds, rather thanreceiving them outright. The corpus of the proceedsis then directed to others on the death of the primebeneficiary and are not part of his (her) estate.

Pourover trusts are relatively new and some techni-cal issues remain unresolved. When used with a will,the trust should be in existence before the will’sexecution, kept separate, and incorporated byreference.

Grantor R etained Interest Trust.- -W ith th e so-calledgrantor retained income trust (GRIT), grantor retainedannuity trust (GRAT), and grantor retained unitrust(GRUT), the grantor reserves a qualified term interestin the form of either a fixed dollar or fixed percentageannuity (IRC Section 2702). At the end of the speci-fied term, the principal passes to the remainder per-sons. The nontax benefits of such trusts are generallynegligible. The trust income is taxable to the grantor.The value of the corpus is not taxable to the grantor‘sestate unless he (she) dies within the reserved incometerm (period). The gift tax that may be due on estab-lishment of the trust depends on the value of theremainder interest at the time the trust is created.

The term of GRAT’s and GRUT’s is not limited bystatute but by practical considerations. If the grantordies within the term, the principal is taxable in his(her) estate. Thus, the period of the trust should besubstantially shorter than the grantor’s life expectancyconsidering both mortality tables and actual lifeexpectancy due to health and other factors.

Current rules substantially limit the use of GRIT’sthat provide transfers for the benefit of a familymember. Family members are defined to includespouses, ancestors of the transferor or transferor’sspouse, lineal descendants of the transferor or trans-feror’s spouse, brothers and sisters of the transferor,and spouses of the above. Family members do notinclude nieces and nephews or friends. There arespecial rules for the valuation of tangible nondepre-ciable property, especially undeveloped land thatgenerates limited or uncertain income. It would seemthat forest land would be included in this category.The valuation under IRC Section 2702(d) of the terminterest is the amount that the holder of the terminterest establishes as the amount for which theinterest could be sold to an unrelated third party.

Testamentary Trusts

Trusts created in accordance with the instructionscontained in a decedent’s will are known as testamen-tary trusts. They provide supervised control andinvestment management of the trust assets, and trustincome is taxed to the beneficiaries if currentlydistributed. The fair market value of the decedent’sassets that are put into the trust are includable in his(her) estate, but there is no gift tax liability.Generally, a testamentary trust is utilized by indi-viduals who are unwilling to give up control of assetswhile alive.

The advantage of a testamentary trust is that it canprotect the trust property from successive estate taxlevies as the income is utilized by successive genera-tions, such as surviving spouse, then children, andthen grandchildren. The generation-skipping transfertax (see chapter 9) may become applicable upon finaldisposition of the property. The nonmarital credittrust is a good example of an estate tax-saving testa-mentary trust. Up to $600,000 of the decedent’sassets, including timber, could be put into trust at thedecedent’s death and qualify for the unified credit.The trust would then pay the surviving spouse incomefor life and permit use of the principal subject toascertainable needs, but withhold control from him

(her). The property will thus not be taxed in eitherthe decedent’s or the surviving spouse’s estate and thecorpus passes to the children or other secondgeneration beneficiaries estate-tax-free.

Example 10.2. Greentree owned 1,200 acres oftimberland--one-half was a lo-year-old plantationvalued at $600,000 and growing currently at 25percent per year; the other half was mature timbervalued at $1,500,000. Assume that this constitutedthe net taxable estate for his spouse, two marriedchildren, and four grandchildren. None of the uni-fied credit had been previously utilized.

When Greentree died, his will’s marital deductionformula clause directed the $600,000 exemptionequivalent into the nonmarital-unified credit trust(see fig. 10.1 on the following page). This transferwas protected from estate tax by the unified creditof $192,800. The trustee had the discretion to paythe surviving spouse the trust income if needed, plusthe option to invade the principal for her benefit ifrequired, subject to an ascertainable standard ofliving. The executor funded this bequest with theplantation valued at $600,000 so that its rapidappreciation would accumulate tax free for thechildren and their families.

The balance of the estate, $1,500,000 in maturetimber, went into a marital deduction trust for thesurviving Greentree spouse. The estate tax wasdeferred by Greentree’s marital deduction, and anadditional $600,000 will pass tax free to the childrenand their families at the spouse’s death. In themeantime, the timber will be harvested and eachfamily member will be given $10,000 per year plustuition while in college and gradate school. Becausethe surviving Greentree spouse has a life expectancyof 22 years and a yen for travel, these proceduresare expected to thin the estate sufficiently to avoidsignificant tax problems at the second Greentreedeath.

The Importance of Flexibility

Trusts are usually drafted to last for long periods oftime, but many things change over the years that aredifficult to anticipate in advance. With revocabletrusts, these can be addressed by the grantor asrequired. With irrevocable trusts, however, it is nec-essary to build in flexibility so that the trustee has thepower to respond to changed conditions in order toachieve the grantor’s objectives. Psychologically, thisis difficult to do for many grantors. Nevertheless,

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Es tate ofFirs t Spous e

To Die

Tax Fre e i-Trans fe r

- $600,000Exe m ption Eq uivale nt

Surviving Curre nt Incom e Ch ildre nSpous e

Marital De duction

, , and , , Outrigh brBe q ue s t

Outrigh t Be q ue s t Invade Principal Unifie d Cre ditor Trus t Trus t

I

- $600.000

J’ I

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Figure lO.l-- Intergeneratinal transfer of timber assets using the uniJed credit witheither a marital deduction trust or with an outright bequest.

there are a number of features that permit flexibilityand safety for both the family and the trust assets.

Incom e-sprink ling Clause.- -Th is clause permits thetrustee to act as a parental substitute by distributingincome as needed or accumulating it according toguidelines established by the grantor. When there aremultiple beneficiaries, the guidelines should providepreferences and priorities with respect to the needsand purposes to be accomplished. They shouldaddress the treatment of excess income and plans fordistribution as the beneficiaries come of age. Thiscan be done by a letter outside the trust instrument.In the case of timber assets, it can be done in theforest management plan. The grantor may wish toconsider a separate trust for each sibling in order toavoid conflicts. Income-sprinkling clauses can alsobe utilized to provide surviving spouses with fixedminimum levels of income by giving the trustee thepower to sprinkle the spouse with funds as needed.It is important that the grantor be distanced from thedecision in order to avoid having the assets revert tohis (her) estate. The choice of the trustee is critical,and an institutional trustee may need to be accom-panied by a cotrustee who knows the needs of thefamily members.

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Invasion of Trust Principal.- -Th e trustee should havethe discretion to use the trust principal to benefit theincome beneficiaries under an “ascertainablestandard. ” Under IRS regulations, this may includeeducation (including college), support in reasonablecomfort, and other factors.

Pow er of Beneficiary to W ith draw Principal.- -Th ebeneficiary may be given the power to withdraw prin-cipal subject to the limitation that the total amountwithdrawn in any 1 year may not exceed $5,000 or 5percent of the value of the current trust property,whichever is greater. In this way, the beneficiary isnot totally subject to the trustee’s discretion, and onlythe annual right of withdrawal is included in thebeneficiary’s estate.

“Crum m ey” Pow er.- -Th e beneficiary is given alimited unilateral power, called the “Crummey”power, to withdraw income or principal or both fromthe trust. The power is generally exercisable onlyduring a limited period of time, such as 30 days, eachyear. Inclusion of the “Crummey” power in a trustpermits gifts made to the trust to qualify as gifts ofpresent interests. This in turn permits such gifts up to$10,000 per donee ($20,000 per donee for split gifts)to qualify for the annual gift tax exclusion (see chapter8 for discussion of the exclusion).

Other Provisions.--Beneficiaries with disabilitiescan be provided for by defining “disability” andaddressing trust distributions for the benefit of suchpersons. Spendthrift provisions can expressly rejectassignment of trust income to creditors or others inanticiaption of income distributions by the trustee.Efficiency provisions can provide for termination ofthe trust by the trustee if trust administration becomesuneconomical. Although anticipating changes in theeconomy is nearly impossible, a sprinkling provisionin the trust can allow beneficiaries’ needs to beaddressed in terms of inflation over time. Unitrustprovisions might be considered (see Chapter 8) sothat the beneficiaries receive a fixed percent of thetrust principal if it is greater than trust income. Thetrustee may be given hold-back powers that woulddelay or cancel trust distributions upon unacceptablebehavior by a beneficiary--for example, if thebeneficiary is involved with drugs or in a divorceproceeding. The grantor may wish to designate theage at which a beneficiary will receive distribution oftrust principal so that he (she) will have time tomature and become a productive member of society.

USE OF TRUSTSIN MARITAL DEDUCTION PLANNING

Generally, the goal for married couples withsignificant wealth is to eliminate all estate taxes at thedeath of the first spouse and to minimize estate taxeson the death of the surviving spouse. This is usuallydone with a marital deduction bequest, which may beeither outright or in trust (see chapter 6). Planningfor a marital deduction trust must be coordinated withthe bequests to the children or other heirs of propertycovered by the unified credit if the unified credit isalso utilized. The unified credit portion can also beoutright or in trust. Thus, if professionalmanagement of the tree farm will be in the survivingspouse’s best interest, trusts can be used for themarital deduction bequest, the unified credit bequest,or both. A trust also provides protection againstdemands by children and creditors. For theremainder of this discussion, it is assumed that bothbequests will be in trust.

The unified credit trust (sometimes callednonmarital credit trust) provides for the survivingspouse as beneficiary, if he (she) needs the income,and the trust principal will be exempt from Federalestate taxation on his (her) death (see figure 10.1 and

example 10.2). It can include sprinkle provisions asdiscussed above. The trust can provide that theincome provisions terminate upon remarriage of thesurviving spouse. Perhaps, more importantly, it canbe designed to realize the maximum benefit of estateappreciation when the grantor desires that thesurviving spouse not benefit from it for whateverreason.

In addition, several types of marital deduction trustsmay be utilized (see chapter 6 for discussion of themarital deduction). These include power of appoint-ment trusts, qualified terminal interest property (QTIP)trusts, and estate trusts. The choice among theseshould be made based on accomplishing the grantor’sgoals most effectively.

QTIP Trust

The QTIP trust provides the surviving spouse a lifeincome interest. The key feature is the ability of theestate owner to control the disposition of the remain-der interest after the spouse’s death while at the sametime utilizing the marital deduction for the trust assetsin his estate. For example, when there are childrenfrom previous marriages, the grantor can be assuredthat their wants will be met at the surviving spouse’sdeath. The surviving spouse must be given the trustincome payable, at least annually, for life. The QTIPelection must be made by the executor; a full or par-tial election can be made based on the form of thebequest and the degree of utilization of the full unifiedcredit. For a more extensive discussion of QTIP’s,see chapter 6.

Power of Appointment Trust

The power of appointment trust gives the survivingspouse a life income interest in the trust property,which must be paid at least annually. The survivingspouse or trustee is given the right to use the prin-cipal for designated purposes such as making gifts thatqualify for the gift tax annual exclusion. Although itis not necessary that this right be granted, it is ameans of reducing estate taxes in the survivingspouse’s estate. A general power of appointment exer-cisable by will also gives the surviving spouse theright to provide in his (her) will for the disposition ofthe trust assets at his (her) death. The trust providesthat, if the surviving spouse fails to exercise the rightto name the beneficiaries of the trust assets, they willpass to beneficiaries, if any, named in the trust by thegrantor.

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Estate Trust

The estate trust is designed for the survivingspouse who does not need income. The trustee maybe given the discretion to make distributions based onneed, but the surviving spouse does not have a rightto demand them. The trust assets qualify for themarital deduction as long as the trust ends on thedeath of the surviving spouse and the trust assets areto be paid to the survivor’s estate at that time. Thus,the survivor’s will controls the disposition of the trustassets. This type of trust can also eliminate incomedistributions on remarriage of the surviving spouseand accumulate them for the eventual benefit of thesurviving spouse’s heirs. It can also hold nonincome-producing property with growth potential, such astimberland, which could pose a problem with apower of appointment trust.

A Disclaimer

A qualified disclaimer by a surviving spouse (asdiscussed in chapter 7) is valid even if the will directsthe property disclaimed to a marital deduction trust inwhich the surviving spouse has an income interest.Similarly, the children can use a disclaimer todisclaim legacies that will permit the surviving spouseto receive a larger marital deduction amount. (Seechapter 7 for more on disclaimers.)

TRUSTEES

The selection of and powers given to the trustee(s)are a critical problem that bedevil many otherwisesound trust plans. The person or institution chosenas trustee must, of course, measure up in a practicalsense. If timberland is an important part of the estateassets, a forester with business experience may bepreferred, if not as sole trustee, perhaps as acotrustee. Ability, integrity, judgment and durabilityare all important qualities for a trustee. State lawrequirements must be satisfied. These are particu-larly important with respect to the rules regardingtrust property in one State and trustee(s) who residein another State.

Tax considerations come into play if the grantornames himself (herself) as trustee with powers overincome and principal, which can make the incometaxable to the grantor. Similarly, if nongrantortrustees have the power solely or partially to vest

income or principal in themselves, the trust incomewould be taxable to them.

Individual Versus Institutional Trustee

A family member who has all the requisite skillsand experience may be persuaded to be named atrustee and perhaps serve without a fee. However,that may not be fair to the trustee because it takesvaluable time to do the job right. The family membernamed may resent the imposition of the dutiesinvolved and/or make them a low priority in his (her)work schedule if uncompensated. On the other hand,an institutional trustee offers experience, continuity,and a variety of skills (usually in a department withseveral individual specialists). It may not, however,have the personal interest in the timberland assets orin the beneficiaries that a family member would have.

Trustee fees should be investigated and negotiatedwhile the grantor is alive. For institutional trustees,there are acceptance and termination fees, as well asminimum annual management fees for handling trustinvestments and income distributions. There may beadditional fees for handling timber sales, preparationof fiduciary income tax returns, and other services thatmay be required. These fees will vary by institutionand should be carefully investigated when determiningif an institutional trustee has the ability and the interestin the tree farm to do the job that the grantor requires.There is always the element of uncertainty over aninstitutional trustee’s acceptance of the trust corpus.Is the property sufficiently large to be attractive, andwill the trustee have the skill to manage it effectively?Some trust departments are experienced at managingtimber properties, but others may want to dispose ofthe woodland and invest in more liquid investments.

Family Cotrustees

In some, cases a family member may serve ascotrustee with an institutional trustee. He (she) bringsa common touch to the personal needs of the bene-ficiaries and a personal, sometimes sentimental, familyattachment to the timber property. However, this willcost more, even if the cotrustee serves without fee,because additional time will be required for meetings,consultations, and resolution of conflicts. Thecotrustee may also deserve a fee, which would be anadditional expense. Thus, there are benefits andcosts for both personal service and financial skills,which should be carefully considered and balanced.

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Appropriate language should be included in the trustinstrument to insure that favorable tax treatment willnot be compromised by having beneficiaries ascotrustees.

Succe s s or Trustees

Naming of alternate trustees should be considered.Family members age and change, and institutions alsochange and may go out of business. Thus, theoriginal ‘rustee may not or cannot continue to serveat some point in time. Alternates should be named,or procedures should be in place, to address thiscontingency. Such foresight may save court fees,bond costs, and valuable time. A grantor can retainthe power to appoint a successor institutional trusteeonly if the trustee resigns or is removed by judicialorder (Revenue Ruling 77-182); broader powers tothe grantor will most likely result in the propertybeing includable in his (her) estate.

Trustee Powers

The trustee should be given sufficient power toenable him (her) to accomplish the objectives of thegrantor. State law will address any powers omittedfrom the trust instrument. With timber assets, specialprovisions may be needed to address the distinctionbetween principal (timber capital and/or growingstock) and income (growth). Because timberland maybe nonincome producing in some years, the allocationof value appreciation should be considered. In yearswith income, the allocation of timber sale revenue tocapital expenditures, operating expenses, and incomedistributions must be addressed. It is often prudentto include other income-producing assets in the trustin addition to timber in order to cover expenses innonincome years or to permit retention of timber saleincome for that purpose. The trustee needs sufficientflexibility to respond to changing economic and envi-ronmental conditions, market opportunities, and bene-ficiary needs.

TRUST APPLICATIONS FOR FORESTRY

Timber is a unique asset. In most States, the titleto standing timber can be legally separated from thetitle to the land on which it grows. In such a case,the timber continues to grow after severance of thetitle. Because the timber represents both the principal

and income and the land remains dedicated to theproduction of the timber, the severance of titlenecessarily reduces the value of the land because ofthe incumbrance. Therefore, the value of the land canbe reduced for estate purposes without affecting itsability to produce a timber crop and thus income.This severance is not without cost, however, and mayresult in higher administration and management costs.

Example 10.3. The Irrevocable Living Trust--ACase Study.This is an actual case study that illustrates how awell-planned, well-managed, irrevocable trustinvolving timberland has worked over a 3-yearperiod for a 20-year Washington Farm ForestryAssociation small timber landowner.’ The fol-lowing factors, all discussed in more detailelsewhere in this book, were considered by thegrantor in establishing this trust.Once the trust instrument--the guiding document that

controls the trust, its assets, and the functions of thetrustees for the duration of the trust--is completed,funding of the trust actually starts the business andmanagement of the trust. This funding is achievedwith property (timberland) and/or securities (stocks,bonds, or money accounts) and should involve goodfinancial planning and knowledge of the way incomewill be produced, the income tax provisions, the costbasis of assets gifted to beneficiaries through the trustvehicle, and the impact of capital gains taxation, if thetrust should sell timber or securities. Certain basicfacts regarding gifts and taxation that are important arelisted below.

(1) Gift taxes are exempt on the first $10,000 giftper donee per year or on the first $20,000 froma married couple to each donee. If property isseparately owned by one person with the$10,000 exemption, the exemption can beincreased to $20,000 if the spouse consents,even though the spouse does not own theproperty. If the person or married coupledecide they wish to exceed the $10,000 or$20,000 annual exemption, then a gift taxreport must be filed, but no taxes need to bepaid because the excess gifts can carry over toproportionately use up the unified credit forestate taxes--a $600,000 estate tax exemption.

‘Used with permission of the author, who, although wishing toremain anonymous, welcomes any criticisms, comments, orinquiries by writing to Lori I. Rasor, Editor, “NorthwestWoodlands,” 4033 S.W. Canyon Road, Portland, OR 97221.

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(2)

(3)

(4)

If the gift donor’s estate assets are above theFederal estate tax level ($600,000 for oneperson or $1,200,000 for a married couple),astute estate planning will involve giftingassets into the trust that have the potential ofgrowing rapidly or that have longer termgrowth such as land (a scarce commodity),timber, which is also becoming scarce and isexperiencing escalating market prices, andcertain securities, namely common stocks ingood investment grade companies over thelong term. Stocks have outperformed mostother investments, according to past historyperformance. Mature timber on good siteland can grow 7 percent a year in board feetvolume, compounded; therefore, timber valuecan double in 10 years in board feet volume.

The capital gain or loss basis for income taxesfor the trust assets is the cost basis of theassets gifted of the donor, which is carriedover permanently to the donee. So, if assetssuch as timber are sold in the future, capitalgains tax will be paid on the differencebetween the donor’s original cost and thedonee’s sale value. The market value of thegifted asset, at the time of gifting, is used forthe asset value at the time the gift is made,applicable where considering gift tax exemp-tion calculations.

Consideration should be made by the giftdonor as to the annual income produced bythe asset and the annual needs of the trust tocover expenses. The needs of the trustbeneficiaries for annual income distributionsfor personal family support also should beconsidered.

In gifting securities, one would need to gift high-dividend or high-interest-producing securities to pro-duce cash flow for the trust. These might be high-dividend stocks such as utility, petroleum, or naturalresource stocks. The latter two pay good dividendsand have a good growth record. Bonds have nogrowth factor other than high income (8 to 10 per-cent), which if reinvested, like compound interest,acts as an asset growth factor.

The following actual case history of a 3-year dur-ation, family-oriented, irrevocable living trust, illus-trates the above factors in funding a trust throughgifts and eliminating future estate taxation problems.

The trust is named “XYZ Family Farm Trust.” Itspurpose is to hold, control, manage, and distributeassets and income from the trust to the children andgrandchildren of the trust grantors, and to create avehicle for future gifts of farm and timberland andnonreal estate assets for the future benefit of thebeneficiaries.

The goal and wishes of the donors, in funding thistrust, is that management through its trustees willpreserve the assets of the trust, help those assets growin value and not distribute the capital assets tobeneficiaries without specific needs, such as worthyeconomic or business needs or support; housing,educational, or health needs; or necessary retirementincome.

The trust was funded in the following manner:

12-3 l -86--Initial funding

Real estate (timberland) deed recorded forfirst undivided one-third of 80 acresfully stocked with timber

Stocks-720 shares of Borg Warner@J 38 l/8

Total 1986

1987--Funding trust

2-4-87--Real estate (timberland) deedrecorded for a second undividedone-third of above 80 acres

3-4-87--Cash gift to establish achecking/savings account

Total 1987

1988--Funding trust

3-3-88--Real estate (timberland) deedrecorded deed recorded for a thirdundivided one-third of above80 acres

12-24-88--Stocks (valued at closing ofmarket Dec. 22)

500 shares of Pacificorp@? 35 7/S $17,937.50

300 shares of Wash WaterPWR @ 27 l/2 8,250.OO

300 shares of Walgreen@ 30 S/8 9,187.50

400 shares of Enron@ 35 112 14,600.OO

Total 1988

$70,000

27,145$97,145

$70,000

1,000$71,000

$70,000

49.975$119,975

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19 89 --Funding trust 19 87

12-2 l -89 - -Real e state (tim b e rland )d e e d re cord e d for 22.4 acre s ,fully stock e d w ith tim b e r $132,670

Total funding of trust, 3 ye arsth rough 12/3 1189 $420,79 0

The summary of annual income, incomedistributions, and taxation are as follows:

19 87--Incom eDividends on stock sInte re st on bondsInte re st on bank accounts

$ 356.00333.33

1.146.00

Long-te rm capital gains

Les s expensesNet taxable incom e

6.50$32,9 74.41

19 88--Incom eNote : Borg W arne r stock m e rge r 4122187 resulted in a$31,145.58 capital gain. Incom e d i stribution: 30 pe rcentre tained in trust and taxed at an 11-pe rcent starting rate .Se venty percent w as d istribute d to beneficiarie s and taxe dm ainly at 28 pe rcent.

Inte re st on bank accountsInte re st on corporate bondsInte re st on tax-fre e bonds

$ 115.731,500.00

654 442,270.17

Les s expenses 165 42Net incom e 2,104.75

Less tax-free inte re stNet taxable incom e

‘654 44$1,450.31

19 89 --Incom eDividends on stock sInte re st on bank accountsInte re st on corporate bondsInte re st on tax& e bonds

$3,376.65170.14

1,500.009 50 00

5,9 9 6.79Les s expenses .141 60

Net incom e 5,855.19Less tax-free inte re st 9 50 00

Net taxable incom e $4,9 05.19

The year-end annual inventory of assets onDecember 31 of each year is as follows:

19 86

R e al e state , parce l 1, 80 acre s(first one -th ird value)

StockTotal 19 86

$140,000.003.279 .74

25;374.73$168,654.47

R e al e state , parce l 1 (tw oone -th irds value)

Bank accountsBond s

Total 19 87

19 88

R e al e state parce l 2 (th re eone -th irds value)

Bank accountsBond sStOCkS

Total 19 88

$210,000.003,375.9 0

25,374.7349 ,475.oo

$288,654.47

19 89R e al e state , parce l 1 (th re e

one -th irds value)R e al e state , parce l 2 (22.4

acre s of tim b e rland )

$210,000.00

132.670.00Bank accounts ’ 51073.9 3Bond s 25.374.73stocks 71;764.58

Total 19 89 (on 12/20/89 ) $444,883.24

This case history of an irrevocable living trust for a3 year duration illustrates an example of the originalpurpose and goal of the trust as mentioned above:

(1)

(2)

(3)

(4)

Gifts of timberland and/or securities into thetrust ($97,145 initially, cumulative currentvalue $420,790) removes these assets from thedonor’s estate and future estate and inheritancetaxation.The goals and wishes of the funding donors ofthe trust have been dramatically fulfilled--assetshave grown in value. The current inventory oftimberland is valued at the time of gifting intothe trust and does not indicate current marketprices for timber in parcel 1 nor does itinclude the annual compounded 7-percentgrowth in board feet volume. Present valuesare markedly higher today.Securities, mainly stocks, had remarkablegrowth in value in 1 year--$49,975 at the endof 1988versus $71,764.58 at the end of 1989--for an increased value of 43.6 percent,surpassing the growth in 1989 of the DowJones Industrial Average increase of roughly 20percent. Note: The 43.6-percent increaseincludes income reinvested in the DividendReinvestment Program.

The trust vehicle, under supervision of anexperienced trustee, provides continuity ofcontrol of assets and, hopefully, good

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management by one entity for the benefit, inthis case history, of seven beneficiaries, ofwhom four are minors, and prevents injudici-ous. expenditures of capital assets by aspendthrift beneficiary.

The timberland and securities were gifted into thetrust over 13 months (3 tax years) in order to utilizethe annual gift tax exclusions for the seven benefici-aries. Only one timberland appraisal was necessarybecause the assets were transferred into the trust overa span of 13 calendar months, which, by using the

end of 1 tax year and the beginning of 2 others,actually covered 3 tax years.

The rate of value appreciation for the timber,including both growth and price appreciation to mid-1992, was a robust 25.6 percent. Since then thestumpage prices for Douglas-fir, which comprisesmost of the standing timber, have more than doubled.

The grantor is the trustee, but he faces perhaps themost challenging aspect of the trust strategy in iden-tifying a successor trustee who has the business accu-men to manage securities and timber plus the personalinterest in the welfare of the family.

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Chapter 11Life Insurance

ROLE OF LIFE INSURANCE

Insurance Program

The life insurance program must be part of theoverall evaluation of the estate plan. The estateplanner should review all of the landowner’s policies,inventory the provisions and benefits, and make pro-jections of needed insurance changes over time inconjunction with other estate assets.

There are two primary reasons for buying lifeinsurance: (1) to replace the foregone income of theprincipal breadwinner and (2) to provide liquidity.The liquidity is needed to prevent shrinkage fromforced liquidations of estate assets under unfavorableterms, to cover the cost of estate administration, andto pay estate taxes, if any.

For a young family with limited assets and heavyfinancial commitments, insurance protection is anecessary expenditure. Many observers have notedthat the family’s greatest insurance needs peakimmediately following the birth of their last child.Insurance can provide an instant estate for thesurviving spouse in the event of a primary bread-winner’s premature death. Over time, the family’sinsurance needs generally decline with the self-sufficiency of the children and with the accumulationof capital assets, such as timberland and otherretirement benefits.

There are also alternatives to insurance for liquiditypurposes, such as government and corporate bonds,and publicly traded securities. These investmentsfluctuate in value, and there is always the risk thatone or all could be at a low ebb in their cycle whencash is needed. However, the risk-return tradeoff isthe nature of the investment choice. Most life insur-ance carries an investment component, which is rela-tively safe with highly rated companies. Insurancefirms are highly regulated, well diversified, andprofessionally managed. A minimum return is usual-ly guaranteed, but a policyholder should be cautiousin believing the projected returns because they arejust that--projections--and, thus, subject to error.

Life insurance receives favorable tax treatmentunder the Federal estate tax laws. Insurance payableto the named beneficiary is tax exempt in manyStates. The Federal estate tax exempts insurance

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proceeds payable to beneficiaries other than theexecutor of the insured’s estate, if the decedentretained no incidents of ownership in the policy atdeath. Insurance is also favorably treated for incometax purposes at the Federal level and in most States. Inaddition to favorable tax treatment, insurance benefitsinclude the flexibility of different settlement options,financial security for survivors, and the convenience oflow-interest, cash value loans when the policyholdermay need them.

Life Z nsurunce Contract.--Perhaps, the most impor-tant provision of the policy is that of ownership. Theinsured is usually the owner, but he (she) may divesthimself (herself) of incidents of ownership and makethe proceeds payable to someone other than to theinsured’s estate. With no incidents of ownership andwith proceeds payable to a named beneficiary otherthan the estate, the value will not be included in thedecedent’s estate. Because the policyholder exercisescontrol over the insurance contract, he (she) can nameone or more beneficiaries including contingent bene-ficiaries. The owner controls the payment optionsdepending on the needs of the beneficiaries, but theprocedural rules of the policy should be followedcarefully.

The insurance contract lists the schedule of cashvalue over time, if any. The cash value is a closeapproximation of the policy’s gift tax value. If apolicy is a participating type, it will stipulate how thedividends--the nontaxable return of excess premiums--will be paid. It describes the various options that areavailable for dividends, such as cash payments, paid-up additions, retention of premiums with interest, andothers.

In the event that premiums are not paid in a timelymanner, most permanent insurance provides for aperiod of extended coverage as term insurance. Thisis generally not the preferred method. If the ownerdecides to stop paying the premiums on the policy,paid-up insurance can be obtained instead of cash.

The insurance policy will spell out the proceduralrules for making an assignment of the policy. Thisnormally must be done in writing and must bereceived by the company to be effective. Many newerpolicies have special provisions for so-called “livingbenefits” that are available when the insured contractsa terminal illness. In effect, the insured draws on the

death benefit during his (her) life to cover livingexpenses associated with the final illness.

Permanent insurance (as compared to term) permitsthe policy owner to borrow a specified proportion ofthe policy’s cash value. The contract has a guaran-teed rate that is available to the policyholder and isnormally below the rate charged by commercial len-ders. There are also various options for loan repay-ment, as well as provisions for premium paymentwith loan proceeds.

DeJinition of Life Insurance.--Life insurance isdefined for tax purposes--estate, gift, and income--inInternal Revenue Code (IRC) Section 7702. Theapplicable test is basically the distinction betweencontracts of life insurance and thinly veiled invest-ment vehicles. If an insurance policy fails to meetthe test, the pure insurance component--the differencebetween the cash surrender value and the deathbenefit--is treated as term insurance for tax purposes.The cash surrender part is treated separately with theincome being taxable to the insured. More impor-tantly, all income--not only that from the current yearbut also that earned in prior years--will be includedin gross income and taxed to the policyholder atordinary rates. Income is defined in this context asthe amount by which the net surrender value less thecost of insurance exceeds the premiums paid lessdividends credited, if any. If a policy is disqualified,the pure insurance portion--the excess of the deathbenefits over the net surrender value--will qualify forthe income tax exclusion. Thus, buying an invest-ment contract disguised as an insurance policy carriesthe added risk of disqualification by the InternalRevenue Service (IRS). If life insurance is needed,a forest landowner should buy an appropriate policy.The types of policies are described below.

Estate’s Needs

The estate’s needs should be considered, thealternatives for meeting family needs should beevaluated, and the economy of meeting these needswith insurance should be considered.

retirement. For young couples, insurance can createan instant estate for the surviving spouse and childrenin the case of untimely death.

TYPES OF INSURANCE

Insurance comes in many combinations of pure pro-tection (term) and types of investment. Term insur-ance is the cheapest and provides the greatest protec-tion per dollar invested in the short run. It may not bethe best vehicle over time because the rates increasewith the age of the insured and a person may becomeuninsurable. Term insurance is a means of deferringrisk until the owner can afford higher cost, investmentcomponent policies. The ultimate choice of pureinsurance versus insurance with an investment com-ponent depends on the opportunity for sound outsideinvestments, the tax effects (including both the ratesand whether the investment component gets tax-freebuildup), the premium cost and amount of cash build-up, and finally, the probability of the insured dyingwith the policy in force. Cash buildup in a policyreduces the actual death benefit, but at the same time,it increases the pool of funds against which the insuredcan borrow at a low, favored rate for any purpose.

Term Insurance

Term insurance is purchased for pure protection.Policy premiums are related directly to probability ofdeath. It is sold in fixed-benefit policies withincreasing premiums or decreasing term policies withfixed premium payments. Some policies may be con-verted to whole life (see below) without a physicalexamination, which guards against the problem ofinsurability. The primary characteristic of term insur-ance is low-cost protection, and it is most suitable foran insured who needs large amounts of coverage forshort periods of time--for example, a young, marriedcouple who have young children. Reducing termpolicies are often a good idea in conjunction withmortgage redemption, installment contracts, or othershort-term loan repayments.

usesWhole Life Insurance

Insurance may provide equity for absentee heir(s)who have chosen to live and work away from thetimberland. Insurance can provide liquidity to payestate or other debts, protect a dependent’s incomestream, and perhaps accumulate funds for the parent’s

Whole life combines a cash value with pure pro-tection. Payments in early years exceed the cost ofpure protection. The saving-investment element ofinsurance found with whole life policies should be

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compared with alternative saving opportunities. Withordinary life policies, the insured pays a fixedpremium for life. Generally, the death benefits arefixed, there is a fixed maturity date, fixed premiums,and a fixed buildup of cash values. This is the mostcommon type of policy, because it provides protect-ion, some investment, and a source of emergencyfunds for young, single persons and newly marriedcouples.

Other Insurance

Numerous options are available for specializedneeds, but all should be compared with alternatives.The Technical and Miscellaneous Revenue Act(TAMRA) of 1988 not only changed the definition ofinsurance, but it also instituted income tax changesfor policies that fail a seven-payment premium test.The Act created a new category of policy called amodified endowment contract (MEC). An MECsatisfies the life insurance test but fails the premiumtest. That is, the cumulative amount paid on thepolicy exceeds the sum of the net level premiums thatwould have been paid if the policy contract had pro-vided for paid-up future benefits after the payment ofseven level premiums. Loans and partial withdrawalsare taxed on a last-in, first-out (LIFO) accountingbasis. Earnings are treated first and are taxable. Inaddition the insured has a lo-percent, early with-drawal penalty for withdrawals made before age 59l/2. This penalty also applies to insurance policyterminations.

