Significant
changes in Federal individual income tax and estate and gift tax
policies have occurred over the last few years. Since the Federal
individual income tax imposes the largest tax burden on the broadest
group of farmers and the Federal estate tax can affect the ability
to transfer the farm operation to the next generation, these changes
are of considerable importance to the farm community. Modifications
to these tax policies can affect not only the financial well-being
of farm households but also the number and size of farms, their
organizational structure, and their use of land, labor, and capital
inputs.
Federal tax code
changes affecting both individual and business income taxes have
reduced average tax rates for all farm households, but the effects
of these changes vary by type of farm. Commercial farm households
are the primary beneficiaries of many of the business tax provisions,
including increased capital expensing and a new deduction for manufacturers,
which is defined to include farmers.
Changes to Federal estate tax policies have raised the value
of property that can be transferred to the next generation
free of the estate tax to $1.5 million in 2005, and tax rates have
been reduced. This has reduced the number of estates required to
pay tax and the amount of taxes owed. Despite these changes and
targeted relief to farmers and owners of small businesses, because
of appreciating land values and increasing farm size, a larger
share of farm estates are subject to the Federal estate tax. While
about 1 percent of all estates currently owe Federal estate tax,
between 3.5 and 4 percent of all farm estates and nearly 18 percent
of commercial farm estates currently owe estate taxes. While existing
law provides for the phase-in of additional reductions in Federal estate taxes,
considerable uncertainty clouds the longrun effects of these changes due to
the scheduled 1-year repeal of the tax in 2010 and a reversion to 2001 law
in 2011.
The frequent revisions of the Federal tax code have added to its
complexity, especially since many of the recent changes have been
phased-in or are temporary. This effect has increased support for
tax simplification efforts or even fundamental reform of the Federal
tax system. The President has made tax reform a priority policy
initiative and has appointed a commission to make recommendations
for reform by November 2005. Fundamental reform could have important
consequences for both the tax compliance burden and the financial
well-being of farm households.
Individual Income and Business
Taxes Reduced
Tax relief measures enacted in each of the last 4 years have reduced
Federal income taxes for both individual and business taxpayers.
For individual taxpayers, this legislation has reduced marginal
income tax rates, increased standard deduction allowances, lowered
tax rates on capital gains and dividends, increased savings incentives,
and raised child and earned income credit amounts. Federal tax policies
affecting businesses have also been modified, including reduced
tax rates on business investment and manufacturing income.
Since most farms are operated as sole proprietorships, partnerships,
or small business corporations, most farm income is taxed as individual
income rather than as corporate income. As a result, farmers and
many other small businesses are major beneficiaries of recent tax
changes since they benefit not only from the lower individual tax
rates and other changes aimed at all taxpayers but from faster
writeoff of investment in machinery, equipment, and other eligible
capital purchases and the newly enacted manufacturers’ deduction.
The cumulative effect of these Federal tax policy changes has resulted
in the lowest Federal tax burden on farm income and investment in decades.
The average tax rate has been reduced from 18 percent in 2000 to about
14 percent for 2005. Like all households, about one out of every three
farm households now owe no Federal income tax, with some actually receiving
a refundable child or earned income credit. Nearly all farm households
have realized some tax savings as a result of the changing Federal tax
policy environment.
Impact Varies by Farm Type
Since the household is the typical
unit of taxation, farm and nonfarm income are combined when computing Federal
income taxes for farm households. In fact, most Federal income tax paid
by farm households can be attributed to nonfarm income. Since 1980, farmers
have reported negative aggregate net farm income for tax purposes. In 2000,
farm sole proprietorships reported total taxable gross farm business income
over $91 billion but reported aggregate net farm operating losses of $9
billion. One-third of all farm sole proprietorships reported profits of
$8.3 billion but the other two-thirds reported losses of $17.3 billion.
About half of all partnerships and small farm business corporations also
reported losses.
Examining these losses by farm type provides some additional insight on
the effects of tax code changes. ERS classifies farms as rural residence
farms (lifestyle, retirement, and limited resource farms), intermediate
farms (sales less than $250,000 and primary occupation is farming), and
commercial farms (sales greater than $250,000). Nearly $10 billion of the
$17.3 billion in losses reported can be attributed to rural residence farms,
with three out of four reporting a loss. Still, these farm households on
average reported adjusted gross income of just over $73,000.
The fact that many rural residence and intermediate farms report losses
should not suggest that changes to those tax policies affecting farm income
and investment are unimportant. In most instances, losses arising as a
result of these changes can be used to reduce the taxes on income from
other sources. However, since rural residence and many intermediate farm
households derive most of their income from nonfarm sources, these farm
households are primarily affected by the changes in individual marginal
income tax rates, standard deduction and other exemption amounts, and those
policies affecting the tax treatment of income from nonfarm sources.
