Treatment of heirs in the transfer process
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- One of the most difficult questions many retiring farm families face is how to get a young son or daughter started farming while being fair to the kids or other heirs who are not farming.
- You can take several steps to help ensure a successful farm transfer while also providing for your non-farming heirs.
Protecting the on-farm heirs
The farm business can be a fragile structure. The high risk nature of farming, coupled with huge start-up costs and generally narrow profit margins, dictates the need for safeguards to protect the farming heirs.
In today’s economy, it usually takes a great deal of parental help to get a young person started farming. This help is usually provided through reduced charges for housing, lower machinery and land rents, lower interest rates, gifting of assets, financial supplements and various other types of help. Unless the young person starts out with a nest egg, parental concessions are needed if the young farmer is to get started successfully.
Farming heirs can protect themselves by carrying life insurance on the parents, by carrying risk insurance on their assets and by seeking continued education to upgrade farm management skills. However, the parents also have to play a key role in protecting the financial vulnerability of the farming heirs.
It is not enough to say "You'll be taken care of when we are gone." You need to take legal written action to make the transfer happen. Farming heirs who are insecure as to their future in the business are unhappy, often indifferent and easily alienated from farming.
1. Develop and implement a transfer plan
Formulate a detailed written transfer plan with the help and input of all farming parties involved, especially spouses and in-laws. Discuss it. Work with your transfer team (attorney, accountant, etc.) to implement the plan so everyone knows what is ahead. Transfer some assets soon so the farming heirs can begin business and feel some pride of ownership. This process includes transfer of management and control of those assets as well.
2. Offer a purchase agreement/buyout provision
If you haven't made any commitments as to the sale of assets, a purchase option may be useful. The purchase option gives the buyer the right, but not the obligation, to buy farm property at a later date. The agreement can involve land, buildings, livestock or machinery. It should state price, terms of payment and date of execution. It is binding on the spouse and non-farm heirs, so the agreement gives the farming heirs a definite and reasonable purchase price and terms for buying farm assets. This may prevent the farming heirs from having to buy out non-farm heirs in an unsatisfactory lump sum after your death.
3. Provide protection in your estate plan
When writing your will or trust, include the purchase agreement or buy-out provisions. You might wish to establish provisions as to how, when, at what price, terms, etc. the farming heirs can buy out the other heirs.
Example 1: Farm site and adjoining land and equipment are left to the farming heirs and cash or non-farm assets are left to the non-farm heirs.
Example 2: Enact a provision allowing your son/daughter to buy the land from your trust over a 15-year period at a stated interest rate with specified principal payments per year.
Example 3: Pass farm property to all children equally but establish reasonable terms, through a buy-out provision, as to how the farming heir(s) might buy out the other heirs.
4. Consider life insurance
Parents have several options regarding life insurance.
- Parents carry enough life insurance on themselves to provide adequate dollars at death to pass to the non-farm heirs, leaving farm assets to the farming heirs.
- Parents gift some money to the farm heir during their lifetime which would be used to purchase life insurance on the parents with the farming heirs as beneficiaries. This would provide money to enable the farm heir to exercise the buy-out provision and buy out non-farm heirs when the parents die.
- If you are in debt, a life insurance policy on yourself can provide money for debt payments and for estate tax obligations. This can relieve heirs of having to liquidate vital farm assets to pay off those expenses.
Life insurance should not be your only strategy but it can be a valuable strategy in your planning. Do not buy more than you need or can afford. Remember, if you own the insurance policy regardless of beneficiaries, the death benefit amount will be included in your estate value upon your death. This could cause a tax issue so check with your insurance agent, attorney or accountant.
5. Share your farming know-how
Pass on your wisdom. Share your "as a rule," "things that went bad" and "what has always worked" philosophies. The entering generation may not always be receptive to your ideas, but this transfer of knowledge and know-how can give them a competitive edge on others. It can also help ensure their success in running the farm business.
One of the most difficult questions many retiring farm families face is how to get a young son or daughter started farming while being fair to the non-farming heirs.
Non-farming heirs often leave the farm in their late teens for careers elsewhere. Most parents are concerned with being fair to all of their children at estate settlement time. Fairness, however, may not mean equal treatment of heirs.