Single premium policies were hit hard by TAMRAbecause they were primarily designed for the invest-ment component. They are attractive to investors forthe tax-free buildup and estate-tax-free transfer ofassets. They also avoid probate and challenges to thedecedents’s will. Universal life, limited payment life,and single premium life policies with a high invest-ment component have similarly been restricted bychanges in the definition of life insurance underTAMRA (IRC Section 7702). Universal life andvariable life policies separate the cash value and termprotection elements of whole life. The investmentoption will cover the term insurance portion of thepremium. If the investment side of the policy fails toearn enough for the insurance portion, then additionalpremiums are required or the death benefit isreduced. These are most attractive to high-incomeindividuals who want the tax-free buildup.

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Spousal or second-to-die insurance is used to paythe estate tax liability of the surviving spouse. It isoften used in conjunction with charitable remaindertrusts (see example 8.7) to replace the principal thatwent into the charitable trust. First-to-die insurance isoften used in buy-sell agreements to balance the inter-ests of the heirs who choose to live in other areas withthose who choose to live on the tree farm and continueto help with the day-to-day management.

ESTATE

Proceeds

As noted

AND GIFI- TAX CONSIDERATIONS

above, life insurance proceeds are includedin the gross estate if payable to the estate or, if pay-able to others, from policies in which the decedentretained “incidents of ownership.” Transfer of policyownership within 3 years of the decedent’s death, asdiscussed in chapter 8, will also result in a policybeing included in the decedent’s estate, together withany gift tax paid.

Example 10.1. The taxable estate of a landownerwas exactly $600,000 after careful estate planning.Unfortunately, the decedent forgot about an insur-ance policy of $100,000 that he owned and whichwas payable to the estate to take care of bene-ficiaries’ needs. The policy was includable in thedecedent’s estate, and the $100,000 that the dece-dent had intended for the heirs’ benefit actuallyamounted to $63,000. This difference accounts forFederal estate tax only, and additional State deathtax may be due. To avoid this problem all“incidents of ownership” must be transferred out ofthe insured’s control more than 3 years before thedate of death. The recipient must not be under anyobligation to the estate for the proceeds or they willbe drawn back into the estate. The term “incidentsof ownership” is emphasized because it is defined toinclude the power to change the beneficiaries, cancelthe policy, assign it, pledge the policy for a loan, orborrow against the cash value. The insured shouldnot pay the premiums on the policy within 3 yearsof death after giving up ownership. Gifts of cash orincome-producing property to the policyholder onthe insured’s life should not be in amounts or timedso as to have the appearance that the insured issupplying funds for the premiums.

Transfers of Ownership

A transfer of insurance policy ownership results ina gift roughly equal to the cash value of the policy.The value of the gift of insurance is the cost ofreplacing the policy--the cash surrender value. Theinsurance company will supply the amount onrequest. This amount is generally much smaller thanthe face amount of the policy when it endows (that is,becomes paid up).

Premiums paid by the insured on his (her) life fora policy owned by the beneficiaries constitutes a tax-able gift even though the donee’s rights are condi-tioned on their surviving the insured. The $10,000annual gift tax exclusion is available for the transferof the insurance policy and for making gifts of thepremium payments. If the payment is for premiumsof insurance held by a trust, the gift is treated as afuture interest and the annual exclusion is not avail-able. The unified credit can be used to cover the giftand premium payments. If the donor makes a splitgift of insurance or premiums within 3 years ofdeath, there is an exception that expressly exemptsthe transfer of life insurance [IRC Section2035(b)(2)1.

If the policyholder dies before the insured, thevalue of the unmatured policy is included in thepolicyholder’s estate. The value is the interpolatedterm reserve; the insurance company will provide theamount.

To avoid problems of inclusion, a younger familymember should be made the owner, or the insuranceshould be put in trust. The trustee of a revocabletrust should not be designated as beneficiary norshould a policy be subject to a loan. Both situationscause problems.

CHOICE OF BENEFICIARIES(INCLUDING CONTINGENCIES)

Tax Lability

Beneficiary designation is especially important indetermining if policy proceeds are subject to Federalestate tax. The policy owner has nearly completefreedom in naming a beneficiary. Should it be thespouse, the estate, the executor of the insured, thetrustee of either a lifetime trust or a testamentarytrust set up by the insured, or one or moreindividuals?

If proceeds are made payable to the executor of theestate, they are includable in probate and increaseadministration cost, and estate tax, if taxable. Thisaction will not hurt tax wise if the estate tax isdeferred by virtue of the marital deduction. But, thereis a better way.

Beneficiary Designation

Beneficiary designation is extremely important indetermining the overall plan for the distribution ofassets. It should be coordinated with the will, anytrusts established, and the overall plan.

A responsible individual (family member), who canbe trusted to make the proceeds available to meet theestate’s liquidity needs, will keep the proceeds out ofprobate. If the owner does not have an individual inwhom he (she) has confidence, a trust should be con-sidered.

Normally, the spouse is named the beneficiary withthe children listed as contingent beneficiaries. Doingso will avoid probate and, generally, State death taxes.However, if the children are minors, a guardian willhave to be appointed for each with added expense anicomplications.

Insurance Trusts

An insurance trust can combine the flexibility oftrusts with the protection advantages of insurance. Itmay be funded or unfunded, revocable or irrevocable;testamentary trusts are possible. The key advantage ofnaming a trust as beneficiary is greater flexibility indistributing the proceeds to meet the needs of thefamily. There is also the ability to put restrictions andlimitations on use of funds for beneficiaries underother settlement options. The need for guardians forminor beneficiaries can be eliminated in most cases,subject to State law. The trust can eliminate thesecond estate tax for life insurance beneficiaries.Depending on the goals of the grantor, the trustee canbe authorized to accumulate income and have broadinvestment discretion for the benefit of the family.The flexibility and use of restrictions are perhaps mostimportant and must be balanced against the costs,broadly defined, of using a trust.

An Irrevocable Insurance Trust.- -Th e advantages tobe gained are avoidance of estate taxes, avoidance ofprobate, and possibly avoiding State death tax. Thereasons noted above for choosing a trust also apply.An irrevocable trust has two big problems for the

78

grantor that were discussed in chapter lo--loss ofcontrol and the gift tax liability in establishing thetrust. These are complex problems and should beconsidered with the expert advice of an estate plannerwho is familiar with both trusts and insurance.

OTHER CONSIDERATIONS

Settlement Options

Life insurance proceeds may be received underfour basic options: (1) interest--paid for a limitedtime and then another option is selected, (2) fixedperiod--equal installments paid for a fixed period ata guaranteed rate, (3) fixed income--amount is fixedfor a specific period after which the balance is pay-able under some other option, and (4) life income--anannuity for life. The choice is basically a gambleand, once made, involves rigidity not present in atrust. An insurance specialist should be consulted inarriving at the best choice for meeting the indi-vidual’s objectives.

Replacing Policies in Force

Replacing policies in force is rarely advisable dueto new acquisition costs, policy value increases withage, a contestable period, unequal dividends, unequalcash values, and replacement by policies of a differ-ent type.

HOW MUCH INSURANCE IS ENOUGH?

The choice of how much insurance to purchase ishighly subjective, but there are some guidelines thatcan be followed in reaching a logical, affordable, andcommon sense decision. Avoid rules of thumb suchas the lo-times-earnings rule.

stream that requires replacement if the generator diesprematurely. First, information about the familyassets and liabilities and the family estate plan shouldbe assembled. What are the family’s goals andaspirations? Then, the net value of the assets andliabilities should be projected for a reasonable planninghorizon. A 5-year horizon should be sufficient, butnot more than 10 because anything more than 10 yearsis pure guesswork. The effects of an untimely deathof the primary breadwinner should be calculated--suchas estate taxes, administration costs, funeral expenses,and family income needs due to the loss of his (her)salary and leadership. The status of the liquid fundsneeded to maintain the family’s standard of livingshould be evaluated. That is, will the family have tocash in principal in the form of savings accounts orharvest timber to meet the deficits? What are thefamily’s goals for shelter, college, retirement,recreation, more timberland, or better management ofwhat is owned?

If the primary income producer should happen to diebefore the family goals are met through hard work,how much and what kind of insurance is needed toprotect the family? There are two basic courses ofaction if the resources are not sufficient to meet thegoals--increase earnings or reduce costs and goals.Insurance can fill some of the gaps.

Periodic Review

The policies should be reviewed periodically so thatadequate coverage will continue to be provided ataffordable cost. Also, the steps that are outlinedabove should be reviewed periodically. What are theresources? What are the goals? Can the resources(timberland, growing stock, and capital) be increasedto produce the income (growth) that is needed to meetthe family’s goals?

Minimum StandardIncome Producer

The insurance should be concentrated on the personwho generates the family income. This is the income

Use insurance to bring income protection up to theminimum level desired to assure a particular standardof living.

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Chapter 12Installment Contracts

GENERAL PROVISIONS

If certain conditions are met, the gain recognizedon an installment sale of real property can be spreadover the duration of the contract for income tax pur-poses. An outright sale, on the other hand, triggersimmediate recognition of all gain in the year of salefor income tax purposes. Although the 1987Revenue Act repealed the installment sale method ofreporting for dealers in real and personal property, itspecifically exempted sales of property used or pro-duced in the trade or business of farming as definedin Sections 2032A(4) and (5) of the Internal RevenueCode (IRC) (see chapter 13). This definition offarming includes timber growing.

In addition to the income tax advantages, install-ment sales can also be a good estate planning tool.Their use has become much more prevalent in recentyears for facilitating the lifetime transfer of farm andforest property to succeeding generations, whiledeferring recognition of gain to future years.

Basic Requirements

The former requirements that an installment obliga-tion must have two or more payments spread out overat least 2 tax years and that the payment(s) in th eyear of sale not exceed 30 percent of the selling pricewere repealed in 1980. Now the installment methodof reporting gain is available when at least one pay-ment is to be received after the close of the taxableyear in which the sale occurs. No payment isrequired in the year of sale, although one or morecan be made. The installment method is availableonly for reporting gains; losses cannot be deferredbut must be recognized in the tax year of the sale.

Paym ents in th e Year of Sale.--Payments in theyear of sale include down payments made in a prioryear as well as payments received in the year that thebenefits and burdens of ownership pass to the buyer.This is usually the year of transfer of possession, orthe year of title passage, whichever occurs first.

Example 12.1. Suppose a forest landowner agreesto sell his tree farm for $150,000 and receives adown payment of $2,000 on September 15, 1992.

The first installment payment of $25,000 is receivedon April 30, 1993, and possession is given to thebuyer at that time. A total payment of $27,000 isreportable as income by the seller in 1993.

Restrictions

Certain restrictions on the use of installment salesshould be noted. For example, a sale of depreciableproperty between related persons, as defined in Section1239(b) of the IRC, cannot be reported by the install-ment method unless it is established that the trans-action did not have as one of its principal purposes theavoidance of taxation. Another restriction governs thesale of nondepreciable property between related partiesand then a resale by the purchaser. If the purchaser,in turn, sells the property before the installment pay-ments are made in full, the amount realized by therelated party second seller from the second dispositionis treated as being received by the initial seller at thattime. In other words, the first seller’s gain is accel-erated to the extent of the payment received by thesecond seller. In many cases, however, because of thespecific provisions governing the resale rule, therelated party restrictions will not apply if the secondsale takes place more than 2 years after the first. Arelated person includes a spouse, child, grandchild,parent, grandparent, brother, and sister; and corpora-tions, partnerships, and estates that are 80 percent ormore owned by such persons.

Mechanics of the Election

If the eligibility requirements discussed above aremet, the installment method of reporting income isautomatic for sales of real property and casual sales ofpersonal property unless the taxpayer elects out ofsuch a reporting method. This “negative” electionrecognizes that almost all taxpayers prefer the install-ment method of reporting income when possible. Anelection not to use the installment method must bemade on or before the due date, including extensions,for filing the taxpayer’s return for the tax year inwhich the installment sale occurs.

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Computing the Gain

In order to compute the portion of each installmentpayment that will be reported as gain, the sellingprice (the contract price) and the gross profit must bedetermined. The selling price includes the amount ofthe down payment, the face value of the installmentobligations, and the amount of any liability orindebtedness that the purchaser assumes. Gross pro-fit is the difference between the selling price and theseller’s basis in the property. The contract price isthe selling price less the amount of liabilities orindebtedness assumed by the purchaser. However, ifthe liabilities or indebtedness exceeds the seller’sbasis, the excess is not subtracted from the sellingprice to calculate the contract price. Once the grossprofit and contact price have been calculated, thepercentage of each payment to be reported as gain isdetermined by dividing the gross profit by the con-tract price. The following example illustrates thecomputation procedures:

Example 12.2. The taxpayer decides to sell 150acres of timberland on the installment method andenters into an agreement providing for a $20,000down payment, annual installments of $7,000 eachover a period of 10 years, a final balloon paymentof $25,000, and assumption by the purchaser of a$65,000 mortgage. The taxpayer’s basis in theproperty is $50,000 and sale expenses are $5,000.The calculations are as follows:

Selling priceDown paymentTotal annual installmentsBalloon paymentAssumption of mortgageSelling price

Gross profitSelling priceAdjusted basisGross profitSale expensesGross profit to be realized

Contract priceSelling priceMortgage assumedSubtotalMortgage exceeds basisTotal (contract price)

$ 20,ooo70,00025,00065.000

$180,000

$180,000- 50,000130,000- 5,000

$125,000

$180,000- 65,000115,000

+ 15,000$130,000

The percentage gain on each payment is:

$125,000/$130,000=96.2%.

ESTATE PLANNING CONSIDERATIONS

Advantages

An installment sale contract may be an ideal tool forparents to use if they wish to begin lifetime transfersof forest land to their children. Such contracts may beparticularly attractive to a surviving spouse wanting toavoid heavy involvement in management of the treefarm. In this regard, the following can be accomp-lished: (1) an interest in the property as security canbe retained by keeping the title, (2) a steady, annualincome can be received for the duration of thecontract--with income not subject to the social securitytax or reducing social security benefits, (3) manage-ment responsibility can be transferred to the children,(4) an opportunity for the children to acquire an inter-est in the property with a low down payment can beprovided, (5) the size of the estate can be reduced byconsuming or making gifts of the installment paymentsreceived, and (6) because the contract value is fixed,further increases in value after the contract is signedwill not increase the size of the estate.

Disadvantages

There may also be certain disadvantages associatedwith an installment sale from parents to children thatshould be considered. For example, the parents mayoutlive the term of the contract and then have todepend on other sources of income. Inflation mayelevate the parents’ cost of living to a point where theywill have difficulty living on the fixed-contract pay-ments. Although an installment contract reduces theuncertainty of available annual income, it increases theuncertainty of outliving one’s assets.

Other Considerations

It is necessary to give careful consideration toestablishing the price and terms in an installment salein order to further the objectives of transferring futureappreciation out of the parent’s estates, and facilitatingtransfer of ownership and management control fromone generation to the next. If the price is too high orthe terms too inflexible, the purchaser may be unableto meet the payments. If the price is too low, thetransaction may be characterized as part sale and partgift, thus making the sale subject to gift tax as well asincome tax.

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If the parents are concerned that the child(children) purchasing the tree farm will have dif-ficulty in generating a sufficient cash flow to financethe purchase, they may wish to establish a sellingprice below market value. The danger of this, how-ever, is that transfers for inadequate considerationwill be treated as gifts to the extent that the fairmarket value of the property exceeds the sale price.Because transfers of property between family mem-bers will be carefully scrutinized to determinewhether a gift has occurred, unless a gift is intendedthe parties must structure the sale to insure that it hasthe characteristics of a business transaction.

Although many court decisions suggest that the saleneed not be at the top of the market in order to avoidcharacterization as a gift, the parties should proceedwith caution. Because the gift tax statute of limita-tions does not begin to run until a gift tax return isfiled, there is always the danger that the IRS willexamine the transaction many years later, perhapsduring an estate tax audit, and contend that the salewas in fact a gift. For that reason, it might be advis-able, if the sale is substantially below market, to filea gift tax return at the time of transfer.

Use of Installment Sales to Facilitate Gifts

On the other hand, an installment sale may facili-tate the gifting of forest property by making it possi-ble for the parents to convey the woodland to a childor children and avoid the gift tax by keeping annualgifts to each child within the $20,000 split gift taxexclusion amount. For example, if the parents havealready used their unified credit against gift taxes andwish to give the tree farm to their children, the valueof the gift in excess of $20,000 per child would besubject to gift tax. If the parents wished to staywithin the $20,000 limit, they would have to conveythe property a few acres at a time or give small frac-tional interests, neither of which are very suitablealternatives. An installment sale, however, can pro-vide a vehicle for immediate transfer of the woodlandto the children while making it possible for theparents to stay within the exclusion amount for eachchild.

For example, the property may be conveyed inexchange for $10,000 principal amount, interest-bearing notes, payable semiannually. If the parentswish to make a gift to the acquiring child, they mayforgive the notes as they become due. Caution must

be exercised, however, so that the IRS will notcontend that a gift of the entire value of the propertyoccurred in the year of sale. There should be noproblem if the notes are legally enforceable and sub-ject to assignment or sale to third parties, if theproperty is subject to foreclosure in the event ofdefault, and if the parents have no legal obligation tomake annual gifts to the children [see Estate ofKelZ ey,63 TC 321 (1974); and H udspeth v. Com m issioner,509 F2d 1224 (9th Circuit 1975)].

INSTALLMENT OBLIGATIONDISPOSITIONS AT DEATH

Income Tax Basis

Generally, upon death of a property owner, theproperty receives a new income tax basis (the so-called“stepped-up basis”), and the potential gain or loss iseliminated. But on the death of a seller within theterm of an installment sale transaction, the installmentobligation as an asset of the estate does not receive anew basis. Payments received after death are reportedin the same manner, for income tax purposes, as theseller would have done if living. There is, however,a deduction for the estate tax attributable to the obli-gation. This feature may pose an income tax dis-advantage compared with retention of the propertyuntil death. The disadvantage is greatest for propertythat has appreciated substantially in value.

Transfer to the Obligor

Previously unreported gain from an installment salewill be immediately recognized by (become part of) adeceased seller’s estate, if the installment obligation istransferred by bequest or inheritance from the dece-dent to the obligor (purchaser) or is canceled by theseller’s executor. For example, suppose a father sold10 acres of woodland to his only son, John, in 1990for $96,000 using an installment sale. After receivingthe first two payments under the contract, the fatherdied with the contract passing to John by inheritance.All unreported gain in the installment obligation wouldbe taxable to the father’s estate.

In order to avoid this result, installment obligationscould be bequeathed to family members other than theobligor. This would mean that family memberswould own each other’s installment obligations but not

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their own and that payments would have to continueto be made. Another possible method of avoidingacceleration of income to the estate as a result of adisposition of an installment obligation to the obligermight be to provide that the obligation be transmittedto an irrevocable trust in which the obligor is abeneficiary. The obligor would have to continue tomake payments that would constitute income to thetrust, but the estate could argue that no taxableobligation had occurred because the trust has to betreated as a separate taxpayer.

INSTALLMENT SALES BY THE ESTATE

A different rule applies if the estate is the sellerunder an installment obligation. In that case, distri-bution of the obligation to the heirs causes immediatetaxation of the gain in the obligation under all cir-cumstances. For some assets with a new income taxbasis received at death, the amount of gain may belittle or none. But if the sale involves timber propertythat had been valued under special use valuation (seechapter 13), the amount of gain could be substantial.The new basis at death would only be up to the valueset for Federal estate tax purposes--in this case, specialuse value--and not up to fair market value.

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PART III

APPLICATION OF FORESTRY-SPECIFIC ESTATE PLANNING TOOLS

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Chapter 13Special Use Valuation

Section 2032(A) of the Internal Revenue Code(IRC) permits certain real property to be valued forFederal estate tax purposes on the basis of its“current use” rather than at “highest and best use.”This is commonly termed “special use valuation.”Real property may qualify for special use valuation ifit is located in the United States and is devoted toeither (1) use as a farm for farming purposes or (2)use in a closely held trade or business other thanfarming. In either case, there must be a trade orbusiness use. Personal property also qualifies forspecial use valuation if it is used in connection witheligible real property.

The term “farm” is defined to include woodland.The term “farming purposes” includes the planting,cultivating, caring for, cutting down, and preparingfor market of trees. The qualified property to bespecially valued includes buildings, structures, andimprovements functionally related to the qualifieduse. Unrelated items of value, such as mineralrights, are not eligible.

REDUCTION IN VALUE

Special use valuation cannot reduce the fair marketvalue of the gross estate by more than $750,000. Ifthe woodland in question was owned by bothspouses, the $750,000 limitation applies to eachestate. Consequently, a reduction in value of up to$1.5 million is available. This can have a profoundeffect on application of the unlimited maritaldeduction to a forest estate.

Community Property

The full statutory reduction in value ($750,000) isallowed for a decedent’s community property interestin timberland, even though the decedent made nocontribution to the property (Letter Ruling 8229009).Revenue Ruling 83-96 applies the same rule to allcommunity property eligible for special use valuation.

QUALIFYING CONDITIONS

In the right situations, special use valuation of treefarms can save substantial amounts of estate taxes.

Careful planning--both predeath and postdeath--will berequired, however, in order to qualify and receive themaximum benefits. There are six major predeathrequirements, as follows:

(1) The decedent must have been a resident orcitizen of the United States, and the propertymust be located in the United States.

(2) The property must pass to a qualified heir orheirs.

(3) The decedent and/or a member of his (her)family must have owned the qualifying prop-erty for at least 5 of the last 8 years imme-diately preceding the decedent’s death; andduring at least 5 years of such ownership, thequalifying property must have been used forfarming or a closely held business purpose--toinclude timber growing--by the decedent and/ora member of the decedent’s family, and havebeen devoted to such use on the date of thedecedent’s death.

(4) The decedent and/or a family member musthave materially participated in the operation ofthe property for at least 5 years during the 8year period ending on the earliest of: (a) thedate of the decedent’s death, (b) the date onwhich the decedent became disabled, provideddisability continued until the date of death, or(c) the date on which the decedent beganreceiving social security retirement benefits,provided the benefits continued until the date ofdeath.

(5) The adjusted value of the real and personalproperty qualifying for special use valuationmust comprise, at fair market value, at least 50percent of the adjusted value of the decedent’sgross estate.

(6) At least 25 percent of the adjusted value of thedecedent’s gross estate must be qualified realproperty.

Requirements 2 through 6 will be discussed in moredetail in the following paragraphs.

Qualified Heirs

The term “qualified heir” is defined as an ancestorof the decedent; spouse of the decedent; lineal descen-dent of the decedent, of the decedent’s spouse, or ofthe decedent’s parents; or the spouse of any such lineal

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descendent. Where there is a further disposition ofany interest in the property from a qualified heir to amember of the qualified heir’s family, such memberof the family must also meet the definition of“qualified heir. ” In interpreting this provision, theTax Court has held that the nephew of a decedent’spredeceased spouse was not a qualified heir becausethe nephew was not a lineal descendent of the dece-dent’s parents, but rather was a lineal descendent ofthe decedent’s spouse’s parents (Z.M. Cone Estate, 60TCM 137, TC Memo 1990-359).

Possible Passage to Nonq uali$ed H e irs. --Allinterests in the property to be specially valued mustpass to a qualified heir or heirs. Any possibility thatall or part of the property may pass from the dece-dent to a nonqualified heir will render the propertyineligible. For example, the power existing in atrustee or executor to use discretion to place propertyeither in trust for qualified heirs or in trust fornonqualified heirs will destroy eligibility (LetterRulings 8244001, 8441006). Also, the InternalRevenue Service (IRS) regulations stipulate that ifsuccessive interests are created in the property, suchas a life estate followed by a remainder interest,qualified heirs must receive all interests. Neverthe-less, the IRS has ruled that an estate could electspecial use valuation for property in which a qualifiedheir received a life estate under the decedent’s will,even though the heir also received the power toappoint the remainder interest in the property to anonqualified heir. The election was allowed becausethe heir executed a qualified disclaimer (see chapter7 for a discussion of disclaimers) of the power ofappointment, thus causing the remainder interest tovest in another qualified heir (Revenue Ruling 82-140). Additionally, at least three court decisionshave held that, when unqualified heirs are in aposition to receive remainder interests, special usevaluation will not be precluded if the possibility ofreceiving those interests is extremely remote (see D.Davis IV Estate, 86 TC 1156; C. M. Clinurd Estate,86 TC 1180; and L. Sm oot, Executor, CA-7, 9 0-lUSTC 160,002).

QZ 7P Trusts.--Proposed QTIP regulations (seechapter 6 for definition and discussion of QTIP) mayhave created a trap for the unwary in the use of aQTIP trust to receive property for which a special usevaluation election is planned to be made in the sur-viving spouse’s estate. Under Proposed Regulation20.2044-1(b), in order for property passing to aQTIP to be eligible for special use valuation, theremaindermen following the surviving spouse’s life

interest must be qualified heirs of the survivingspouse, not of the decedent.

Qualified Use

The 5of-8-years requirement for predeath qualifieduse will be met if either the decedent or a member ofhis (her) family has utilized the property for therequired time in a qualified use. “Member of family”is defined to include the same persons as are listed inthe definition of “qualified heir. ” The IRS has furtherinterpreted the qualified use requirement to mean thatthe decedent or a family member must have bornesome of the financial risk (have had an equity interest)associated with the operation (Technical AdviceMemorandum 8201016, 9-22-81). In furtherance ofthis concept, numerous court decisions have held thata cash lease of otherwise qualified property by thedecedent, particularly to nonrelatives, did not con-stitute a qualified use.

Projit- m ak ing Activity.- -Th e IRS has also mandatedthat qualified use be synonymous with a profit-makingactivity by the decedent (Letter Ruling 8820002).Here the estate included forest land and a cattleoperation. Woodland was ruled ineligible because notimber had been cut from it, there were no records ofregular inspections or maintenance activities, and therewas no showing of an intention by the decedent toprofit from timber growing and harvesting.

Ch ristm as Tre e Operations. --In Letter Ruling9117046, the IRS ruled that an executor of an estatewas entitled to make a special use valuation electionfor a Christmas tree farm. The farm was qualifiedreal property because it was used for farming pur-poses. It was willed to qualified heirs who werechildren of the deceased. The heirs also hadmaterially participated in the operation of the tree farmfor the required length of time by making all manage-ment decisions and performing substantially all of thephysical work..

Material Participation

The material participation regulations adopted underIRC Section 2032(A) discuss in detail the factors to beconsidered in determining whether the decedent and/ora member of his (her) family materially participated inoperation of the property in question for the requiredperiod of time prior to the decedent’s death. Nosingle factor is determinative; each situation stands onits own set of facts.

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Em ploym ent and Managem ent.- -Ph ysical work andparticipation in management decisions are theprincipal factors considered. At a minimum, thedecedent and/or family member must have regularlyadvised or consulted with the other managing parties(if any) on operation of the business. The decedentand/or family member need not have made all man-agement decisions alone but must have participated inmaking a substantial portion of the decisions.Production activities on the property should beinspected at regular intervals by the participant.

Financial Risk.--Another factor considered in thedetermination of material participation is the extent towhich an individual has assumed financial responsi-bility for the business. This includes the advance-ment of funds and assuming financial responsibilityfor a substantial portion of the expenses involved.

Self- em ploym ent Tax.--Payment of self-employmenttaxes on income derived from the business is also anindicator of material participation. Although paymentof such taxes is not conclusive evidence, if they havenot been paid, material participation is presumed notto have occurred unless the executor demonstratesotherwise and explains why no tax was paid. With atimber operation, of course, the presumption wouldbe that all timber income is capital gain under Section63 1 of the IRC--not ordinary income--and, therefore,not subject to the self-employment tax. Thus pay-ment or nonpayment should not be a considerationwith respect to specially valued tree farms unlesstimber sale receipts are reported as ordinary income.

O th e r Considerations.- -Th e sole activities of eitherthe decedent or a family member must amount tomaterial participation at a given time, because theactivities of more than one person at a given timecannot be considered in the aggregate. If nonfamilymembers participate in the business, part time activ-ities by the decedent and/or family members must bepursuant to a provable oral or written agreementproviding for actual participation by the decedentand/or family member(s).

Active Managem ent.- -A special rule applies toliberalize the material participation requirement withrespect to a surviving spouse who receives qualifyingproperty from a decedent in whose estate the propertywas eligible for special use valuation, whether or notsuch valuation was actually elected. Active manage-ment by the surviving spouse will satisfy the materialparticipation requirement for purposes of electingspecial use valuation in the surviving spouse’s grossestate. The IRC defines active management as themaking of management decisions of a business ratherthan daily operating decisions.

Tree Farm Consid erations.- -Exam ple 7 of the IRSSection 2032A material participation regulationsconcerns a tree farm. Although not definitive of eachtimberland situation, the example does provide aninsight as to how the IRS views material participationwith respect to woodland.

Example 13.1. [Regulation 8 20.2032A-4 (Example711. K, the decedent, owned a tree farm. Hecontracted with L, a professional forester, tomanage the property for him as K, a doctor, livedand worked in a town 50 miles away. The activitiesof L are not considered in determining whether Kmaterially participated in the tree farm operation.During the 5 years preceding K’s death, there wasno need for frequent inspections of the property orconsultation concerning it, inasmuch as most of theland had been reforested and the trees were in thebeginning stages of their growing cycle. However,once every year, L submitted for K’s approval aproposed plan for the management of the propertyover the next year. K actively participated inmaking important management decisions, such aswhere and whether a precommercial thinning shouldbe conducted, whether the timber was adequatelyprotected from fire and diseases, whether fire linesneeded to be plowed around the new trees, andwhether boundary lines were properly maintainedaround the property. K inspected the property atleast twice every year and assumed financial respon-sibility for the expenses of the tree farm. K alsoreported his income .from the tree farm as earnedincome for purposes of the tax on self-employmentincome. Over a period of several years, K had har-vested and marketed timber from certain tracts ofthe tree farm and had supervised replanting of theareas where trees were removed. K’s history ofharvesting, marking, and replanting of trees showedhim to be in the business of tree farming rather thanmerely passively investing in timber land. If thehistory of K’s tree farm did not show such an activebusiness operation, however, the tree farm wouldnot qualify for special use valuation. In light of allthese facts, K is deemed to have materially partici-pated in the farm as his personal involvementamounted to more than managing an investment.The Sh e rrod Case.--The forestry example above has

been considered in at least one court decision (Sh e rrodv. Com m issioner, 82 TC 40). At death, the decedent(Mr. Sherrod) was the beneficial owner of nearly1,500 acres of land. During the last 25 years of hislife, 1,108 acres were in timber, 270 acres in rowcrops, and 100 acres in pasture. All of it was underthe exclusive management and control of the decedent

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until 5 years before his death when he put theproperty into a revocable living trust. Thereafter,until the decedent’s death, management and controlwere exercised by the decedent’s son who was one ofthe trustees. Management activities included: (1)negotiation of annual rental payments on the crop andpasture lands; (2) contact from time to time with ten-ants and neighbors to check tenant performance andto see if they were aware of any problem with respectto the timberland; (3) supervision of the timberlandby personal inspection, and contact with the tenantsand adjoining landowners to protect against tres-passers, insect infestation, and disease; (4) nego-tiation of timber-cutting contracts; and (5) payment ofproperty taxes. Timber harvesting consisted of selec-tion cutting and all regeneration was natural. Thedecedent personally supervised all logging by thetimber purchasers. The IRS argued that these acti-vities did not rise to the level of a qualified use andmaterial participation because they did not includeconstruction of fire lines, pruning dead andundesirable growth, and thinning--citing the forestryexample in the material participation regulations.The Tax Court, however, held that the activities ofthe decedent and his son did constitute a qualified useand material participation because they had madeevery managerial decision and had performed everyact necessary to carry on the business for the last 25years. That these activities did not require a greatdeal of time, were not extensive, and did not conformin a number of respects to the forestry example in theIRS regulations was immaterial. The court concludedthat the activities cited by the IRS as lacking were notpractical or financially feasible with respect to theproperty in question--that management actions takenon one woodland are not necessarily those requiredfor good management of another timber property.

i%e Mangels Case.--Timberland material partici-pation has also been considered in at least one othercourt decision (Mangels, DC Iowa, 4/22/86). Here,for 6 years before the decedent’s death, her con-servator, a bank, leased her timberland and pastureon a cash basis to parties unrelated to her. The issuewas whether the material participation test was met.The court ruled for the government. The conser-vator’s participation in the operations of the propertywas insufficient to satisfy the threshold requirementsfor material participation. No agent of the conser-vator did physical work on the property, and par-ticipation in management decisions was minimal.

The 50- and 25percent Tests

Several important considerations must be kept inmind with respect to meeting the 50- and 25percenttests. The determination of sufficiency of property forboth tests is based on fair market value minus mort-gages and related liens. Increasing an existing mort-gage or taking out a new one on property previouslyqualified for special use valuation could cause the netvalue to drop below one or both of the percentagethresholds.

Partial Election.- -Th e special use valuation elec-tion does not have to be made for all the qualifiedproperty used to satisfy the 50-percent test. The25-percent test, however, must be met from propertyactually elected for special use valuation.

Gift w ith in 3 Years of Death.--Nonqualified prop-erty cannot have been gifted by the decedent within 3years of death in order to meet the 50- or 25-percenteligibility tests. Any transfer of property within thistime period will be includable in the gross estate forthe limited purpose of determining the estate’s qualifi-cation for special use valuation.

Example 13.2. Mr. Tree Farmer, a widower, ownsa tree farm with a fair market value of $300,000and a special use value of $150,000. His otherassets, which are not eligible for special usevaluation, have a fair market value of $400,000.The total estate thus has a fair market valueof $700,000. On this basis, the tree farmcould not qualify for special use valuationbecause its fair market value is only 42.9 percent($300,000 + $700,000) of the fair market value ofthe total estate. Assuming no change in asset value,$100,000 would be subject to Federal estate tax atMr. Tree Farmer’s death. With the spec.al use val-uation percentage requirements in mind, Mr. TreeFarmer gifts $105,000 of securities to his onlychild, using $95,000 of his unified credit. The fairmarket value of the estate is now $595,000, with thetree farm’s fair market value now comprising morethan half. Mr. Tree Farmer gives a sigh of relief--he has just saved $33,300 in estate taxes--or so hebelieves. Unfortunately, he has a heart attack anddies 35% months after making the gift. The giftwill, therefore, be brought temporarily back into hisestate for the sole purpose of determining whetherthe special use valuation percentage requirementshave been met. On this basis, the fair market valueof the tree farm as a percentage of total fair marketestate value once again drops below 50 percent.

