Using partnerships and corporations to transfer farm assets
- Establishing a business entity, such as a partnership or corporation, can help with the process of transferring a farm business to the next generation.
- In Minnesota, there are two major categories of partnerships: partnerships and limited partnerships.
- The two corporation entities available to farm businesses are S corporation and C corporation.
- Developing any business entity is a complicated process. Seek assistance from a qualified legal expert and accounting assistance if you plan to explore developing a business entity.
Transferring the farm business to the next generation can be a daunting task. However, there are strategies and methods that can help simplify the process.
When operating as a sole proprietorship, it can be challenging to establish a transition plan. There are many individual assets that need to be accounted for such as machinery, equipment, livestock and land. It is difficult and time consuming to transfer separate, individual assets.
One possible solution is to establish a business entity such as a partnership or a corporation to accomplish the business transition. As members and owners of the entity, the parents are issued ownership shares or shares of stock in the entity. These shares can be sold, gifted or passed through an estate to the entering generation, over time, as a method of transferring the business. This does away with the need to transfer separate, individual assets. This also spreads out the parent’s income and thus tax obligations. It allows the entering generation the ability to acquire assets over time thus minimizing their need for large amounts of capital.
Learn about partnerships and corporations
In Minnesota, there are two major categories of partnerships: 1. partnerships and 2. limited partnerships. There are separate entities under each category which function differently.
There are two entities: general partnerships and limited liability partnerships.
General partnerships (GP)
Two or more people are required for the GP and are referred to as general partners. All partners are generally liable for all debts and obligations of the GP. There is no liability protection for their personal or partnership assets. Minnesota state law does not require a written partnership agreement. However, such an agreement outlining decision making and job responsibilities might be useful. If the name of the partnership is that of the partners (Henderson Family Partnership), the entity does not have to be registered with the State of Minnesota. The entity is taxed as a partnership, pass-through entity, with income allocated to each partner based on their ownership and included in their personal income tax.
Limited liability partnerships (LLP)
The LLP is similar to the GP with exceptions. All partners are general partners (no limited partners) but their liability exposure is limited to the assets they have placed into the LLP. Their personal assets are protected from liability exposure. The LLP is required to register with the Secretary of State in Minnesota. The LLP is taxed as a partnership, pass-through entity.
2. Limited partnerships
There are three partnership categories: limited partnership (LP), limited liability limited partnership (LLLP), and limited liability company (LLC).
Limited partnership (LP)
Two or more persons are required. There are both general and limited partners. General partners have no liability protection for their business assets but do for their personal assets. The limited partners’ assets in the LP as well as their personal assets have liability protection under the LP. The LP is required to register with the Secretary of State in Minnesota. and the Minnesota Department of Agriculture to comply with the Minnesota Corporate Farm Law. The LP is taxed as a partnership, pass-through entity.
Limited liability limited partnership (LLLP)
Two or more people are required. There are both general and limited partners and they have liability protection of both their LLLP assets and their personal assets. The State of Minnesota requires the LLLP be registered with the Secretary of State and the Minnesota Department of Agriculture to comply with the Minnesota Corporate Farm Law. The LLLP is taxed as a partnership, pass-through entity.
Limited liability company (LLC)
Requires only one person as a member of the entity. From a tax standpoint, the LLC can be taxed as a partnership pass-through entity or as an S Corporation. In addition, the LLC can afford tax savings via discounting assets and potential savings of self-employment taxes. The LLC provides liability protection much like that of a corporation.
The LLC has both members and managers. Members elect or appoint a board of directors. The State of Minnesota requires that the LLC register with the Secretary of State and the Minnesota Corporate Farm Law of Agriculture to comply with the Minnesota Corporate Farm Law.
