farm transition planning

Second marriages present unique challenges for farm transition planning.  This is especially true when the second marriage occurs later in life and the spouses have accrued significant assets and/or have children from prior marriages.  The spouses in a second marriage obviously want to help provide for each other but may have a competing interest of providing for their children but not necessarily stepchildren.  Without good planning, it is possible that farm assets will end up with a spouse or stepchildren who were not involved in the farming operation.

One of the challenges with second marriages occurs when one or both spouses have children from a prior marriage.  The spouses usually intend to provide adequate income to the surviving spouse upon the death of the first spouse to pass away.  Also, the spouses will usually want some or all of their assets to ultimately go to their children, not their spouse’s children.  So, the issue becomes, how to establish a plan to take care of the surviving spouse while ensuring the deceased spouse’s assets go to their own children?

Consider the following example, a typical second-marriage, farm transition scenario:  

Mark and Mindy each have two children from previous marriages.  Mark has farmed his entire adult life and built a large farming operation prior to marrying Mindy.  Mindy has two children and is not involved in the farming operation.  Mark’s two children plan to take over the farming operation.  If Mark dies before Mindy, he wants to make sure Mindy has adequate income for the rest of her life.  However, he wants his assets to be inherited by his children and not Mindy’s children.

Let’s first look at what poor planning might look like.  If Mark and Mindy do not have an estate plan or a simple estate plan where everything goes to the surviving spouse then to the children, Mindy’s children could end up with some or all of Mark’s assets.  In this scenario, if Mark dies first, all of his assets will go to Mindy.  At that point, Mindy will have total control of the assets and could sell them all or leave them all to her children.  For second marriages, no plan or a simple plan is usually not adequate to meet the goals of a farm transition plan.

The better plan is to use a trust.  A trust can hold the deceased spouse’s assets for the surviving spouse’s life, thus providing income.  Then, at the surviving spouse’s death, the assets are distributed to the deceased spouse’s children.  The surviving spouse never has ownership of the deceased spouse’s trust assets, so the assets are never in danger of ending up with the surviving spouse’s children.

Continuing the previous example, Mark establishes a trust with the following terms: 

“Upon my death, my farm assets shall be held in trust for the life of Mindy.  While held in trust for Mindy, my Trustee shall distribute all income to Mindy.  Upon the death of Mindy, my Trustee shall distribute the assets to my children.”  

These trust provisions will meet Mark’s goals of providing for Mindy while having his children eventually inherit his assets.  

Sometimes we may want some assets to go directly to the deceased spouse’s children at death and some held in trust.  This is very common for farm plans.  When children will be taking over the farming operation, we may not want to tie up the operating assets in trust but instead have those go directly to the farming children.  To implement this plan, the trust may have provisions similar to the following: 

“Upon my death, my Trustee shall distribute all my farm machinery, grain, crops and other farm operating assets to my children.  The remainder of my assets, including my farmland, shall be held in trust for Mindy.  While held in trust for Mindy, my Trustee shall distribute all income to Mindy.  My Trustee shall offer to lease the farmland to my children for 80% of the county cash rent average.  Upon the death of Mindy, my Trustee shall distribute all remaining trust assets to my children.”

These trust provisions allow the farming operation to be inherited directly by Mark’s children, allowing a seamless transfer of the farming operation.  The farmland is held in trust and leased by the children.  The rental income from the farmland is provided to Mindy for the remainder of her life.

A third variation provides some assets outright to the children, some assets outright to the surviving spouse and some assets held in trust.  This type of plan might be used when the spouses wish for some assets to go directly to the surviving spouse, without being held in trust.  This is often done with cash or other financial accounts to provide immediate and freely available money to the surviving spouse.  Trust provisions reflecting this type of plan may be as follows:

“Upon my death, my Trustee shall distribute all my farm machinery, grain, crops and other farm operating assets to my children.  My Trustee shall distribute my First National Bank account and Acme Financial Account to Mindy, outright and free of trust.  The remainder of my assets, including my farmland, shall be held in trust for Mindy.  While held in trust for Mindy, my Trustee shall distribute all income to Mindy.  My Trustee shall offer to lease the farmland to my children for 80% of the county cash rent average.  Upon the death of Mindy, my Trustee shall distribute all remaining trust assets to my children.”