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Eligibility for special use valuation has been lost,and the estate is liable for more than $33,000 inunanticipated Federal taxes. If Mr. Tree Farmerhad died 3 weeks later, special use valuation couldhave been elected with the result that no estatetaxes would be due.

ELECTION AND AGREEMENT

When making the special use valuation election andsigning the accompanying agreements, attention todetail is necessary. Many elections have been voidedbecause of carelessness.

Election

The election for special use valuation is made onForm 706 (U. S. Estate and Generation SkippingTax Return--see appendix) by checking the boxmarked “yes” in the “Elections by the Executor”section of the return. For timber properties, a secondelection is also necessary by checking the woodlandselection box in part 2 of schedule A-l. The electionsmay be made on a late-filed return if it is the firstreturn filed. In order to validate the election, anestate must complete and file schedule A-l, andattach all of the required statements and appraisals.Schedule A-l contains the “Notice of Election” andthe “Agreement to Special Use Valuation.” The“Notice of Election” provides the fair market value ofthe property to be specially valued, its special usevaluation, and the method used for computing thespecial use value. An estate may elect special usevaluation for less than all of the qualified propertyincluded in the gross estate. However, as notedearlier, real property for which an election is mademust comprise at least 25 percent of the total value ofthe adjusted gross estate.

Corporate and Partnersh ip Interests. --In order fora decedent’s partnership interest in qualified propertyto be eligible for the special use valuation election, 1of 2 requirements must be met: (1) the partnershipmust have had 15 or fewer partners, or (2) 20 percentor more of the partnership capital interest (see page98 for a discussion of partnership capital interest)must be in the decedent’s estate. Eligibilityrequirements for corporate interests are similar. Thecorporation must have had 15 or fewer shareholders,or 20 percent or more of the voting stock must beincluded in the decedent’s estate.

Protective Election.- -W h en it is not certain that realproperty meets the requirements for special use valua-tion, the estate executor may make a protective elec-tion to specially value the property, contingent uponproperty values as finally determined. The protectiveelection is made by filing a notice of protective elec-tion with a timely filed estate tax return. If it isfinally determined that the property qualifies forspecial use valuation, the estate must file an additionalnotice of election within 60 days of the determination.

Tech nically Defective Elections. --If a timely specialuse valuation election is made, and the estate taxreturn, as filed, shows evidence of substantial com-pliance with the requirements relating to special usevaluation, the executor has a reasonable time--not toexceed 90 days--in which to cure any technical defectsor flaws in the form of the election that would preventit from being otherwise valid. The 90-day periodcommences following notification by the IRS that adefect exists. Examples of such technical defects orflaws are the failure to include all required informationin the notice of election and the failure to includesignatures of heirs with relatively small interests.

The Agreement

The “Agreement to Special Use Valuation,” whichis part 3 of schedule A-l of the Federal estate taxreturn, must be signed by each person having an inter-est in the qualified real property for which the electionis made. It does not matter whether any of these per-sons are in possession of the property or not. In thecase of a qualified heir, the agreement expresses con-sent to persona1 liability for any additional estate taxthat may become due in the event of recapture due toany of the postdeath requirements (as discussed onpage 87) not being met. Signees other than thequalified heirs are not personally liable but mustexpress consent to collection of any such additional taxfrom the qualified property.

Corporate and Trust Interests.- -Corporate interestscannot be valued under special use valuation unless theagreement contains a signature that binds the corpor-ation. Signatures by shareholders or heirs in theirindividual capacities is not enough (Technical AdviceMemorandum 8602007, 9/7/85). Similarly, a dece-dent’s interest that passes to a testamentary trust isnot eligible for special use valuation unless the trustbeneficiaries consent to be personally liable for therecapture tax. The trustee’s signature alone is

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insufficient (Technical Advice Memorandum8802005, 9/29/87).

Tenants in Com m on.- -Th e Tax Court has held thatthe IRS regulation governing the signing of the agree-ment is invalid insofar as it requires that allindividuals having tenancy in common interests inproperty subject to a special use election sign theagreements. The court noted that the survivingtenants in the situation in question did not have “aninterest in the property” because only the decedent’stenancy in common interest was includable in hisgross estate and thus subject to the election.

VALUATION

In making the election, two valuations must bedetermined for the affected property: special usevalue and fair market value. Both must be reportedon the estate tax return. With respect to woodlands,either bare land or standing timber or both may bespecially valued. Often, it is only by including someor all of the standing timber on the property that the50- and/or 25percent tests can be met. For adetailed discussion of the procedures applicable tofair market valuation of timber property, see chapter4.

Alternate Valuation

When an estate elects to use the alternate valuationdate of 6 months after the decedent’s death (seechapter 4 for a discussion of the alternate valuationdate) and also elects special use valuation, the specialuse value must be determined as of the alternatevaluation date. The alternate valuation date must alsobe used when determining whether the aggregatedecrease in value of the qualified property exceedsthe statutory limit of $750,000 (Revenue Ruling 88-90).

Special Use Valuation of Woodlands

Timberland special use valuation procedures mustfollow the general special use valuation rules appli-cable to farms, as set out in the IRS regulations. Novaluation procedures specifically applicable to wood-lands are provided. Two methods of farm valuationare described: the “farm” method and the “multiplefactors” method.

Farm M e th od .- -Th e farm method is the preferredIRS special use valuation method. It is determined

by dividing the average annual gross cash rental forcomparable land used for the same purpose andlocated in the same locality, minus the average annualproperty tax for such land, by the average annualeffective interest rate for all new Federal land bankloans. The average annual computations are to bemade on the basis of the 5 most recent calendar yearsending before the date of the decedent’s death.

Timberlands in the South are sometimes speciallyvalued under the farm method by using rental pay-ments specified in long-term leases of forest lands toforest product companies--when the details of suchleases for comparable forest property can be obtained.

If no comparable land can be identified for whichthe average annual gross cash rental can be deter-mined, the farm method may be used by substitutingthe average annual net share rental. Obviously, thishas no applicability to forest land.

Multiple Factors M eth od .- -As an alternative to thefarm method, if no comparable rented timberland canbe documented, the executor may elect to value theproperty using the multiple factors method. The regu-lations list the following factors: (1) capitalization ofincome that the property can be expected to yield overa reasonable period of time under prudent manage-ment, taking into account the soil and other featuresaffecting productivity; (2) capitalization of the fairrental value of the land for farming purposes; (3) theassessed property tax value in a State that providesdifferential or use value property tax assessment proce-dures for rural land; (4) comparable sales of otherproperty in the same geographical area far enoughremoved from a metropolitan or resort area so thatnonagricultural use is not a significant factor in thesales price; and (5) any other factor which fairlyvalues the farm value of the property.

The IRS has ruled, with respect to the multiplefactors method, that the executor cannot select onlyone of the factors enumerated above as the exclusivebasis of valuation unless none of the other factors isrelevant. Each factor relevant to the valuation must beapplied, although, depending on the circumstances,certain factors can be weighed more heavily thanothers (Revenue Ruling 89-30).

Tech nical Advice Mem orandum 9 328004. - -Th e IRSrecently (March 1993) addressed the valuation methodto be used for special use valuation purposes withrespect to a Douglas-fir tract included in a decedent’sestate. The executor used the farm method, citing asingle property in the area that included woodlandsand that was leased on a cash basis. The IRS ruled

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that the two properties were not comparable and thatthe executor thus was required to use the multiplefactors method of valuation. The memorandum dis-cusses at length the applicability of the multiplefactors method to woodlands and how it is to be usedto specially value forest property.

W oodland Special Use Valuation.- -Th e special usevaluation election for forest land is directed towardlimiting the highest and best use of such acreage totimber growing. Purely speculative and inflationarycomponents of value are designed to be eliminated bythe election. Factors 1, 3 and 4 above are the mostlikely to apply to forest land. Of these, incomecapitalization is probably the most often used factor.This method of valuation, depending on the circum-stances and characteristics of the property involved,may actually result in a value lower than the currentmarket value for timber use.

POSTDEATH REQUIREMENTS

Certain requirements must continue to be metduring a lo-year recapture period measured from thedecedent’s date of death. If not met, a recapture taxapplies.

Continued Ownership within the Period

Ownership of the specially valued property mustcontinue solely within the decedent’s family, as theterm “family members” was defined earlier. Excep-tions apply in the event of involuntary conversions ortax-free, like-kind exchanges. With respect to theformer, however, the proceeds from the involuntaryconversion must be reinvested in real property that isused for the same qualified use as was the involun-tarily converted property. Similarly, propertyreceived in an exchange must also be employed in thesame qualified use.

Material Participation

At least one member of the decedent’s family asdefined earlier must materially participate inoperation of the property during 5 of every 8 yearsbefore the qualified heir’s death during the lo-yearperiod following the decedent’s death. The lessstringent active management test, as discussed onpage 83, may be substituted for material partici-pation by surviving spouses, qualified heirs under the

age of 21, full-time students, or disabled persons. Ifthe property in question has been left in a trust towhich the surviving spouse is the life beneficiary andother qualified heirs are the remaindermen, the sur-viving spouse is the qualified heir for purposes ofcompliance with the material participation require-ments (Letter Ruling 8652005).

Qualified Use

The property must continue to be used and man-aged for the qualified use. However, a qualified heirmay begin the qualified use at any time within 2 yearsof the decedent’s death without triggering the recap-ture tax; the recapture period does not begin to rununtil the qualified use begins. If property is left in atrust to which the surviving spouse is the life bene-ficiary and other qualified heirs are the remaindermen,the spouse is the qualified heir for purposes of com-pliance with the qualified use test (Letter Ruling8652005).

Recapture Tax

The tax benefits realized by the estate when specialuse valuation has been elected may be fully or partiallyrecaptured if one of the postdeath requirements dis-cussed above fails to be met during the recaptureperiod. A second violation will not trigger a secondtax on the same qualified property, however. Thus,when a qualified heir ceases to use the property for itsqualified purpose and later sells it during the recaptureperiod, a recapture tax will be imposed as to the firstevent that triggers recapture, that is, cessation of use,but not as to the second event (sale of the property).

Conservation Reserve Program Enrollment

Letter Ruling 8745016 discusses diversion of crop-land to tree cover under the Conservation ReserveProgram (CRP). Here the qualified heir, for speciallyvalued farmland, converted the farmland from crop-land to tree cover after enrolling in the CRP program.The IRS ruled that such diversion is not a cessation ofqualified use so as to trigger the recapture tax.

Amount Subject to Recapture

The amount of the tax benefit potentially subject torecapture is the estate tax liability that would have

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been incurred had the special use valuation procedurenot been used minus the actual estate tax liabilitybased on special use valuation. In other words, themaximum additional or recapture tax is the amountthat special use valuation has saved the estate. Thisis called the adjusted tax difference. The additionaltax will be less than the maximum if the fair marketvalue of the property interest in question--or theproceeds from its arm’s_length sale--exceed the valueof the property interest determined under special usevaluation by less than the adjusted tax difference.

Payment of the Recapture Tax

The additional tax on recaptured property is due onthe day that is 6 months after the recapture event.Interest runs from the due date (Revenue Ruling81-308). However, if an election is made to adjustthe basis of the property in question to its fair marketvalue on the date of the decedent’s death, interest isowed from the due date of the estate tax return.Such an election is permitted under IRC Section1016(c). If interest is paid, it is not deductible bythe original estate as an administrative expense. TheIRS reasons that the recapture tax and the interest onit is not imposed in connection with a testamentarytransfer of estate property, but rather is a separate taximposed on the qualified heir as a result of the heir’sown actions (Letter Ruling 8902002).

Recapture Lien

A government lien is imposed on all qualifiedproperty for which a special use election has beenmade and applies to the extent of any recapture taxthat may be imposed. It begins at the time the elec-tion is filed and continues until: (1) the tax benefit isrecaptured, (2) the qualified heir either dies or therecapture period ends, or (3) until it can be estab-lished to the satisfaction of the IRS that no furtherliability will arise. If qualified replacement propertyis purchased following an involuntary conversion ofspecial use valuation property, the lien that was appli-cable to the original property attaches to the new.Similarly, if specially valued property is exchangedfor qualified exchange property, the lien also attachesto the new property. The IRS can subordinate thegovernment’s lien if it determines that the interest ofthe United States will be adequately protectedthereafter.

Release from Recapture Tax Liability

A qualified heir’s liability for the recapture tax canbe extinguished in two instances: (1) if the recaptureperiod lapses and (2) if the heir dies without con-verting or disposing of the property. Additionally, asale or other disposition by one qualified heir toanother of specially valued property is not considereda recapture event, and the second heir is treated as ifhe (she) received the property from the decedent ratherthan from the first heir. The second heir thenbecomes liable for the recapture tax, and the seller isreleased of further liability.

D isch arge from Liability.- -An heir may be dis-charged from personal liability for future potentialrecapture taxes by. furnishing a bond for the maxi-mum additional tax that could be imposed on his (her)interest in the property.

Timber and the Recapture Tax

Unfortunately, an onerous special rule applies to thecutting of specially valued timber during the recaptureperiod. Any harvesting of such timber or the disposi-tion to another of the right to harvest before the deathof the qualified heir will be termed a disposition of theinterest in the specially valued timber and, therefore,trigger a recapture tax. The recapture amount will bethe lesser of: (1) the amount realized on the disposi-tion (or if other than a sale or exchange at arm’slength, the fair market value of the portion of theinterest disposed of), or (2) the amount of tax thatwould be recaptured under the general recapture rules,without regard to the woodland election, were theentire interest in the qualified woodland disposed of.The second of these requires that the computation bemade as if there had been a disposition of the land aswell, even though it was not actually disposed of.

The valuation of severed specially valued timberfor recapture tax purposes is discussed in detail in a1983 Tax Court decision (D onald C. Pee k , TC Memo1983-224, TCM 1382). Calculation of the recapturetax with respect to the sale of a tract of farm andforest property is set out in Letter Ruling 8741048.

Designation of Specially Valued Tim ber.- - In mostinstances, executors will probably choose not to spe-cially value standing timber except as needed to meetthe 25- or 50-percent qualifying tests when there isother property included, such as the underlying forestland and/or farm acreage. Obviously, young timber

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that would not be harvested during the lo-year recap-ture period should be utilized first for the special usevaluation election. The designation should be madeon an acreage basis, if possible, to avoid confusion asto just which trees are included. If older timber isalso to be specially valued, the most feasible waywould be to do it on an acreage basis as well, for thesame reason--describing specifically the acres con-taining the trees to be so valued. Alternatively, thedistinction could be made by species or diameterclasses as they exist at the time of the election, but avery careful description would be required. Speciallyvaluing a certain percentage of a stand’s volume--forexample, 50 percent of the merchantable volume thatexists in a stand at the time of election--shoulddefinitely be avoided. A situation was related to theauthors in private correspondence where this wasdone. The IRS accepted the election, but when theexecutor decided to harvest some of the trees andsought clarification from the IRS as to which trees hecould cut, he was confronted with an unexpectedproblem. The executor wanted to cut the number oftrees whose volume would equal the percentage oforiginal stand volume not specially valued. The IRStook the position, however, that the volumebreakdown applied to each tree--not to the stand as awhole--and, therefore, part of each tree was speciallyvalued and the other part of the tree was not. This

meant that no trees whatsoever could be cut withoutconstituting a premature disposition and triggering arecapture tax.

THE ELECTION DECISION

Like many other provisions that grant tax relief inparticular situations, special use valuation should notbe elected without careful thought and analysis. Theexecutor has an obligation to evaluate the electionbecause of its potential significant impact on estate taxliability, and such an evaluation should not be avoidedmerely because it may be difficult and complex. Likemany other provisions of tax law, its effects can be _assessed only through mathematical application to thecircumstances of the particular estate in question.

The election may be used on a partial basis to con-trol the valuation of only part of the estate, such as theproperty for which the greatest reduction in value peracre may be achieved, while leaving other property toconventional valuation. Depending on the size andnature of the estate, land that will provide themaximum value reduction may be selected fromproperty intended to be retained in the family, whilepreserving other property for future liquidation, ifdesired.

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Chapter 14Deferral and Extension of Estate Tax Payments

OVERVIEW OF THE ESTATE TAX

The estate tax is due and payable at the same timethe tax return is due, that is 9 months after the dateof death. It must be paid within the time prescribedto avoid assessment of various penalties. Extensionsof time for payment may be granted, but such extens-ions, although preventing the application of certainpenalties, do not entirely negate the assessment ofinterest.

Due Date

The payment due date is the same numbered day ofthe ninth month after the date of death as that datewas of the month in which death occurred. If thereis no similarly numbered day in the ninth month, thetax is deemed to be due on the last day of thatmonth. For example, if the date of death were July3 1, the due date would be April 30 of the followingyear.

Place of Payment

The law requires that the tax be paid, without anyassessment or notice by the Internal Revenue Service(IRS), to the IRS office where the estate tax return isfiled. Unless the return is hand carried to the officeof the IRS District Director, it should be mailed tothe IRS Service Center for the State in which thedecedent was domiciled on the date of death.

Method of Payment

The tax may be paid by check or money orderpayable to the IRS. If the amount of tax paid withthe return is different from the amount of the netestate tax payable as computed on the return, theexecutor should explain the difference in an attachedstatement.

Flower Bonds

Treasury bonds of certain issues (known as“flower” bonds) are redeemable at par (plus theaccrued interest from the last preceding date to thedate of redemption) upon the death of the owner, at

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the option of the estate representative. No treasuryobligations issued after March 3, 1971, will beredeemable at par value for this purpose.

ESTATE TAX OPTION FORCLOSELY HELD BUSINESS INTERESTS

The estate of an individual who dies owning aclosely held business interest--including an interest intimberland--may, by meeting certain requirements,qualify for a special elective method of paying theestate tax attributable to that interest. Under IRCSection 6166, payment of the tax may be totallydeferred for the first 5 years, with the estate making 4annual payments of interest only, followed by paymentof the balance in up to 10 annual installments of prin-cipal and interest. The maximum payment period,however, is 14 rather than 15 years because the duedate of the last payment of interest coincides with thedue date for the first installment of tax. Election ofspecial use valuation as discussed in chapter 13 doesnot prevent an election under Section 6166.

Percentage Test

The closely held business interest must comprisemore than 35 percent of the decedent’s adjusted grossestate. It can be composed entirely of timber prop-erty, or partially include timberland, but must be anactive business. If special use valuation has beenelected by the estate (see chapter 13), that value isused for purposes of determining whether the 35percent test has been met.

Mortgage E.crs.--Insofar as the eligibility of anownership interest as a percentage of the decedent’sgross estate is concerned, mortgages secured by realproperty used in the business must be deducted. Eligi-bility is measured in terms of the net value of theproperty in question and whether that value meets the35percent threshold requirement. See IRS LetterRuling 8515010, which discusses the effect of a mort-gage that encumbers both property used in the closelyheld business and other property. The IRS here ruledthat the gross value of the decedent’s closely heldtimber-growing business had to be reduced by thatportion of the outstanding mortgage attributable to it

for purposes of valuation under the Section 6166installment provisions. The mortgage in questionencumbered both timberland and pasture. The rentalof the pasture by the decedent was determined to bea passive activity, not the conduct of an activebusiness. The timberland was held to be an activebusiness, however, and an allocation of the mortgagebetween it and the pasture on the basis of acreagewas therefore necessary.

Com bining Interests.--Interests in two or moreclosely held businesses may be combined for pur-poses of meeting the 35percent test if more than 20percent of the value of each is included in the grossestate. The value of a surviving spouse’s interest inproperty held as tenancy in common, tenancy by theentirety, joint tenancy, or community property will becounted in determining whether more than 20 percentof the business was owned by the decedent.

Interest Payable on Deferred Tax

Interest on deferred tax is payable at a special,low, 4-percent rate, compounded daily, on the por-tion attributable to the first $1 million in value of theclosely held business. After accounting for the unifiedcredit, this means that a maximum of $153,000 in taxis covered by the 4-percent rate--a significant advan-tage for a qualifying estate. Amounts of deferred taxbeyond that level are subject to interest based on theFederal short-term rate, also compounded daily.Interest payments are deductible for income tax pur-poses or as an estate administration expense if alsodeductible for that purpose under State law.

Making the Election

The election must be made on a timely filed estatetax return containing the following information: (1)the decedent’s name and taxpayer identification num-ber; (2) the amount of the tax to be paid in install-ments; (3) the date elected for payment of the firstinstallment; (4) the number of annual installments,including the first installment, in which the tax is tobe paid; (5) the properties shown on the estate taxreturn that constitute the closely held business inter-est; and (6) the facts supporting the conclusion thatthe estate qualifies for the deferral and installmentelection.

Subsequent D ejk iencies.- - If th e election is made atthe time the estate tax return is filed, it will alsocover subsequent estate tax deficiencies determined

by the IRS that are attributable to the closely heldbusiness. This is in addition to the estate taxoriginally due with the return as filed.

Protective Election.- - If it is not certain at the time offiling the return that the estate qualifies for the elec-tion, a protective election can be made. It will allowsubsequent deferral of any portion of the tax attribut-able to the closely held business that is shown on thereturn, or deferral of deficiencies remaining unpaid atthe time values are finally determined. The protectiveelection must be made on a timely filed return. Afinal election notice must then be filed within 60 daysafter it has been determined that the estate qualifies forthe election.

Acceleration of Unpaid Taxes

Deferred tax payments are accelerated if more thanone-half of the value of the qualified business interestis withdrawn or disposed of during the deferral period.The same rule applies if funds or assets are withdrawnthat represent 50 percent or more of such value. Forthis purpose, values are measured as of the date of thewithdrawal(s), not the date of death.

D eath of O riginal H e ir.- -Th e transfer of the dece-dent’s interest upon the death of the original heir, orupon the death of any subsequent transferee who hasreceived the interest as a result of the prior trans-feror’s death, will not cause acceleration of taxes ifeach subsequent transferee is a member of the trans-feror’s family.

D elinquent Paym ents.- -A delinquent payment ofeither interest or tax will accelerate the due date of theunpaid tax balance if the full delinquent amount is notpaid within 6 months of its original due date. The latepayment, however, will not be eligible for the special4-percent interest rate. Additionally, a penalty of 5percent per month of the amount of the payment willbe imposed.

Liability for Payment of the Tax

With a Section 6166 election, the estate representa-tive is basically liable for payment of the tax. How-ever, an executor or administrator seeking discharge ofliability may file an agreement that gives rise to aspecial estate tax lien. The lien is against “real andother property” expected to survive the deferralperiod. The maximum amount subject to the lien isthe amount of deferred tax plus the first 4 years ofinterest. All parties having an interest in the property

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to which the lien is to attach must sign an agreementto its creation.

Once filed, the lien is a priority claim against theproperty, with some exceptions. These exceptionsare as follows: (1) real property tax and specialassessment liens; (2) mechanics’ liens for repair orimprovement of real property; (3) real estate con-struction or improvement financing agreements; and(4) financing for the raising or harvesting of a farmcrop, or the raising of livestock or other animals.

What Constitutes a Closely Held Business Interest?

Sole Proprietorsh ips.- - Sole proprietorships mayqualify as closely held businesses. Assets, includingcash, must actually be involved in the trade orbusiness of the sole proprietorship before their valuecan be included. Passive assets held by a soleproprietorship are not considered in determiningvalue.

Partnersh ips.- - If certain rules are met, partnershipinterests may qualify. Either 20 percent or more ofthe partnership’s total capital interest (see page 98 fora discussion of partnership capital interests) at thetime of the decedent’s death must be included in thedecedent’s gross estate, or the total number ofpartners must not exceed 15. The inclusion of thevalue of passive assets held by a partnership is dis-allowed for purposes of the 35percent test. Part-nership interests held by a decedent’s family aretreated as if owned by the decedent. InternalRevenue Code Section 267(c)(4) defines the family ofan individual as including brothers and sisters (whole-or halfblood), spouses, ancestors, and lineal descen-dants. A husband and wife are considered as onepartner if the property is held as community prop-erty, tenancy in common, joint tenancy, or tenancyby the entirety.

Corporations.--Corporate interests may also qualifyas interests in closely held businesses. In order fora corporate interest to qualify, however, 20 percentor more of the corporate voting stock must beincluded in the decedent’s gross estate, or the totalnumber of shareholders must not exceed 15. Onlystock constitutes an interest in a corporate closelyheld business. Corporate debt securities are notinterests. It is not necessary that the shareholderdecedent have been personally involved in the busi-ness in order for his (her) stock ownership to qualifyunder Section 6166. As with partnerships, corporateinterests held by a decedent’s family are treated as ifowned by the decedent. The definition of family isas noted above. A husband and wife are treated as

one shareholder if the stock is held as communityproperty, tenancy in common, joint tenancy, ortenancy by the entirety.

Trusts.- -Th e installment payment IRC provisionsand IRS regulations do not refer specifically to trustownership of an interest in a closely held business.The IRS, however, does recognize business interestsin trust as qualifying under Section 6166.

When is a Closely Held Businessan Active Business?

The line between what is and what is not an activebusiness is often a fine one. The required involvementfor installment payment purposes can be contrastedwith the material participation requirements for specialuse valuation as discussed earlier. There are two keydifferences between material participation for purposesof special use valuation and the necessary activity forpurposes of Section 6166. For purposes of Section6166, the question of whether the operation amountsto an active business is determined as of immediatelyprior to the decedent’s death. For special use valu-ation purposes, material participation by the decedentor a family member is required for 5 or more of thelast 8 years before death, retirement, or disability,whichever occurs earliest. It cannot be gained throughthe services of an agent, such as a property manager.On the other hand, even an unrelated agent, as well asa family member, can assure the necessary degree ofinvolvement for purposes of Section 6166 (IRS LetterRuling 8020101). Section 6166 eligibility can also beestablished through power of attorney (Letter Ruling8134010).

D isq ualification Not Appealable.- -An IRS determi-nation that an estate does not qualify for a Section6166 election because the decedent’s activities did notconstitute an interest in a closely held business is notappealable to the Tax Court. See Estate of Sh errod[82 TC 523, 85-2 USTC 13,644 (CA-ll)] in whichthe decedent’s activities with respect to his timberlandwere held by the IRS not to constitute an active tradeor business for Section 6166 purposes. The courtnoted that its jurisdiction was strictly limited by statuteand that it did not have the authority to enlarge uponthe sole statutory grant of jurisdiction given to the IRSwith respect to Section 6166 eligibility.

Tech nical Advice Mem orandum 8437001 (May 9 ,1984).--Here the IRS held that 5,126 acres of timber-land owned by the decedent (comprising 87.7 percentof the adjusted gross estate) did not qualify as aninterest in a closely held business within the meaningof Section 6166(b)(l)(A) of the IRC. The decedent’s

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activities with respect to the property includedvisiting the property routinely to observe timbergrowth and development, and to study the land andits potential for raising timber; making managementdecisions, such as whether to plant seedlings, whento sell timber, whether to clear and replant aftercutting, and in general what forestry techniques werebest suited to his particular situation; negotiatingcontracts for the sale and harvesting of timber;observing cutting operations to insure compliancewith contract terms; and overseeing the maintenanceof roads and firebreaks, and the prevention of tres-pass. During a 6-year cutting contract, however, thedecedent had granted the contractor almost completecontrol over the cutting operation and the property.The IRS found that during this period the decedent’sprerogatives with respect to the property were limitedto policing the cutting for the purpose of enforcingthe contract terms, and that the cutting arrangementwas thus similar to a “net\net” lease arrangementwherein the lessor merely receives a net incomebased on ownership of the leased property. This factwas the overriding factor in the IRS conclusion thatthe decedent’s relationship to his timber assets wasnot that of a proprietor carrying on a trade orbusiness.

IR S Atlanta D istrict Mem orandum .- - In an unnum-bered and undated memorandum issued by the IRSAtlanta District Oft-ice, the IRS held that the natureand level of the decedent’s activities with respect tohis nearly 500 acres of timber property was insuf-ficient to constitute an active trade or business forSection 6 166 purposes. The estate representative’sstatements that the decedent had actively managed theproperty in accordance with good forestry practiceswas countermanded by an IRS appraiser who statedthat the timber was all natural; that none had beenplanted; that there was no evidence of cutting inrecent years or of thinning; that the only firebreakswere roads; and that here had been no prescribedburning within the past 5 years. He concluded thatthe decedent had just let the timber take its naturalcourse and that there was no evidence of forestrypractices.

Letter Ruling 9 015003 (D ecem ber 22, 1989).--Insupplementing Letter Ruling 9001062, the IRS con-cluded that a decedent’s one-third interest in a timberbusiness held in trust qualified as an interest in anactive, closely held business for Section 6166 pur-poses. The property was under active forest manage-ment; daily operations and timber sales were carried

out by an independent forest management company.The decedent, individually and through her agents,participated in the decision-making process in runningthe business. She and other grantors met annuallywith the trustee and a representative of the forest man-agement company to review the prior year’s forestmanagement activities, to discuss plans for the comingyear, and to make long-term plans. The decedent alsoshared equally with the other grantors the income fromand the expenses of the business, and thus also sharedin the risks involved. For purposes of Section6166(a), activities of an agent may be attributed to adecedent. In this case, the trustee was the decedent’sagent.

What Constitutes Withdrawal or Disposition?

Changes in organizational form do not terminate theinstallment payment right if they do not materiallyaffect the business. Thus, incorporation of a sole pro-prietorship, a shift from sole proprietorship status topartnership, liquidation of a corporation, and transferof a sole proprietorship to a limited partnership haveall been held not to accelerate payment. Installmentsale of property, however, will terminate Section 6166status if the 50-percent limit is reached.

Converting cropland, for which a Section 6166 elec-tion is in force, to grass or tree cover under theConservation Reserve Program is not a withdrawal ordisposition (IRS Letter Ruling 9212001). The taxattributable to the property will continue to be eligiblefor deferral and payment in installments.

Lik e - k ind Exch ange .- -Th e transfer of assets in a tax-free exchange does not accelerate payment of tax thathas been deferred. In Letter Ruling 8722075, anestate’s partition of an undivided interest in wood-lands, followed by a like-kind exchange, did not affectthe 6166 election that was in force. Although morethan 50 percent of the property may have been trans-ferred, depending on whose values were accepted, theexchange did not materially alter the timber businessor the estate’s interest in the timber business. Thepartition and exchange was, therefore, not a disposi-tion for acceleration purposes.

Letter Ruling 8437043 (June 8, 19 84). --The IRShere held that a proposed sale of timber, comprising51 percent of the closely held business interests and aproposed 29-year lease of the land (comprising 35 per-cent of the closely held business interests) to a forestproducts company would constitute a disposition underSection 6166 (g)(l)(A). The estate, according to the

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ruling, would be liquidating its active businessenterprise of timber production in exchange for anarrangement in which it would merely hold the landas an investment asset from which income would bederived solely on the basis of ownership.

Planning Opportunities

Because the value of the closely held business mustexceed 35 percent of the adjusted gross estate, wood-land owners seeking to qualify under Section 6166should be familiar with the various elements that con-stitute the adjusted gross estate. If the value of thetree farm is very close to 35 percent, considerationshould be given to increasing its value or decreasingthe adjusted gross estate during the decedent’s life-time. In order to reduce the adjusted gross estate,

the types of expenses which may be deducted to arriveat it should be reviewed for possible changes (seechapter 3 for a discussion of adjusted gross estate).

Great care should be taken in deciding whether tomake gifts of assets in order to qualify for Section6 166 treatment. Gifts made within 3 years of deaththat would not normally be included in the gross estatewill be considered to determine if the 35percenttest is met. This provision was specifically designedto prevent deathbed transfers intended to qualify theestate for Section 6166 treatment.

Special use valuation should also be carefully eval-uated. While its election will decrease estate taxliability, its use may preclude qualifying for install-ment treatment. The value of deferring the estate taxpayments should be compared to the value of theestate tax reduction.

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PART IV

FORM OF TIMBERLAND OWNERSHIP AND BUSINESS ORGANIZATION

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Chapter 15

Sole and Joint Ownership Considerations

SOLE OWNERSHIP

Ownership of property in one name is normally thesimplest method and gives the holder the most com-plete ownership possible. Transfers are relativelyeasy because the holder of title to the property hasthe absolute right to dispose of it under most cir-cumstances. In some cases, a spouse may have toconsent to the transfer of real property owned solelyby the other spouse because of the dower right avail-able under the laws of some States. At death, solelyowned property passes under provisions of the willor, if the decedent died intestate, according to theprovisions of State law. Federal estate and Statedeath taxes generally apply to the total value of theproperty held in sole ownership. Outright ownershipof property is referred to as “fee simple,” the nearestthing to absolute and complete ownership.

JOINT OWNERSHIP BETWEEN SPOUSES

A key estate planning element for family-ownedtimberland is the manner in which the property isheld by husband and wife. Typically, the spouseshave worked together to accumulate and manage thewoodland. The result is a feeling of commonality ofownership, and the intent that the property becontrolled by and applied to the use of the survivoras long as he or she lives.

It is beyond the scope of this book to provide adetailed discussion of the various methods of inter-spousal property holding among the 50 States. Abasic analysis of the application of estate and gifttaxes to property transfers within the marital com-munity will, however, be presented.

Legal Development

The traditional English concept of jurisprudencewas that as long as both spouses lived, they repre-sented a single unit of ownership, with this ownershipbeing represented by the surviving spouse after thedeath of the other. A blending of this common lawconcept of the legal unit of husband and wife with thecommon law theory of joint ownership of propertyled to the development of tenancy by the entirety.

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The distinguishing feature of tenancy by the entirety isthat no partition or severance of the ownership of realproperty or destruction of the survivorship feature canbe achieved by the unilateral action of either spouse.Many States have abolished this concept as a form ofproperty holding; others have continued it, sometimeswith modifications.

