Your Farm is a Business; Structure it Right.
Farms are businesses. When farmers decide they want to start or reorganize their business, they should consider what type of business structure fits their operation. Some common types of business structures are sole proprietorships, partnerships, corporations and limited liability companies.
Each type of business entity has its advantages and limitations. Farmers will need to choose a business structure based on their specific operation and goals. A number of factors must be weighed, including limited liability, management structure, tax consequences and flexibility. Farmers are advised to meet with an attorney to weigh these factors. A farmer that organizes his business through an online “Build-your-own LLC” may find himself mixed in tax headaches and lawsuits that these websites cannot fix.
The first step in setting up your farm’s business structure is to understand what you are trying to accomplish on your farm. Are your goals:
- To limit your liability;
- To bring family members into the farm operation;
- To expand your operation;
- To raise money for a bigger operation; or
- To reduce taxes?
The second step is to gain some basic understanding of the common types of business entities. This article contains a basic overview of the most commonly-used business organizations.
Sole Proprietorship. The farmer that has never filed any paperwork with the State is, by default, a sole proprietorship. This is the most basic form of business organization: one person owns all of the assets and is responsible for all of the obligations. The sole proprietor is personally liable for all of the debts, obligations and liabilities incurred. That means the sole proprietor farmer is personally liable for an injury that occurs as part of the business. A sole proprietor reports all business income and losses on an individual tax return.
Partnership. A partnership is formed when two or more farmers come together to form a business, but do not file paperwork with the State. The partners are both personally liable for all of the business debts and obligations. The partners have equal management authority and share equally in profits unless there is an agreement that says otherwise. Partnership agreements create the ground rules for how the partners will work together and how they are paid. All income “flows through” the partnership and is paid to the partners according to the agreement. The partner’s income is then taxed on his or her individual tax return.
Corporation. A corporation is a legal person, separate from the people that own and operate it. The corporate structure provides its owners, typically called shareholders, with limited liability. This means a shareholder is only liable for the amount of money he paid into the corporation; outside creditors typically cannot get at the shareholder’s personal wealth. Corporate profits are taxed twice: the money is taxed first as it is earned by the corporation and later when the profits are paid out to the shareholders as dividends.
A corporation formed under Subchapter S of the tax laws, or S-Corporation, is a “close corporation.” An S-Corporation is meant for a small business made up of a small number of investors. S-Corporations are taxed like partnerships in that the income “flows through” the corporation and is taxed at the individual level.
By law, corporations require certain formalities. Among other formalities, corporations are required to hold shareholder and director meetings, to adopt bylaws, to elect officers and directors, and to keep accurate corporate records. Despite these formalities, corporations are often the business-vehicles for raising significant amounts of capital from multiple investors.
Limited Liability Company. The limited liability company, or LLC, combines the limited liability of a corporation with the management flexibility of a partnership. A single person or a group of people may form an LLC simply by filing papers with the State. LLC owners, called members, are typically shielded from liability above the amount they invested in the company. The members can draft a separate operating agreement that sets the ground rules for how the business is managed and how the members are paid. The LLC income passes through the company to the members who then report their incomes on their individual tax returns.
Examples
Some real-life examples will help you see how these factors work in practice. Imagine two farms with very different business models. First is Tim. Tim is a sole proprietor with 50 cows and 400 acres of tillable acreage. Tim is concerned with protecting his farm from personal liability and wants to share the business with his two sons. Tim can organize an LLC to take advantage of the limited liability and to make his sons members, or owners, of the business.
The second example is a 100 cow dairy operation jointly owned by Al and Frank. These two have a default partnership as they did not file paperwork with the State. They want to expand their operation to 1,000 cows with an accompanying manure digester. They know they cannot afford this expansion on their own. Al and Frank can organize a corporation and sell shares to investors to raise the necessary capital while protecting them from liability.
These are simple examples meant to teach you the basics. Business planning and structuring is complex and incorporates business, tax, and estate planning law. An attorney can help you navigate these complex areas and help determine a business structure that can help you accomplish your goals for your farm.