The type of agricultural business structure chosen will have many implications on the future of a farm/ranch business and on future generations. Some common business structures used in agriculture include sole proprietorships, partnerships, C-corporations, S-corporations, and limited liability companies (LLCs).
According to the USDA's National Agricultural Statistics Service, 86% of farms in the U.S. are structured as sole proprietorships and 7% as partnerships. Of the 3% structured as corporations, 80% of these farms are organized as family-owned corporations.
“Each structure has advantages and disadvantages,” says Lynn F. Kime, Pennsylvania State University Extension senior associate in agricultural economics. “In some cases, the choice you make at the business startup will be the choice for the life of the business.”
Some of the structures discussed below require a lawyer to implement; obtaining a lawyer's advice before choosing a business structure is advised. The chosen business structure also will play a part in the risk-management strategy.
Kime lists some advantages and disadvantages of each business structure:
Sole proprietorships are the easiest to begin and end. No legal filings are required unless it operates under a fictitious name. Advantages include less administration, lower fees and sole control of the business by the owner. Some disadvantages include self-employment taxes and personal liability.
Partnerships begin when two or more people agree to enter into a business. There may be “silent” partners, and some partners may have less invested than others. Although partnerships don't need formal documents for implementation, all parties should write and sign a partnership agreement.
The advantages of partnerships include no double taxation of profits or capital gains, losses are passed through to the partners, distribution of responsibilities, and pooling of risk. The disadvantages include unlimited liability; taxation of earnings, even if not distributed; and control of the business shared among the partners. General partners are also subject to self-employment tax.
C-corporations are traditionally used for larger businesses. Many agricultural operations are structured under these guidelines. The corporation is a separate legal entity that incurs all liability and continues until dissolved.
The advantages of C-corporations include potentially lower taxes on (retained) earnings; limited liability to shareholders, directors and officers; the ability to set their own accounting year; and simplified division of income between family members.
Two major disadvantages of the C-corporation include double taxation (taxes are paid by the corporation on earnings and by stockholders on distributions), and a requirement for formal stockholder meetings that must include minutes. Disadvantages may also include high dissolution and liquidation costs.
In some states, corporations tend to be more expensive to organize because of stock requirements, whereas other entities don't require stock.
S-corporations are similar to C-corporations in that they share many of the same tax characteristics and are more like partnerships for tax purposes. The advantages of the S-corporation include passing losses to the stockholders, and any stockholder who receives profits from the company must also receive a reasonable salary.
There's debate whether this latter aspect is an advantage, however. Its purpose is to prevent shareholders from paying themselves a minimal salary while distributing most of the profits as dividends in a bid to minimize self-employment tax.
Some of the disadvantages include a requirement for special elections and potentially higher tax rates. S-corporations are also limited to 100 shareholders and one class of stock.
Limited liability companies (LLCs) are one of the newest business structures available. An LLC may have only one member and can elect to be taxed at the partnership or corporate level. Advantages of an LLC include limited owner liability to the amount of the investment, ease of establishment, and no double taxation.
Some disadvantages of LLCs are varying setup requirements by states and differing state tax treatment from federal tax treatment. The business structure is best decided by the owner with advice from the business team. Another disadvantage is that, given LLCs' newness, much of LLC law is yet to be clarified and firmed up by the judicial system.
Discounting business interests
When the owner of interests in a closely held (family) partnership, corporation, LLC or limited liability partnership dies, the value of the interests owned by the decedent are included in the estate.
“One of the common objectives in estate planning is to value these closely held interests in the business at a lower value than one would get if one simply divided the fair market value of the business assets by the number of business interests outstanding,” explains Peggy Kirk Hall, Ohio State University agricultural law professor.
“You're usually more likely to obtain a discount on the business value when the owner of the business interests doesn't own a majority or controlling interest of the business,” she says. “There are a number of different discounting techniques, but the most common are discounts for lack of marketability, for lack of control, and for built-in gains in a corporation.”
The fair market value of any interest of a decedent in a business is the net amount that a willing purchaser would pay for the interest to a willing seller. This is true when neither is under any compulsion to buy or to sell, and both have reasonable knowledge of “relevant” facts, says Robert Moore, Wright Law Co. LPA, Dublin, OH.
“Because of the limited market for interests in closely held businesses, the value of the interests frequently qualify for discounts of 20-30% or more,” Moore adds. “The valuation is often affected by whether the decedent had a ‘controlling interest’ at the time of death and by the existence of restrictive agreements as to transfer.”
He says that, although dependent on an appraisal, combined discounts for both lack of marketability and lack of control may commonly total 35%. Because corporations don't get a step-up in basis for assets owned by the corporation on the death of a shareholder, there are usually built-in capital gains due to appreciation in value or tax depreciation.
“The taxes on these built-in gains will be incurred whenever there's a liquidation, so a buyer isn't willing to pay as much for the corporation as for the same assets outside of the corporation,” Moore continues. “Therefore, corporations may end up with greater discounts because of the greater tax costs on liquidation.”
Considerable effort and ingenuity are frequently used to make sure the interests qualify for such substantial discounts. Moore says the IRS continues to develop arguments to limit the discounts, to disallow the gifts for the annual exclusion, and to pull gifts back into the taxable estate.
“The business and its owners can establish a discount rate in the business organization documents,” Moore says. “However, the IRS isn't bound to any self-determined discount rates and has the ultimate say on what the discount rate is on any business.”
He says business discounts of 30% or lower are more likely to be approved, while discount rates of 40% or more are more likely to receive scrutiny from the IRS.
Clint Peck is a contributing writer and a former Senior Editor of BEEF magazine based in Billings, MT.