Where tenancy by the entirety has been abolished,common law joint tenancy may generally be utilized tocreate property holdings between husband and wifethat have the survivorship feature. Joint tenancyresembles tenancy by the entirety in that both entail aright of survivorship. A joint tenancy, in addition,may be created among nonspouses. Joint tenancy alsopermits partition of the property at the will of any ofthe cotenants, unlike tenancy by the entirety.

Community Property

Nine states--Arizona, California, Idaho, Louisiana,Nevada, New Mexico, Texas, Washington, andWisconsin--derive their concepts of property holdingbetween husband and wife from the civil law ratherthan from common law. These are the so-called“community property States. ” The basic communityproperty concept is that all property acquired by thespouses from the efforts of either during the marriagebelongs in common to both. Separate property is gen-erally that received by either spouse by inheritance orgift and that owned prior to the marriage. Generally,in community property States, the surviving spouse isprotected to a greater degree in the succession to com-munity property than in succession to separate prop-erty. The profits and earnings from community prop-erty, and in some cases from separate property, areconsidered community as well.

Advantages of Joint Ownership

In many States, the probate procedure is perceivedto be so cumbersome, time consuming, and expensivethat joint tenancies are common. Joint propertyholding tends to express the common feeling of jointendeavor and mutual accomplishment enjoyed byowners of farm, forest, and other rural prop-erties. It has been commonly utilized as a substitutefor more complex business organization arrangements.

Survivorship property ownership arrangements canoffer each the emotional and financial security ofknowing that the mutually acquired property cannotbe lost by the survivor, in whole or in part, upon thedeath of the other. Additional advantages include theease of understanding and implementing the concept;and the uncomplicated and inexpensive transferprocess.

Disadvantages of Joint Ownership

Basis Limitations.--Despite the valuable uses ofjoint property holding arrangements between spouses,there are potential problems--particularly with respectto those estates that have values greater than the uni-fied credit exemption equivalent. When spouses areexclusively joint tenants in property, regardless ofwhich spouse provided the consideration for thejointly held property, one-half of the value of theproperty is included in the gross estate of the firstspouse to die. Although no Federal estate tax is paidon property passing to the surviving spouse becauseof the unlimited marital deduction, the survivingspouse in noncommunity property States will receivea stepped-up basis only in that property included inthe gross estate of the decedent spouse. If the firstspouse to die had owned all of the property, a fullstep-up would be obtained.

Unintentional Term ination.- - In some States, jointtenancy ownership may be severed by a contract tosell to third parties or even by the placing of a mort-gage on the property. As a result, the parties mayfail to achieve their purpose through an unintentionaltermination of the survivorship feature.

Lim itation on Using a D isclaim er.- -Th e role of dis-claimers (see chapter 7) as a post mortem estateplanning tool is extremely limited. Only a few Statespermit a disclaimer of the interest in property that hasbeen perfected in the survivor. Thus, this highlydesirable method of post mortem tailoring of propertydescent is not available if not provided for by Statestatute, and the resultant afterdeath tax planning isgenerally denied to the surviving joint tenant.

Additionally, the Internal Revenue Service (IRS)has taken the position that a disclaimer of a jointtenancy interest is not effective for estate tax pur-poses, even though it may be valid under State law,on the ground that the donee accepted the propertywhen the joint tenancy was created (Letter Rulings7829008,7911005, and 7912049). The reasoning setout in the rulings is that property transferred to a

joint tenant who may become the survivor is acceptedby that joint tenant when the joint tenancy is createdand, thus, must be disclaimed within the statutorilyrequired period of 9 months from the date of creationof the joint tenancy. It is the position of the rulingthat by the time of the death of the first tenant to die,acceptance has been completed, and the statutoryperiod for the disclaimer has expired.

Postdeath Income Tax Considerations

Another disadvantage of joint tenancy involvespostdeath income tax considerations. There are agreat many advantageous income tax options availableto the estate of a decedent. Because survivorshipproperty passes to the survivor immediately upon thedeath of the deceased, there is no intervening estate toact as a taxable entity. Thus, the surviving jointtenant cannot take advantage of the post mortem taxoptions generally available to estates.

Creation of Joint Tenancies in Real Estate

Most States with joint tenancy statutes now permitthe creation of joint tenancies in real property by aconveyance to the joint tenants(s) that sets forth theexistence of the survivorship feature. In those Statesthat recognize tenancies by the entirety, State statutesand sometimes case law provide various methods ofcreation. Once such ownerships have been estab-lished, the ownership of income resulting therefromsometimes becomes an issue. The status of the incomeis critical to the tax consequences associated with it,particularly with respect to proof regarding contribu-tions by a nonspousal donee or surviving joint owner.Profits and proceeds generally, including those fromthe sale of standing timber, that are derived fromentirety property are themselves treated as entiretyproperty. Similarly, property purchased with theproceeds from selling entirety property is also entiretyproperty. Income realized from joint tenancy prop-erty, on the other hand, is treated in most States as theseparate property of the joint tenants in proportion totheir ownership interests.

Federal Estate Tax Aspects of Joint Tenancies

The estate tax consequences of the death of anindividual who has an interest in a joint tenancy aregoverned by Internal Revenue Code (IRC) Section2040. Section 2040(b) establishes the concept of a

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“qualified joint interest. ” This concept is defined as“any interest in property held by the decedent and thedecedent’s spouse as (1) tenants by the entirety or (2)joint tenants with right of survivorship, but only ifthe decedent and his (her) spouse are the only jointtenants. ” For such an interest in property, the valueto be included in the decedent’s gross estate is one-half of the value of the interest.

NonspousaZJointZnterests.--Section2040(a) appliesto all situations involving nonspousal joint interests.The value of any such joint interest held by the dece-dent at death is to be included in his (her) grossestate to the extent of the decedent’s fractional shareof the property, in cases where the property wasacquired by gift, bequest, devise, or inheritance; or

to the extent that it cannot be demonstrated that thesurviving tenant(s) provided consideration for theacquisition of the property in those cases in which theproperty was acquired by other means. Thus, if apersonal representative is unable to show that theproperty was acquired by gift, bequest, devise, orinheritance--or that the surviving tenant(s) providedconsideration for acquisition of the property--the valueof all of the jointly held property will be included inthe decedent’s gross estate. Because determination ofthe amount of consideration provided by each tenantcan sometimes be difficult, it is very important thataccurate records be kept when using nonspousaf jointproperty-holding arrangements.

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Chapter 16Partnerships

Most family timberlands have been traditionallyoperated as sole proprietorships or in joint fee owner-ship. Increasingly, however, nonindustrial woodlandowners are turning to partnerships and corporationsas ownership vehicles, particularly if two or morepersons are involved in the ownership or manage-ment. This is due in part to the increasing financialvalues associated with managed woodlands and thedesire to utilize prudent business and income taxpractices. However, there is also a special interest inusing partnerships and corporations for estate plan-ning purposes.

A key factor in selecting a form of organization iswhether it is intended that the tree farm operationwill continue beyond the lives of the currentowner(s). If this is not the case, sole proprietorshipmay be the best device. But if it is expected that thetree farm as an entity will continue into the nextgeneration, a corporation or partnership may be abetter choice. Partnerships will be discussed in thischapter, corporations in chapter 17.

DEFINITION OF A PARTNERSHIP

A partnership is generally defined as an associationof two or more persons, as coowners, to operate abusiness for profit. Tests for determining what is andwhat is not a partnership have been developed in eachState. Written partnership agreements are not neces-sarily required if the actions of the parties involvedand the attributes of their relationship are sufficient toindicate partnership status. Most States require asharing of profits for a partnership to exist. Somealso require a sharing of losses. Most States gen-erally give weight to the way the parties believe theyare organized. Therefore, it may not be wise to usethe term “partnership” in business transactions, dis-cussions with others, or correspondence unless part-nership status is desired.

The best procedure is to develop a written part-nership agreement and to state clearly the provisionsgoverning the arrangement. Unless otherwise speci-fied in the agreement, all partners in a general part-nership have an equal voice in managing the businessand a majority vote governs. Limited partnerships,as discussed later, are an exception to this rule.

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Partnership Mechanics

Partnership accounting procedures define partnershipinterests in terms of capital, profits, and losses. Apartner’s capital interest is measured by his (her)capital account which reflects that person’s economicstake in the partnership at any given time. Initialcontributions are recorded and are increased to reflectincome and decreased to reflect losses and distribu-tions .

Partnership Units

Family partnerships sometimes utilize partnershipunits to reflect ownership interests. These are similarto shares of stock and may be represented by papercertificates as is stock. The use of units on the part-nership books rather than percentage adjustmentsmakes gifts and sales of partnership interests to familymembers easier to accomplish. Such transactions canbe made by simply transferring certificates.

PARTNERSHIP ATTRIBUTES

Under State law a partnership is an entity that mayacquire and convey title to property. When a partner-ship does own property, any partner (except in alimited partnership) may convey title on behalf of thepartnership.

Flexibility

As compared to corporations, partnerships areextremely flexible devices. The partnership agreementcan easily be amended up until the time the partnershipincome tax return is filed in order to realize desiredeconomic and tax consequences. This additional flexi-bility in structuring financial arrangements may lead,however, to a substantially more complex partnershipagreement and increased scrutiny under the Federalincome tax law.

Contributions.--Contributions of property may bemade to a partnership without recognition of gain; insome cases, this is not possible with a corporation.The partnership adopts the partner’s basis for propertytransferred to it, and the contributing partner’s capital

account, in turn, adopts the basis of the transferredproperty.

Withdrawals.--The ability to withdraw propertyfrom a partnership without adverse tax consequencesis a significant advantage. The distribution ofproperty, other than cash, by a partnership to itspartners normally is not subject to taxation. Instead,the partner receives the property with a carryoveradjusted basis unless the distribution is being made inliquidation of a partner’s interest. In that case, theadjusted basis of the property is determined withreference to the adjusted basis of the partner’s part-nership interest. Corporate distributions, on the otherhand, are treated as dividend payments or, if made asliquidating distributions, as payments in exchange forstock. And finally, liquidation of a partnership isgenerally a nontaxable event. This is generally notthe case with a corporate liquidation.

Unlimited Liability

Probably the best known characteristic of a generalpartnership is the unlimited liability of all partners forobligations of the partnership. The partnership credi-tors must first make a claim against the partnershipassets; they can then make a claim against the per-sonal assets of the individual partners if any debtremains. Also, creditors of an individual partner canmake a claim against the partnership assets up to theamount of that partner’s interest. These rules do notapply to the limited partners in a limited partnershipas discussed later.

Management Rights

In a general partnership (as opposed to a limitedpartnership), all partners have equal rights in themanagement and conduct of the business. No onecan become a member (partner) of the partnershipwithout the consent of all of the members. Boththese rules, however, are subject to any agreement tothe contrary among the partners. Thus, while Statecorporate statutes establish specific requirementsrelating to voting rights, partnership statutes permitalmost complete flexibility subject to the requirementthat the partners all agree.

will bind the partnership. Partnership liability doesnot result, however, if the partner has no authority tobind the partnership and the party with whom the part-ner is dealing has knowledge of that fact.

Assignment of Partnership Interest

A partner’s assignment of interest in the partnershipdoes not automatically entitle the assignee to partici-pate in the business. Unless the assignee is acceptedas a partner by agreement of all of the original part-ners, the assignee is merely entitled to receive a shareof the partnership profits.

Partnership Termination

A partnership may not have as much stability as themembers might like. As with a sole proprietorship orjoint ownership, a partnership is generally vulnerableto premature liquidation in the absence of prior plan-ning. If there is a written partnership agreement, theterm of existence can be stated. Usually, however,partnership agreements provide that the partnershipexists at the will of the partners. Even though a termof existence may be specified, the courts do not gen-erally force partnership continuation against the desireof a partner to withdraw. Dissolving partners havethree choices: (1) liquidate, (2) form a new partner-ship, or (3) shift to a sole proprietorship or corpo-ration.

On the death of a partner, the surviving partners aregenerally under a duty to wind up the business andmake a distribution to the deceased partner’s estate.But some courts have recognized the right of the sur-viving partners to bind the deceased partner’s heirs tocontinue the business. When continuation is desired,steps should be taken to include a provision in thepartnership agreement that requires continuation andthat gives the executor of each partner the power to actas a partner.

ESTATE PLANNING WITH PARTNERSHIPS

Minors as Partners

Partners as Agents

Every partner in a general partnership is an agentof the partnership for purposes of its business, andany action by a partner within the scope of business

Estate planning for members of a family partnershipoften involves transfer of partnership interests tominors. The intention may be to reduce the familyincome tax bill, reduce death taxes, or simply moveolder children into the business. But minors as

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partners can create problems. For Federal incometax purposes, a minor is not recognized as a partnerunless control is exercised by another person for thebenefit of the minor or the minor is “competent tomanage his (her) own property and participate in thepartnership activities in accordance with his (her)interest in the property. ” The test of competency iswhether the minor has sufficient maturity and experi-ence to be competent in business dealings, regardlessof State law. Unless the minor has significantinvolvement in the management of the partnership,the interest should probably be conveyed to a trusteefor the minor’s benefit, because the IRS regulationsrequire adequate judicial supervision. A minor may,however, be a limited partner because limitedpartners are precluded from management. In anyevent, a gift of a partnership interest should be madein accordance with the Uniform Gift to Minors Act.

Retained Control

Whether the parents should retain control of thepartnership is usually a nontax matter involving basicpersonal goals. Retention of control, however, mayinvolve significant income and estate tax conse-quences. The owner of a capital interest in a part-nership in which capital is a substantial income-producing factor, such as one structured aroundfamily timberlands, will be recognized as a partnerfor income tax purposes whether the owner receivedthe interest by purchase or gift. However, retainedcontrol over a gifted interest may cause the donor tobe treated as the owner for income tax purposes.Whether the retained controls are significant enoughto cause such a result is a question of fact. Thisproblem can be circumvented with a limited partner-ship.

Limited Partnerships

Limited partnerships are closer in structure tocorporations than are general partnerships. A limitedpartnership may be organized in most States with oneor more limited partners if there is at least onegeneral partner. Limited partners do not have per-sonal liability beyond their investments in thepartnership, but the price of this status is that alimited partner may not participate in management.Only general partners have management authority. A

limited partner who does participate in managementmay become liable as a general partner. Nevertheless,the limited partnership provides an ideal vehicle forexcluding certain family members, such as minors anddistant co-owners, from management control. Alimited partnership may also be useful if one of thepartners, such as a parent, wishes to withdraw fromactive participation in management of the tree farm.It permits the parent to leave capital invested withoutthe fear of unlimited liability.

Unlike a general partnership, which requires noformal action other than agreement among the part-ners, a limited partnership must be formed in com-pliance with specific State law. This requires theexecution of a certificate of limited partnership, whichis placed on file with a public official, usually thecounty clerk.

Example 16.1. Mr. and Mrs. Brown together owna substantial tree farm and have decided to utilizethe annual gift exclusion in conjunction with alimited family partnership in order to lower thevalue of the timberland for estate and gift taxpurposes. This procedure will allow the Browns togradually transfer ownership of the timberland totheir children but yet permit them to continue man-aging the property and make all the operatingdecisions. To implement the plan, the Browns firstexecute a limited partnership agreement in accor-dance with the law of their State, with themselves asgeneral partners and the children as limited partners.Concurrently with establishment of the partnership,ownership of the tree farm is transferred to the part-nership, with Mr. and Mrs. Brown each having apartnership interest equal to 50 percent of the treefarm’s value. Beginning that year, and each yearthereafter, the Browns gift to their children aninterest in the partnership equal to or less than theannual gift tax exclusion. The value of the gifts canbe substantially discounted because---for manyyears, at least--the Browns are giving their childrenminority interests in the partnership. Both Mr. andMrs. Brown, or one of them, could be paid a salaryor other compensation by the partnership for man-aging the tree farm from timber sale or otherincome received by the partnership. The Browns,as managing (general) partners, would determinehow to distribute and/or invest the cash received bythe partnership.

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Chapter 17

Corporations

Closely held, family-owned tree farm corporationshave increased in number during the past severaldecades in most States that have a substantial com-mercial timber acreage. Research findings indicatethat estate planning considerations are a major reasonfor incorporation of nonindustrial tree farms. Thecorporate stock is typically owned by persons relatedby blood or marriage or both. Some nonindustrialwoodland corporations are also owned by unrelatedshareholders, most of these are small and closelyheld.

CORPORATE FORMATIONAND MANAGEMENT

A corporation is a distinct entity, separate from theshareholders who own it or from those who manageor work for it. Thus, a corporation can sue and besued, enter into contracts, and own property--all in itsown name. A corporation has most of the rights ofan individual.

A corporation is formed by drafting the necessarydocuments and filing them with the designated Stateofficial, usually the Secretary of State. Generally,these documents consist of the corporate name, thenature of the business, the names and addresses ofthe incorporating parties, the corporate charter, andthe articles of incorporation. State law specifiescertain items to be addressed in the charter andarticles of incorporation; others can be added by theincorporators. Additional documents may also berequired, depending on the State in question. Anincorporation fee will have to be paidfiled at least annually with the State.

and reports

Qualifying as a Foreign Corporation

Because a corporation is formed under the laws ofa particular State, it cannot do business in otherStates without qualifying in them as a foreign corpo-ration. This requirement should be considered if thetimber land ownership in question lies in more thanone State. However, occasional transactions outsidethe State of incorporation that do not occur on aregular basis generally do not constitute “doingbusiness. ”

Limited Liability

Probably the most notable feature of a corporationis the limited liability status of its shareholders.Corporate debts and liabilities may be satisfied onlyfrom corporate assets. Thus, unlike partnerships,shareholder personal assets--other than investment inthe corporate stock--are protected from corporateliability. If the shareholders commit substantialpersonal assets to the corporation, limited liabilityobviously has less meaning than if such assets aremaintained outside the corporate structure.

Loss of Lim ited Liability--A corporate shareholdermay lose his (her) limited liability in three ways:(1) if the shareholder is personally involved in a tortthat gives rise to corporate liability; (2) if theshareholder personally signs a corporate contractualobligation--that is, signs without acting on behalf ofthe corporation; and (3) if the corporation fails to meetand maintain corporate organization and managementrequirements on a continuing basis.

Corporate Management

A corporation contains three clearly defined man-agerial groups: shareholders, board of directors, andofficers. In a closely held family corporation, thesame individuals often fill all these positions.

Sh are h olders.- -Th e shareholders are the personswho have contributed money or property to the cor-poration in return for shares of stock. In some cases,the stock may have been received by gift or inheri-tance. The shareholders are the basic decision-makinggroup. They approve changes in the corporate charterand articles of incorporation, and also elect the boardof directors. Each shareholder has one vote for eachshare of voting stock. Most States permit nonvotingstock but a few do not.

Generally, a majority vote governs, and the holdersof 51 percent or more of the stock have direct controlover corporate decisions made at the shareholder level.The shareholders also indirectly control decisionmaking at the other levels because of their power toelect the board of directors. Minority shareholdershave little, if any, decision-making power unlesspermitted by the majority.

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It is possible to grant minority shareholders greaterparticipation in decision making. In most States, thevote level required for shareholder action may beincreased from a simple majority to some higherlevel. The majority of States also allow cumulativevoting. This procedure permits shareholders tomultiply their votes by the number of directors to beelected and cast the entire number for one director.It helps insure that minority shareholders will at leastbe represented on the board of directors.

Board @Directors.--The board of directors is thepolicy-making body of the corporation. It developscorporate policy and long-range management strate-gies. The board also establishes the bylaws, whichare written rules and guidelines for corporate struc-ture and day-to-day management. The directors mayreceive fees for their services but are not salaried. Ina family corporation, the fees may be waived. Theselection of the officers is another important responsi-bility of the board.

[email protected] officers are the day-to-day corporatedecision makers. Usually in a small or family cor-poration these are a president, vice president, secre-tary, and treasurer. The officers often also functionas employees and receive salaries. They are chargedwith executing policy developed by the board ofdirectors. Authority to hire employees, sign negoti-able instruments, enter into contracts, and borrowmoney may be granted to designated officers by theboard.

INCOME TAX IMPLICATIONSOF INCORPORATION

Before addressing estate planning considerationsrelated to corporations, a discussion of income taximplications is appropriate. An incorporated familytree farm is treated virtually the same with respect toexpenditures as is a noncorporate timber ownership.Certain other aspects of corporate income taxation,however, differ from the rules applicable toindividual woodland owners.

Depreciation

Although depreciation is handled in essentially thesame way after incorporation as before, there are afew exceptions. One of these concerns the expensemethod of depreciation under Section 179 of theInternal Revenue Code (IRC). Section 179 previously

permitted most taxpayers in a trade or business toimmediately deduct rather than depreciate up to$10,000 of otherwise depreciable costs per tax year.The 1993 Revenue Reconciliation Act raised the maxi-mum Section 179 deduction to $17,500 beginning in1993. As under prior law, the maximum deductionphases out dollar-for-dollar for that portion of the totalcost of qualifying property placed in service during theyear that exceeds $200,000. For example, if $210,000of qualifying property were placed in service duringthe year, the maximum deduction under Section 179would be $16,500. With respect to corporations,members of a group of controlled corporations (dis-cussed on page 109) divide the expensed amount.Normally, however, a family tree farm corporationwill not be part of a group of controlled corporations.In that case, there is no difference in Section 179treatment between corporate and noncorporate tax-payers.

Taxation of Corporate Income

Two methods for the taxation of corporate incomeare available to qualifying corporations. These are theregular method for so-called “C” corporations and thetax-option method for so-called “Subchapter S” cor-porations. Most closely held family tree farms willqualify for either method.

“C” Corporation.--If no Subchapter S election ismade as discussed on page 109, a family woodlandcorporation will pay income tax under the regularmethod. Federal corporate tax rates were reduced in1987 and increased slightly in 1993 by the 1993Revenue Reconciliation Act. The current corporaterates are as follows:

Corporate taxable income Marginal rate

$5O,ooE :$5O,ooo 15 percent$75400 25 percent

$ 7 5 4 0 0 - $10,ooo,ooo 34 percentover - $10,ooo,ooo 35 percent

An additional 5-percent surtax (for a maximum of$11,750) is imposed on a corporation’s taxable incomeabove $100,000. This provision will completely phaseout the benefit of the 15- and 25-percent rates forcorporations with taxable incomes of more than$325,000. For corporations with taxable incomesbetween $100,000 and $335,000, the 15- and 25-percent rate benefits will be partially phased out.Corporations with taxable income above $15 millionalso pay a 3-percent surtax on income above thatamount to a maximum of $100,000 extra tax. Thisrecaptures the benefit of the 34-percent rate.

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The attractiveness of the regularly taxed corpora-tion is dependent on the relationship of corporateincome tax rates to the rates applicable to individuals.The top individual marginal rate on ordinary incomeis currently 39.6 percent as compared to the top mar-ginal corporate ordinary rate (including surtax) of 39percent. Although this represents little difference,the spread between corporate and noncorporate long-term capital gains rates is considerably greater. Themaximum long-term capital gain rate for individualsis 28 percent; for corporations it is 39 percent atincome levels where the 5percent surtax applies.This is particularly significant in the case of corporatefamily tree farms where, presumably, most of theincome would be from timber sales and thus capitalgain.

In effect, formation of a regularly taxed corpora-tion represents creation of a new taxpayer at the 15percent rate for the first $50,000 of corporate taxableincome and at the 25percent rate for the next$25,000. This may save on income taxes for thoseshareholders whose individual rate is 28 or 31 per-cent, with respect to net income left in the cor-poration for business purposes or expansion. How-ever, if the net earnings are removed from the cor-poration and paid to the shareholders as dividends,the shareholders will have to pay tax on the dividendsreceived as ordinary income, resulting in the so-called “double taxation” associated with “C” cor-porations.

A group of controlled corporations cannot be usedto circumvent the graduated corporate rate brackets.In other words, it is not possible to create two ormore corporations with common ownership in orderto take advantage of the reduced corporate tax rateson the first $75,000 of corporate taxable income.Thus, if two corporations are established with respectto a family tree farm--one to own the land and theother the timber--there will be only one set of gradu-ated rate brackets below 35 percent. With no stipula-tion for unequal apportionment, each corporationwould be taxed at 15 percent on the first $25,000 oftaxable income and at 25 percent on the next$12,500.

Subchapter S Corporations

Although the double taxation of dividends associ-ated with family owned “C” corporations can some-times be avoided to a certain extent by making pay-ments in the form of salaries and bonuses, which are

deductible by the corporation, this method will neveralleviate the problem entirely. Another problem con-cerns the corporation accumulating funds rather thanusing them to pay dividends. The so-called“accumulated earnings tax” is designed to discouragethe buildup of funds within a corporation in excess ofreasonable business needs. A corporation can accumu-late up to $250,000 of earnings and profits withoutimposition of the tax. Beyond that level, accumula-tions are taxed at rates ranging from 27 l/2 to 38 l/2percent unless higher accumulations are justified asbeing retained for the reasonable needs of the busi-ness. For those woodland corporations investing inadditional timberland, the $250,000 level should poseno problem.

The Subchapter S corporation method of taxationwas enacted in 1958 to remove the disadvantages ofthe regular corporate method of income taxation forsmall, family-owned corporations. If a corporationthat meets the requirements (discussed on page 104)elects Subchapter S status by filing Form 2553 withthe Internal Revenue Service (IRS), double taxation iseliminated. There is no taxation of earnings at thecorporate level; only the dividends paid to the share-holders are taxed and then on their individual returns.For all other purposes, however, a Subchapter S cor-poration remains identical to a “C” corporation.

A Subchapter S corporation passes through to itsshareholders their pro rata share of capital gains andlosses, operating losses, business deductions, depletionallowances, tax exempt interest, and credits. The passthrough is on a daily basis. These items are thenreported by the shareholders on their individualincome tax returns. Gains and earnings are taxed tothe shareholders as if actually received, even if heldby the corporation for expansion or paid out as divid-ends at a later time. Generally, distributions from aSubchapter S corporation without earnings and profitsare tax free to the extent of a shareholder’s adjustedincome tax basis in the stock (the amount of originalinvestment in the stock not previously recovered). Ifa distribution exceeds a shareholder’s adjusted basis,the excess is treated as a capital gain.

Distributions from a Subchapter S corporation canthus affect the income tax basis of the corporate stock.Undistributed taxable income on which tax is paid bythe shareholders increases the basis of their stock.Losses and tax-free distributions of previously taxedincome reduce the basis. To avoid later confusionover stock basis, the basis for each shareholder shouldbe computed annually and made a matter of record.

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Requirements for Electing and MaintainingSubchapter S Status

A number of requirements must be met in orderfor a corporation to elect Subchapter S status with theIRS and continue to maintain that status.

Shareholders.--There can be no more than 35shareholders. Stock owned by both spouses, regard-less of how it is held or in whose name, is consideredto be owned by only one shareholder. A survivingspouse and the estate of a deceased spouse are alsotreated as only a single shareholder. Generally, allshareholders must be individuals or the estates ofindividuals. In certain limited circumstances, how-ever, trusts can be shareholders. Nonresident alienshareholders are not permitted.

Stock.--A Subchapter S corporation can have onlyone class of stock outstanding. Differences in votingrights are allowed, however, and do not violate therequirement for a single class of stock. This can bean important consideration when minor children areshareholders. Preferred stock is not allowed.

Accum ulated Earnings Carryover.- - Som e “C” cor-porations have accumulated earnings and profits whenthe Subchapter S election is made, which are carriedover to the Subchapter S corporation. A SubchapterS corporation in this position cannot have passiveinvestment income, such as interest, in excess of 25.percent of gross corporate receipts for more than 2consecutive years. If it does, its Subchapter S statuswill be terminated. This rule could constitute a trapfor the unwary Subchapter S tree farm that maintainsan interest-bearing bank account in years in which notimber harvesting is done.

Election.- -Th e election, as noted earlier, is madeby filing Form 2553 with the IRS. It may be madeat any time during the preceding taxable year, or onor before the 15th day of the 3d month of the taxableyear in question. An election too late for 1 year maybecome effective the following year. All share-holders of record must consent to the election. It canbe voluntarily revoked but only if the holders ofmore than half of the corporate stock consent to therevocation. Thus, a new shareholder by reason ofgift or inheritance cannot unilaterally terminate theelection, as was once allowed, unless he (she) ownsa majority of the voting stock. The election can alsobe terminated by the IRS for failure to continue tomeet the Subchapter S requirements.

In general, a new election cannot be made within5 years of a revoked election without IRS consent.

This provision was recently utilized by a Subchapter Scorporation formed to hold and manage timber prop-erties (Letter Ruling 9 111036). The corporationobtained a new treasurer in 1986 who was unaware ofthe Subchapter S election and, thus, began filing con-ventional “C” corporation tax returns. In addition, thecorporation, through the treasurer, had violated the 25-percent passive income rule because no timber saleshad been made for a number of years due to depressedprices, but yet interest was earned on the accumulatedearnings realized from the “C” corporation years. Forthese reasons, the IRS revoked the Subchapter S statusin 1990. At the corporation’s request, however, theIRS determined that the election had been inadver-tently terminated because of the treasurer’s lack ofknowledge. It permitted the corporation to return toSubchapter S status in 1991 after filing amended taxreturns for the tax years after 1987, paying additionaltaxes due, and eliminating the interest-bearing accountuntil such time as timber sales were resumed.

ESTATE PLANNING CONSIDERATIONS

Certain characteristics of corporate ownership mayenable it to more completely accomplish a forest land-owner’s estate planning objectives than will otherforms of ownership. This is particularly true if thetree farm is to continue as an economic unit beyondthe death of the parents as majority or sole owners.

Lifetime Transfer of Stock

When planning for continuation of the family treefarm, particular attention should be given to transfersof ownership and management from one generation tothe next. This process is simplified with a corpora-tion, in which ownership and control is facilitated bymerely transferring shares of stock.

Parents who are sole owners or co-owners of forestproperty may be reluctant, for reasons of personalsecurity, to make gifts of the property to the childrenin order to achieve death tax savings or business con-tinuation. Their fear may be compounded by the factthat the donees are free to retransfer the property toothers once the gifts are made. Restrictions onretransfers are often unenforceable. Even if gifts areotherwise acceptable, however, donations of forestland are not easily made--either in terms of undividedinterests or as separate parcels (see chapter 8).

On the other hand, transfer of corporate stock doesnot involve these disadvantages. Tree farm ownership

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can be divided into easily transferred shares of stockso that the gift or sale of stock translates into a pro-portionate share of the tree farm. Majority ownerscan dispose of some stock without losing control overdecision making. They can be assured of continuedemployment as corporate officers and of control overcorporate dividend policy. This eases the incomesecurity problem. Restrictions can also be placed onthe retransfer of stock by those receiving it throughgift or sale. Stock can additionally be used to chan-nel tree farm income to low tax bracket taxpayers soas to minimize overall income tax liability.

Transfers to Minors

It may be desirable to transfer interests in thetimberland to minors in order to reduce the familyincome tax burden or to encourage the minors todevelop a greater involvement and interest in the treefarm. Minors, however, are not considered legallycompetent to manage their property. The transfers ofproperty interests to minors have long created prob-l e m s . Such gifts are usually made easier if thetransfer is in the form of shares of corporate stock.

Uniform Gifts to Minors Acts.--Stock in a familycorporation is eligible for transfer to minors underthe Uniform Gifts to Minors Acts now available inevery State. These statutes are relatively easy to use,inexpensive, and involve little red tape. They basic-ally provide for a simple custodianship by which abank or an adult holds and manages the property forthe minor. Only gifts of stock, securities, or moneyare eligible for transfer in most States. Gifts of landand timber, by contrast, are generally not eligible.An important consideration is that, if the donor isalso the custodian and dies before the child reachesmajority, the amount of the property held would verylikely be included in the donor’s estate for death taxpurposes. Therefore, the custodian should probablybe someone other than the donor.

Unearned Income.--Unearned income of a childunder. age 14 who has at least one living parent willbe taxed at the parent’s marginal income tax rate ifthe child’s investment income is more than $1,100for the year. This rule may lessen the advantage ofmaking transfers to young children.

Estate Settlement

A corporation is an entity that does not terminatewhen one of the owners (a shareholder) dies. On the

other hand, at the death of an individual owner withfee title, all of his (her) property is normally subject toprobate--a process during which all assets are usuallyadministered by the estate representative. Upon thedeath of a corporate shareholder, in contrast, only thecorporate stock owned by the decedent is subject toprobate and transfer--not the underlying assets. Thestock, of course, must be valued for Federal estate andState death tax purposes, but operation of the tree farmmay be continued without interruption.

Ancillary Probate.--If an individual owns real prop-erty in two or more States, a probate proceeding isnormally required in each State. A probate court pro-ceeding in one State cannot pass title to real property,including land and timber, in another State. Thus, theoriginal probate proceeding is held in the State ofresidence and ancillary probate in the other State(s).In the event that real property is owned in two State(s)by a corporation, however, ancillary proceedings arenot required because corporate stock is personalproperty--not real property--and generally is subject tothe law of the decedent’s State of domicile at death.

Loss of Capital

The right of partition and sale (see chapter 15),which is generally available to joint tenants or tenantsin common for terminating co-ownership arrange-ments, is not available to corporate shareholders.While those shareholders not actively participating inoperation of the tree farm may have sufficient votes todissolve the corporation, they do not have the optionof receiving their portions through division or forcedsale of the property. This corporate feature may causedisputes, however. Restrictions are often placed onretransfer of inherited or gifted stock, and minorityshareholders have relatively few management rights.

Stock Purch ase Options.--To avoid this problem, itmay be advisable for those most concerned with con-tinuity of the tree farm to gradually purchase the stockheld by the other shareholders. A buy-sell or firstoption agreement could specify that the purchase priceis to be paid either in cash or by installments over aperiod of time with interest.

As an alternative, stock could be permitted to passto minority heirs with specific rights granted in regardto management, a minimum dividend level in conjunc-tion with timber sales, and a ready market for theirstock in the event they may wish to sell. This wouldbalance corporate stability against minority shareholderrights.