Commercial farms account for about two-thirds of farm sales and nearly
half of farm investment. These farms are the primary beneficiaries of
the tax changes affecting farm business income and investment. The most
significant changes over the last few years include reduced capital gains
tax rates, increased capital expensing, and the new manufacturers’ deduction.
The reduced tax rate of 15 percent on capital gains (5 percent for taxpayers
in the 15-percent-or-lower income tax brackets) is especially significant
for farmers. Capital gains are a key component of income for many farmers
since assets used in farming are eligible for capital gains treatment and
the amount of capital gains is increased by the ability to deduct certain
costs, especially for livestock. According to the Internal Revenue Service
(IRS), 40 percent of all farmers report some capital gains, nearly double
the share for all taxpayers. The average amount of capital gain reported
by farmers is about 50 percent higher than the average capital gain reported
by other taxpayers. Over 60 percent of commercial farmers report capital
gain income, and these farms account for 25 percent of all capital gains
reported by farmers.
Farming requires large investments in farm machinery, equipment,
and other capital. The tax treatment of these investments is of
considerable importance to the farm sector, especially commercial
farmers. Prior to the Economic Growth and Taxpayer Relief Reconciliation
Act of 2001, capital purchases were eligible for an immediate expensing
of $25,000. Investments above this amount were required to be depreciated
over a specified recovery period. The 2001 Act added a temporary
30-percent first-year allowance. The Jobs and Growth Tax Relief
Reconciliation Act of 2003 increased the bonus first-year depreciation
from 30 to 50 percent of eligible investment and, more importantly,
raised the amount of investment that can be expensed from $25,000
to $100,000. The temporary first-year bonus depreciation allowance
has expired but the expensing provision was extended through 2007
by the American Jobs Creation Act of 2004. The amount is adjusted
for inflation and is equal to $105,000 for 2005. Less than 10 percent
of residential and intermediate farms invest more than $25,000,
compared with over 40 percent of commercial farms. Most farmers
will be able to deduct their entire 2005 capital investments. This
increased capital expensing allowance reduces the effective tax
rate on farm capital and greatly simplifies the recordkeeping burden
associated with the deprecation of capital purchases, with commercial
farmers the primary beneficiaries.
One of the most important business changes in the 2004 Act was the replacement
of the foreign sales corporation/ extraterritorial income provisions, which
allowed U.S. exporters to exclude a portion of their foreign sales income,
with a new deduction for U.S. manufacturers. This exclusion had been declared
a prohibited export subsidy by the World Trade Organization (WTO). It was
replaced to avoid retaliatory tariffs, but a recent WTO ruling regarding
the phaseout of benefits under the old law raises the possibility that
the tariffs could be reimposed. While few farm households directly benefited
from the prior exclusion, about one out of five farm households will
directly benefit from the new deduction. The deduction is equal to 3
percent of qualifying production income in 2005. It increases to 7 percent
in 2007-09 and 9 percent in 2010. The deduction is limited to no more
than 50 percent of wages paid to hired labor. While this limitation will
reduce the deduction for many smaller farms that hire little or no labor,
farm households are expected to be eligible to deduct about $800 million
in 2005 and nearly $2 billion in 2010. Commercial farm households are
the primary beneficiaries, with about two-thirds expected to benefit
with an average deduction estimated at $6,900. While commercial farms
account for only about 7 percent of all farms, they will receive about
75 percent of all benefits from the manufacturing deduction.
Federal Estate Taxes Lowered…
Since 1916, the Federal
estate tax has applied to the transfer of property at death. While
the tax has been amended many times, the estate tax and the companion
gift tax imposed upon transfers prior to death have historically accounted
for only a relatively small share of total Federal revenues. In 2005,
these taxes are projected to account for less than 1 percent of total
Federal tax revenue. While the aggregate importance of Federal estate
and gift taxes is small relative to other Federal Government revenue
sources, the potential effect of these taxes on farmers and other small
business owners has been a major concern among policymakers. Over the
years, this has led to the enactment of a number of targeted provisions,
including a special use value provision that allows farm real estate
to be valued at its farm use value rather than its fair market value.
Farmers and certain other closely held businesses are also permitted
to pay their taxes over a 15-year period instead of the normal 9 months
following the date of death.
Providing tax relief to farmers and other small business owners
was also an impetus for changes to Federal estate and gift tax policies
in the Taxpayer Relief Act of 1997 and the Economic Growth and Taxpayer
Relief Reconciliation Act of 2001. These changes provided a new
deduction for family-owned businesses, reduced tax rates, and increased
the amount of property that can be transferred to the next generation
free of Federal estate tax to $1.5 million for 2005. As a result
of this increase, only about 1 percent of all estates are expected
to owe Federal estate tax in 2005. It has been estimated that about
twice as many estates of small business owners are subject to the
Federal estate tax.