Many farm families have reasons for unequal treatment of heirs. Some of those reasons include:
- Non-farm children received college tuition, a down payment on a house or other compensation, so they received some of their inheritance early.
- The farming heir helped create part of the final estate of the parents by actively contributing to the parents' business over the years, so they may be entitled to more. This is an issue of “contribution vs. compensation” – fair does not always mean equal! See putting a value on sweat equity.
- Parents want the farm to "stay in the family." Consequently they are willing to give more to the farming heir whose goal it is to stay on the farm.
- Farming heirs are getting delayed compensation for work performed in years when they were underpaid.
- Farming heirs have been or will be attending to the majority of the physical and business needs of the parents in their declining years.
There are several methods farm families can use to transfer assets unequally but, in their minds, fairly to their heirs. They include but are not limited to the following:
- Parents write buy/sell agreements with farming heirs, committing to exact sale prices, terms, and timing of payments on farm properties. These agreements are binding on non-farm heirs; provide the farm heirs a guarantee of property purchase at an acceptable pace and price, and guarantee off-farm heirs a fair price.
- Use of life insurance as mentioned earlier. In addition, parents purchase life insurance on themselves and list the off-farm heirs as the beneficiaries. In this case, farm heirs get farm assets and non-farm heirs get the cash generated by the insurance.
- Parents establish a testamentary trust (through a complex will) or revocable living trust. It states that the farm heirs have the right to purchase farm assets from the trust at predetermined prices, terms and conditions over a number of years. This guarantees the non-farm heirs their percentage of the estate over time.
- The parent’s will has been used to equalize or to make fair any previous distributions to heirs. The will may make special provisions to fit the situation. If the farming heirs or any heir has received earlier compensation, they may now get less than other heirs. Non-farm heirs may be given an inheritance of cash, non-farm assets or remote land holdings. Farm assets are transferred to the farming heirs.
It may be beneficial to involve all heirs in the transfer process but certainly to communicate to all heirs the final plans for distribution and transfer of assets. This communication should be done prior to your death so farming heirs are not left in the embarrassing position of trying to explain your actions. Doing this can avoid catastrophic family controversy.
One final point. Parents who develop a business transition and personal estate plan DO NOT have to stop farming the day they sign the plan. Developing a plan preserves what they have worked so hard to build. The plan ensures the parent’s wishes of having assets pass to whom they want them to go.
This section is authored by David Goeller, Transition Specialist, Dept. of Agriculture Economics, U of Nebraska-Lincoln.
For some farm/ranch families, deciding what to do with the family business can be very troublesome. How can we pass the farming business to the next generation while at the same time not create animosity or envy between the heirs? If we divide it equally between all the children, will it create such small pieces that the successor child cannot make a living operating the family farm? If one child is required to buy out his/her siblings will the business generate enough income to make this a feasible option? Most parents would say “We want to treat our children fairly.” Is dividing the farm equally between all the children always a fair solution?
Last week I found myself thinking about a family farming operation struggling with the dilemma of planning their estate. Let’s call this family the Smiths. Like many families, Dad and Mom Smith would like to keep the “farm in the family.” Fortunately for them, son Jimmy, the youngest of three children, decided to return to the business in 1990. But unfortunately, if the farm business were divided into three equal pieces, the resulting slice would not be of adequate size to create a viable operation.
When Jimmy came back into the family business in 1990, the fair market value net worth of the business was $600,000. Dad and Mom discussed the contribution that each child had made over their “growing up” years and decided that each child had contributed more or less about equally to the business during those years. So $600,000 divided equally between the three children is $200,000 each. Today’s net worth of the business has grown to $1,500,000. If divided equally between the three children $500,000 would be left to each. The contributions from the three children toward the success of the farm business have very definitely not been equal since Jimmy’s return, however.
There were no promises made to Jimmy when he returned to the farm, but many decisions were made differently because he was part of the business.