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Corporate Disadvantages

A corporation has estate planning disadvantages aswell as advantages. Some can be resolved withproper planning, others cannot.

Subch apter S Corporations.- -As discussed earlier,a Subchapter S corporation can have no more than 35shareholders. If death and inheritance result in morethan 35, Subchapter S status is lost. Another dis-advantage is that a Subchapter S corporation’s stockcannot be held by a trust except in certain limitedinstances, even though trusts are key estate planningdevices (see chapter 10). It is not possible toestablish a testamentary trust for minors, with thetrust holding Subchapter S stock, and have the trustcontinue as a shareholder for more than a shortperiod of time after the death of the grantor. Nor isit possible for stock in a Subchapter S corporation tobe held by a marital deduction trust (see page 68).

Adjustment of Basis

One corporate attribute that may prove to be adecided disadvantage with respect to tree farms con-cerns the basis of the land and timber. Assets helduntil death receive a new income tax basis, which isgenerally equal to the fair market value of the assetson the date of the decedent’s death or 6 months after.This adjustment in basis cancels out any unrecognizedgain or loss on the property and the new basis pro-vides values (depletion values in the case of timber)for computing future gains or losses upon sale.

Thus, when a shareholder dies, the shares of stockowned at death receive a new income tax basis equalto their value as determined for death tax purposes.But the basis of the underlying property, such as landand timber, in the hands of the corporation remainsunchanged. Therefore, the sale of timber by a cor-poration after the death of a shareholder creates thesame amount of taxable gain or loss as if the timberhad been sold before the shareholder died. Also,depreciable property already fully depreciated by thecorporation may not be placed on a new depreciationschedule with a new income tax basis after a share-holder dies. These features of the corporation may

discourage incorporation by those older family mem-bers holding valuable timber assets that have a lowbasis.

Com plexities and Expenses.--Incorporation is a moreformal and complex method of organization than apartnership or sole proprietorship, and a corporationis more expensive to form and maintain. In additionto the legal cost of incorporation, most States imposean annual fee and require the filing of an annualreport. The initial costs are deductible over the first5 years, however, and subsequent costs are usuallydeductible annually.

Liquidation.- -A corporation may usually be dis-solved under State law either by written consent of allshareholders or by approval of the board of directorsfollowed by a simple majority or higher vote of theshareholders. This process usually poses few prob-lems. The greatest concern is the income tax con-sequences of liquidation as the corporate assets aredistributed to the shareholders in exchange for theirstock. A corporation can be formed rather easilywithout paying income tax on the gain in propertytransferred to the corporation. Liquidating a cor-poration, however, without adverse income tax con-sequences is more difficult. Basically, a liquidatingcorporation, including a closely held family corpora-tion, recognizes gain or loss on the distribution ofproperty that takes place in a complete liquidation asif the property had been sold at its fair market value.

Revised Estate Plans

Upon formation of a corporation, the wills andestate plans of each shareholder should be reviewed.Corporate stock is personal property and will pass assuch at the death of the shareholder. If a will wasdrafted to pass real property, it may have become out-dated by incorporation. If Subchapter S status hasbeen elected, wills should be checked and revised, ifnecessary, to insure that the stock does not pass intoa testamentary trust. If it does, the Subchapter Selection will be lost after 60 days, and the corporationwill revert to “C” corporation status and the doubletaxation rules.

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Chapter 18

Limited Liability Companies

OVERVIEW

A limited liability company (LLC) is a hybridentity that combines the corporate benefit of limitedliability for its owners with the partnership’s advan-tage of pass-through treatment for income tax pur-poses. It is created under State law, just like a corpo-ration. As of this writing, 28 States have enactedlimited liability company statutes, as follows:Alabama (effective 10-l-93), Arkansas (effective 4-12-93), Arizona (effective 9-30-92), Colorado (effec-tive 4-18-90), Delaware (effective 10-l-92), Florida(enacted 4-92), Georgia (effective 3-l-94), Idaho(effective 7-l-93), Illinois (effective l-1-94), Indiana(effective 7-l-93), Iowa (effective 7-l-92), Kanas(effective 7-l-90), Louisiana (effective 7-7-92),Maryland (effective lo- l-92)) Michigan (effective6-l-93), Minnesota (effective 10-l-93), Montana(effective 10-l-93), Nebraska (effective 9-9-93),Nevada (effective 10-l -9 l), North Dakota (effective7-l-93), Oklahoma (effective 9-l-92), Rhode Island(effective 9-19-92), South Dakota (effective 7-l-93),Texas (effective 9-l-91), Utah (effective 7-l-91),Virginia (effective 7-l -9 l), West Virginia (effective3-6-92), and Wyoming (enacted 1977). In addition,authorizing legislation is pending in California,Massachusetts, New Jersey, New York, andPennsylvania.

ORGANIZATION AND OPERATION

Articles of Organization

Instead of filing articles of incorporation, limitedliability companies file articles of organization.These notify potential creditors that, generally, theLLC itself will be the sole recourse for payment.Companies that fail to properly file articles oforganization may be fined, barred from doing busi-ness in the State, or have difficulty establishing legalstatus to sue. Furthermore, creditors might tryreach the personal assets of the LLC’s membersthough they were partners in a partnership.

toas

Members

An LLC is owned by its members, rather than byshareholders or partners. Generally, an LLC musthave at least two members. This requirement is con-sistent with its classification for income tax purposesas a partnership. Although several States apparentlypermit only one member, it is likely that the InternalRevenue Service (IRS) would treat such an entity as acorporation rather than a sole proprietorship for taxpurposes. A corporation, partnership, trust, estate,another LLC, or other legal entity, as well as anindividual, may be a member. These coincide withthe partnership classification rules of the InternalRevenue Code (IRC), which do not condition partner-ship status on the legal form of an entity’s owners.

Contributions to an LLC in exchange for a member-ship interest may be made in the form of cash, prop-erty, the use of property, services, or any othervaluable consideration. In some States, contributionsmay also be made in the form of promissory notes orother binding obligations.

Operation

Generally, an LLC is not required to have anoperating agreement. Some States, however, requirethe adoption of one and specify certain mandatoryprovisions. In the absence of an operating agreement,an LLC is governed by its articles and State law.Provisions concerning an LLC’s affairs usually may beincluded in an operating agreement to the extent thatthey are not inconsistent with State law or the articlesof organization.

Management

The typical LLC statute makes extensive use ofdefault rules, which allow an LLC to be customized tosuit the needs of its members. The statute generallyreserves management rights for the members in pro-portion to their capital contributions or incomeinterest, unless the articles of organization provideotherwise. An LLC that concentrates managementauthority in the hands of a few elected or appointedmanagers will be considered to have the corporate

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characteristic of centralized management (see page115) and could be treated as a corporation if it hasother corporate attributes.

Ownership Interests.--Members of an LLC areusually permitted under State law to customize bothdistribution of cash and property, and allocation ofprofits and losses, to themselves through the oper-ating agreement or articles. In the absence of suchspecial financial provisions, distributions are gen-erally made, and profits and losses allocated, on aproportional basis in accordance with the members’respective contributions.

Withdrawals.--Members of an LLC are also gen-erally permitted under State law, unless otherwiseprovided in the articles or operating agreement, towithdraw on 6-months notice and receive the fairmarket value of their interests. Withdrawals, deaths,bankruptcies, and other events that cause the loss ofa member can have serious consequences because theLLC could terminate unless the remaining membersagree to continue the business. This requirement isusually imposed by State law so that the LLC will nothave the corporate characteristic of continuity of life.An LLC can also be dissolved by written consent ofits members or by court order if it is unable to carryon the business.

Assignment ofZnterest.--Unless the operating agree-ment or articles provide otherwise, a membershipinterest is assignable in whole or in part. The assign-ment entitles the assignee to receive to the extentassigned only the distributions to which the assignorwould otherwise have been entitled. In most States,in order for an assignee to participate in an LLC’smanagement and affairs and to exercise other mem-bership rights, the remaining members must unani-mously agree to the assignee’s admission as a mem-ber. Although some State statutes may not prohibitan agreement over and above the operating agreementthat allows an assignee to become a member on theconsent of fewer than all the remaining members,such a side agreement may cause an LLC to beclassified as a corporation for Federal income taxpurposes.

Limited Liability.--One of the key advantages of anLLC is that it provides limited liability to all of itsmembers and managers. The typical State statuteprovides that an individual or entity belonging to anLLC does not have any personal obligation for theLLC’s obligations solely because of being a member,manager, or other agent of the LLC. This ability toinsulate an LLC member from personal liability as a

member, regardless of management activities, is oneof the chief distinctions between an LLC and a limitedpartnership. Some States permit a member to waivelimited liability.

TAX CONSIDERATIONS

A primary reason for using the limited liability com-pany form of organization is to avoid the double tax-ation associated with a corporation but yet achievepass-through taxation for the members and, at thesame time, protect the members’ personal assets fromliability for the debts and obligations of the business.

Corporate Attributes

The key to the favorable tax status of LLG’s is thatthey are unincorporated business entities, and the IRSwill not treat unincorporated entities as corporationsunless they have more corporate than noncorporatecharacteristics. Internal Revenue Service Regulation301.7701-2 lists four characteristics common to cor-porations but not to partnerships. The IRS will notimpose corporate tax treatment unless the businessentity has more than two of these. The four are:limited liability, continuity of life, free transferabilityof interests, and centralized management. Becauselimited liability is almost always present in an LLC,the test hinges on whether the LLC has more than oneof the three remaining corporate attributes.

Continuity of Life

An LLC lacks continuity of life if the death, retire-ment, mental incapacity, bankruptcy, or expulsion ofany member causes the LLC to dissolve. In RevenueRuling 88-76, the IRS determined that a WyomingLLC lacked continuity of life because the Statestatutory provision requiring the LLC to be dissolvedupon the occurrence of a withdrawal event, unless itsbusiness was continued by the unanimous consent ofthe remaining members, only established a mere con-tingent continuity of life. However, an outsideagreement obligating a member to approve the contin-uation of the LLC’s business upon either all or certainspecified withdrawal events, or on the direction ofanother member or a certain percentage of the othermembers, may change this conclusion.

Example 18.1. Four related persons, each with anundivided interest in 1,500 acres of timberland in

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Virginia, organized a limited liability company tomanage the property. In Virginia, LLC’s mustdissolve upon the death, resignation, expulsion,bankruptcy, or other departure of a member, orupon the occurrence of any other event that ter-minates continued membership (other than assign-ment of the member’s interest), unless allremaining members agree to continue the business.Therefore, this LLC lacks the corporate charac-teristic of continuity of life.When a dissolution event occurs, LLC’s no longer

need the consent of all the remaining members tocontinue the business. The IRS has amendedRegulation 301.7701-1(b)(l) so that continuity of lifewill be lacking as long as at least a majority of theLLC’s members must consent to continuation of thebusiness to prevent its dissolution. Although thischange applies to tax years beginning on or after June14, 1993, taxpayers also have the option of applyingit to earlier years.

Example 18.2. A tree farm organized as an LLChas four members. One member holds 80 percentof the interests. The LLC has a provision in itsarticles of organization allowing dissolution, uponthe loss of a member, to be prevented by a major-ity vote of the remaining members. This LLC hasthe corporate characteristic of continuity of life. Itcould allow members holding only a 20-percentinterest to continue the LLC despite the inaction orobjections of the go-percent interest holder.

Centralization of Management

A business entity has centralized management ifone or more of its members, but fewer than all mem-bers, has (have) exclusive authority to make businessdecisions for the entity. Most State LLC statutes vestmanagement authority in the hands of all members,unless the members choose to concentrate suchauthority with just a few of their number or hirenonmembers to manage the business. When allmembers--as a membership right--can exercise man-agement authority to bind the LLC, the corporatecharacteristic of centralized management is lacking.Centralized management, however, is always presentif State law requires the LLC members to electmanagers to run the business and vests the managerswith the managerial authority that most States reservefor the members (Revenue Ruling 93-6).

Example 18.3. The Silver Pines family tree farmLLC states that it is reserving management

authority for its members in the articles oforganization filed with the State agency thatregulates LLC’s. However, the seven LLCmembers agree among themselves that only three oftheir number will actually manage the woodland.Nevertheless, State law binds the LLC for businessor management actions taken by any of its memberswith third parties that do not have notice of theinformal agreement. Because any of the LLCmembers could easily exercise binding managementauthority despite the informal agreement, the threedesignated managers lack the sole authority requiredfor the corporate characteristic of centralizedmanagement.

Free Transferability of Interests

An organization has the corporate characteristic offree transferability of interests if members owning sub-stantially all of the interests in the organization cantransfer all attributes of their interest to others withoutthe consent of the rest of the members. However,interests are not deemed to be freely transferrable ifonly the right to share in profits can be assigned with-out consent, but not the right to participate in manage-ment. An LLC does not have the corporate character-istic of free transferability of interests if membershipand related management rights cannot be transferredwithout the consent of the other members.

Example 18.4. The Lonesome Oak Tree Farm wasorganized with only two members, John and Peter.State law allows LLC members to freely transfertheir income and capital interests, but theirmembership interest expires unless all the othermembers consent to the transfer to the third party.The Lonesome Oak Tree Farm lacks free transfer-ability of interests, even though the consent of onlyone remaining LLC member (Peter) is needed inorder for John to transfer half of his membershipinterest to his son.

IMPLICATIONS FOR TIMBER PROPERTIES

The LLC represents the latest advance in the formsof business entities. An LLC that is classed as a part-nership and which is assured of limited liability in alljurisdictions in which it will operate will combineownership, operational, tax, and liability advantages ina way that neither the Subchapter S corporation northe limited partnership can do. For family-owned tree

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farms, the LLC certainly shows promise as anadvantageous way to organize for current operations.

With respect to estate planning, the advantages areless clear. The restriction on transferability ofinterests could pose a problem in some situations.However, with a closely knit, family-owned treefarm, there may be no problem. The unanimous

consent of the members to give membership rights toan heir of a deceased member or donee of a livingmember may be easily obtainable. In consideringwhether to become an LLC, however, a family timberownership should proceed with caution and with goodprofessional advice. Because the LLC format isrelatively new, its use still involves manyuncertainties.

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Chapter 19State Death Tax Considerations

TYPES OF STATE DEATH TAXES

The Federal estate tax liability may be readilydeferred at the death of the first spouse by properestate planning; however, State death taxes must stillbe considered. Three types of death taxes are leviedby individual States. They are inheritance, estate,and piggy-back taxes.

Inheritance Tax

An inheritance tax is a levy on the right to receiveproperty by individual heirs or legatees. The sharevalue received by each individual beneficiary formsthe basis for this tax. Currently, 18 States levy aninheritance tax (see table 19.1).

Estate Tax

An estate tax is a levy on the right to transfer prop-erty by the decedent’s estate. Presently, the Federalgovernment and four States levy an estate tax, fivefewer States than in 1980 (see table 19.1).

Piggy-back Tax

A so-called “piggy-back tax” is equal to the Statedeath tax credit allowable as a deduction against theFederal estate tax (see appendix, page 134). Thepiggy-back tax is now the most prevalent form ofState death tax and is levied currently in 28 States(see table 19.1). A piggy-back levy does not resultin any additional tax burden, but merely apportionsthe total tax burden between the Federal and Stategovernments. In addition, Massachusetts is phasingin a piggy-back tax, which becomes effective in1997.

Pickup-Tax

In the States that impose inheritance and estatetaxes and the State death tax levy is less than theState death tax credit allowable as a Federaldeduction, this additional, so-called “pick-up tax”absorbs the difference. Currently, 21 States have apick-up tax (see table 19.1).

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Gift Tax

In addition to death taxes, six States also levy a gifttax (see table 19.1). Most of these States have incor-porated the Federal gift tax provisions and, thus, taxgifts above the $10,000 annual gift tax exemption perdonee.

Death Tax Provisions

Although there are only three basic forms of Statedeath taxes (inheritance, estate, and piggy-back), thespecific tax provisions vary greatly among the States.The allowable deductions, tax credits, exemptionamounts, and tax rates depend on State law. TheStates with a piggy-back form of tax have levies thatare based on the Federal return; therefore, the deduc-tions, exemptions, rates, and credits will be the samein each of these States. However, the tax statutes ofthe 22 remaining States--those with inheritance andestate taxes--differ considerably, and require coordi-nated planning with the Federal provisions in order toobtain the best results.

Profound changes were introduced into the Federalunified estate and gift transfer taxes by the EconomicRevenue Tax Act of 1981 and subsequent tax legisla-tion. Many States have followed suit and changedtheir State statutes in order to move closer to theFederal tax model in form. For example, since 1980,States with an estate tax have decreased from 9 to 4;States with an inheritance tax have decreased from 30to 18; and States with a piggy-back form of estate taxhave increased to 28. State Departments of Revenuehave cooperated closely with the Internal RevenueService in the administration of these taxes.

COMBINED FEDERAL-STATETAX LIABILITY

Since the passage of the Economic Recovery TaxAct of 1981, substantial flexibility at the Federal levelhas been provided for forest landowners. However,State death taxes have often been overlooked. Effec-tive estate planning requires consideration of bothFederal and State taxes.

Table 19.1 .-State death and gzji taxes in the United States, by region, 1993.

state Type of Tax

Estate Inheritance Piggy-back Pick-up Gift

Northeastern region

Connecticut

Delaware

X X X

X X X

Maine

Maryland

Massachusetts

New Hampshire

New Jersey

New York

Ohio

Pennsylvania

Rhode Island

Vermont

West Virginia

Southern region

Alabama

Arkansas

Florida

Georgia

Kentucky

Louisiana

Mississippi

North Carolina

South Carolina

Tennessee

Texas

Virginia

Midwestern region

Illinois

Indiana

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X X

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Table 19.1.~State death and gift taxes in the United States, by region, 1993.--Continued

State Type of Tax

Estate Inheritance Piggy-back pick-up Gift

Northeastern region

Iowa

Kansas

Michigan

Minnesota

Missouri

Nebraska

North Dakota

Oklahoma

South Dakota

Wisconsin

X X

X X

X X

X

X

X X

X

X

X

Western region

Alaska

Arizona

California

Colorado

Hawaii

Idaho

Montana

Nevada

New Mexico

Oregon

Utah

X

X

X

X

X

Washington

Wyoming

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First Spouse to Die

In the States with the piggy-back form of estatetax, effective use of the Federal unified credit of$192,800 and the unlimited marital deduction to defertaxes on the estate of the first to die also accom-plishes the same result at the State level. Therefore,if no Federal estate tax is due, then no State death taxwill be due.

In States with estate and inheritance taxes, theallowable deductions may be quite different from theFederal deductions. Some States do not have a mari-tal deduction; thus, the estate value deferred at theFederal level may be taxable by the State. In 1987,the State death tax for forested ownerships with grossestates ranging from $600,000 to $3,000,000 variedfrom 4 to 7 percent of the net taxable estate value,depending on the State in which the property waslocated, even though the Federal tax had been com-pletely deferred.

Special Use Valuation.- -Th e advantages and dis-advantages of electing special use valuation underInternal Revenue Code (IRC) Section 2032A at theFederal level are discussed in chapter 13. In 1993,special use valuation was indirectly available at theState level in the 28 States with a piggy-back tax law.It is also available in approximately one-half of theStates with inheritance and estate tax laws by meansof a special use valuation law at the State level. Theremaining States with inheritance and estate tax lawseither have no provisions for special use valuation ordeny it explicitly.

Deferral and Extension of Tax Paym ents. - -Th e deferraland extension of Federal tax payments under IRCSection 6166 is discussed in chapter 14. At the Statelevel, the 28 States with piggy-back tax laws permitdeferral and extension indirectly when these areelected on the Federal return. Varying levels ofextension and deferral are available in approximatelytwo-thirds of the other States.

Second Spouse to Die

At the death of the second spouse, effective estateplanning at the Federal level has carried through to theState level for the 28 States with piggy-back tax laws.Assuming no remarriage, the unified credit is availableto the estate of the second spouse to die, but there isno martial deduction to further defer the tax. Trusts,joint ownerships, aggressive gifting programsincluding charitable bequests, and other measuresdiscussed elsewhere is this book provide mixed resultsin States with inheritance and estate taxes when theState death tax provisions are not explicitly incor-porated in the planning process. These results occurbecause so much variability exists among the variousState statutes and because some State statutes workcounter to the Federal provisions. Thus, State lawshould be explicitly included in the timber estateplanning process, especially in the 22 States that haveeither an inheritance or an estate tax law.

126

Appendixes

127

Appendix I

A

Adjusted gross estate-The gross estate less funeralexpenses, expenses of estate administration duringprobate, debts of the estate, and casualty lossessuffered during estate administration.

Administration-The care and management of anestate by a trustee, guardian, administrator, orexecutor.

Administrator-A male person appointed by thecourt to administer the estate of a deceased person(collect assets of the estate, pay debts, distributeresidue to those entitled to it) who (1) dies leavingno will, or (2) leaves a will naming an executor orexecutors who for some reason cannot serve.

Administratrix-The female counterpart of anadministrator.

Agent-A person who acts for another person bythe latter’s authority.

Amortization-Paying off a loan by regularinstallments.

Ancillary administration-Probate administrationof property (usually real property) owned in a Stateother than the one in which the decedent had his orher principal residence at the time of death.

Annuity-A periodic (usually annual) payment ofa fixed sum of money for either the life of therecipient or for a fixed number of years.

Appraisal-A determination of property value.

Assets-(l) The property comprising the estate ofa deceased person, (2) the property in a trustaccount.

Attorney-at-law-A person who is legally quali-fied and licensed to practice law, and to representand act for clients in legal proceedings.

Attorney-in-fact-A person who, acting as anagent, is given written authorization by anotherperson to transact business for him (her) out ofcourt.

GLOSSARY

B

Beneficiary-A person or institution named in awill or other legal document to receive property orproperty benefits.

Bequeath-To gift property by will.

Bequest-Property gifted by will.

Bond-An agreement under which a person or cor-poration (such as an insurance company) becomessurety to pay, within stated limits, for financial losscaused to a second person or legal entity by the actor default of a third person, such as loss to an estateby action of the administrator.

C

Charity-An agency, institution, or organization inexistence and operating for the benefit of anindefinite number of persons, and conducted foreducational, religious, scientific, medical, or otherbeneficent purposes.

Codicil-An addition, change, or supplement to awill executed with the same formalities as arerequired for the will itself.

Common disaster-A sudden and extraordinarymisfortune that brings about the simultaneous ornear-simultaneous deaths of two or more associatedpersons, such as husband and wife.

Contemplation of death-The expectation of deaththat provides the primary motive to make a gift.

129

Contingent beneficiary-Receiver of property orbenefits if the first named beneficiary fails toreceive any or all of the property or benefits inquestion before his (her) death.

Contract-A legal written agreement that becomesbinding when signed.

Corporation-A legal entity owned by the holdersof the shares of stock that have been issued, andthat can own, receive, and transfer property, andcarry on business in its own name.

Curtesy-A widower’s legal interest in his wife’sreal estate.

D

Decedent-A deceased person.

Deed-The legal instrument used to transfer titlein real property from one person to another.

Dependent-A person dependent for supportanother.

upon

Descendent-One who is directly descended fromanother, such as a child, grandchild, or great-grandchild.

Devise-To gift property by will.

Distribution-The appointment of personal prop-erty or its proceeds to those entitled to receive itunder the terms of a will or trust.

Don-The recipient of a gift.

Donor-The person who makes a gift.

Dower-A widow’s legal interest in her deceasedhusband’s real estate.

E

Escrow-Money given to a third party to be heldfor payment until certain conditions are met.

Estate-All real and personal property and prop-erty rights owned by a person.

Executor-A male person named in a will to carryout the decedent’s directions, administer thedecedent’s estate, and distribute the decedent’sproperty in accordance with the will.

Executrix-The female counterpart of an executor.

F

Fee simple-Absolute title to property with no limi-tations or restrictions regarding the person who mayinherit it.

Fiduciary-A trustee, executor, or administrator.

G

Gift-A voluntary transfer or conveyance of prop-erty without consideration, or for less than full andadequate consideration based on fair market value.

Grantor-The person who places property into andestablishes a trust.

Gross estate-The total fair market value of allproperty and property interests, real and personal,tangible and intangible, of which a decedent hadbeneficial ownership at the time of death before sub-tractions for deductions, debts, administrativeexpenses, and casualty losses suffered during estateadministration.

Guardian-A person legally empowered andcharged with the duty of taking care and managingthe property of another person who, because of age,intellect, or health, is incapable of managing his/herown affairs.

H

Heir-One entitled by law to inherit the propertyof a decedent who died without a will.

130

ILineal descendant-Direct descendant of the same

ancestors.

Intangible property-Property that has no intrin-sic value, but is merely the evidence of value, suchas stock certificates, bonds, and promissory notes.

Intestate-Dying without leaving a will.

Inter vivos-Transfer of property from one livingperson to another living person.

Irrevocable trust-A trust arrangement that cannotbe revoked, rescinded, or repealed by the grantor.

J

Joint tenancy-A form of property ownership inwhich two or more parties hold an undivided inter-est in the same property that was conveyed underthe same instrument at the same time. A jointtenant can sell his (her) interest but not dispose ofit by will. Upon the death of a joint tenant, his(her) undivided interest is distributed among thesurviving joint tenants.

L

Law of descent-The State statutes that specifyhow a deceased person’s property is to be dividedamong the decedent’s heirs if there is no will.

Legacy-A gift of property made by will.

Legate-A beneficiary of a decedent’s propertynamed in the decedent’s will.

Liabilities-The aggregate of all debts and otherlegal obligations of a particular person or legalentity.

Lien-A claim against real or personal property insatisfaction of a debt.

Life estate-A property interest limited in durationto the life of the individual holding the interest (lifetenant).

M

Marital deduction-The deduction(s) that can betaken in the determination of gift and estate taxliabilities because of the existence of a marriage ormarital relationship.

Mortgage-The written agreement pledging prop-erty to a creditor as collateral for a loan.

Mortgagee-The person to whom property ismortgaged and who has loaned the money.

Mortgagor-The person who pledges property toa creditor as collateral for a loan and who receivesthe money.

P

Partnership-A voluntary contract between two ormore persons to pool some or all of their assets intoa business, with the agreement that there will be aproportional sharing of profits and losses.

Personal property-All property that is not realproperty-

Per stirpes-The legal means by which the chil-dren of a decedent, upon the death of an ancestor ata level above that of the decedent, receive by rightof representation the share of the ancestor’s estatethat their parent would have received if living.

ProbateProving a will’s validity to the court andsecuring authority from the court to carry out thewill’s provisions. Also used in a broad sense tomean administration of a decedent’s estate.

R

Real property-Land, and all immovable fixtureserected on, growing on, or affixed to the land.

131

Remainder-An interest in property that takeseffect in the future at a specified time or after theoccurrence of some event, such as the death of alife tenant.

Remainderman-One entitled to the remainder ofan estate after a particular reserved rightinterest, such as a life tenancy, has expired.

Revocable trust-A trust agreement that cancanceled, rescinded, revoked, or repealed bygrantor (person who establishes the trust).

or

bethe

Right of survivorship_The ownership rights thatresult in the acquisition of title to property byreason of having survived other co-owners.

S

Sole ownershipThe type of property ownershipin which one individual holds legal title to theproperty and has full control of it.

T

.Tenancy in common-The type of property owner-ship in which two or more individuals have anundivided interest in property. At the death of onetenant in common, his (her) fractional percentageof ownership in the property passes to thedecedent’s heirs rather than to the surviving tenantsin common. Also called nonspousal joint tenancy.

Tenancy by the entirety-A type of joint tenancybetween husband and wife that is recognized insome States. Neither party can sever the joint ten-ancy relationship and, upon death of one, the sur-vivor acquires full title to the property.

Testate-To die leaving a will.

Testator-A male person who leaves a will atdeath.

Testatrix-The female counterpart of a testator.

Trust-An arrangement made during life or underthe terms of a will by which a property interest isheld by one party (the trustee) for the benefit of oneor more beneficiaries.

Trustee-A person or institution holding andadministering property in trust.

Trustor-The person who makes or creates atrust. Also known as the grantor or settlor.

w

Will-A legal declaration of the manner in whicha person wishes to distribute his (her) estate afterdeath.

132

Appendix II

ADDITIONAL READINGS

Chapters 1 and 2

Harl, N.E. 1988. Farm estate and businessplanning. Niles, IL: Century Publications. 411 p.

Kess, S.; Westlin, B. 1991. CCH financial andestate planning guide. Chicago: Commerce ClearingHouse, Inc. 869 p.

Small, S.J. 1989. Preserving your family’s land.Forest Farmer. 49(2): 273-275.

Chapter 3

Armstrong, A.A.; St. John, R.R. 1986. Federalestate and gift taxes--past, present and future. Taxes.64(10): 634-653.

Commerce Clearing House. 1992. Federal estateand gift taxes explained. Chicago: CommerceClearing House, Inc. 446 p.

Chapter 4

Champagne, E. 1984. The valuation of forest landsfor estate tax purposes. Alabama’s Treasured Forest.3(2): 7-9.

Fowler, A.C. 1986. Valuation of undivided inter-ests in realty: when do the parts sum to less than thewhole? Journal of Real Estate Taxation. 13(2): 123-167.

Horsman, S.E. 1987. Minority interest discounts ongifts among family members. Trusts and Estates.126(7): 54-55.

Chapter 6

Steiner, B.D. 1986. Estate tax marital deductionplanning for alternative valuation. Journal ofTaxation. 65(4): 232-236.

Chapter 7

Ramlow, J.M. 1988. Qualified disclaimers: planningconsiderations under the final regulations. Idaho LawReview. 24(3): 413-442.

Chapter 8

Harris, R.W.; Jacobson, S.W. 1992. Maximizing theeffectiveness of the annual gift exclusion. Taxes.70(3): 204-214.

Kornfield, I.E. 1993. Conserving natural resourcesand open spaces: a primer on individual givingoptions. Environmental Law. 23( 1): 185-22 1.

Chapter 10

Denny, C., III; Rogers, N.N. 1990. Use of trusts bytimberland owners. Forest Farmer. 50(2): 9-l 1, 26-28.

Elzer, R.W. 1987. Using a revocable trust to mini-mize probate proceedings or avoid them entirely.Estate Planning. 14(5): 286-294.

Pennel, J.N. 1982. Avoiding tax problems forsettlors and trustees when an individual trustee ischosen. Estate Planning. 9(5): 264-272.

Chapter 11

Perkins, D.A. 1988. Survivorship life insuranceoffers many advantages for estate planning. EstatePlanning. 15(5): 296-302.

Sutherland, CF.; Siegel, W.C.; Palena, D.A. 1981.Using insurance to pay forest taxes at death. ForestFarmer. 40(3): 10, 15.

133

Chapter 13 PtilV

Condrell, W.K.; Neidich, G. 1982. Amendmentsmade by the Economic Recovery Tax Act of 1981 toSection 2032A for woodlands. Agricultural LawJournal. 3(4): 346-363.

Gardner, A.B.; Olson, S.C.; Haney, H.L., Jr.;Siegel, W.C. 1984. Election by forest estates ofcertain Federal estate tax provisions. Journal ofAgricultural Taxation and Law. 6(l): 400-428.

Garrison, L.R. 1987. Later actions can result inloss of special use valuation benefits. Taxation forLawyers. 16(3): 180-183.

Jurinski, J.J.; Singleton, W.R. 1987. Maximizetimberland elections. Trusts and Estates. 126(12):45-56.

Kelly, D.M.; Bellatti, R.M. 1987. Computing andreporting the Section 2032A recapture tax. Journalof Agricultural Law and Taxation. g(2): 120-141.

Summer, R.D. 1990. Select a business entity that’sright for you. Forest Farmer. 50(2): 14-15.

Chapter 16

Levun, C.R. 1987. Partnerships--the preferred formof doing business after the Tax Reform Act of 1986.Taxes. 65(9) : 600-603.

Chapter 17

Coleman, J.E.; Reed, A.E. 1988. Factors to con-sider in electing Sub S status. Massachusetts CPAReview. 62(5): 14-34.

Steinsapir, S. 1989. Estate planning for the Scorporation shareholder. Journal of Taxation of Trustsand Estates. l(2): 47-50.

Chapter 18Chapter 14

Gardner, A.B.; Olson, S.C.; Haney, H.L., Jr.;Siegel, W.C. 1984. Election by forest estates ofcertain Federal estate tax provisions. Journal ofAgricultural Taxation and Law. 6(l): 400-428.

Jurinski, J.J.; Singleton, W.R. 1987. Maximizetimberland elections. Trusts and Estates. 126(12):45-56.

Kasner, J.A. 1993. When does cash qualify asproperty used in a trade or business? Tax Notes.58(11): 1484-1485.

Kiziah, T.S. 1993. Deferring estate tax is notalways a beneficial move. Estate Planning. 20(l):12-19.

Virga, S.; Brandt, L. 1985. Current techniques forusing installment payments of estate tax to increaseliquidity. Estate Planning. 12(6): 344-349.

Ale, J.C. 1992. An introduction to limited liabilitycompanies. Practical Lawyer. 38(8): 35-50.

Mezzullo, L.A. 1993. Limited liability companies:a new business form? Taxation for Lawyers. 21(5):296-302.

Chapter 19

Walden, J.B.; Haney, H.L., Jr.; Siegel, W.C. 1987.The impact of recent changes in State and Federaldeath tax laws on private nonindustrial forest estate inthe South. Southern Journal of Applied Forestry.1 l(1): 17-23.

Walden, J.B.; Haney, H.L., Jr.; Siegel, W.C. 1988.Federal-state death tax implications for privatenonindustrial forest landowners in the Northeast.Northern Journal of Applied Forestry. 5(2): 135-141.