These trust provisions provide cash to Mindy for which she has immediate access and control.  The farm assets continue to go directly to the children so that they can continue the farming operation and the farmland is held in trust to provide income for Mindy.

In conclusion, a trust can be designed with a great deal of flexibility and creativity. The surviving spouse can be provided with adequate income while protecting the assets for the deceased spouse’s children.  A simple transition plan or no plan at all can result in some or all the deceased spouse’s assets being inherited by the surviving spouse’s children.  Trusts are often an important component of a farm transition plan for second marriage scenarios.

In Part 2, we will discuss prenuptial and postnuptial agreements.

One of the primary challenges for a retiring farmer is the large tax burden that retirement may cause.  Throughout their farming careers, farmers do a good job of managing income taxes, in part, by delaying sales and prepaying expenses.  This strategy works well while the farm is operating but can cause significant tax liability upon retirement.  The combination of a large increase in revenue from the sale of assets and little or no expenses to offset the revenue can cause a retiring farmer to be pushed into high tax brackets.  It is not unusual for 40% or more of the sale proceeds from a retirement sale to go to taxes.  One strategy to reduce income tax liability at retirement is a Charitable Remainder Trust (CRT).  A CRT can be an effective way of managing income taxes at retirement, but it is not for everyone. 

A CRT is a charitable trust because at least some of the assets in the CRT must eventually pass to a qualified U.S. charitable organization such as a church or 501(c)(3) corporation.  This charitable nature of the CRT is central to the CRT strategy.  As a charitable trust, the CRT may sell assets without paying tax on the sale.  So, instead of the retiring farmer selling assets in their own name, they donate the assets to the CRT and then the CRT sells the assets.  The retiring farmer then receives an income stream from the CRT.  After a period of time, the income stream stops and the remaining trust assets are contributed to the named charity.  The following are the steps of the CRT strategy:

1. Assemble a team of advisors and develop a CRT strategy.
2. Donor establishes a CRT.  The trust document declares the income beneficiaries and the charitable beneficiaries. 
3. Donor determines the assets to be contributed to the CRT.
4. Donor contributes assets into the CRT, typically grain, machinery and/or livestock.
5. The CRT sells the assets but does not pay tax.
6. The Trustee of the CRT uses the sale proceeds to establish an annuity.  The annuity must be designed to provide at least 10% of the sale proceeds to the charity.
7. The annuity pays out to the Donor over a number of years.  The Donor pays income tax on the annuity distributions.
8. When the trust is terminated, the charity is paid the remaining assets.

Consider the following example to help further explain how a CRT strategy works:

Farmer decides to retire at the end of the 2023 crop year.  After harvesting the 2023 crop, Farmer owns $1 million of grain and $1.5 million of farm equipment.  Farmer’s accountant tells him that if he sells all the grain and machinery in one year, he will pay around $1 million in taxes. Farmer decides to implement the CRT strategy.  He establishes a CRT and names himself and his spouse as the income beneficiaries and the local children’s hospital as the charitable beneficiary.  Farmer transfers his grain and machinery into the CRT.  The CRT sells the grain and machinery and receives $2.5 million in sale proceeds. 

The CRT establishes an annuity that will pay out $125,000 for the next 20 years.  Farmer pays income tax on each $125,000 payment which results in $20,000 of annual income taxes.  After 20 years, the trust is terminated, and the children’s hospital receives the remaining funds in the CRT.  

As the example shows, the strategy avoids a large, up-front tax payment in the year of the asset sale.  Farmer pays taxes on each annual $125,000 payment which allows him to stay in a lower tax bracket.  In the example, instead of paying $1 million in taxes in 2023, Farmer spreads the payments out and ultimately pays $400,000 over 20 years.

The primary disadvantage of a CRT is that it is an irrevocable trust.  Once the CRT is set into motion, it cannot generally be undone.  A CRT may not be the best option for farmers who wish to keep flexibility with managing their assets or who are transitioning the farming operation to family members.  While a CRT provides many tax and business benefits, it is not an adaptable plan that can be changed in the future.

