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Do You Need an Entity?

July 6, 2011
By: Guest Editor, Farm Journal
sowing seed
You work too hard sowing the seed and reaping the harvest each year to lose it all to a poor business structure. An entity is necessary to see the farm through to the next generation.  

By Kenneth J. Fransen

Passing on the family farm requires a specific business structure.

Most farmers start out as sole proprietors. You own and operate the farm under your name—it’s the simplest business structure. The farm might have a name (such as the Bar XYZ Ranch), but all that means is that you had to file a form required by your state so you could operate under that name and obtain protection from someone else using that name. It’s still just you—no muss, no fuss.

Maintaining the sole proprietor structure makes sense for small farms where the owner does most of the work and has no one else to take over the farm.

The purpose of an entity. Most farmers, however, desire the farm to continue for another generation, and a sole proprietorship doesn’t work well in that situation. An entity is required so that percentages of the farm business can be gifted or sold to those in the next generation who want to farm, while keeping the farm as a single unit.

In addition, an entity protects farmers from being sued because it outlines your rights and obligations as a business owner. Liability insurance is and should always be the primary line of litigation defense for the business, but even a million-dollar limit may not be enough.

Legacy Pioneer BadgeI once had a client with a $15 million liability policy who faced the loss of his third-generation farm following an accident that resulted in a serious brain injury. Many states have "joint and several liability" for accidents. This means that if you or an employee are found 1% responsible but the other party who is 99% responsible has no assets (and as a general rule, they never do seem to have assets), you will have to pay the entire judgment and then try to collect 99% back from the truly guilty party.

The following are the terms and descriptions of the different types of entities that are most often used for farm businesses.

General Partnership

The simplest entity is a general partnership. You don’t need something in writing to create a partnership, but you should always have a written agreement to be clear about your rights and obligations. A partnership requires at least two people. It needs a tax ID number, and you’ll have to file a partnership tax return. The partnership itself pays no federal or state taxes, and the profits and losses flow through to the owners in proportion to their interest.

A general partnership is an easy way to bring a child into the farm. The parents can contribute most of the assets and the child can bring in whatever he or she is able (often, this amount is gifted to the child by the parents). As a result, the child has a stake in the future of the business, and the parents can gift or sell partnership interests to the child without having to transfer specific parcels of land or other assets.

General partnerships are favored entities when it comes to farm program payments. Other entity forms are entitled to a single payment. But the Farm Service Agency looks beyond the partnership and applies the payment limitation to the partner, not the partnership. For example, a general partnership with five equal partners could receive up to $200,000 of direct payments, while a corporation would be limited to a single $40,000 payment.

For small farms, a general partnership can work well to bring children into the business. There is one significant problem. Each general partner is liable for the debts and obligations of the partnership. If you are a 1% general partner of a partnership that gets hit by a huge judgment and the partnership is out of assets and the other partners have no assets, you will get stuck with the entire bill.

Limited Liability

In order to obtain limited liability, you will have to leave behind the simplicity of sole proprietorships and general partnerships. One option is a corporation, the time-honored way to prevent the liabilities of the entity from passing through to the owners (unless the owner himself was the negligent party). Corporations sometimes make sense, but they come with income tax problems. A garden-variety C corporation pays its own income tax, and the shareholders pay another tax on any dividends that are distributed.

As a general rule, it is a bad idea to put appreciating assets, such as land, into a corporation, due to the high tax cost of pulling the land out or dissolving the company in the future. A corporation can elect to be an S corporation, which can eliminate some but not all of the adverse income tax consequences.

All states have limited liability company (LLC) statutes, which provides another option. An LLC is taxed like a partnership—no double tax—but enjoys the limited liability of a corporation. Some states, such as California, hit LLCs with higher fees, however.

A limited partnership (LP) has both general partners (involved in management with full liability) and limited partners (no management and no liability). The key is to assign the general partnership interest to a corporation or LLC, so the owners have limited liability for their general and limited interests. Why go to the trouble of having an LP with a corporate or LLC general partner? Because this structure provides limited liability with fewer income tax issues, no high LLC fees and often the best valuation discounts.

Valuation discounts. For farm enterprises that face estate taxes (and remember that the current $5 million exemption may last only for two years and then drop to $1 million), there is another reason to explore types of entity structures besides a simple general partnership: valuation discounts.

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FEATURED IN: Legacy Project - Legacy Project 2011 Report

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