134

Appendix III

STATE DEATH TAX CREDIT’,’

Estates of Decedents Dying After 1976

Adjusted Taxable Estate(“Adjusted Taxable Estate” is

the decedent’s taxableestate less $6O,OCQ

From To Credit =

0 $40,000 0$40,000 90,000 090,000 140,000 $400140,000 240,000 1,200240,000 440,000 3,600440,000 640,000 10,000

640,000 840,000 18,000840,000 1,040,000 27,600

1,040,000 1,540,000 38,8001,540,000 2,040,OOO 70,8002,040,OOO 2,540,OOO 106,800

2,540,OOO 3,040,000 146,8003,040,000 3,540,ooo 190,8003,540,ooo 4,040,000 238,8004,040,OOO 5,040,000 290,8005,040,000 6,040,OOO 402,800

6,040,OOO 7,040,000 522,8007,040,000 8,040,OOO 650,8008,040,OOO 9,040,000 786,8009,040,000 10,040,000 930,80010,040,000 1,082,800

' The above table may not be used in computing taxes cm estates of certain servicemen.

Of Excess Over+A

0.8 01.6 $40,0002.4 90,0003.2 140,0004 240,000

440,000

4.8 640,0005.6 840,0006.4 1,040,0007.2 1,540,0008 2,040,OOO

8.8 2,540,OOO6.6 3,040,ooo

10.4 3,540,ooo11.2 4,040,00012 5,040,000

12.8 6,040,OOO13.6 7,040,00014.4 8,040,OOO15.2 9,040,00016 10,040,000

’ There is a limitation on the credit in estates of nonresidents not citizens dying after November 13, 1966. See Code Sec. 2102.

135

Appendix IV

137

Form 706 United States Estate (and Generation-Skipping Transfer)(Rev. October 1991) Tax Return OME NO. 1545-0015

Estate of a citizen or resident of the United States (see separate instructions). To be Expires 6-30-93Lmpatiment of the Treasury filed for decedents dying after October 8,1990, and before January 1, 1993. Forl”krml Revenue Smvlce Papemork Reduction Act Notice, see page 1 of the instructions.

1 la Decedent’s first name and middle initial (and maiden name, if any) 1 lb Decedent’s last name 1 2 Decedent’s social s e curity no.

22

;

2

~

;2

i

i2

je r

3a Domicile at time of death (county and state, or foreign country) 3b Year domicile established 4 Date of birth 5 Date of death

ja Name of executor (see Instructions) 6b Executor’s address (number and street including apartment or suite no. or ruralroute; city, town, or post office; state; and ZIP code)

%z Executor’s social secunty number (see instructions)

la Name and locatIon of court where WIII was probated or estate administered 7b Case number

8 If decedent died testate, check here W 0 and attach a certified copy of the wilLI 9 If Form 4768 is attached, check here b 0IO If Schedule R-l is attached, check here b n

5

6

7a

b

C

8

9

IO

I I

12

1314

15

1617

I8

19

!o!l

!2

!3!4!5

!6!7

Total gross estate (from Part 5, Recapitulation, page 3, item 10) ...........Total allowable deductions (from Part 5, Recapitulation, page 3. item 20) .........Taxable estate (subtract line 2 from line 1) ..................Adjusted taxable gifts (total taxable gifts (within the meaning of section 2503) made by the decedentafter December 31, 1976, other than gifts that are includible in decedent’s gross estate (section 2001 (b))

Addlines3and4 .........................Tentative tax on the amount on line 5 from Table A in the instructions. .........If line 5 exceeds $lO,OOO.OOO, enter the lesser of line 5 or $21.040.000. Ifline 5 is $10.000,000 or less, skip lines 7a and 7b and enter -O- on line 7c.

Subtract $lO,OOO,OOO from line 7a ...........Enter 5% (.05) of line 7b ..............Total tentative tax (add lines 6 and 7c) ...................Total gift tax payable with respect to gifts made by the decedent after December 31, 1976. Include gifttaxes by the decedent’s spouse for such spouse’s share of split gifts (section 2513) only if the decedentwas the donor of these gifts and they are includible in the decedent’s gross estate (see instructions)

Gross estate tax (subtract line 9 from line 8) ........Maximum unified credit against estate tax .........Adjustment to unified credit. (This adjustment may not exceed $6.000.See instructions.). ................Allowable unified credit (subtract line 12 from line 11). ..............Subtract line 13 from line 10 (but do not enter less than zero) ............Credit for state death taxes. Do not enter more than line 14. Compute the credit by using the amounton line 3 less $80.000. See Table B in the instructions and attach credit evidence (see instructions)

Subtract line 15 from line 14 .............Credit for Federal oift taxes on pre-1977 gifts (section 2012) (attach computation)

Credit for foreign death taxes (from Schedule(s) P). (Attach Form(s) 706CE)

Credit for tax on prior transfers (from .&hedule a). ......Total(addlines17,18,and19) .....................Net estate tax (subtract line 20 from line 16) ..................Generation-skipping transfer taxes (from Schedule R, Part 2, line 10) ..........Section 4980A increased estate tax (from Schedule S. Part I, line 17) (see instructions)

Total transfer taxes (add lines 21, 22, and 23) ........Prior payments. Explain in an attached statement .......United States Treasury bonds redeemed in payment of estate taxTotal (add lines 25 and 26). .............

!8 Balance due (or overpayment) (subtract line 27 from line 24). . . . . . . 1 28 1 Ipenalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief,

it IS true, correct. and complete. Declaration 01 preparer other than the executor IS baWd on all lntormahon 01 which preparer has any knowledge.

Signature(s) of executor(s) Date

Signature of preparer other than executor Address (and ZIP code)Cat. No. 20548R

Date

138

Form 706 (Rev. 10-91)

Estate of:

Part 3.-Elections by the Executor

1 Do you elect alternate valuation? .................2 Do you elect special use valuation? .......................

Pati 4.-General ~nfOrrIlatiOn (Note: Please attach the necessary supplemental documents. YOU must attach the death certificate.)

Authorization to recerve confidential tax information under Regulations section 601.502(c)(3)(ii), to act as the estate’s representative before the Internal RevenueService, and to make written or oral presentations on behalf of the estate if return prepared by an attorney, accountant, or enrolled agent for the executor:

Name of representative (print or type) State Address (number, street. and room or suite no., city, state, and ZIP code)

I declare that I am the 0 attorney/u accountant/ 0 enrolled agent (you must check the applicable box) for the executor and prepared this return forthe executor. I am not under suspension or disbarment from practice before the Internal Revenue Service and am qualified to practice in the state showngbo e.Signtture CAF number Date Telephone number

1 Death certificate number and issuing authorfty (attach a copy of the death certificate to this return).

2 Decedent’s business or occupation. If retired, check here b 0 and state decedent’s former business or occupation.

3 Marital status of the decedent at time of death:

0 Married

0 Widow or widower-Name, SSN. and date of death of deceased spouse W _ __ __ _. _ __ __ _ _. _ __ __ _. . . ___ _. __ ___ _. _ __ _ __ _ _ _. _.____.._.___....___....__~_...______...____._._____....____....._...................................................~.........................

0 Single0 Legally separated

0 Divorced-Date dtvorce decree became final b4e Surviving spouse’s name 4b Social security number 4o Amount received (see instructions)

5 Individuals (other than the surviving spouse), trusts, or other estates who receive benefits from the estate (do not include charitable beneficiariesshown in Schedule 0) (see instructions). For Privacy Act Notice (applicable to individual beneficiaries only), see the Instructions for Form 1040.

Name of indmdual. trust. or estate recetving $5.000 or more Identifying number Relationship to decedent

All unascertainable beneficraries and those who receive less than $5,000 . . . . . . . . . . . . . . b

T o t a l . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(Continued on next page)

7Amount (see rnstructrons)

Page 2

140

Form 706 (Rev. 10-91)

Part 4.-General information (continued)Please check the ‘Yes” or “No” box for each question. [Yes] No

6 Does the gross estate contain any section 2044 property (qualified terminable interest property (CITIP) from a prior gift or

e decedent at the time of death own any property as a joint tenant with right of survivorship in which (a) one or moreof the other joint tenants was someone other than the decedent’s spouse, and (b) less than the full value of the property is

15 Was the decedent, immediately before death, receiving an annuity described in the “General” paragraph of the instructions

Part 5.--Recapitulation

1

2

3

4

5

6

789

10

11

12

13

14

15

16171819

20

. . . . . . . . . . . . . . . . .Schedule B-Stocks and Bonds. . . . . . . . . .Schedule C-Mortgages, Notes, and Cash . .Schedule D-Insurance on the Decedent’s Life (attach Form(s) 712) . . .Schedule E-Jointly Owned Property (attach Form(s) 712 for life insurance)

Schedule F-Other Miscellaneous Property (attach Form(s) 712 for life insurance)Schedule G-Transfers During Decedent’s Life (attach Form(s) 712 for life Insurance)Schedule H-Powers of Appointment . . .

Schedule J-Funeral Expenses and Expenses Incurred in Administenng Property Subject to Claims .Schedule K-Debts of the Decedent . . .Schedule K-Mortgages and Liens . . . . . .Total of items 11 through 13. . .Allowable amount of deductions from item 14 (see the instructions for Item 15 of the Recapitulation)

Schedule L-Net Losses During Administration . .S c h e d u l e L - E x p e n s e s I n c u r r e d i n A d m i n i s t e r i n g P r o p e r t y N o t Sublect t o C l a i m s

Schedule M--Bequests, etc.. to Surviving Spouse . . . . . . .IISchedule O-Charitable, Public, and Similar Gifts and Bequests . . . . . . . I

Total allowable deductions (add items 15 through 19). Enter here and on line 2 of the Tax Computation

Page 3

141

Form 706 (Rev 10-91)

Estate of:SCHEDULE A-Real Estate

(For joint/y owned propeny that must be disclosed on Schedule E, see the instructions for Schedule E.)(Real estate that is part of a so/e proprietorship should be shown on Schedule F: Real estate that is included in thegross estate under section 2035, 2036, 2037, or 2038 should be shown on Schedule G. Real estate that is included inthe gross estate under section 2047 should be shown on Schedule H.)(If vou elect section 2032A valuation, you must complete Schedule A and Schedule A- 1.)

Description Alternatevaluation date

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule.

TOTAL. (Also enter on Part 5, Recapitulat ion, page 3, at i tem 1.) .

Alternate value Value at date of death

(If more space is needed, attach the continuation schedule from the end of this package or additional sheets o

(See the instructions on the reverse side.)

the same size.)

Schedule A-Page 4

142

Form 706 (Rev. 10-91)

Instructions for Schedule A.- Real Estate

If the total gross estate contains any real estate, youmust complete Schedule A and file it with the return.On Schedule A list real estate the decedent owned orhad contracted to purchase. Number each parcel inthe left- hand column.

Describe the real estate in enough detail so that theIRS can easily locate it for inspection and valuation.For each parcel of real estate, report the area and, ifthe parcel is improved, describe the improvements. Forcity or town property, report the street and number,ward, subdivision, block and lot, etc. For rural property,report the township, range, landmarks, etc.

If any item of real estate is subject to a mortgage forwhich the decedent’s estate is liable, that is, if theindebtedness may be charged against other propertyof the estate that is not subject to that mortgage, or ifthe decedent was personally liable for that mortgage,you must report the full value of the property in thevalue column.

itemnumber

Itemnumber

Enter the amount of the mortgage under“Description” on this schedule. The unpaid amount ofthe mortgage may be deducted on Schedule K. If thedecedent’s estate is NOT liable for the amount of themortgage, report only the value of the equity ofredemption (or value of the property less theindebtedness) in the value column as part of the grossestate. Do not enter any amount less than zero. Do notdeduct the amount of indebtedness on Schedule K.

Also list on Schedule A real property the decedentcontracted to purchase. Report the full value of theproperty and not the equity in the value column.Deduct the unpaid part of the purchase price onSchedule K.

Report the value of real estate without reducing it forhomestead or other exemption, or the value of dower,curtesy, or a statutory estate created instead of doweror curtesy.

Explain how the reported values were determinedand attach copies of any appraisals.

Schedule A ExamplesIn this example the alternate valuation is not adopted; the date of death is January 1, 1991.

Description

House and lot, 1921 Willram Street NW, Washington, DC (lot 6. square 481). Rentof $2,70-O due at end of each quarter, February 1, May 1, August 1, and November1 . V a l u e b a s e d o n apprarsal, c o p y o f w h i c h i s a t t a c h e d .

Rent due on item 1 for quarter ending November 1, 1990. but not collected at dateof death. . .

R e n t a c c r u e d o n i t e m 1 f o r N o v e m b e r a n d D e c e m b e r 1 9 9 0

House and lot, 304 Jefferson Street, Alexandria, VA (lot 18, square 40). Rent of $600payable monthly. Value based on appraisal, copy of which is attached .

Rent due on item 2 for December 1990, but not collected at date of death

\Alternate

raluation dateA lte rnate

value

In this example alternate valuation is adopted; the date of death is January 1, 1991.

Description

House and lot, 1921 William Street NW, Washington, DC (lot 6. square 481). Rentof $2,700 due at end of each quarter, February 1, May I, August 1, and November1. Value based on appraisal, copy of which is attached. Not disposed of within 6months following death . . .

Rent due on item 1 for quarter ending November I. 1990, but not collected untilFebruary 1, 1991 . . . . . . . . .

Rent accrued on item 1 for November and December 1990, collected on February1,1991 . . . . . . . . . .

House and lot, 304 Jefferson Street, Alexandria, VA (lot 18, square 40). Rent of $600payable monthly. Value based on appraisal, copy of which is attached. Propertyexchanged for farm on May 1, 1991. . . . . .

Rent due on item 2 for December 1990, but not collected until February 1, 1991

Alternatevaluation date

7/I /91

2/l/91

2/l/91

5/l/91

2/l/91

Alternatevalue

90.000

2,700

1.800

90,000 96,000

600 600

Schedule A-Page 5

4

Value atdate of death

108,000

2,700

1.800

9 6,000

600

Value atdate of death

108.000

2,700

1.800

143

Form 706 (Rev. 10-91)

Checklist for Section 2032A Election-/f you aregoing to make the special use valuation election onSchedule A-l, please use this checklist to ensure thatyou are providing everything necessary to make a validelection.

To have a valid special use valuation election undersection 2032A, you must file, in addition to the Federalestate tax return, (a) a notice of election (Schedule A-l,Part 2) and (b) a fully executed agreement (ScheduleA-l, Part 3). You must include certain information inthe notice of election. To ensure that the notice ofelection includes all of the information required for avalid election, use the following checklist. The checklistis for your use only. Do not file it with the return.

1. Does the notice of election include the decedent’sname and social security number as they appear onthe estate tax return?

2. Does the notice of election include the relevantqualified use of the property to be specially valued?

3. Does the notice of election describe the items ofreal property shown on the estate tax return that are tobe specially valued and identify the property by theForm 706 schedule and item number?

4. Does the notice of election include the fair marketvalue of the real property to be specially valued andalso include its value based on the qualified use(determined without the adjustments provided insection 2032A(h)(3)(B)?

5. Does the notice of election include the adjustedvalue (as defined in section 2032A(h)(3)(B)) of (a) all realproperty that both passes from the decedent and isused in a qualified use, without regard to whether it isto be specially valued, and (b) all real property to bespecially valued?

6. Does the notice of election include (a) the items ofpersonal property shown on the estate tax return thatpass from the decedent to a qualified heir and that areused in qualified use and (b) the total value of suchpersonal property adjusted under section2032A(h)(3)(B)?

7. Does the notice of election include the adjustedvalue of the gross estate? (See section 2032A(h)(3)(A).)

8. Does the notice of election include the methodused to determine the special use value?

9. Does the notice of election include copies ofwritten appraisals of the fair market value of the realproperty?

10. Does the notice of election include a statementthat the decedent and/or a member of his or her familyhas owned all of the specially valued property for at

least 5 years of the 8 years immediately preceding thedate of the decedent’s death?11. Does the notice of election include a statement

as to whether there were any periods during the 8-yearperiod preceding the decedent’s date of death duringwhich the decedent or a member of his or her family(a) did not own the property to be specially valued, (b)use it in a qualified use, or (c) materially participate inthe operation of the farm or other business? (Seesection 2032A(e)(6).)

12. Does the notice of election include, for each itemof specially valued property, the name of every persontaking an interest in that item of specially valuedproperty and the following information about each suchperson: (a) the person’s address, (b) the person’staxpayer identification number, (c) the person’srelationship to the decedent, and (d) the value of theproperty interest passing to that person based on bothfair market value and qualified use?

13. Does the notice of election include affidavitsdescribing the activities constituting materialparticipation and the identity of the materialparticipants?

14. Does the notice of election include a legaldescription of each item of specially valued property?

(In the case of an election made for qualifiedwoodlands, the information included in the notice ofelection must include the reason for entitlement to thewoodlands election.)

Any election made under section 2032A will not bevalid unless a properly executed agreement (ScheduleA-l, Part 3) is filed with the estate tax return. Toensure that the agreement satisfies the requirementsfor a valid election, use the following checklist.

1. Has the agreement been signed by each andevery qualified heir having an interest in the propertybeing specially valued?

2. Has every qualified heir expressed consent topersonal liability under section 2032A(c) in the event ofan early disposition or early cessation of qualified use?

3. Is the agreement that is actually signed by thequalified heirs in a form that is binding on all of thequalified heirs having an interest in the specially valuedproperty?

4. Does the agreement designate an agent to act forthe parties to the agreement in all dealings with theIRS on matters arising under section 2032A?

5. Has the agreement been signed by the designatedagent and does it give the address of the agent?

Page 6

144

Form 706 (Rev. 10-91)

Estate of:Decedent’s Social Security Number

SCHEDULE A-l-Section 2032A Valuation

Part I.-Type of Election:0 Protective election (Regulations section 2CL2032A-6(b)).-Complete Part 2, line 1, and column A of lines 3 and 4. (See instructions.)0 Regular election.-Complete all of Part 2 (including line 11, if applicable) and Part 3. (See instructions.)

Part 2.-Notice of Election (Regulations section 20.2032A-8(a)(3))Note: A// real property entered on lines 2 and 3 must also be entered on Schedules A, E, F; G, or H, as applicable.

A

Schedule and item numberfrom Form 706

1 Qua l i f i ed use -check one b 0 Farm used for farming, ork 0 Trade or business other than farmina

2 Real property used in a qualified use, passing to qualified heilI

rs, and tobe specially valued

0

Full value(without section 2032A(h)(3)(B)

adjustment)

CAdjusted value (with section Value based on qualified use

2032A(h)(3)(B) (without section 2032A(h)(3)(B)adjustment) adjustment)

)n this Form 706.

T o t a l sAttach a legal description of all property listed on line 2.Attach copies of appraisals showing the column B values for all property listed on line 2.

3 Real property used in a qualified use, passing to qualified heirs, but not specially valued on this Form 706.I I

A

Schedule and item numberfrom Form 706

0 CFull value

(without section 2032A(b)(3)(6)adjustment)

Adjusted value (with section2032A(h)(3)(B)

adjustment)

Value based on qualified use(without section 2032A(h)(3)(B)

adjustment)

D

TotalsIf you ch&ked’“Rkg~lar’el&ztibn

(Continued on next page)

D

IOU must attach copies of appraisals showing the column B values for all property listed on line 3.

Sch e dule A - l- - Page 7

146

ed heirs.

A (continued)

Schedule and itemnumber from Form 706

Form 706(Rev. 10-91)

4 Personal property used in a qualified use and passing to q

A

Schedule and itemnumber from Form 706

BAdjusted value (with

section 2032A(b)(3)(8)adjustment)

Subtotal . . . .

“Subtotal” from Col. B. below left

~tal adjusted value . .

B (continued)Adjusted value (with

section 2032A(h)(3)(B)adjustment)

5 Enter the value of the total gross estate as adjusted under section 2032A(h)(3)(A). b6 Attach a description of the method used to determine the special value based on qualified use.7 Did the decedent and/or a member of his or her family own all property listed on line 2 for at least 5 of the

8 years immediately preceding the date of the decedent’s death? . . . . . 0 Yes 0 No

6 Were there any periods during the 8-year period preceding the date of the decedent’s death during whichthe decedent or a member of his or her family:. Yes No

a Did not own the property listed on line 2 above? . . . . . . . . . . . .b Did not use the property listed on line 2 above in a qualified use? . . . . .c Did not materially participate in the operation of the farm or other business within the meaning of section

2032A(e)(6)?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . EIf “Yes” to any of the above, you must attach a statement listing the periods. If applicable, describe whether the exceptions ofsections 2032A(b)(4) or (5) are met.

9 Attach affidavits describing the activities constituting material participation and the identity and relationship to thedecedent of the material participants.

10 Persons holding interests. Enter the requested information for each party who received any interest in the specially valued property.Name Address

F \ I

Identifying number Relationship to decedent Fair market value Special use valueA ) I IBC

_ DEF

You must attach a computation of the GST tax savings attributable lo direct skips lor each person listed above who is a skip person. (See instructions.)11 Woodlands election.-Check here F 0 if you wish to make a woodlands election as described in section 2032A(e)(13). Enter the

Schedule and item numbers from Form 706 of the property for which you are making this election b.. __._.__.__ _. ______ _. __ _________You must attach a statement explaining why you are entitled to make this election. The IRS may issue regulations that require moreinformation to substantiate this election. You will be notified by the IRS if you must supply further information.

Schedule A-l -Page 8

147

Form 7 0 6 IR ev. lo-9 11

Part 3.-Agreement to Special Valuation Under Section 2032AEstate of: Date of Death Decedent’s Social Security Number

We (list all qualified heirs and other persons having an interest in the property required to sign this agreement)

being all the qualified heirs and

being all other parties having interests in the property which is qualified real property and which is valued under section 2032A of theInternal Revenue Code, do hereby approve of the election made byExecutor/Administrator of the estate ofpursuant to section 2032A to value said property on the basis of the qualified use to which the property is devoted and do hereby enterinto this agreement pursuant to section 2032A(d).

The undersigned agree and consent to the application of subsection (c) of section 2032A of the Code with respect to all the propertydescribed on line 2 of Part 2 of Schedule A-l of Form 706, attached to this agreement. More specifically, the undersigned heirs expresslyagree and consent to personal liability under subsection (c) of 2032A for the additional estate and GST taxes imposed by that subsectionwith respect to their respective interests in the above-described property in the event of certain early dispositions of the property or earlycessation of the qualified use of the property. It is understood that if a qualified heir disposes of any interest in qualified real property toany member of his or her family, such member may thereafter be treated as the qualified heir with respect to such interest upon filing aForm 706-A and a new agreement.

The undersigned interested parties who are not qualified heirs consent to the collection of any additional estate and GST taxes imposedunder section 2032A(c) of the Code from the specially valued property.

If there is a disposition of any interest which passes or has passed to him or her or if there is a cessation of the qualified use of anyspecially valued property which passes or passed to him or her, each of the undersigned heirs agrees to file a Form 706-A, United StatesAdditional Estate Tax Return, and pay any additional estate and GST taxes due within 6 months of the disposition or cessation.

It is understood by all interested parties that this agreement is a condition precedent to the election of special use valuation under section2032A of the Code and must be executed by every interested party even though that person may not have received the estate (or GST)tax benefits or be in possession of such property.

Each of the undersigned understands that by making this election, a lien will be created and recorded pursuant to section 63246 of theCode on the property referred to in this agreement for the adjusted tax differences with respect to the estate as defined in section2032A(c)(2)(G).

As the interested parties, the undersigned designate the following individual as their agent for all dealings with the Internal Revenue Serviceconcerning the continued qualification of the specially valued property under section 2032A of the Code and on all issues regarding thespecial lien under section 63248. The agent is authorized to act for the parties with respect to all dealings with the Service on mattersaffecting the qualified real property described earlier. This authority includes the following:

a To receive confidential information on all matters relating to continued qualification under section 2032A of the specially valuedreal property and on all matters relating to the special lien arising under section 63248.

0 To furnish the Service with any requested information concerning the property.a To notify the Service of any disposition or cessation of qualified use of any part of the property.l To receive, but not to endorse and collect, checks in payment of any refund of Internal Revenue taxes, penalties, or interest.l To execute waivers (including offers of waivers) of restrictions on assessment or collection of deficiencies in tax and waivers of

notice of disallowance of a claim for credit or refund.

l To execute closing agreements under section 7121.l Other acts (specify) b

By signing this agreement, the agent agrees to provide the Service with any requested information concerning this property and to notifythe Service of any disposition or cessation of the qualified use of any part of this property.

Name of Agent Signature Address

The property to which this agreement relates is listed in Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return,and in the Notice of Election, along with its fair market value according to section 2031 of the Code and its special use value accordingto section 2032A. The name, address, social security number, and interest (including the value) of each of the undersigned in this propertyare as set forth in the attached Notice of Election.

IN WITNESS WHEREOF, the undersigned have hereunto set their hands atthis day ofQualified Heirs

Other Interested Parties

Schedule A-l--Page 9

148

Form 706 (Rev. 10-91)

Instructions for Schedule A - l .-Section2032A ValuationThe election to value certain farm and closely held businessproperty at its special use value is made by checking “Yes” toline 2 of Part 3. Elections by the Executor, Fom-r 706. ScheduleA-l is used to report the additional information that must besubmitted to support this election. In order to make a validelection, you must complete Schedule A-l and attach all of therequired statements and appraisals.

For definitions and additional information concerning specialuse valuation, see section 2032A an&the related regulations.

Part l.-Type of ElectionEstate and GST Tax Elections.-If you elect special usevaluation for the estate tax, you must also elect special usevaluation for the GST tax and vice versa.

You must value each specific property interest at the samevalue for GST tax purposes that you value it at for estate taxpurposes.Protective Election.-To make the protective election describedin the separate instructions for line 2 of Part 3, Elections by theExecutor, you must check this box, enter the decedent’s nameand social security number in the spaces provided at the top ofSchedule A-l. and complete line 1 and column A of lines 3 and4 of Part 2. For purposes of the protective election, list on line 3all of the real property that passes to the qualified heirs eventhough some of the property will be shown on line 2 when theadditional notice of election is subsequently filed. You need notcomplete columns B-D of lines 3 and 4. You need not completeany other line entries on Schedule A-l. Completing ScheduleA-l as described above constitutes a Notice of ProtectiveElection as described in Regulations section 20.2032A-8(b).

Part P.-Notice of ElectionLine lO.-Because the special use valuation election creates apotential tax liability for the recapture tax of section 2032A(c),you must list each person who receives an interest in thespecially valued property on Schedule A-l. If there are morethan eight persons who receive interests, use an additional sheetthat follows the format of line 10. In the columns “Fair marketvalue” and “Special use value,” you should enter the totalrespective values of all the specially valued property interestsreceived by each person.GST Tax Savings.-To compute the additional GST tax dueupon disposition (or cessation of qualified use) of the property,each “skip person” (as defined in the instructions to Schedule R)who receives an interest in the specially valued property mustknow the total GST tax savings on all of the interests in speciallyvalued property received. This GST tax savings is the differencebetween the total GST tax that was imposed on all of theinterests in specially valued property received by the skip personvalued at their special use value and the total GST tax thatwould have been imposed on the same interests received by theskip person had they been valued at their fair market value.

Because the GST tax depends on the executor’s allocation ofthe GST exemption and the grandchild exclusion, the skipperson who receives the interests is unable to compute this GSTtax savings. Therefore, for each skip person who receives aninterest in specially valued property, you must attach worksheetsshowing the total GST tax savings attributable to all of thatperson’s interests in specially valued property.How To Compute the GST Tax Savings.-Before computingeach skip person’s GST tax savings, you must completeSchedules R and R-l for the entire estate (using the special usevalues).

For each skip person, you must complete two Schedules R(Parts 2 and 3 only) as worksheets, one showing the interests inspecially valued property received by the skip person at theirspecial use value and one showing the same interests at theirfair market value.

If the skip person received interests in specially valuedproperty that were shown on Schedule R-l, show these interestson the Schedule R. Parts 2 and 3 worksheets, as appropriate.Do not use Schedule R-l as a worksheet.Completing the Special Use Value Worksheets.-On lines 2-4and 6, enter -0-.Completing the Fair Market Value Worksheets.--Lines 2 and3, fixed taxes and other charges-If valuing the interests at theirfair market value (instead of special use value) causes any ofthese taxes and charges to increase, enter the increased amount(only) on these lines and attach an explanation of the increase.Otherwise, enter -0-.Line 6-GST exemption-If you completed line 10 of ScheduleR, Part 1. enter on line 6 the amount shown for the skip personon the line 70 special use allocation schedule you attached toSchedule R. If you did not complete line 10 of Schedule R, Part1, enter -0- on line 6.Total GST Tax Savings.-For each skip person, subtract the taxamount on line 10, Part 2 of the special use value worksheetfrom the tax amount on line 10, Part 2 of the fair market valueworksheet. This difference is the skip person’s total GST taxsavings.

Part 3.-Agreement to Special Valuation UnderSection 2032AThe agreement to special valuation by persons with an interestin property is required under section 2032A(s)(l)(B) and (d)(2)and must be signed by all parties who have any interest in theproperty being valued based on its qualified use as of the dateof the decedent’s death.

An interest in property is an interest that, as of the date of thedecedent‘s death, can be asserted under applicable local law soas to affect the disposition of the specially valued property bythe estate. Any person who at the decedent’s death has anysuch interest in the property, whether present or future, orvested or contingent, must enter into the agreement. Includedare owners of remainder and executory interests; the holders ofgeneral or special powers of appointment; beneficiaries of a giftover in default of exercise of any such power; joint tenants andholders of similar undivided interests when the decedent heldonly a joint or undivided interest in the property or when only anundivided interest is specially valued; and trustees of trusts andrepresentatives of other entities holding title to, or holding anyinterests in the property. An heir who has the power under locallaw to caveat (challenge) a will and thereby affect disposition ofthe property is not, however, considered to be a person with aninterest in property under section 2032A solely by reason of thatright. Likewise, creditors of an estate are not such personssolely by reason of their status as creditors.

If any person required to enter into the agreement eitherdesires that an agent act for him or her or cannot legally bindhimself or herself due to infancy or other incompetency, or dueto death before the election under section 2032A is timelyexercised, a representative authorized by local law to bind theperson in an agreement of this nature may sign the agreementon his or her behalf.

The Internal Revenue Service will contact the agentdesignated in the agreement on all matters relating to continuedqualification under section 2032A of the specially valued realproperty and on all matters relating to the special lien arisingunder section 63248. It is the duty of the agent asattorney-in-fact for the parties with interests in the speciallyvalued property to furnish the IRS with any requestedinformation and to notify the IRS of any disposition or cessationof qualified use of any part of the property.

Schedule A-l -Page IO

149

Form 706 (Rev. 10-91)

Estate of:

SCHEDULE B-Stocks and Bonds(For jointly owned property that must be disclosed on Schedule E. see the instructions for Schedule E.)

Itemnumbs

1

. .Description tncludmg face amount of bonds or number of shares and par

value where needed for Identification. Gwe CUSIP number 11 avaIlable. Unit valueAlternate

valuation date


Alternate value

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 2.) /(If more space is needed, attach the continuation schedule from the end of this package or additional sheets of the same(The instructions to Schedule B are in the separate instructions.) Schedule

Value at date of death

si ze .)B-Page 11

150

Form 706 (Rev. 10-91)

Estate of:

SCHEDULE C-Mortgages, Notes, and Cash(For jointly owned property that must be disclosed on Schedule E, see the instructions for Schedule E.)


Ite mnumb

1

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule .

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 3.). . . . . .

Value at date of death

(If more space is needed, attach the continuation schedule from the end of this package or additional sheets of the same size.)(See the instructions on the reverse side.)

Schedule C-Page 12

152

Form 706 (Rev. 10-91)

Instructions for Schedule C.-Mortgages, Notes, and CashIf the total gross estate contains any mortgages, notes,or cash, you must complete Schedule C and file it withthe return.On Schedule C list mortgages and notes payable tothe decedent at the time of death. (Mortgages andnotes payable by the decedent should be listed (ifdeductible) on Schedule K. Also list on Schedule Ccash the decedent had at the date of death.Group the items in the following categories and list thecategories in the following order:1. Mortgages-List: (a) the face value and unpaidbalance; (b) date of mortgage; (c) date of maturity; (d)name of maker; (e) property mortgaged; and (f) interestdates and rate of interest. For example: bond andmortgage of $5O,OGO, unpaid balance $24,000; datedJanuary 1, 1980; John Doe to Richard Roe; premises22 Clinton Street, Newark, N.J.; due January 1, 1992,interest payable at 10% a year January 1 and July 1.

2. Promissory notes.-Describe in the same way asmortgages.3. Contract by the decedent to sell land.-List: (a)the name of the purchaser; (b) date of contract; (c)description of property; (d) sale price; (e) initialpayment; (9 amounts of installment payment; (g)unpaid balance of principal; and (h) interest rate.4. Cash in possession.-List separately from bankdeposits.5. Cash in banks, savings and loan associations,and other types of financial organizations.-List: (a)the name and address of each financial organization;(b) amount in each account; (c) serial number; and (d)nature of account, indicating whether checking,savings, time deposit, etc. If you obtain statementsfrom the financial organizations, keep them for IRSinspection.

Schedule C-Page 13

153

Form 706 (Rev. 10-91)

Iternnumbe

1

SCHEDULE D-Insurance on the Decedent’s LifeYou must attach a Form 712 for each policy.


Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule

T Anernate value Value at date of death

T O T A L . (A ls o enter on Part 5, Recapitulation, page 3, at item 4.). .(If more space is needed, attach the continuation schedule from the end of this package or additional

(See the instructions on the reverse side.)

sheets c1

the same size.)

Sch e dule D-Page 14

154

Instructions for Schedule D.-Insurance onthe Decedent’s Life

If there was any insurance on the decedent’s life,whether or not included in the gross estate, you mustcomplete Schedule D and file it with the return.Insurance you must include on Schedule D.-Undersection 2042 you must include in the gross estate:

l Insurance on the decedent’s life receivable by orfor the benefit of the estate; and

l Insurance on the decedent’s life receivable bybeneficiaries other than the estate, as describedbelow.

