The Farm CPA: When to Use a Preferred Membership Interest

January 4, 2017 02:04 AM
 
Farmland

Many farm families have children who do not want to be involved with the family farm. At the same time, producers often like to split assets equally. If ownership of the farm is bequeathed in equal shares among active and passive children, the chance of disputes over compensation, cash rents and other issues can rise dramatically.

In these cases, a preferred membership interest might be useful. In a limited liability company (LLC), ownership rights such as allocations of income, distributions and voting can be divided into classes. These differences are spelled out in an operating agreement. 

The preferred membership interests can be designed to have no voting rights, which on-farm heirs often want, but can be given preference to distributions, which off-farm heirs often want. This structure entitles preferred members to an annual distribution before the common membership gets any distribution. Let’s look at a possible scenario to see how this works.

The Challenge. James and his wife, Gina, each own 50% interest in a successful Illinois farm. Their son Sam is active in the business. Their other children, Jennifer and Mark, live out of state. James and Gina want to leave assets in substantially equal shares but are concerned only Sam is active in the operation.

The out-of-state children want to see the farm sold when James and Gina die. If it is not sold, they want income from the farm. Sam wants to farm but knows he must reinvest cash in the operation to grow. He expects to control the farm after his parents retire or die and does not want his siblings to interfere with farm management.

James and Gina realize Sam can’t immediately buy out his siblings. They also know Jennifer and Mark will demand substantial distributions that will prevent Sam from growing the farm.

A Possible Solution. Simply giving non-voting interests to Jennifer and Mark will not meet the family objectives. Sam might elect to retain all cash flow in the farm and pay nothing to Jennifer and Mark. One solution is to change the LLC structure to provide for preferred membership interests.

They could recapitalize the LLC into 1,000 preferred units and 500 common units. The preferred units have no voting rights, but each unit has a fixed annual cumulative preferred payment and priority on liquidation. The preferred units would not receive any participation in upside growth of the farm. The common units have a call feature that allows them to purchase preferred units at the agreed liquidation value plus any unpaid distributions.

Some of the objectives that can be met with the preferred membership structure are listed in the box on this page. If you would like to give your farm to your children on an equal basis, you should discuss this structure with your tax adviser.  


Case Study: Some Objectives of Preferred Membership

Suppose Sam farms his parents’ land actively and siblings Jennifer and Mark seek only farm income. Here are some of the possible benefits of a preferred membership arrangement.

Give farm control to Sam. He has the voting units and can appoint himself as manager. He can make most decisions without input from Jennifer and Mark.

Provide income to Jennifer and Mark. The preferred units are entitled to a fixed annual cumulative distribution. This allows flexibility to reduce the distribution in years when farm income is not so high and then catch up when income is better. The net cash flow generated in excess of this preferred distribution may be kept inside to expand the farm.

Allow Sam to buy out his siblings. If Sam generates sufficient profits, he can exercise his call option to purchase the interest of Jennifer, Mark or both in the future. This price is based upon the preferred liquidation value at the time of inheritance.

Reduce tension among siblings. Mark and Jennifer know they will receive distributions before Sam does. Yet Sam is entitled to a guaranteed payment for running the business. 

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