The LLC can offer one additional level of liability protection by being registered in one of what are referred to as “protective states”. Although the list changes occasionally, some of the protective states include: Alaska, Arizona, Delaware, Nevada, New Jersey, South Dakota, Texas, Virginia and Wyoming. These states have written their LLC statutes to include an additional level of liability protection as long as the LLC members abide by all the statute rules. It is legal to register, for example, your Minnesota farm business in one of these protective states and still operate in Minnesota as you have been. You would need a contact in the state where registered. That contact would establish the entity on your behalf and at year end send you a K-1 form for income and you file your tax return just as you do now. This is a complicated process so seek expert legal help if you decide to develop an LLC in one of the protective states.
Registering with Minnesota Department of Agriculture
For the entities that are required to register with the Minnesota Department of Agriculture for compliance with the Minnesota Corporate Farm Law, this is an annual requirement and there is a $15 fee required to file the documentations. In addition, land held in trust must also register annually with the Minnesota Department of Agriculture for compliance with the Minnesota Corporate Farm Law.
As mentioned, partnerships pay no income taxes. All profit/loss, capital gains and credits are passed through to the partners on a prorated basis, depending upon the percent of ownership. However, the partnership must file a Form 1065 informational tax return, which is due each year by April 15.
Advantages and disadvantages
An advantage over sole proprietorship is that the owners have ownership units or shares. These units or shares can be sold, gifted or passed through an estate as a means of transferring the business over time to the entering generation.
One disadvantage with a partnership, except the LLC, is that the death of a shareholder or willful withdrawal by a partner can seriously disrupt partnership operations. The partnership agreement, if put into place at time of formation of the entity, should clearly describe buy-out provisions or state how the remaining partners are protected, no matter how circumstances change.
Partnership tax laws
Partnership tax laws are similar to individual tax laws. A partnership can generally take over the depreciation schedule of contributed machinery or buildings. A partnership can claim the Section 179 depreciation expense which is passed on pro rata to the partners. Each partner can claim depreciation, which includes his or her portion of the partnership allocation plus any other personal Section 179 depreciation.
Partnership members are self-employed individuals and must pay self-employment tax on their share of earned partnership profits. Partnerships do not receive the favorable tax treatment on fringe benefits (medical, accident and life insurance, housing and meals) as do “C” corporations. However, it generally costs less to form a partnership than a corporation and partnerships can be less formal to operate.
There are two corporation entities available to farm businesses. They are: S corporation and C corporation.
1. S corporation
The S corporation offers a higher level of asset liability protection than a sole proprietorship and some of the partnerships. It must be registered with the Secretary of State in Minnesota. The S corporation is taxed as a pass-through entity with profits allocated to the stock shareholders based upon their ownership percentage. The income then shows up on the shareholders personal income tax. There is no double taxation issue.
Business operating assets can be placed into the S corporation or they can be left out with only the corporate checkbook as part of the corporation operating entity. Placing assets into the corporation is a non-taxable event but getting them out is not. For that reason, it is a general rule of thumb not to place land into the corporation. See your attorney and accountant for advice specific to your situation.
2. C corporation
The C corporation also affords a higher level of asset protection than the sole proprietorship or some of the partnership entities. The C corporation offers longevity to the business because it is technically an entity onto itself with a life of its own. That is, people can enter and leave the C corporation and it continues on without interruption. It also affords many tax advantages regarding deductible expenses.
The C corporation however, can be subject to double taxation. The dividends paid to shareholders are taxed. If the corporation is not growing or acquiring new assets resulting in the corporation retaining earnings, those earnings can be taxed as well. Corporate tax rates are generally higher than other tax rates. Business operating assets can be placed into the C corporation or they can be left out with only the corporate checkbook as part of the corporation operating entity. Placing assets into the corporation is a non-taxable event but getting them out is not. For that reason, it is a general rule of thumb not to place land into the corporation. See your attorney and accountant for advice specific to your situation.
One additional point that applies to both S and C corporations. Shareholders have to maintain an employer-employee relationship with the corporation. If the shareholders maintain personal ownership of what they consider corporate assets, charge corporate business expense against those assets, are audited by the IRS, they may be denied those expense deductions because the assets were owned by the shareholders, not the corporation.
