Rev. Rul. 85-73

1985-1 C.B. 325, 1985-23 I.R.B. 17.

VALUATION; SPECIAL USE; STOCK IN CORPORATE FARMLAND BEQUEATHED TO

QUALIFIED HEIR; INCREASE IN QUALIFIED HEIR'S EQUITY INTEREST DUE TO REDEMPTION

Published: June 10, 1985

Section 2032A.-Valuation of Certain Farm, Etc., Real Property, 26 CFR 20.2032A- 3: Material participation requirements for valuation of certain farms and closely-held business real property.

  Valuation; special use; stock in corporate farmland bequeathed to qualified heir; increase in qualified heir's equity interest due to redemption. A decedent bequeaths to a qualified heir stock in a corporation, the principal asset of which is farmland. The decedent's executor causes the corporation to redeem a portion of its shares to the qualified heir. The application of the special valuation rules in this situation is explained.

ISSUE

  Whereas D bequeaths shares of A, a qualified heir, in X Corporation, the principal asset of which is farmland, and D's executor causes X to redeem a portion of the shares in X and distributes the remaining shares to A, how are the special use valuation rules of section 2032A of the Internal Revenue Code applied to the farmland?

FACTS

  D died in January 1982. Prior to death, D transferred farmland to X Corporation, a newly formed corporation, in exchange for 80 shares of voting stock. A, a qualified heir as defined in section 2032A(e) of the Code, contributed cash to the corporation and was issued 10 voting shares. B, a person unrelated to D, also contributed cash to X and was issued 10 voting shares. D's will bequeathed D's entire estate to A. D's estate satisfied all the requirements of section 2032A for valuing indirectly held farm property and D's executor elected special use valuation. See sections 20.2032A-3(b) and (f) of the Estate Tax Regulations. Prior to the filing of the federal estate tax return, in a redemption that satisfied the requirements of section 303, D's executor redeemed 10 shares of X for $130,000 and subsequently distributed the remaining 70 shares to A. The 10 shares redeemed were cancelled.

  Prior to the redemption X owned $300,000 and farmland with a fair market value of $1,000,000 and special use value of $600,000.

LAW AND ANALYSIS

  Section 2032A of the Code provides that, if certain conditions are satisfied, real property includible in a decedent's gross estate that is used for farming or other closely held business purposes may be valued on the basis of its current use rather than its fair market value. One of the requirements of section 2032A(b) is that the real property must be acquired from or pass from the decedent to a qualified heir.

  Under section 2032A(e)(9)(B) of the Code, property considered to have been acquired from or passed from the decedent to a qualified heir includes property that is acquired by purchase from the estate by a qualified heir. Further, the legislative history accompanying the Tax Reform Act of 1976, Pub. L. 94-455, 1976-3 C.B. (Vol. I) 1, states that a decedent's estate generally should be able to use the benefits of special use valuation where the decedent owns the qualifying real property indirectly as, for example, through a corporation. See, H.R. Rep. No. 94-1380, 94th Cong., 2d Sess. 24, 1976-3 (Vol. 3) C.B. 758.

  Consequently, if the indirect ownership requirements described in sections 20.2032A-3(b) and (f) of the regulations are satisfied, and interest in qualified real property is acquired by a qualified heir if a decedent's estate sells corporate shares representing the decedent's equity in farm property, directly to a qualified heir.

  However, an interest in qualified real property is not acquired from the decedent merely because the executor redeems the corporate shares in a corporation in which the qualified heir is a shareholder, and, as a result of the redemption, there is an increase in the qualified heir's interest in the corporation attributable to the shares owned by the heir prior to D's death.

  In this case, prior to the redemption of the 10 shares of X corporation, A had a 10 percent equity interest in X, B had a 10 percent interest, and D's estate had an 80 percent interest. After the redemption of 10 of the 80 shares in D's estate, A and B each owned 90 outstanding shares, or 11.1 percent (an increase in equity interest for each of 1.1 percent), and D's estate owned 70 of 90 shares or 77.8 percent (a decrease in equity ownership of 2.2 percent). Correspondingly, the value of the corporation's assets after the redemption was decreased by the amount of money paid to D's estate for the redeemed shares, which the corporation then cancelled.

  The portion of the farm property represented by the increase in A's equity interest in X (attributable to the 10 shares previously owned) may not be specially valued, because the increase in A's proportionate interest in X due to the redemption was not the result of A's acquisition or inheritance of X shares from the decedent, but instead is attributable to the 10 shares owned by A prior to D's death. A's 10 shares now represent a larger percentage of the shares of a corporation with fewer assets.

  D's estate may not specially value the portion of the farmland reflected in the 10 shares that were redeemed because they were acquired from the estate by the corporation, which is not a qualified heir.

  Although D owned 80 percent of X at the time of death, the redemption resulted in only 77.8 percent of X (70 of 90 outstanding shares) passing by inheritance from D's estate to a qualified heir, A. Thus only 77.8 percent of the value of the farmland as reflected in the shares may be specially valued in determining the value of D's interest. See section 20.2032A-3(f) of the regulations. As indicated above, X owned fewer assets after the redemption, but the farmland represented a larger percentage of the total assets owned by X.

  In this case X owned prior to the redemption:
        cash            $300,000
        land
    (real value)      $1,000,000
        land
(special use value)    $600,000
  D owned 80 of 100 shares and bequeathed them to a qualified heir. X redeemed 10 of these shares from D's executor for $130,000.
  After the redemption, D's estate owns 70 of 90 outstanding shares of 7/9 of the corporation that has $170,000 of cash remaining and land with a special use value of $600,000. The values of D's estate's 7/9 interest in X is computed as follows:
7/9 of $170,000
     (cash)           = $132,222
7/9 of $1,000,000
     x (60%)          = $466,666
                   -------------
                        $598,888
  D's estate's 7/9 interest, $598,888, passes by inheritance to the qualified heir.

HOLDING

  Where D bequeathed to A, a qualified heir, shares in X Corporation, the principal asset of which is farmland, and D's executor causes X to redeem a portion of the X shares and distributes the remaining shares to A, D's estate (1) may not specially value under section 2032A of the Code the farmland represented by any increase, resulting from the redemption, in A and B's equity interests in X attributable to the shares they owned prior to D's death, (2) may not value the 10 shares that were redeemed taking into consideration a proportionate amount of the specially valued farmland, and (3) may value the remaining shares of X received by A by taking into consideration the increased proportionate interest in the specially valued farmland that such shares represent because of the redemption.

Rev. Rul. 85-73, 1985-1 C.B. 325, 1985-23 I.R.B. 17.