The term “insurance” refers to life insurance of everydescription, including death benefits paid by fraternalbeneficiary societies operating under the lodge system,and death benefits paid under no-fault automobileinsurance policies if the no-fault insurer wasunconditionally bound to pay the benefit in the eventof the insured’s death.Insurance in favor of the estate.-Include onSchedule D the full amount of the proceeds ofinsurance on the life of the decedent receivable by theexecutor or otherwise payable to or for the benefit ofthe estate. Insurance in favor of the estate includesinsurance used to pay the estate tax, and any othertaxes, debts, or charges that are enforceable againstthe estate. The manner in which the policy is drawn isimmaterial as long as there is an obligation, legallybinding on the beneficiary, to use the proceeds to paytaxes, debts, or charges. You must include the fullamount even though the premiums or otherconsideration may have been paid by a person otherthan the decedent.Insurance receivable by beneficiaries other than theestate.- Include on Schedule D the proceeds of allinsurance on the life of the decedent not receivable byor for the benefit of the decedent’s estate if thedecedent possessed at death any of the incidents ofownership, exercisable either alone or in conjunctionwith any person.

Incidents of ownership in a policy include:l The right of the insured or estate to its economic

benefits;l The power to change the beneficiary;

l The power to surrender or cancel the policy;l The power to assign the policy or to revoke an

assignment;0 The power to pledge the policy for a loan;l The power to obtain from the insurer a loan

against the surrender value of the policy;l A reversionary interest if the value of the

reversionary interest was more than 5% of thevalue of the policy immediately before thedecedent died. (An interest in an insurance policyis considered a reversionary interest if, forexample, the proceeds become payable to theinsured’s estate or payable as the insured directsif the beneficiary dies before the insured.)

Life insurance not includible in the gross estateunder section 2042 may be includible under someother section of the Code. For example, a lifeinsurance policy could be transferred by the decedentin such a way that it would be includible in the grossestate under section 2036, 2037, or 2038. (See theinstructions to Schedule G for a description of thesesections.)

Completing the ScheduleYou must list every policy of insurance on the life ofthe decedent, whether or not it is included in the grossestate.

Under “Description” list:l Name of the insurance company andl Number of the policy.

For every policy of life insurance listed on theschedule, you must request a statement on Form 712,Life Insurance Statement, from the company thatissued the policy. Attach the Form 712 to the back ofSchedule D.

If the policy proceeds are paid in one sum, enter thenet proceeds received (from Form 712, line 24) in thevalue (and alternate value) columns of Schedule D. Ifthe policy proceeds are not paid in one sum, enter thevalue of the proceeds as of the date of the decedent’sdeath (from Form 712, line 25).

If part or all of the policy proceeds are not includedin the gross estate, you must explain why they werenot included.

Schedule D-Page 15

155

Form 706 (Rev. 10-91)

Estate of:SCHEDULE E-Jointly Owned Property

(If you elect section 2032A valuation, you must complete Schedule E and Schedule A- 7.)

PART I.-Qualified Joint Interests-Interests Held by the Decedent and His or Her Spouse as the Only Joint Tenants(Section 2040(bM2)1

Itemnumbe

DescnptionFor securities, give CUSIP number. If avarlable.

Alternatevaluatron date

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule. . . .


la Totals . . . . . . . . . . . . . . . . . . . 1lb Amounts included in gross estate (one-half of ltne la) . . . I . . 1PART 2.-All Other Joint interests

t

2a State the name and address of each surviving co-tenant. If there are more than three surviving co-tenants, fist the additional co-tenantson an attached sheet.

IName Address (number and street. city, state. and ZIP code)

A.

B.

C.Item Enter

ener foro-renanl

Descriotion(including alternate valuation date d any) Forsecurities. 9we CUSIP number. if avarlable.

Percentageincludible l- lncludrble

alternate value


2b Total other joint interests . . .3 Total includible joint interests (add lines 1 b and 2b). Also enter on Part 5. Recapitulation, page

3,atitem5. .(If more space is needed, attach the continuation schedule from the end of this package or additional sh;gKe;(See the instructions on the reverse side.)

lncludible value atdate of death

the same size.)ule E-Page 16

156

Form 7 0 6 ( R e v. 1 0 - 9 1 )

Instructions for Schedule E.-JointlyOwned PropertyYou must complete Schedule E and file it with thereturn if the decedent owned any joint property at thetime of death, whether or not the decedent’s interest isincludible in the gross estate.

Enter on this schedule all property of whatever kindor character, whether real estate, personal property, orbank accounts, in which the decedent held at the timeof death an interest either as a joint tenant with right tosurvivorship or as a tenant by the entirety.

Do not list on this schedule property that thedecedent held as a tenant in common, but repot-t thevalue of the interest on Schedule A if real estate, or onthe appropriate schedule if personal property. Similarly,community property held by the decedent and spouseshould be reported on the appropriate Schedules Athrough I. The decedent’s interest in a partnershipshould not be entered on this schedule unless thepartnership interest itself is jointly owned. Solelyowned partnership interests should be reported onSchedule F, “Other Miscellaneous Property.”Part l.-Qualified joint interests held by decedentand spouse.-Under section 2040(b)(2), a joint interestis a qualified joint interest if the decedent and thesurviving spouse held the interest as:l Tenants by the entirety, or0 Joint tenants with right of survivorship if the

decedent and the decedent’s spouse are the onlyjoint tenants.

Interests that meet either of the two requirementsabove should be entered in Part 1. Joint interests thatdo not meet either of the two requirements aboveshould be entered in Part 2.

Under “Description,” describe the property asrequired in the instructions for Schedules A, B, C, andF for the type of property involved. For example, jointlyheld stocks and bonds should be described using therules given in the instructions to Schedule B.

Under “Alternate value” and “Value at date ofdeath,” enter the full value of the property.Note: You cannot claim the special treatment undersection 2040(b) for property held jointly by a decedentand a surviving spouse who is not a U.S. citizen. Youmust report these joint interests on Part 2 of ScheduleE, not Part 1.

Part 2.-Other joint interests.-All joint interests thatwere not entered in Part 1 must be entered in Part 2.

For each item of property, enter the appropriateletter A, B, C, etc., from line 2a to indicate the nameand address of the surviving co-tenant.

Under “Description,” describe the property asrequired in the instructions for Schedules A, B, C, andF for the type of property involved.

In the “Percentage includible” column, enter thepercentage of the total value of the property that youintend to include in the gross estate.

Generally, you must include the full value of thejointly owned property in the gross estate. However,the full value should not be included if you can showthat a par-t of the property originally belonged to theother tenant or tenants and was never received oracquired by the other tenant or tenants from thedecedent for less than adequate and full considerationin money or money’s worth, or unless you can showthat any part of the property was acquired withconsideration originally belonging to the surviving jointtenant or tenants. In this case, you may exclude fromthe value of the property an amount proportionate tothe consideration furnished by the other tenant ortenants. Relinquishing or promising to relinquish dower,curtesy, or statutory estate created instead of dower orcurtesy, or other marital rights in the decedent’sproperty or estate is not consideration in money ormoney’s worth. See the Schedule A instructions for thevalue to show for real property that is subject to amortgage.

If the property was acquired by the decedent andanother person or persons by gift, bequest, devise, orinheritance as joint tenants, and their interests are nototherwise specified by law, include only that part of thevalue of the property that is figured by dividing the fullvalue of the property by the number of joint tenants.

If you believe that less than the full value of theentire property is includible in the gross estate for taxpurposes, you must establish the right to include thesmaller value by attaching proof of the extent, origin,and nature of the decedent’s interest and theinterest(s) of the decedent’s co-tenant or co-tenants.

In the “lncludible alternate value” and “lncludiblevalue at date of death” columns, you should enter onlythe values that you believe are includibte in the grossestate.

Schedule E-Page 17

157

Form 706 (Rev. 10-91)

Estate of:SCHEDULE F-Other Miscellaneous Property Not Reportable Under Any Other Schedule

(For jointly owned property that must be disclosed on Schedule E, see the instructions for Schedule E.)(If you elect section 2032A valuation, you must complete Schedule F and Schedule A- 1.)

omitted.

Ite mnumbc

1

of the decedent’s em ment or death?. . . . . . . . . . . . . . . .

me and relationship of joint

If any of the contents of the safe deposit box are omitted from the schedules in this return, explain fully why

DescriptionFor securities, give CUSIP number, if available.



TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 6.) . . . .


(If more space is needed, attach the continuation schedule from the end of this package or additional sheets of the same size.)(See the instructions on the reverse side.)

Schedule F-Page 18

158

Form 706 (Rev. 10-91)

Instructions for Schedule F.-OtherMiscellaneous PropertyYou must complete Schedule F and file it with thereturn.

On Schedule F list all items that must be included inthe gross estate that are not reported on any otherschedule, including:l Debts due the decedent (other than notes and

mortgages included on Schedule C)l Interests in businessl Insurance on the life of another (obtain and attach

Form 712, Life Insurance Statement, for eachpolicy)

Note for single premium or paid-up policies: Incerfain situations, for example where the surrendervalue of the policy exceeds its replacement cost, thetrue economic value of the policy will be greaterthan the amount shown on line 56 of Form 712. Inthese situations, you should report the full economicvalue of the policy on Schedule E See Rev. Rul.78- 13 7, 19 78- 1 C. 6. 280 for derails.0 Section 2044 propertyl Claims (including the value of the decedent’s

interest in a claim for refund of income taxes orthe amount of the refund actually received)

l Rights0 Royaltiesl Leaseholdsl Judgmentsl Reversionary or remainder interestsl Shares in trust funds (attach a copy of the trust

instrument)

l Household goods and personal effects, includingwearing apparel

l Farm products and growing cropsl Livestock0 Farm machineryl AutomobilesIf the decedent owned any interest in a partnership

or unincorporated business, attach a statement ofassets and liabilities for the valuation date and for the5 years before the valuation date. Also attachstatements of the net earnings for the same 5 years.You must account for goodwill in the valuation. Ingeneral, furnish the same information and follow themethods used to value close corporations. See theinstructions for Schedule 6.

All partnership interests should be reported onSchedule F unless the partnership interest, itself, isjointly owned. Jointly owned partnership interestsshould be reported on Schedule E.

If real estate is owned by the sole proprietorship, itshould be reported on Schedule F and not onSchedule A. Describe the real estate with the samedetail required for Schedule A.Line 1 .-If the decedent owned at the date of deatharticles with artistic or intrinsic value (e.g., jewelry, furs,silverware, books, statuary, vases, oriental rugs, coin orstamp collections), check the “Yes” box on line 1 andprovide full details. If any one article is valued at morethan $3,000, or any collection of similar articles isvalued at more than $10,000, attach an appraisal byan expert under oath and the required statementregarding the appraiser’s qualifications (seeRegulations section 20.2031-6(b)).

Schedule F-Page 19

159

Form 706 (Rev. 10-91)

Item

A.

6.

1

SCHEDULE G-Transfers During Decedent’s Life(If you elect section 2032A valuation, you must complete Schedule G and Schedule A-l.)

DescriptionFor securities, QIW CUSIP number. if available.

Gift tax paid by the decedent or the estate for all gifts made bythe decedent or his or her spouse within 3 years before thedecedent’s death (section 2035(c)) . . . . . . . . . . .Transfers includible under section 2035(a), 2036. 2037. or 2038:


xxxxx

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule . ,

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 7.). . . . . . . .

SCHEDULE H-Powers of Appointment

Alternate value 7Value at date of death

(/f you elect section 2032A valuation, you must complete Schedule H and Schedule A-l.)


Total from continuation schedule(s) (or additional sheet(d) attached to this schedule .

A&mate value ilalua at date of death

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 8.). . . . . . . . ((If more space is needed, attach the continuation schedule from the end of this package or additional sheets o(The instructions to Schedules G and l-i are in the separate instructions.)

the same size.)

Schedules G and H-Page 20

160

Form 706 (Rev. 10-91)

Estate of:

SCHEDULE l-AnnuitiesNote: Genera//y, no exclusion is allowed for the estates of decedents dying after December 3 7, 1984 (see instructions).

A Are you excluding from the decedent’s gross estate the value of a lump-sum distribution described in section yes 1 No2039(f)(2)? .If ’‘Yes,” you must attach the’information’reouired’by the instructions. ’ ’ ’ . ’ ’ ’ ’ ’ . .

IItem

numbf

1

lncludlblealternate value

lncludiblevalue at date of deathShow the entire value of the annuity before any exclusions.


Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule .

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 9.). . . . . .(If more space is needed, attach the continuation schedule from the end of this package or ;(The instructions to Schedule 1 are in the separate instructions.)

jitional sheets c the same size.)

Schedule I-Page 21

161

Estate of:SCHEDULE J-Funeral Expenses and Expenses incurred in Administering Property Subject to ClaimsNote: Do not list on this schedule expenses of administering property not subject to claims. For those expenses, see the instructionsfor Schedule L.

re allowable asIf executors’ commissions, attorney fees, etc., are claimed and allowed as a deduction for estate tax purposes, they are not

allowable as a deduction in computing the taxable income of the estate for Federal income tax purposes. They a:ome tax deduction on Form 1041 if a waiver is filed to waive the deduction on Form 706 (see the Form 10~

Ian inc

Item

I1 instructions).

A. Funeral expenses:

Descrlptlon Expense amount Total Amount

Total funeral expenses. . . . . . .B. Administration expenses:Executors’ commissions-amount estimated/agreed upon/paid. (Strike out the words that do not apply.) . . . . . . . . . . . . . . . . . .

Attorney fees-amount estimated/agreed upon/paid. (Strike out the words that do not apply.) .

Accountant fees-amount estimated/agreed upon/paid. (Strike out the words that do not apply.). .

Miscellaneous expenses:Expense amount

Total miscellaneous expenses from continuation schedule(s) (or additional sheet(s))attached to this schedule. . . . . . .Total miscellaneous expenses . . . . . . . . .

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 11.) . . . . . . .(If more space is needed, attach the continuation schedule from the end of this package or additional sheets c(See the instructions on the reverse side.) Schedule J-Page 22

he same size.)

162

Form 706(Aev. 10-91)

Instructions for Schedule J.-Funeral Expenses and Expenses Incurredin Administering Property Subject toClaimsGeneral.-You must complete and file Schedule J ifyou claim a deduction on item 11 of Part 5,Recapitulation.

On Schedule J itemize funeral expenses andexpenses incurred in administering property subject toclaims. List the names and addresses of persons towhom the expenses are payable and describe thenature of the expense. Do not list expenses incurredin administering property not subject to claims onthis schedule. List them on Schedule L instead.Funeral Expenses-Itemize funeral expenses on lineA. Deduct from the expenses any amounts that werereimbursed, such as death benefits payable by theSocial Security Administration and the VeteransAdministration.Executors’ Commissions.-When you file the return,you may deduct commissions that have actually beenpaid to you or that you expect will be paid. You maynot deduct commissions if none will be collected. If theamount of the commissions has not been fixed bydecree of the proper court, the deduction will beallowed on the final examination of the return, providedthat:l The District Director is reasonably satisfied that the

commissions claimed will be paid;0 The amount entered as a deduction is within the

amount allowable by the laws of the jurisdictionwhere the estate is being administered;

l It is in accordance with the usually acceptedpractice in that jurisdiction for estates of similar sizeand character.If you have not been paid the commissions claimed

at the time of the final examination of the return, youmust support the amount you deducted with an

affidavit or statement signed under the penalties ofperjury that the amount has been agreed upon and willbe paid.

You may not deduct a bequest or devise made toyou instead of commissions. If, however, the decedentfixed by will the compensation payable to you forservices to be rendered in the administration of theestate, you may deduct this amount to the extent it isnot more than the compensation allowable by the locallaw or practice.

Do not deduct on this schedule amounts paid astrustees’ commissions whether received by you actingin the capacity of a trustee or by a separate trustee. Ifsuch amounts were paid in administering property notsubject to claims, deduct them on Schedule L.Note: Executors’ commissions are taxable income tothe executors. Therefore, be sure to include them asincome on your individual income tax return.Attorney Fees.-Enter the amount of attorney feesthat have actually been paid or that you reasonablyexpect to be paid. If on the final examination of thereturn the fees claimed have not been awarded by theproper court and paid, the deduction will be allowedprovided the District Director is reasonably satisfiedthat the amount claimed will be paid and that it doesnot exceed a reasonable payment for the servicesperformed, taking into account the size and characterof the estate and the local law and practice. If the feesclaimed have not been paid at the time of finalexamination of the return, the amount deducted mustbe supported by an affidavit, or statement signedunder the penalties of perjury, by the executor or theattorney stating that the amount has been agreedupon and will be paid.

Do not deduct attorney fees incidental to litigationincurred by the beneficiaries. These expenses arecharged against the beneficiaries personally and arenot administration expenses authorized by the Code.

Schedule J-Page 23

163

Fon 706 (Rev. 10-91)

Estate of:

SCHEDULE K-Debts of the Decedent, and Mortgages and LiensIte m Debts of the Decadent--Cred#or and nature of claim, and

allowable death taxes Amount unpaid to date Amount in contest

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule . . . . . . . .

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 12.) . . . . .

Mortgages and Liens-De?.criptiin

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule . . . . . . . .

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 13.) . . . . .

Amount claimed asa deductlon

Amount

(If more space is needed, attach the continuation schedule from the end of this package or additional sheets of the same size.)(The instructions to Schedule K are in the separate instructions.) Schedule K -Page 24

164

Form 706 (Rev 10-91)

Estate of:SCHEDULE L-Net Losses During Administration and

Expenses Incurred in Administering Property Not Subject to Claims

Item Net losses during admnstratlonnumb, (Note : D o not de duct losse s claim e d on a Fe de ral m com e tax return.)

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule . . .

Itemnumbe

1

TOTAL. (Also enter on Part 5. Recapitulation, page 3, at item 16.) . . .Expenses incurred in admnsterlng property not subject toclaims (Indfcate whether estimated aareed uoon. or oa!d.)

--

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule . .

TOTAL. (Also enter on Part 5, Recapitulation, page 3, at item 17.) .

~ Amount

Amount

(If more space-is needed, attach the continuation schedule from the end of this package or additional sheets of the same size.)(The instructions to Schedule L are in the separate instructions.) Schedule L -Page 25

165

Form 706 (Rev. 10-91)

Estate of:

SCHEDULE M-Bequests, etc., to Surviving Spouse

Election To Deduct Qualified Terminable Interest Property Under Section 2066(b)(l).-If a trust (or other property) meets therequirements of qualified terminable interest property under section 2056(b)(7), and

a. the trust or other property is listed on Schedule M, andb. the value of the trust (or other property) is entered in whole or in part as a deduction on Schedule M,

then (unless the executor specifically identifies property to be excluded from the election) the executor shall be deemed to havemade an election to have such trust (or other property) treated as qualified terminable interest property under section 2056(b)(7).

If less than the entire value of the trust (or other property) that the executor has included in the gross estate is entered as adeduction on Schedule M, the executor shall be considered to have made an election only as to a fraction of the trust (or otherproperty). The numerator of this fraction is equal to the amount of the trust (or other property) deducted on Schedule M. Thedenominator is equal to the total value of the trust (or other property).

Yes N o

1

2abC

de

3

4

Did any property pass to the surviving s p o u s e as a result of a qualified disclaimer? . . . . .If “Yes, ” attach a copy of the written disclaimer required by section 25 18(b).In what country was the surviving spouse born?What is the surviving spouse’s date of birth?Is the surviving spouse a U.S. citizen? . . . . . . . . . . . . .If the surviving spouse is a naturalized citizen, when did the surviving spouse acquire citizenship?If the surviving spouse is not a U.S. citizen, of what country is the surviving spouse a citizen?

Qualified Domestic Trust-Do you elect under section 2056A(d) to treat any trusts reported on Schedule M asqualified domestic trusts? (identify in the description column on Schedule M below the trusts to which the QDTelection applies) (see instructions). . . . . . . . . . . . . . . .Election out of QTIP Treatment of Annuities.-Do you elect under section 2056(b)(7)(C)(ii) not to treat as qualifiedterminable interest property any joint and survivor annuities that are included in the gross estate and wouldotherwise be treated as qualified terminable interest property under section 2056(b)(7)(C)? (see instructions‘

Itemnumber

1

Descrlptlon of property Interests passing to surviving spouse

56a

bC

d7

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule . . . . .I

Total amount of property interests listed on Schedule M . . . . . . . . . . . . L5Federal estate taxes (including section 4980A taxes) payable out of propertyinterests listed on Schedule M . . . . . .Other death taxes payable out of property interests listed on Schedule M . .Federal and state GST taxes payable out of property interests listed onSchedule M . . . . . . .Add items a, b, and c . . . . . . . . . . .Net amount of property interests listed on Schedule M (subtract 6d from 5). Also enter on Part 5,- - .^f-lecaprtulatron, page 3. at Item 16 . . , , . . , . . . . . , . . . . . , 1 7

Amount

(If more space is needed, attach the continuation schedule from the end of th is package of additional sheets of the same size.)

Schedule M-Page 26

166

Form 706 (Rev 10-91)

Examples of Listing of Property Interests on Schedule M

Itemnumber Description of property interests passing to surviving spouse Amount

1 One-half the value of a house and lot, 256 South West Street, held by decedent and surviving spouse as joint tenantswith right of survivorship under deed dated July 15, 1937 (Schedule E, Part I, item 1) . . . . . . . . . $ 32,500

2 Proceeds of Gibraltar Life Insurance Company policy No. 104729, payable in one sum to surviving spouse (ScheduleD,ltem3) . . . . . . . . . . . . . 20,000

3 Cash bequest under Paragraph Six of will . . . . . . . . . 100,000

Instructions for ScheduleM.-Bequests, etc., toSurviving Spouse (MaritalDeduction)General.-You must complete ScheduleM and file it with the return if you claima deduction on item 18 of Part 5,Recapitulation.

The marital deduction is authorized bysection 2056 for certain propertyinterests that pass from the decedent tothe surviving spouse. You may claim thededuction only for property interests thatare included in the decedent’s grossestate (Schedules A through I).Note: The marital deduction is genera//ynot allowed if the surviving spouse is nota U.S. citizen. The marital deduction isallowed for property passing to such asurviving spouse in a “qualified domestictrust” or if such property is transferred orirrevocably assigned to such a trustbefore the estate tax return is filed. Theexecutor must elect qualified domestictrust status on this return. See theinstructions for line 3 on the followingpage for details on the election.Line 1 .-If property passes to thesurviving spouse as the result of aqualified disclaimer, check “Yes” andattach a copy of the written disclaimerrequired by section 2518(b).Property interests that you may list onSchedule M.-Generally, you may list onSchedule M all property interests thatpass from the decedent to the survivingspouse and are included in the grossestate. However, you should not list any“Nondeductible terminable interests”(described below) on Schedule M unlessyou are making a QTIP election. Theproperty for which you make thiselection must be included on ScheduleM. See “Qualified Terminable InterestProperty” on the following page.

For the rules on common disaster andsurvival for a limited period, see section2056(b)(3).

You may list on Schedule M onlythose interests that the surviving spousetakes:

1. As the decedent’s legatee, devisee,heir, or donee;

2. As the decedent’s surviving tenantby the entirety or joint tenant;

3. As an appointee under thedecedent’s exercise of a power or as ataker in default at the decedent’snonexercise of a power;

4. As a beneficiary of insurance on thedecedent’s life;

5. As the surviving spouse takingunder dower or curtesy (or similarstatutory interest); and

6. As a transferee of a transfer madeby the decedent at any time.Property interests that you may notlist on Schedule M.-You should not liston Schedule M:

1. The value of any property that doesnot pass from the decedent to thesurviving spouse.

2. Property interests that are notincluded in the decedent’s gross estate.

3. The full value of a property interestfor which a deduction was claimed onSchedules J through L. The value of theproperty interest should be reduced bythe deductions claimed with respect toit.

4. The full value of a property interestthat passes to the surviving spousesubject to a mortgage or otherencumbrance or an obligation of thesurviving spouse. Include on ScheduleM only the net value of the interest afterreducing it by the amount of themortgage or other debt.

5. Nondeductible terminable interests(described below).

6. Any property interest disclaimed bythe surviving spouse.Terminable interests.-Certain interestsin property passing from a decedent to asurviving spouse are referred to asterminable interests. These are intereststhat will terminate or fail after thepassage of time, or on the occurrence ornonoccurrence of some contingency.Examples are: life estates, annuities,estates for terms of years, and patents.

The ownership of a bond, note, orother contractual obligation, which whendischarged would not have the effect ofan annuity for life or for a term, is notconsidered a terminable interest.Nondeductible terminable interests.-A terminable interest is nondeductible,and should not be entered on ScheduleM (unless you are making a QTIPelection) if:

1. Another interest in the sameproperty passed from the decedent tosome other person for less thanadequate and full consideration inmoney or money’s worth; and

2. By reason of its passing, the otherperson or that person’s heirs may enjoy

part of the property after the terminationof the surviving spouse’s interest.

This rule applies even though theinterest that passes from the decedentto a person other than the survivingspouse is not included in the grossestate, and regardless of when theinterest passes. The rule also appliesregardless of whether the survivingspouse’s interest and the other person’sinterest pass from the decedent at thesame time. Property interests that areconsidered to pass to a person otherthan the surviving spouse are anyproperty interest that: (a) passes under adecedent’s will or intestacy; (b) wastrarisferred by a decedent during life; or(c) is held by or passed on to anyperson as a decedent’s joint tenant, asappointee under a decedent’s exerciseof a power, as taker in default at adecedent’s release or nonexercise of apower, or as a beneficiary of insurancein the decedent’s life.

For example, a decedent devised realproperty to his wife for life, withremainder to his children. The lifeinterest that passed to the wife does notqualify for the marital deduction becauseit will terminate at her death and thechildren will thereafter possess or enjoythe property.

However, if the decedent purchased ajoint and survivor annuity for himself andhis wife who survived him, the value ofthe survivor’s annuity, to the extent thatit is included in the gross estate,qualifies for the marital deductionbecause even though the interest willterminate on the wife’s death, no oneelse will possess or efioy any part of theproperty.

The marital deduction is not allowedfor an interest that the decedentdirected the executor or a trustee toconvert, after death, into a terminableinterest for the surviving spouse. Themarital deduction is not allowed for suchan interest even if there was no interestin the property passing to anotherperson and even if the terminableinterest would otherwise have beendeductible under the exceptionsdescribed on the following page for lifeestate and life insurance and annuitypayments with powers of appointment.For more information, see Regulationssections 20.2056(b)-1 (fJ and 20.2056(b)-l(g), Example (7).

Page 27

167

Form 706(&v 10-91)

If any property interest passing fromthe decedent to the surviving spousemay be paid or otherwrse satisfied out ofany of a group of assets, the value ofthe property interest is, for the entry onSchedule tvl, reduced by the value ofany asset or assets that, if passing fromthe decedent to the surviving spouse,would be nondeductible terminableinterests. Examples of property intereststhat may be paid or otherwise satisfiedout of any of a group of assets are abequest of the residue of the decedent’sestate, or of a share of the residue, anda cash legacy payable out of the generalestate.

Qualified Terminable Interest Proper-&

Example: A decedent bequeathed$100,000 to the surviving spouse. Thegeneral estate includes a term for years(valued at $10,000 in determtning thevalue of the gross estate) in an officebuilding, which interest was retained bythe decedent under a deed of thebuilding by gift to a son. Accordingly, thevalue of the specific bequest entered onSchedule M is $90,000.Life Estate With Power ofAppointment in the SurvivingSpouse.-A property interest, whetheror not in trust, will be treated as passingto the surviving spouse, and will not betreated as a nondeductible terminableinterest if: (a) the surviving spouse isentitled for life to all of the income fromthe entire interest; (b) the income ispayable annually or at more frequentintervals; (c) the surviving spouse hasthe power, exercisable in favor of thesurviving spouse or the estate of thesurviving spouse, to appoint the entireinterest; (d) the power is exercisable bythe surviving spouse alone and (whetherexercisable by will or during life) isexercisable by the surviving spouse in allevents; and (e) no part of the entireinterest is subject to a power in anyother person to appoint any part to anyperson other than the surviving spouse(or the surviving spouse’s legalrepresentative or relative if the survivingspouse is disabled. See Rev. Rul. 85-351985-l C.B. 328). If these five conditionsare satisfied only for a specific portion ofthe entire interest, see the section2056(b) regulations to determine theamount of the marital deduction.Life Insurance, Endowment, or AnnuityPayments, With Power of Appointmentin Surviving Spouse.-A propertyinterest consistrng of the entire proceedsunder a life insurance, endowment, orannuity contract is treated as passingfrom the decedent to the survivingspouse, and will not be treated as anondeductible terminable interest if: (a)the surviving spouse is entitled toreceive the proceeds in installments, oris entitled to interest on them, with allamounts payable during the life of thespouse, payable only to the survivingspouse; (b) the installment or interestPage 28

payments are payable annually, or morefrequently, beginning not later than 13months after the decedent’s death; (c)the surviving spouse has the power,exercisable in favor of the survivingspouse or of the estate of the survivingspouse, to appoint all amounts payableunder the contract; (d) the power isexercisable by the surviving spousealone and (whether exercisable by will orduring life) is exercisable by the survivingspouse in all events; and (e) no part ofthe amount payable under the contractis subject to a power in any otherperson to appoint any part to anyperson other than the surviving spouse.If these five conditions are satisfied onlyfor a specific portion of the proceeds,see the section 2056(b) regulations todetermine the amount of the maritaldeduction.

is property (a) that passes from the _decedent, and (b) in which the survivingspouse has a qualifying income interestfor life.

The surviving spouse has a qualifyingincome interest for life if the survivingspouse is entitled to all of the incomefrom the property payable annually or atmore frequent intervals, or has ausufruct interest for life in the property,and during the surviving spouse’slifetime no person has a power toappoint any part of the property to anyperson other than the surviving spouse.An annuity is treated as an incomeinterest regardless of whether theproperty from which the annuity ispayable can be separately identified.

The QTIP election may be made for allor any part of a qualified terminableinterest property. A partial election mustrelate to a fractional or percentile shareof the property so that the elective partwill reflect tts proportionate share of theincrease or decline in the whole of theproperty when applying sections 2044 or2519. Thus, if the interest of thesurviving spouse in a trust (or otherproperty in which the spouse has aqualified life estate) is qualifiedterminable Interest property, you maymake an election for a part of the trust(or other property) only if the electionrelates to a defined fraction orpercentage of the entire trust (or otherproperty). The fraction or percentagemay be defined by means of a formula.Line X-Qualified Domestic TrustElection.-The marital deduction isallowed for transfers to a survivingspouse who IS not a U.S. citizen only Ifthe property passes to the survivingspouse in a “qualified domestic trust”(QDT) or if such property is transferredor irrevocably assigned to a QDT beforethe decedent’s estate tax return is filed.

Charitable Remainder Trusts.-Aninterest in a charitable remainder trustwill not be treated as a nondeductibleterminable interest if:

1. The interest in the trust passes fromthe decedent to the surviving spouse;and

2. The surviving spouse is the onlybeneficiary of the trust other thancharitable organizations described insection 170(c).

A “charitable remainder trust” is eithera charitable remainder annuity trust or acharitable remainder unitrust. (Seesection 664 for descriptions of thesetrusts.)Election To Deduct QualifiedTerminable Interests @TIP).-You mayelect to claim a marital deduction forqualified terminable interest property orproperty interests. You make the QTIPelection simply by listing the qualifiedterminable interest property on ScheduleM and deducting its value. You arepresumed to have made the QTIPelection if you list the property anddeduct its value on Schedule M. If youmake this election, the survivingspouse’s gross estate will include thevalue of the “qualified terminable Interestproperty.” See the instructions for line 6of General Information for more details.The election is irrevocable.

If you file a Form 706 in which you donot make this election, you may not filean amended return to make the electionunless you file the amended return on orbefore the due date for filing the originalForm 706.

The effect of the election is that theproperty (interest) will be treated aspassing to the surviving spouse and willnot be treated as a nondeductibleterminable interest. All of the othermarital deduction requirements must stillbe satisfied before you may make thiselection. For example, you may notmake this election for property orproperty interests that are not includedin the decedent’s gross estate.

168

A QDT is any trust:1. That requtres at least one trustee to

be either an individual who is a citizen ofthe U.S. or a domestic corporation;

2. That requires tliat no distribution ofcorpus from the trust can be madeunless such a trustee has the right towithhold from the distribution the taximposed on the QDT;

3. That meets the requirements of anyapplicable regulations; and

4. For which the executor has madean election on the estate tax return ofthe decedent.

To make the election, you mustanswer “Yes” to the question on line 3.Once made, the election isirrevocable.

When listing property on Schedule M,identifv that oropertv for which the QDTelection has ‘been made. Include theemployer Identification number for eachtrust and the names and addresses of alltrustees.

Form 706(&v. 10-91)

The determination of whether a trustqualifies as a QDT will be made as ofthe date the decedent’s Form 706 isfiled. If. however, judicial proceedingsare brouaht before the Form 706’s duedate (in&ding extensions) to have thetrust revised to meet the QDTrequirements, then the determination willnot be made until the court orderedchanges to the trust are made.Line 4.-Section 2056(b)(7) creates anautomatic QTIP election for certain jointand survivor annuities that are includiblein the estate under section 2039. Toqualify, only the surviving spouse canhave the right to receive paymentsbefore the death of the surviving spouse.

The executor can elect out of QTIPtreatment, however, by checking the“Yes” box on line 4. Once made, theelection is irrevocable. If there is morethan one such joint and survivor annuity,you are not required to make theelection for all of them.

If you make the election out of QTIPtreatment by checking “Yes” on line 4,you cannot deduct the amount of theannuity on Schedule M. If you do notmake the election out, you must listthe joint and survivor annuities onSchedule M.How To Complete Schedule M.-Listeach property interest included in thegross estate that passes from thedecedent to the surviving spouse andfor which a marital deduction is claimed.This includes othetwise nondeductibleterminable interest property for which

you are making a QTIP election. Numbereach item in sequence and describeeach item in detail. Describe theinstrument (including any clause orparagraph number) or provision of lawunder which each item passed to thesurviving spouse. If possible, showwhere each item appears (number andschedule) on Schedules A through I.