Another disadvantage of a CRT is the cost.  It is usually a rather complicated process to establish the trust, calculate the potential tax savings, file a tax return, and establish an annuity.  Legal and other professional fees will often be tens of thousands of dollars. It is important early in the planning process to weigh the potential tax savings against the cost of establishing the CRT.

For more information on CRTs, see the newly published bulletin Charitable Remainder Trusts as a Retirement Strategy for Farmers available at farmoffice.osu.edu.  This bulleting provides details on how a CRT strategy is implemented and its advantages and disadvantages.  Be sure to consult with an attorney, tax advisor and financial advisor before deciding on a CRT for your retirement strategy.

By Robert Moore, Attorney and Research Specialist, OSU Agricultural & Resource Law Program

Most farmers do a great job of managing their taxable income.  They buy inputs or machinery to offset the current year’s income and wait until next year to sell the current crop.  This strategy works well but it catches up to the retiring farmer.  In the year of retirement, a farmer may find themselves with an entire year (or more) of crops or livestock to sell and no expenses to offset the income.  Additionally, machinery and equipment that will no longer be needed for production will need to be sold.  Selling all these assets upon retirement without offsetting expenses can result in tremendous tax liability.

One strategy for retiring farmers to consider is using a Charitable Remainder Trust (CRT).  The CRT is a special kind of trust that can sell assets without triggering tax liability while providing annual income for the retiring farmer.  The CRT essentially spreads out the income from the sale of the assets over many years to keep the farmer in a lower tax rate bracket.  Also, the CRT allows the retiring farmer to make a charitable donation to their charity of choice.

The primary component of a CRT strategy is that a CRT does not pay tax upon the sale of assets.  Due to its charitable nature, a CRT can sell assets and pay no capital gains tax nor depreciation recapture tax.  The retiring farmer establishes a CRT then transfers the assets they want to sell into the CRT.  The CRT then sells the assets.  For the strategy to work, the trust must be a CRT.  A non-charitable trust will owe taxes upon the sale of the assets.

The proceeds from the sale of the assets are then invested in a financial account.  The farmer works with an investment advisor to determine the desired annual income needed from the proceeds and then an appropriate investment portfolio is created.  It is important to note that income calculations must include leaving at least 10% of the principal to a charity.  The farmer may not receive all the income or the trust will not qualify as a charitable trust.  The term of the payments from the investment portfolio cannot exceed 20 years.

After the financial account is established, the farmer will receive annual income.  This income is taxed at the farmer’s individual tax rate.  By paying the sale proceeds out over a number of years, the farmer’s income tax bracket can be moderated.  Selling all assets in one year would likely cause the farmer to be pushed into the highest income tax and capital gains tax bracket, so spreading out the income keeps the farmer in a lower tax bracket.

Another important component of a CRT is the charitable giving requirement.  As stated above, the farmer must plan to give 10% of the principal to a charity.  The funds are provided to the charity when the term of the investment expires or when the farmer dies.  Depending on the performance of the investment, the charity may receive more than 10% or less than 10%.  The farmer must be able to show that when the investment account was established, the intention was for the charity to receive at least 10% of the original principal.

Consider the following examples, one with a CRT and one without.

Scenario without CRT.  Farmer decided to retire after the 2021 crop year.  Farmer owned $800,000 of machinery and $200,000 of grain.  Farmer sold all the grain and machinery before the end of 2021.  Farmer owed tax on $100,000 of ordinary income due to depreciation recapture on the machinery and sale proceeds of the grain.  Farmer’s tax liability was $450,000 for the sale of the assets.

Scenario with CRT.  Farmer established a CRT and transfered the machinery and grain into the CRT.  The CRT sold the machinery and grain but did not pay tax on the sale proceeds due to its charitable status.  Farmer established an annuity to pay out over 20 years.  Each year Farmer receives $65,000 of income from the CRT.  Farmer pays income tax on the payment but at a much lower rate than the previous scenario.  At the end of the 20-year term, a charity receives $150,000 (original 10% of principal plus interest).