When the neighbor’s land came up for sale, Dad and Mom would not have been interested in purchasing that land if Jimmy had not been involved. It was Jimmy’s idea to increase the rented land and add a cow/calf enterprise to the business. It was also the labor and new energy provided by Jimmy that allowed the business to profit, expand and grow. Jimmy has been paid a modest wage and allowed the use of machinery as he has developed his own farming business. But Dad, Mom and Jimmy all know that his contribution to the family farm has resulted in Jimmy developing a sizable investment of “sweat equity” into the farm business.
There are two dilemmas present in this example. The first arises because most of us want to treat our children fairly. Many of us think that the only way to treat each child fairly is to treat them equally. Maybe that’s the way it was always done in our family. We certainly don’t want to be the cause of any hard feelings. We don’t want our non-farm kids to feel that they have been mistreated or slighted, but if you were to divide the farm business into equal pieces would that equal slice be of adequate size to create a viable business? What about the contribution of the farming child to the success and growth of the business? The second dilemma occurs because farm asset values have increased so dramatically.
Earning adequate income to pay for the increased value of the assets may be difficult, if not impossible for a successor to accomplish. If the Smiths want their son Jimmy to be successful, they need to consider the income the operation will generate as well as the market value of the farm assets.
Let’s look at how the Smith family valued the contribution of their son Jimmy by putting a value on his “sweat equity.” Once completed, they used this to explain to the non-farming kids how they reached their estate planning decisions.
Today the farm’s net worth is $1,500,000. If the Smiths were to divide the assets equally, they would leave $500,000 to each child. But as they considered the contributions made by each child and the impact in the business growth because of Jimmy’s return, they thought of it this way. There has been $900,000 of increase since 1990. The business has grown and diversified. Profits have been reinvested into the farm, and farm assets have appreciated in value. Jimmy has contributed a substantial amount of “sweat equity.” Both parents feel that they may have actually retired several years ago and sold some of the original land (prior to the recent jump in land values) had Jimmy not decided to return to the farm. After much evaluation and discussion Dad and Mom decided that they would equally divide the 1990 value of the farm between their three children, but they decided that Jimmy was responsible for 50 percent of the business growth since 1990. They therefore decided to allocate their assets as follows: recent jump in land values) had Jimmy not decided to return to the farm. After much evaluation and discussion Dad and Mom decided that they would equally divide the 1990 value of the farm between their three children, but they decided that Jimmy was responsible for 50 percent of the business growth since 1990. They therefore decided to allocate their assets as follows:
1990 Jimmy Returns to the Family Business:
-1990 Net Worth of the family business = $600,000
-1990 Net Worth divided equally
between 3 heirs = $200,000
Business Growth, Appreciation, Inflation and Diversification:
-2009 Net Worth has increased to = $1,500,000
-1990 Net Worth of family business = $ 600,000
Net Worth Growth is = $ 900,000
Parents Attribute 50% of Growth in Net Worth to Jimmy:
-50% of $900,000 = $450,000 attributed to
-50% of $900,000 = $450,000 attributed to
-$450,000 parent’s portion divided by three
equals $150,000 each child
Asset Distribution in Estate Plan:
-Jimmy receives $800,000 total:
$200,000 (1/3 of 1990 net worth) plus
$450,000 (50 percent of growth contribution) plus $150,000 (1/3 of parent’s contribution).
-Non-Farm Siblings receive $350,000 each:
$200,000 (1/3 of 1990 net worth) plus
$150,000 (1/3 of parent’s contribution).
Jimmy’s contribution of 50 percent is simply an example. Every operation will have different factors and likely arrive at a different percentage for the value of the successor’s contribution. In the Smith’s case, Jimmy will receive more than twice as much as his brother and sister. However, they all understand the basic process. Contributions equal compensation. The family business looks much different today because Jimmy came back to become part of that business.
Each family situation will be different. The next family may have decided that their successor had contributed to only ten percent or maybe 80 or 90 percent of the growth. The question is how much has the “sweat equity” contributed to the growth of the farm? It is the business owners that are in the best position to evaluate the contribution and adjust the compensation accordingly. The Smith children understand how the estate is to be distributed, and hopefully, they will all be eating Christmas dinner together for years to come.
Treating unequal’s equally, may be the most unfair thing you can do!
Caution: This publication is offered as educational information. It does not offer legal advice. If you have questions on this information, contact an attorney.
Reviewed in 2017