An even larger share of farm estates owes Federal estate tax. The
appreciation in land values, the increase in average farm size,
and the rising investment in farm machinery and equipment have increased
farm estate values and taxes. Based on simulations using farm-level
survey data, about 9 percent of the 34,397 projected farm estates
for 2005 are estimated to have assets in excess of $1.5 million
and would be required to file an estate tax return. After deductions,
between 3.5 and 4 percent of all farm estates would be taxable.
The total amount of Federal estate taxes in 2005 is estimated at
$873 million. The average tax due for those who owe is about $660,000.
These taxable farm estates have an average net worth of $3.5 million,
with about two-thirds of the net worth attributable to farm business
assets, primarily farm real estate.
…but Larger Share
of Commercial Farms Owe Federal Estate Taxes
The potential impact of the Federal estate tax varies by farm type.
While only about 3 percent of all rural residence and intermediate
farm estates are projected to owe any Federal estate taxes in 2005,
a much larger share of commercial farm estates are projected to
owe tax. Commercial farms continue to increase in size. From 1996
to 2003, during which tax code changes initiated a gradual increase
in the amount of property that can be transferred free of estate
tax, the average number of acres operated by commercial farms increased
by about 25 percent, from just over 1,500 to nearly 1,900. This
increase in size and the continued strong appreciation in land values
combined to boost the average value of land and buildings for commercial
farms by about two-thirds to nearly $1.3 million in 2003. These
trends have continued in 2004 and 2005.
Thus, despite estate tax relief targeted to farmland (special use
valuation), increasing farm size and appreciating land values continue
to subject a larger share of commercial farm estates to the Federal
estate tax. For 2005, an estimated 18 percent of all commercial
farm estates will owe Federal estate taxes. These farms are six
times more likely to owe Federal estate taxes than other farms
and nonfarm small businesses. On average, commercial farm estates
are expected to owe over $1.1 million in Federal estate taxes.
While these farms represent only about 4 percent of all farm estates,
they account for about one-third of all Federal estate taxes paid
by farm estates.
Existing Law Provides for Future Tax Reductions
and Uncertainty
Under the 2001 Act, the amount of property
that can be transferred free of estate tax will continue to increase.
The exempt amount is scheduled to increase to $2 million in 2006
and to $3.5 million in 2009. At this level, about 1 percent of
farm estates will owe Federal estate tax in 2009, with total Federal
estate taxes expected to be cut in half, compared with the 2005
level. Commercial farm estates will be the primary beneficiaries
of these changes.
The estate tax is scheduled to be repealed completely in 2010.
However, since the 2001 changes are scheduled to sunset in 2011,
this repeal is only temporary. The resurrected tax in 2011 reverts
to the law in place prior to the 2001 changes. As a result, the
exempt amount would return to $1 million and the top tax rate would
increase to 55 percent. The special deduction for qualified family-owned
businesses would also be available again. This reversion is estimated
to result in as many as 10 percent of all farm estates and about
25 percent of commercial farm estates owing Federal estate tax.
This phase-in of the increased exempt amount and the repeal and
reversion to 2001 law raises concerns regarding the equity of such
disparate treatment for similar estates depending upon the date
of death. It also causes considerable uncertainty for estate planning
purposes.
This uncertainty is compounded by changes in the treatment of unrealized
capital gains at death that are scheduled to become effective with
estate tax repeal. Under current law, the basis (which is the value
used to determine gain or loss) of assets acquired from a decedent
are stepped up to their fair market value at the date of death.
This “step-up in basis rule” essentially
eliminates the capital gains tax on increases in the value of property
not realized before death. The repeal of the estate tax is coupled
with the repeal of the step-up in basis rule. In 2010, the step-up
in basis rule is replaced with a carryover of the decedent’s
basis with an added exemption of $1.3 million (plus an additional
$3 million for transfers to a surviving spouse) that can be allocated
among the various inherited assets with unrealized appreciation.
This change will add to the compliance burden since it would be
necessary to determine the cost or other basis of inherited assets.
In farming, these assets may have been held for several years with
limited documentation with regard to cost or even how they were
acquired. Some farm estates that would owe no Federal estate tax
or capital gains tax under current law would be faced with this
compliance burden and could even owe capital gains taxes upon the
sale of the inherited assets. The combination of no estate tax
and potential capital gains taxes could increase the amount of
farm assets transferred to the next generation and encourage the
heirs to continue to hold the transferred assets to avoid capital
gains taxes.
While repeal and resurrection of the estate tax is still several
years away, there is increasing interest in either permanent repeal
or a substantial permanent increase in the exempt amount combined
with the retention of the stepped-up basis at death treatment for
inherited assets. Addressing the issue now would reduce some of
the uncertainty and inequity created by the phase-in and sunset
provisions under existing law.