Enter the value of each interest beforetaking into account the Federal estatetax or any other death tax. The valuationdates used in determining the valueof the gross estate apply also onSchedule M.

If Schedule M includes a bequest ofthe residue or a part of the residue ofthe decedent’s estate, attach a copy ofthe computation showing how the valueof the residue was determined. Include astatement showing:l The value of all property that isincluded in the decedent’s gross estate(Schedules A through I) but is not a partof the decedent’s probate estate, suchas lifetime transfers, jointly ownedproperty that passed to the survivor ondecedent’s death, and the insurancepayable to specific beneficiaries.l The values of all specific and generallegacies or devises, with reference to theapplicable clause or paragraph of thedecedent’s will or codicil. (If legacies aremade to each member of a class, forexample, $1,000 to each of decedent’semployees, only the number in each

class and the total value of propertyreceived by them need be furnished.)l The date of birth of all persons, thelength of whose lives may affect thevalue of the residuary interest passing tothe surviving spouse.l Any other important information suchas that relating to any claim to any partof the estate not arising under the will.Lines 6a, b, and C.-The total of thevalues listed on Schedule M must bereduced by the amount of the Federalestate tax, the Federal GST tax, and theamount of state or other death and GSTtaxes paid out of the property interestinvolved. If you enter an amount forstate or other death or GST taxes onlines 6b or 6c, identify the taxes andattach your computation of them. Foradditional information, see Pub. 904,Interrelated Computations for Estate andGift Taxes.Attachments.-If you list propertyinterests passing by the decedent’s willon Schedule M, attach a certified copyof the order admitting the will toprobate. If, when you file the return, thecourt of probate jurisdiction has enteredany decree interpreting the will or any ofits provisions affecting any of theinterests listed on Schedule M, or hasentered any order of distribution, attacha copy of the decree or order. Inaddition, the District Director mayrequest other evidence to support themarital deduction claimed.

Page 29

169

Form 706 (Rev. 10-91)

Estate of:

SCHEDULE O-Charitable, Public, and Similar Gifts and Bequests -Y e s No

la If the transfer was made by will, has any action been instituted to have interpreted or to contest the will or anyof i ts provisions affect ing the chari table deduct ions claimed in this schedule? . . . . . . . . .If “Yes,” full details must be submitted with this schedule.

b According to the information and belief of the person or persons filing this return, is any such action planned?.If “Yes,” full details must be submitted with this schedule.

2 Did any property pass to charity as the result of a qualified disclaimer? . . . . . . . . .

Ite mnumbs

1

Yes,” attach a copy of the written disclaimer required by section 2518(b)

Name and address of beneficiary Character of institution

Total from continuation schedule(s) (or additional sheet(s)) attached to this schedule . . . . . .

3 Total . . . . . . . . . . .4a Federal estate tax (including section 4980A taxes) payable out of property

interests listed above . . . . . . . . . . . . . .

b Other death taxes payable out of property interests listed above . . . .

c Federal and state GST taxes payable out of property interests listed above.

Amount

d Additemsa,b,andc. . . . . . . . . . . . . . . . 4d

5 Net value of property interests listed above (subtract 4d from 3). Also enter on Part 5, Recapitulation,page3,atitem 19 . . . . . . . . . . . . . . . . . 5

(If more space is needed, attach the continuation schedule from the end of this package or additional sheets of the same size.)(The instructions to Schedule 0 are in the separate instructions.)

Schedule O-Page 30

170

Form 706 (Rev 10-91)

Estate of:

SCHEDULE P-Credit for Foreign Death Taxes

List all foreign countries to which death taxes have been paid and for which a credit is claimed on this return.

If a credit is claimed for death taxes paid to more than one foreign country, compute the credit for taxes paid to one countryon this sheet and attach a separate copy of Schedule P for each of the other countries.

The credit computed on this sheet is for the _________.________...___________________._____..___..............._._.......................(Name of death tax or taxes)

___.. imposed in __________________________....__.___._.._____________________...___.(Name of country)

Credit is computed under the _.__.___.._._._..____._._..__..._.________._.____...._..._......_...................................................(Insert title of treaty or “statute’)

Citizenship (nationality) of decedent at time of death

(Ail amounts and values must be entered in United States money)

Total of estate, inheritance, legacy, and succession taxes imposed in the country named above attributable to propertysituated In that country, subjected to these taxes, and included in the gross estate (as defined by statute)

Va lue o f t he g ross es ta te (ad jus ted , i f necessa ry , acco rd ing to t he i ns t ruc t i ons fo r Item 2)

Value of property situated rn that country, subjected to death taxes imposed in that country, and included In the grossestate (adjusted, if necessary, according to the instructions for item 3) . . .

Tax Imposed by sectlon 2001 reduced by the total credits clalmad under secttons 2010, 2011, and 2012 (see Instructions)

Amount of Federal estate tax attributable to property specified at item 3. (Divide Item 3 by item 2 and multlply the resultbyitem4.).Credit for death taxes imposed in the country named above (the smaller of item 1 or Item 5). Also enter on line 18 ofPart 2, Tax Computation . . . .

SCHEDULE Q-Credit for Tax on Prior Transfers

Part 1 .-Transferor Information

Name of transferor Social security number IRS office where estatelax return was flled

A

Date of death

0

C

Check here b 0 if section 2013(f) (special valuation of farm, etc., real property) adjustments to the computation of the credit were made (seeinstructions).

Part 2.-Computation of Credit (see instructions)

Re mA

Transferor

B CTotal

A, 6, 8 C

1 Transferee’s tax as apportioned (from worksheet,(Ilne 7 : line 8) x line 35 for each column)

2 Transferor’s tax (from each column of worksheet,line 2 0 )

3 Maxlmum amount before percentage requirement(for each column, enter amount from line 1 or 2.whichever is smal ler) . .

4 Percentage allowed (each column) (see instructions)5 Credit allowable (line 3 x line 4 for each column)

6 TOTAL credit allowable (add columns A, B, and Cof line 5). Enter here and on line 19 of Part 2, TaxComputation

(The mstructions to Schedules P and Q are in the separate instructions.) Schedules P and Q-Page 31

171

Form 706 (Rev. 10-91)

SCHEDULE R-Generation-Skipping Transfer TaxNote: To avoid application of the deemed allocation rules, Form 706 and Schedule R should be filed to allocate the GST exemptionto trusts that may later have taxable terminations or distributions under section 2672 even if the form is not required to be filed toreport estate or GST tax.

Part l.-GST Exemption Reconciliation (Section 2631) and Section 2652(a)(3) (Special QTIP) Election

1 Maximum allowable GST exemption. . .

23

Total GST exemption allocated by the decedent against decedent’s lifetime transfers .Total GST exemption allocated by the executor, using Form 709, against decedent’s lifetimetransfers. . . . . . . . . . . .

4 GST exemption allocated on line 6 of Schedule R, Part 2 .

5 G S T e x e m p t i o n a l l o c a t e d o n l i n e 6 o f S c h e d u l e R, P a r t 3

6 Total GST exemption allocated on line 4 of Schedule(s) R-l . . . .

7 Total GST exemption allocated to intervivos transfers and direct Skips (add lines 2-6)

8 GST exemption available to allocate to trusts and section 2032A interests (subtract line 7 fromline 1). . . . . . . . . . . . . .

9-

Allocation of GST exemption to trusts (as defined for GST tax purposes):

A 0 C DGST exemptlon Addhonal GST

allocated on lines 2-6. exemptlon allocatedabove (see instructwx) (see InstructIons)

Check box b 0 if you are making a section 2652(a)(3) (special QTIP) election (see instructions)

Name of trust Trust’sEIN (if any)

9D Total. May not exceed line 6, above . . . . b!?

10 GST exemption available to allocate to section 2032A interests received by individual beneficiaries(subtract line 9D from line 8). You must attach special use allocation schedule (see instructions)

(The instructions to Schedule R are in the separate instructions.)

6

7

Trust’s inclusionrat10 (optIonal-see

InstructIons)

10

Schedule R-Page 32

172

Form 7 0 6 ( R e v. 10-9 1)

Estate of:

Part 2.-Direct Skips Where the Property Interests Transferred Bear the GST Tax onthe Direct Skips

Name of skip person Description of property interest transferred Estate tax value

123

456789

10

Total estate tax values of all property interests listed above .............Estate taxes, state death taxes, and other charges borne by the property interests listed above .GST taxes borne by the property interests listed above but imposed on direct skips other thanthose shown on this Part 2. (See instructions.) .................Total fixed taxes and other charges. (Add lines 2 and 3.) ..............Total tentative maximum direct skips. (Subtract line 4 from line 1.) ...........GST exemption allocated. ........................Subtract line 6 from line 5 ........................GST tax due (divide line 7 by 2.818182). ...................Enter the amount from line 8 of Schedule R, Part 3. ...............

Total GST taxes payable by the estate. (Add lines 8 and 9.) Enter here and on line 22 of the TaxComputation on page 1 , . . . . . . . . . . . . . . . . . . . . . . 10

Schedule R-Page 33

173

Form 706(Rev. 10-91)

Estate of:

Part 3.-Direct Skips Where the Property Interests Transferred Do Not Bear the GSTTax on the Direct Skips

Name of skip person Description of property interest transferred Estate tax value

1 Total estate tax values of all property interests listed above . . . . . . . . . . . . .

2 Estate taxes, state death taxes, and other charges borne by the property interests listed above .3 GST taxes borne by the property interests listed above but imposed on direct skips other than

those shown on this Part 3. (See instructions.) .................4 Total fixed taxes and other charges. (Add lines 2 and 3.) ..............5 Total tentative maximum direct skips. (Subtract line 4 from line 1.) ...........6 GST exemption allocated ........................7 Subtract line 6 from line 5 ........................

8 GST tax due (multiply line 7 by 55). Enter here and on Schedule R, Part 2, line 9. . . . . , 8Schedule R-Page 34

174

SCHEDULE R-l(Form 706)(October 1991)Depanrnanr of the TreawyInternal Revenue SeWce

Generation-Skipping Transfer TaxDirect Skips From a Trust

Payment Voucher

OMB No. 1545-0015Expires 6-30-93

Executor: File one copy with Form 706 and send two copies to the fiduciary. Do not pay the tax shown. See the separate instructions.Fiduciary: See instructions on following page. Pay the tax shown on line 6.Name of trust Trust’s EIN

Name and title of fldwary 1 Name of decedent

Address of ftduclary (number and street) Decedent’s SSN Serwe Center where Form 706 was flied

City. state, and ZIP code Name of executor

Address of executor (number and street) 1 City. state, and ZIP code

Date of decedent’s death Flltng due date of Schedule R. Form 706 (with extensions)

Part l.-Computation of the GST Tax on the Direct Skip

Description of property interests subject to the direct skip Estate tax value

1 Total estate tax value of all property interests listed above ’2 Estate taxes, state death taxes, and other charges borne by the property interests listed above. 2 __3 Tentative maximum direct skip from trust. (Subtract line 2 from line 1.) 34 GST exemption allocated . . . . 45 Subtract line 4 from line 3 . 56 GST tax due from fiduciary (divide line 5 by 2.818182) (See instructions if property will not

bear the GST tax.) . . . . . . . . 6Under penaltIes of perjury. I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief.It IS true. correct, and complete.

Signature(s) of executor(s) Date

Date

Slgnature of fiduciary or officer representing fiduciary Date

Schedule R-l (Form 706)-Page 3!5

176

Form 7 0 6 ( R e v. 10-9 1)

Instructions for FiduciaryPurpose of Schedule R-lCode section 2603(a)(2) provides that the Generation-Skipping Transfer (GST) tax imposed on a direct skipfrom a trust is to be paid by the trustee. Schedule R-l(Form 706) serves as a payment voucher for thetrustee to remit the GST tax to the IRS. See theinstructions for Form 706 as to when a direct skip isfrom a trust.

How To Pay the GST TaxThe executor will compute the GST tax, completeSchedule R-l, and give you two copies. You shouldpay the GST tax using one copy and keep the othercopy for your records.

The GST tax due is the amount shown on line 6.Make your check or money order for this amountpayable to “Internal Revenue Service,” write “GST tax”and the trust’s EIN on it, and send it and one copy ofthe completed Schedule R-l to the IRS Service Centerwhere the Form 706 was filed, as shown on the frontof the Schedule R-l.

When To Pay the GST TaxThe GST tax is due and payable 9 months after thedecedent’s date of death (entered by the executor onSchedule R-l). Interest will be charged on any GSTtaxes unpaid as of that date. However, you have anautomatic extension of time to file Schedule R-l andpay the GST tax due until 2 months after the due date(with extensions) for filing the decedent’s Schedule R,Form 706. This Schedule R, Form 706 due date isentered by the executor on Schedule R-l. Thus, whileinterest will be due on unpaid GST taxes, no penaltieswill be charged if you file Schedule R-l by thisextended due date.

SignatureYou, as fiduciary, must sign the Schedule R-l in thespace provided.

Schedule R-l (Form 706)-Page 36

177

Form 7 0 6 ( R e v. 1 0 - 9 1 )

Estate of:

SCHEDULE S-Increased Estate Tax on Excess Retirement Accumulations(Under section 498OA(d) of the Internal Revenue Code)

m Tax Computation

1

2

Check this box if a section 4980A(d)(5) spousal election is being made. . . . . . b 0You must attach the statement described in the instructions.Enter the name and employer identification number (EIN) of each qualified employer plan and individual retirement account inwhich the decedent had an interest at the time of death:

Plan #lPlan #2Plan #3IRA #1IRA #2IRA #3

Name

3 V a l u e o f d e c e d e n t ’s i n t e r e s t .

4 Amounts rolled over after death . . . .

56

Total value (add lines 3 and 4) .Amounts payable to certain alternate payees (see in-structions) . .

7 Decedent’s investment in the contract under section 72(f)

6 E x c e s s l i f e i n s u r a n c e a m o u n t .

9 D e c e d e n t ’s i n t e r e s t a s a b e n e f i c i a r y .

1011

Total reductions in value (add lines 6, 7, 8, and 9)Net value of decedent’s interest (subtract line 10 fromline 5) . . .

12

13

Decedent’s aggregate interest in all plans and IRAs (add columns A-D of line 11) b

Present value of hypothetical life annuity (from Part Ill, line 4) .

14

15

Remaining unused grandfather amount (from Part II, lrne 4)

Enter the greater of line 13 or line 14 . . . . .

16 Excess retirement accumulation (subtract line 15 from line 12). .

17 Increased estate tax (multiply line 16 by 15%). Enter here and on line 23 of the Tax Computation on

EIN

A 0 C D

page1 . . . . . .I171

(The instructions to Schedule S are in the separate instructions.)

Schedule S -Page 37

178

Form 706 (Rev. 10-91)

m Grandfather Election

Was a grandfather election made on a previously filed Form 5329? . . . . . .If “Yes,” complete lines 2-4 below. You may not make or revoke the grandfather election afterthe due date (with extensions) for filing the decedent’s 1988 income tax return. If “No,” enter-0- on line 4 and skip to Part III.

Initial grandfather amount . . . . . . . . . . . . . . . . .

Total amount previously recovered . . . . . . . . . . . . . . .

Remaining unused grandfather amount (subtract line 3 from line 2). Enter here and on Part I, line 14,onpage37. . . . . . . . . . . . . . . . . . . . . .

m Computation of Hypothetical Lie Annuity

1 Decedent’s attained age at date of death (in whole years, rounded down) ......... _ ’

2 Applicable annual annuity amount (see instructions). 2.................

3 Present value multiplier (see instructions) 3....................

4 Present value of hypothetical life annuity (multiply line 2 by line 3). Enter here and on Part I, line 13,o n p a g e 3 7 . ............................. 4

Schedule S-Page 38

179

Form 706 (Rev. 10-91)

Estate of:

(Make copies of this schedt~le before completing it if you will need more than one schedule.)

CONTINUATION SCHEDULE

Itemnumbc

Continuation of Schedule --(Enter

DescriptionFor securitii. give CUSIP number, if available.

:er of schedc

Unit valueSchBcIrEor~

-pu are wntinu


aAlternate value

Value at date ofdeath or amount

deductible

TOTAL. (Carry forward to main schedule.) . . . . . . . . . . . . .See the instructions on the reverse side. Continuation Schedule-Page 39

180

Form 706 (Rev. 10-91)

Instructions for ContinuationScheduleThe Continuation Schedule on page 39 provides auniform format for listing additional assets fromSchedules A, B, C, D, E, F, G, H, and I and additionaldeductions from Schedules J, K, L, M, and 0. Use theContinuation Schedule when you need to list moreassets or deductions than you have room for on one ofthe main schedules.

Use a separate Continuation Schedule for each mainschedule you are continuing. For each schedule ofForm 706, you may use as many ContinuationSchedules as needed to list all the assets ordeductions to be reported. Do not combine assets ordeductions from different schedules on oneContinuation Schedule. Because there is only oneContinuation Schedule in this package, you shouldmake copies of the schedule before completing it ifyou expect to need more than one.

Enter the letter of the schedule you are continuing inthe space provided at the top of the ContinuationSchedule. Complete the rest of the ContinuationSchedule as explained in the instructions for theschedule you are continuing. Use the Unit valuecolumn only if you are continuing Schedules B or E.For all other schedules, you may use the space underthe Unit value column to continue your description.

To continue Schedule E, Part 2, you should enter thePercentage includible in the Alternate valuation datecolumn of the Continuation Schedule.

To continue Schedule K, you should use theAlternate valuation date and Alternate value columns ofthe Continuation Schedule as Amount unpaid to dateand Amount in contest columns, respectively.

To continue Schedules J, L, and M, you should usethe Alternate valuation date and Alternate valuecolumns of the Continuation Schedule to continue yourdescription of the deductions. You should enter theamount of each deduction in the amount deductiblecolumn of the Continuation Schedule.

To continue Schedule 0, you should use the spaceunder the Alternate valuation date and Alternate valuecolumns of the Continuation Schedule to provide theCharacter of institution information required onSchedule 0. You should enter the amount of eachdeduction in the amount deductible column of theContinuation Schedule.

Carry the total from the Continuation Schedule(s)forward to the appropriate line of the main schedule.

Continuation Schedule-Page 40

181

Appendix V

182

F o r m 709United States Gift (and Generation-Skipping Transfer) Tax Return

(Rev November 1991) (Secton 6019 of the internal Revenue Code) (For gifts made after October 6. 1990. and before January I. 19931 OMB No ,545_oo20

Depanment of the Treasuryinfernal Revenue Sehlce b See separate

1 Donor S first name and mlddle ~nlt~al

t-

I-t

4 Address (number. street. and apanment number) 5 Legal residence (Domicllel

6 City. state. and ZIP code 7 Cltlzenshlp

8 If the donor died during the year. check here b 0 a n d e n t e r d a t e o f d e a t h . . . .._ ..__. .______..._. , 19 _._9 If you recerved an extensron of time to ftle this Form 709. check here b 0 and attach the Form 4668. 2688. 2350, or extension letter

10 Enter the total number of separate donees lrsted on Schedule A-count each person only once q1 la Have you (the donor) prevrcusly frled a Form 709 (or 709-A) for any other year? If the answer IS “No. do not complete line 11 b1 lb If the answer to line 1 la IS “Yes,” has your address changed since you last filed Form 709 (or 709-A)?

12 Gifts by husband or wrfe to third parties-Do you consent to have the grfts (rncludtng generatton-skrpprng transfers) made ’by you and by your spouse to thrrd pa&es dunng the calendar year consrdered as made one-half by each of you? (Seernstructrons ) (If the answer IS “Yes,” the followtng rnformatron must be furnrshed and your spouse must srgn the consent I Ishown below. If the answer is “No.” skip lanes 13-18 and go to Schedule A )

13 Name of consentmg spouse 14 SSN15 W e r e y o u marned t o o n e a n o t h e r d u n n g t h e entrre c a l e n d a r y e a r ? ( S e e r n s t r u c t r o n s . )16 If the answer to 15 IS “No.” check whether 0 mamed 0 drvorced or q widowed, and grve date (see rnstructrons) b17 Will a grft tax return for thus calendar year be filed by your spouse? _,18 COnSent of Spouse- Consent to have the gifts (and generatIon-SkippIng transfers) made by me and by my SpouSe to third parhes during the calendar year

consdered as made one-half by each of US We are both aware of the ]olnt and several liablllty for tax created by the execwon of this consent

C;onsentmg spouse’s signature t Date p

1

2

3

4

5

6

7:3 8=2

9

J IOz; 11

G 12

T 13

: 14

5 15

L 16

E n t e r t h e a m o u n t f r o m S c h e d u l e A . P a r t 3 . lrne 1 5

E n t e r t h e a m o u n t f r o m S c h e d u l e B. tme 3

T o t a l t a x a b l e grfts ( a d d lanes 1 a n d 2 )

Tax computed on amount on lrne 3 (see Table for Computing Tax in separate Instructtons).

Tax computed on amount on ltne 2 (see Table for Computtng Tax In separate Instructtons).

B a l a n c e ( s u b t r a c t lrne 5 f r o m line 4 )Maxrmum untfied credit ( n o n r e s i d e n t aliens. s e e Instructtons)

Enter the unrfied credtt agatnst tax allowable for all prror periods (from Sch. 8, lrne 1, cot. C)

B a l a n c e ( s u b t r a c t l i n e 8 f r o m lrne 7 )

Enter 20% (.20) of the amount allowed as a spectftc exemptton for grfts made after September 8.1 9 7 6 , a n d b e f o r e J a n u a r y 1, 1 9 7 7 ( s e e Instructtons)

B a l a n c e ( s u b t r a c t lrne 1 0 f r o m ltne 9 )

Umfied c r e d i t ( e n t e r t h e s m a l l e r o f ltne 6 o r lrne 1 1 )

Credrt f o r f o r e i g n g i f t t a x e s ( s e e i n s t r u c t i o n s )

T o t a l credtts ( a d d lanes 1 2 a n d 1 3 )

B a l a n c e ( s u b t r a c t ltne 1 4 f r o m ltne 6 ) ( d o n o t e n t e r l e s s t h a n z e r o )

Generation-skippmg transfer taxes (from Schedule C. Part 3. col. H. total)

17 T o t a l t a x ( a d d lanes 1 5 a n d 16).18 Gift and generatton-sktpptng transfer taxes prepard wtth extension of time to file

19 If irne 18 IS less than lrne 17 , en te r BALANCE DUE (see rns t ruc t rons)

1 j

i:”Y

ki20 If kne 18 IS greater than ltne 17. enter AMOUNT TO BE REFUNDED ( 20 1

5 Under penalties of penury. I declare that I have examwwd this return. lncludlng any accompanying schedules and statemen:s. and to the best of my knowledgeand belief It is true. correct, and complete De&&on of preparer (other than donor) IS based on all lnformallon of which Preparer has any knowledge.

zz

g Dono r’s Sfgnature W

?i

Date b

Preparer’s signature$ (other than donor) +

4

Date b

Q Preparer’s address(other than donor) b

For Paperwork Reduction Act Notice , s e e page 1 of th e s e parate ins tructions for th is form . Cal No 16763M F o r m 709 (Rev 1 f-91)

183

Form 709 (Rev 1 l-91) Page 2

Part l . -Gi f ts Subiect Onlv to Gift Tax. C‘<fts /es: J,t:za/ .Y:._, ;.?l!on. medml. and educational exclwons-see mstfucbonsA

Itemnumbf

1

BDon&s lame. relatlorship lo don01 [lf any) Ind address and

descrlptlon of gtft If Ihe gift was made oy r- -r 2 ‘ws1 enter frus1’stdentifylng number below al?d attach a ,cop) JI :T. ust wJrument If

the gift was secuwes. enter the CUSIP number(s). 11 avatlable

CDonor’s adjusted

basks of glfi

DDateof g1n

EValue at

date of glfl

Part 2.-Gifts Which are Direct Skips and are Subject to Both Gift Tax and Generation-Skipping Transfer Tax. You must list the giftsin chronological order. Gffb less po/Wa/ organization, medical, and educational exclusions-see instruchons. (Also list here direct skipsthat are sub/ect only to the GST tax at this time as the result of the termination of an “estate tax mclusion period.” See’instructions.)

AItem

number

BDonee’s name, relatlonshlp lo donor (If any), and address and

descrlptlon of gift If the gift was made by means of a trus1, enter trust’sidentifying number below and attach a copy of the trust Instrument. If

the glfi was securltles. enter the CUSIP number(s), 11 avaIlable.

CDonor’s adlusted

basis of glfi

1

l-D

Dateof glh

EV: ‘ue at

date of glfl

Part X-Gift Tax Reconciliation

1 Total value 71 p#ft? of donor (add column E of Parts 1 and 2) 1-2 One-half of Items __. _. __... ._._.. _... attributable lo spouse (see lnstruct’ons) 2

3 Balance (subtract line 2 from ltne 1) . 34 Gifts of spouse to be ~rclur?cd Yr Vhedulc n, ?rt 3. line 2 of spouse’s return-see mstri~r’ 9ps: 4

If any of the gifts Included on this lme are also subject to the generatIon-sklppmg transfer tax, checkhere F 0 and enter those gifts also on Schedule C. Part 1.

5 T o t a l gifts ( a d d lines 3 a n d 4 )G -u_ a,,;‘\.,L I,X~ ‘..sii s ‘2’ cd ?: lIsted on 3, _ ;:lle A (mcludlrs:J I;# ,2 ;, ,iL 3) \c‘;-: jnstruct;ons)7 T o t a l I n c l u d e d a m o u n t o f gifts ( s u b t r a c t line 6 f r o m l i n e 5 )

Deductions (see mstructlons)

8 Gifts of Interests to spouse for which a marltal deduction will be claimed, basedon Items ._.. ._. __. ..of Schedule A

9 E x c l u s i o n s attnbutable t o gifts o n lme 810 Marital deductIon-subtract line 9 f r o m line 8

11 Charttable deductlon. b a s e d o n Items t o _. .less exclusions

12 T o t a l deductlons-add lines 1 0 a n d 1 1

13 Subtract line 12 from line 7

(If more space is needed, attach addmona/ sheets of same size.)

184

Form 709 (Rev 11-91) Page 3

16 Terminable Interest @TIP) Marital Deduction. (See instructions.)

If a trust (or other property) meets the requIremen& of quaIlfled terminable Interest property under sectIon 2523(f~ and

a. the trust (or other property) IS Itsted on Schedule A, and

b. rhe value of the trust (or other property) IS entered In whole or II- par-l as a deductIon on line 8. Part 3 of Schedule A.

then the donor shall be deemed to have made an election to have such trust (or other property) treated as quaIlfled terminable Interest propertyunder section 2523(fl

If less than the entlre value of the trust (or other property) that the donor has Included in Par-l 1 of Schedule A IS entered as a deductIon online 8. the donor shall be considered to have made an electlon only as lo a fraction of the trust (or other property). The numerator of lhls fracttonIS equal to the amount of the trust (or other property) deducted on llne 10 of Part 3. The denominator IS equal to the total value of the trust (orother property) Ned in Part 1 of Schedule A.

If you tnake the OTIP electlon (see mstructlons for line 8 of Schedule A), the terminable Interest property Involved WIII be Included in yourspouse’s gross estate upon his or her death (sectton 2044). If your spouse disposes (by gift or otherwlse) of all or part of the qualifying ltfeIncome Interest. he or she WI/I be consldered to have made a transfer of the entlre property that IS subject to the gift tax (see Transfer of CertainCafe Estates on page 3 of the mstructlons)

17 Election out of QTIP Treatment of Annuities

0 l Check h’ere if you elect under section 2523(f)(6) NOT to treat as qualified termmable Interest property any lolnt and survivor annuities thatare reported on Schedule A and would otherwIse be treated as quaIlfled termmable Interest property under sectlon 2523(f) (See InstructIons.)Enter the Item numbers (from Schedule A) for the annultles for which you are makmg this election b

If you answered “Yes” On line Ila Of Page 1, Part 1, see the instructions for completing Schedule B. If your answer is 4zNo,” skip to theTax Computation on Page 1 (or Schedule C, if applicable).

ACalendar year orcalendar quarter,see InStruCtIO”S)

I-c

I

BInternal Revenue OffIce

where prior return was flied

cAmount of unlfled

credit agafnst gift taxfor periods after

December 31. 1976

DAmount of speclflcexemption for prior

periods endIng beforeJanuan, 1, 1977

T

t

EAmount of

taxable gifts

1 Totals for prior periods (without adlustment for reduced speclflc 1exemptIon), I 1

2 A m o u n t . if any by which total specific exemptton. line 1. column D. IS more than $30 .000 23 Total amount of taxable gifts for prior periods (add amount. column E. line 1. and amount. If any, on

l i n e 2 ) ( E n t e r h e r e a n d o n lme 2 o f t h e T a x Computation o n p a g e 1.) 3

7

(If more space is needed, attach add/t/anal sheets of same s/ze.)

185

Form 709 (Rev 11-91) Fqe 4

Note: Inter vivos direct skips which are completely excluded by the GST exemption must SW be fuliy reported(including value and exemptions claimed) on Schedule C.

A 6Item NO. Value

(from Schedule A, (from Schedule A.Part 2 col. A) Part 2. coi E)

Part 1 .-Generation-Skipping Transfers

1

2

3

4. . . . . . . . . . . . . . . ..____..........___________5

6If you elected gtft spllttlng and your spousewas required to file a se&ate Form 709(see the lnstructlons for “Split Gifts”). youmust enter all of the g!fts shown onSchedule A. Part 2, of your spouse’s Form709 hereIn column C. enter the Item number of eachgtfi I” the order It appears I” column A ofyour spouse’s Schedule A, Part 2. We havepreprInted the prefix “S-” lo dlstmgulsh yourspouse’s Item numbers from your own whenyou complere column A of Schedule C. Part3.In column D. for each gift enter the amountreported !n column C. Schedule C. Part 1. of

cSpM Gifts

(enter ‘% of col. B)(see Instrucllons)

D E *Subtract col. C Nontaxable

from COI. B portion of transfer

FNet Transfer

(subtract co1 Efrom co! D!

I I I

Split gifts from Value Includedspouse’s Form 709 from spouse’s(enter Item number) Form 709

INontaxable Net !ransfer

porlion of transfer isubrract col Ej from col DI

S-. . . . . . . . . . . . . . . . . . . . . . J . . . . . . . . . . . . . . . l..........._.___..__ 1s-. . . . . . . . . . . . . . . . . . J . . . . . . . . . . . . . . . . . . . J .._..___._ ____...._ 1.s-. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .._.......s-

your spouse’s Form 709. S-Part P.-GST’Exemption Reconciliation (Code section 2631) and Section 2652(a)(3) Election

Check box b 0 if you are making a section 2652(a)(3) (special QTIP) election (see InstructIons) I I

Enter the item numbers (from Schedule A) of the gifts for which you are making this electlon b _. _. _.1 MaxImum allowable exemption . .

2 T o t a l e x e m p t i o n u s e d f o r p e r i o d s b e f o r e f i l i n g t h i s r e t u r n

3 E x e m p t i o n avallable f o r this r e t u r n ( s u b t r a c t line 2 f r o m lme 1 )

4 E x e m p t i o n c l a i m e d o n this r e t u r n ( f r o m P a r t 3 . col. C t o t a l . b e l o w ) ~ 4 I5 Exemption allocated to transfers not shown on Part 3. below. You must attach a Notlce of AllocatIon. (See j i

instructions.) . 5

6 Addlines4and5 . .

7 E x e m p t i o n a v a i l a b l e f o r f u t u r e t r a n s f e r s ( s u b t r a c t l i n e 6 f r o m line 3 ) 7

Part 3.-Tax ComputationI-

A BItem No. Net transfer

(from Schedule (from Schedule C.C. Part 1) Par7 1. col F)

1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2

3. . ..-..............................45

C DE F G H

GST ExemptIon Dlvlde col. C lncluson Rat10(subtract col D Maxtmum Estate Applicable Ra te ,_ GeneratIon-Sklpplrg

Allocated bycol E from 1 .OOO) Tax Rate ; (mu l t ip ly 201 E Transfer Taxby col F) Imultiply col B b y CO, Sl

--...-........____..__.______._._..6

. . . . . . . . . . . . .._..._._______......_.

. . . . . . . . . .._............._..____

Total exemption claimed. Enterhere and on line 4. Part 2.above. May not exceed line 3,P a r t 2 , a b o v e . .L

Total generation-skipping transfer tax. Enter here. on line 14 ofSchedule A, Part 3, and on line 16 of the Tax Computation on ,

Ipagel. . /(If more space is needed, attach addItiona/ sheets of same sac.) ‘U.S. Government Pnntlng Cika: ,991 - 61%72%40489

186

Haney, Harry L., Jr.; Siegel, William C. 1993. Estateplanning for forest landowners: what will become of yourtimberland? Gen. Tech. Rep. SO-97. New Orleans, LA:U.S. Department of Agriculture, Forest Service, SouthernForest Experiment Station. 186 p.

This book’s purpose is to provide guidelines and assistanceto nonindustrial private woodland owners in applying estateplanning techniques to their forest properties.

Keywords: Estate tax, estate valuation, forest estate, gifttax, timber estate.

The policy of the United States Department of Agriculture Forest Serviceprohibits discrimination on the basis of race, color, national origin, age, religion,sex, or disability, familial status, or political affiliation. Persons believing they havebeen discriminated against in any Forest Service related activity should write to:Chief, Forest Service, USDA, P. 0. Box 96090, Washington, DC 20090-6090.

Q “-8. ammm.m?r PRIWI@E OmIa: 1994-566-738

United StatesDepartment of Agriculture

Forest Service

Southern ForestExperiment Station701 Loyola Ave., Rm.T-10210New Orleans, LA 70113-1931

OFFICIAL BUSINESSPenaity for Private Use $300

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Estate Planning for Forest Landowners - Southern … · Estate Planning For Forest Landowners ... This book has been written to assist nonindustrial ... only the decedent can address