The Hidden Ace-Special Use Valuation

By: Randall A. Denha, J.D., LL.M.

Estate taxes are calculated based upon the value of the assets in the estate. One duty of the executor or administrator is to inventory all estate assets and assign a value to each or obtain an appraisal. The sum of the asset values, less allowable deductions for payment of debts, such as funeral and last illness expenses, is the basis for calculating estate tax.

In general, the value assigned to an asset must be its “fair market value” (FMV) at the time the decedent died, with some exceptions. The Internal Revenue Service (IRS) defines FMV as the price at which property would change hands between a willing buyer and a willing seller, neither of which is under any compulsion to buy or sell, and both of which have reasonable knowledge of relevant facts. There are, however, some exceptions to the FMV rule, including the special use valuation discussed in this piece.

The need for estate planning is essential for small business owners who have most of their personal fortune tied up in the operation. This is compounded by the looming reduction of the federal gift and estate tax exemption beginning in 2026 (absent congressional action).

Fortunately, if you own a small business, you may have an ace up your sleeve: the special use valuation method. With this approach, your executor may be able to secure significant tax savings when your business interest is passed to your heirs. However, the special use valuation method isn’t available to everyone. The election can be claimed only for real estate property used in a closely held business or farm that meets certain requirements.

Current lay of the land

It’s commonly thought that most small business owners don’t have to worry much about federal estate tax relating to their business, if at all. First, the unlimited marital deduction shields from estate tax any amount passed to a spouse. Second, transfers to nonspousal beneficiaries are sheltered from tax by the federal gift and estate tax exemption.

The exemption has grown in leaps and bounds since it was $1 million near the turn of the century. Most recently, the Tax Cuts and Jobs Act (TCJA) doubled the previous exemption amount from $5 million to $10 million, with inflation indexing. For 2022, the amount is now $12.06 million. To provide even more protection, the exemption is doubled for a married couple to a maximum total of $24.12 million in 2022. Also, the estate of the second spouse to die can use the other spouse’s unused exemption under the “portability” provision. This is usually sufficient to cover the assets of most small business owners.

Nevertheless, this $10 million exemption under the TCJA is set to revert to $5 million (plus inflation indexing) after 2025. Thus, based on the current environment, small business owners should take nothing for granted when it comes to estate taxes.

Special use election to the rescue

Significantly, the fair market value of any real estate property you own at death is included in your taxable estate. Generally, the fair market value is determined by the property’s “highest and best use.” In other words, if the property is raw land that would be worth a small fortune to real estate developers as a mall or a condo complex, the higher value is treated as the “fair market value” for estate tax purposes.

This can often work against business owners and farmers who own real estate in a prime location. Their heirs may have to pay an inflated estate tax. However, there’s a potential way out for qualified property owned by closely held businesses and farms. If a special use election is made by the executor and certain requirements are met, the business owner’s property is valued according to its current actual use on the owner’s death — instead of its highest and best use.

For these purposes, the real estate includes buildings and other structures regularly occupied or owned by the owner or lessee used to operate a closely held business or farm.

To qualify for this estate tax break, the net value of the property must equal at least 50% of the deceased’s gross estate and 25% of his or her adjusted gross estate (the gross estate reduced by certain deductible debts, expenses, claims and losses). Also, the deceased must have transferred the business to a qualified heir or heirs (such as his or her children).

Finally, the business must have been owned and operated by the deceased or a close family relative for five out of the last eight years before death.

Bear in mind that the reduction in the estate tax value under this election can’t exceed a threshold that’s adjusted annually for inflation. The maximum for those who die in 2022 is $1.23 million.

The recapture provision

There’s one other catch to bear in mind. If your heirs sell to outsiders or otherwise dispose of the property within 10 years of your death, or they begin using the property for another purpose, the estate tax savings must be recaptured. As part of the process, the IRS will file a lien to secure its rights during this period. After 10 years has elapsed, the lien is removed.

Accordingly, it’s important that all parties fully understand the 10-year recapture provision and comply with all the rules.

Is a special use valuation right for you?

If you own a small business or farm, consider the pros and cons of using a special use valuation in your estate plan. Your estate planning advisor can help you determine if it’s right for your situation.

The election to use the special use valuation method is made by your executor on the estate tax return, IRS Form 706. It must be accompanied by a written agreement that’s signed by each person with an interest in the property. Once this election is made, it’s irrevocable.

The inclusion of the written agreement is critical. Without it, the IRS may challenge the election and will likely prevail in court.