Most farmers start out as sole proprietors, and nothing could be simpler. You just own and operate the farm in your own name and carry on with business. If you use a fictitious name (such as the "Bar XYZ Ranch") you typically file a form required by your state so you can operate under that name and obtain protection from someone else using that name. But it is still just you - no muss, no fuss.
Keeping it simple works for many situations and staying a sole proprietor can make sense for small farms where the owner does most of the work and has no one else to take over the farm someday.
Most farmers, however, do have a desire for the farm to continue for another generation. For them, a sole proprietorship will not work well. 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, but even a million dollar limit may not be enough. I once had a client with a $15Million 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 descriptions of the different entities for farm businesses.
The simplest entity is a general partnership. You don’t even need a written agreement to create one, but you should always have a written partnership agreement to be clear about your rights and your obligations. A partnership requires at least two people – you cannot be in partnership with yourself. It will need its own tax id number and file a partnership tax return. However the partnership itself pays no tax (federal or state) and the profits and losses flow through to the owners in proportion to their partnership interests.
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 what he or she can (and 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 (FSA) payments. Other entity forms can receive only a single payment entitlement (for example a $40,000 direct payment). But FSA essentially looks through the partnership and applies the payment limitation at the partner’s level, not the partnership’s. For example, a general partnership with five equal partners could receive up to $200,000 of direct payments, while an entity like a corporation would be limited to a single $40,000 payment.
For small farms a general partnership can work well as a vehicle for bringing children into the business. But there is one major problem. Each general partner has joint and several liability 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.
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 can 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. And as a general rule it is a bad idea to put appreciating assets like 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 that can eliminate some but not all of the adverse income tax consequences.
All states now have LLC statutes and this provides another option. A limited liability company (LLC) is taxed like a partnership (no double tax) but enjoys the limited liability of a corporation. This can work well in many situations. Some states like California, however, hit LLC’s with high fees.
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 an LP with a corporate or LLC general partner? This structure provides the limited liability we seek, with fewer income tax issues, no high LLC fees in states like California, and frequently the best valuation discounts.
For farm enterprises that face estate taxes (and remember that the current $5 million exemption may only last for two years and then drop to $1 million), there is another reason to explore other types of entity structures than a simple general partnership: valuation discounts.
Say I have a $10 million farm and I want to gift half of it to my child. If I own it as a sole proprietor and give my child specific parcels of land worth $5 million I have made a $5Million gift and used up my gift tax exemption. When I die, the other $5 million will be subject to estate tax even under the current tax bill. But if instead I own the farm through an entity like an LLC or a corporation, and I gift a 50% interest in that entity to my child, how would it be valued? Not at $5 million! No one in their right mind would pay $5Million for 50% of a $10Million company that they cannot control. They would insist on a "lack of control discount." In addition, it is not easy to legally sell shares of an entity like an LLC or a corporation under federal and state securities laws. This leads to another discount for "lack of marketability." Appraisers tell us that these two discounts can total 40% to 50% or more. After these discounts are applied, my gift of 50% of my $10Million farm entity may be valued at only $2.5 million, leaving me with $2.5 million of my lifetime estate/gift tax exemption to use when I die. And if I die owning only the other 50% interest in that entity, my estate will get to use these discounts again. Assuming no change in values, exemptions and, of course, tax law, you can see that by using an entity I may ultimately be able to pass my entire $10 million farm to my child with no estate or gift taxes.