Often a farmer will ask, "Should I create a LLC or other business entity for my farm operation?" That may seem like a simple question with a simple answer, but the answer depends on several factors. Business entities can be useful in tax management, risk management and estate planning. Determining which, if any, business entity is best for your operation requires you to determine your goals for the future of your operation. Let’s review some common farm ownership structures and then review factors that can influence choosing an entity.
Sole Proprietorship (SP)
A sole proprietorship is the simplest and least expensive form of business organization, making it the most popular form for small businesses. The business is owned and operated by an individual. Essentially, the owner and the business are one in the same; the owner owns all the assets and is responsible for all debts. Business income is reported on the owner’s tax return.
Advantages. There are minimal legal requirements to start a SP and the cost of organizing and dissolution are low. Compared to other business structures, SPs require the least sophisticated accounting system. The owner of an SP is free to make decisions without consulting others, like partners or other owners, giving the owner more flexibility in management. Since there is only one owner of a SP, business affairs are completely confidential and lenders base credit decisions on the owner’s capacity to service debt.
Disadvantages. Most likely the largest disadvantage of a SP is unlimited liability, meaning both business and personal assets can be lost due to loan default or legal actions taken against the business. Financing the business can be difficult since credit is limited to the personal assets of the owner. SPs lack stability and continuity because it depends on one person.
A partnership is the simplest way for two or more people to own and conduct business together. Partnership agreements can be written or oral. Although a written agreement is not legally required, it is highly recommended an agreement be drafted and signed by all partners to protect each owner’s interest if a dispute were to arise. There are two primary types of partnerships: General and Limited.
In General Partnerships (GP) each partner has equal rights and liabilities unless stated otherwise in a partnership agreement. In GPs, each partner shares profits equally with the other partners and each partner is liable for all partnership debt. Each partner can bind the partnership to fulfill any business deal made. GPs give no liability protection to any partner, but all partners participate in management.
Limited Partnerships (LP) allow individuals to contribute capital, but not services, to the partnership without incurring full liability of a general partner. A limited partner’s liability is limited to the amount that person has invested in the business and the limited partner’s surname cannot appear in the business’s name.
Advantages. Partnerships are easy to start and have low startup costs — though the involvement of an attorney to draft a partnership agreement is suggested. Taxes are paid by the partners on their share of the profits. Partnerships have more resources available because more people are involved than in a proprietorship.
Disadvantages. In GPs, each partner has unlimited liability. Partnerships lack continuity and stability — that is why they can be abruptly terminated if a partner dies. Being taxed as individuals can be a disadvantage.
A corporation is a legal entity endowed by law with the powers, rights, liabilities and duties of a person. Articles of incorporation specify the organization, scope of its authority, place of business, etc. The bylaws describe how the corporation will operate. Assets are owned by the corporation itself. An individual’s ownership in a corporation is based on the share of stock they own.
Advantages. Stockholders are not personally liable for the organization’s debts. Transferring ownership is easy. Raising equity capital is relatively easy. The corporation is perpetual which provides business continuity.
Disadvantages. Taxes are paid twice: at the corporate level and then at the shareholder level. Corporations face more regulations and lack the privacy. Individual stockholders may have little control over management or policies. Records must be kept at a higher detail level than that of a sole proprietorship.
S-Corporations allow small groups to gain the advantage of a corporation without double taxation. S-Corps have one class of stock and are limited to 100 shareholders. Shareholders must be individuals, certain trusts or estates. Partnerships, corporations and non-resident aliens are not allowed to be shareholders. Passive income may not be greater than 25 percent.
Limited Liability Company (LLC)
LLCs are similar to partnerships, but provide limited liability for the owners. LLCs are authorized by state statute; thus each state’s requirements for LLCs can be different. LLCs can include any number of members. Ownership and net income are distributed according to proportion of assets contributed. Disadvantages of LLCs are fringe benefits cannot be deducted and the organization is not automatically perpetual. LLCs can elect to be taxed as a disregarded entity (in the case if a single-member LLC), partnership, S-Corp or C-Corp.
Choosing a Business Structure
Farmers have several options to consider when choosing an ownership structure. Since we’ve briefly reviewed the most common business entities, we will now examine factors influencing the choice of business forms.
• Life of Business. Do you wish for the business to continue, without interruption, after your death? Sole proprietorships and partnerships terminate at death. LLCs can continue, as long as they are created to be perpetual. Corporations are perpetual.
• Estate Planning. If you are interested in creating an entity for estate planning purposes, a corporation is very flexible in estate planning. LLCs and partnerships can be useful if used in conjunction with multiple entities.
• Sources of Capital. How much exposure to debt can you tolerate? SPs and GPs risk their business and personal assets.
• Management. How much control of the business do you want? SPs have ultimate control whereas the managers, appointed by a board of directors, of a corporation control the business.
• Inter/Intra Family Issues. How involved do you want your family to be in the business?
• Terminations of Business. How easily do you want to be able to terminate the business or transfer ownership?
• Taxes. Is tax management an issue for your operation? Some structures provide more benefits than others, especially with regards to self-employment tax.
• Risk Management. How concerned are you about liability? No business structure can fully protect you, but some provide more liability protection than others.
• Multiple Entities. In risk management, income tax management, estate and retirement planning, multiple entities can be effective tools. All business structures have some application in these areas except for SPs.
Ultimately, the goals and objectives of the owner(s) are key in choosing a business organization. Decisions should be based on valid reasons like avoiding business disruption, tax management, estate planning and risk management. Do not select a business model in order to avoid repayment to creditors or to avoid a spouse’s interests in an impending divorce. Your goals for the farm operation and assets may differ from that of family members, so be sure to seek input and advice from family members when considering business entities. Before establishing a business structure, obtain all legal and tax ramifications from a qualified attorney and tax professional.
• Alabama Cooperative Extension System, www.aces.edu
• The National Agricultural Law Center, www.NationalAgLawCenter.org
• Center for Commercial Agriculture, Purdue University, www.agecon.purdue.edu/commercialag/index.html
• Center for Farm Financial Management, University of Minnesota, www.cffm.umn.edu
• Farmdoc, University of Illinois, www.farmdoc.illinois.edu
The items covered in this article are informational only and are not meant as tax, legal or financial advice; consult with your tax professional, lawyer or financial consultant for guidance on issues specific to your situation. The author does not endorse any websites, companies or applications, and cannot attest to the accuracy of the information provided by third-party sites or any other linked site.
The author is an Extension Economist with the Alabama Cooperative Extension System. For more information about farm management and financial analysis, please contact your County Extension Coordinator or an Extension Specialist: North Alabama: Holt Hardin, (256) 574-2143 or Robert Page, (256) 528-7133; Central Alabama: Jamie Yeager, (334) 624-4016; Southwest Alabama: Steve Brown, (251) 867-7760; Southeast Alabama: Thomas Hall, (334) 693-2010.