As the scenarios show, A CRT can save significant taxes for the retiring farmer. Also, a CRT allows a retiring farmer to make a charitable contribution to their charity of choice.

A retirement strategy using a CRT is not without its disadvantages.  One disadvantage is the cost to implement the plan.  A CRT plan is complicated and requires the assistance of an attorney, accountant, and financial advisor.  The combined professional fees could be $25,000 or more.  Another disadvantage is the inflexible nature of the plan.  The CRT is an irrevocable trust; once the CRT is implemented the plan cannot be changed.  If the retired farmer finds they need more income than allocated from the CRT, they are unable to make such a change.

Anyone considering retiring from farming should explore the possibility of incorporating a CRT into their plan.  CRTs can save significant income taxes and provide for charitable giving, but it’s not for everyone.  The potential tax savings must be enough to justify the significant costs to establish the CRT and the farmer must be willing to give up control of the sale proceeds.  Retiring farmers should consult with their attorney, accountant and/or financial advisor to assess how a CRT might fit into their retirement plan.

In farm estate and transition planning, we caution against leaving farmland to multiple heirs as co-owners on the deed to the property.  That’s because Ohio law allows any co-owner of property to seek “partition,”  a legal action asking the court to either sell the property and divide sale proceeds among the co-owners or, in some cases, to physically divide the property between co-owners.  If the goal of a farm family is to keep property in the family, co-ownership and partition rights put that goal at risk.  A recent case from the Ohio Court of Appeals illustrates how partition can force the unwilling sale of property from a co-owner of the property.

The recent court case didn’t involve farmland, but concerned a home and four acres of land owned jointly by an unmarried couple, each on the deed to the property as co-owners with rights of survivorship.  The couple separated and one remained in the home, but the two could not agree upon how to resolve their interests in the property.  That led to a court case in which one co-owner asked the court to declare that the other had no remaining interest in the property. The other co-owner disagreed and filed a partition claim asking the court to sell the property and divide sale proceeds according to each person’s property interest.  The trial court determined that each co-owner did have ownership interests in the property and ordered the property to be sold according to the partition law.

The trial court granted each party the right to purchase the property within 14 days before it would be sold, but neither exercised that right.  After an appraisal, the court ordered the property sold and also ordered payment of the outstanding mortgage.   That left the court with the challenge of determining how to divide the remaining sale proceeds according to each party’s interests in the property.  A complicated analysis of payments, credit card debts, a home equity loan, rental value, and improvements to the property resulted in a final determination that granted one co-owner more of the proceeds than the other.

Both parties appealed the division of proceeds to the Twelfth District Court of Appeals, unfortunately adding more cost and consternation to resolving the co-ownership problem.  The court of appeals noted that Ohio law grants a court the duty and discretion to apply broad “equitable” principles of fairness when determining how to divide property interests among co-owners in a partition proceeding. A review of the trial court’s division of the proceeds led the appeals court to affirm the lower court’s holding as “equitable,” ending the three-and-a-half-year legal battle. 

Ohio’s partition statute itself provides a warning of the risk of property co-ownership.  It states in R.C. 5307.01 that co-owners of land “may be compelled to make or suffer partition…”  While the purpose of partition is to allow a co-owner to obtain the value of their property interests, it can certainly force others to “suffer.”  If a co-owner can’t buy out another co-owner, the power of partition can force the loss of farm property.  As a result, family land can leave the family and a farming heir can lose land that was part of the farming operation.  That’s most likely not the outcome parents or grandparents expected when they left their farmland to heirs as co-owners.

Fortunately, legal strategies can avoid the risk of partition.  For example, placing the land in an LLC removes partition rights completely, as the land is no longer in a co-ownership situation—the LLC is the single owner of the land.  The heirs could have ownership interests in the LLC instead of in the land, so heirs could still receive benefits from the land.  The LLC Operating Agreement could contain rules about if and how land could be sold out of the LLC, and could ensure terms that would allow other LLC members to buy out another member’s ownership interests.  An agricultural attorney can devise this and other legal strategies to ensure that partition isn’t a risk to farmland or farm heirs.

Read the case of Redding v. Cantrell, 2022-Ohio-567.