A corporation is established under state law. Each state permits corporations the right to do business. A corporation consists of owners who are called shareholders. The shareholders are the basic decision making group. They elect a board of directors to act for them on most operational decisions. Majority vote governs corporate decisions. Ownership of 51 percent or more of the stock gives you control. Minority shareholders have little if any decision making control unless permitted to do so by the majority shareholders.
Once a corporation is created, it functions much as a self-employed individual might. Corporations must establish their own name and bank accounts. The corporation can become an employer, a lessor or lessee, a buyer or seller, or engage in any other business activity.
Reasons why farms incorporate
- It is easy to transfer shares. Shareholders can gift, sell or pass through an estate, shares to others as they see fit. A majority shareholder can transfer up to 49 percent of the outstanding shares without losing control of the business.
- A corporation may simplify estate settlement in that it may be easier to value shares than individual farming assets.
- Self-employment (SE) tax can sometimes be reduced with a corporate structure. Instead of paying SE tax on all the Schedule F income as a self-employed individual would, the farmer becomes an employee of the corporation and social security taxes are paid only on wages they receive. See your accountant.
- A portion of meals and lodging furnished to employees of a C corporation are generally deductible to the corporation, but not taxable income to the employee. If lodging is provided on the farm and is a condition of employment, the home’s depreciation, heat, electricity and interest become deductible to the corporation. Remember the employer-employee relationship issue.
- Fringe benefits are deductible by C corporations. Health, accident and up to $50,000 of term life insurance is deductible to the corporation, but not taxable to employees.
- The corporation offers perpetual life, some economic efficiencies regarding capital acquisition, and provides income and social security tax flexibility. It can also provide continuation of a farm business through several generations.
Potential concerns related to the corporation
- Getting into a corporation is generally a tax-free event. Getting out is a taxable event. Don’t start a corporation unless you plan to continue it for many years.
- If the C corporation is profitable but is not growing and acquiring new assets, it can be troubled with retained earnings or excess profits. This can result in a tax obligation.
- Corporations have a different set of rules. Corporate meetings, extra record keeping, corporate income tax returns, reporting requirements, and quarterly tax estimates are part of corporate life. Complying with extra legal and regulatory requirements cost time and money each year.
- Minority shareholders have no power in directing the corporate business and can be easily “frozen out.” A majority shareholder (farming heir) can direct that no dividends be paid. Minority (non-farm heirs), may own shares that generate no income, and hence have no practical value.
- Corporate ownership of a house eliminates the use of the exclusion of gain or a sale of personal residence.
- Corporate ownership sometimes reduces independence and individual pride of ownership.
- It can be very difficult for a retired shareholder to receive any retirement income from an operating corporation. This is especially true if the retiree has no rental property, discontinues working for the corporation, and the corporation pays no dividends.
The farm corporation can be a valuable tool in tax planning and in the transfer process. However, it is a major commitment and a complex task to start a farm corporation. Before starting a corporation, make sure it fits your goals, objectives and business personality.
Developing any business entity is a complicated process. Seek assistance from a qualified legal expert and accounting assistance if you plan to explore developing a business entity.
Self-employment tax on land, buildings and facility rent regarding entities
The US Eight Circuit Court of Appeals has ruled that if you are a member of any business entity (such as a partnership or corporation explained above); own land, buildings, or facilities that are outside that entity; and rent those items to the entity; the rental income is exempt for self-employment tax IF the rent is fair and reasonable.
This applies only to those states in the eighth circuit which include Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota. With any of these laws, they are subject to change so seek legal advice on this matter.
Discounting business entity assets
An additional strategy that may be useful is the discounting of assets being placed into a business entity, such as any of the partnerships or corporations described earlier.
When you place business assets such as machinery or livestock into the business entity, you can elect to discount those assets. The main reason for discounting assets being placed into the business entity is to reduce the size of an estate in order to get below the federal and perhaps even the state estate applicable exclusion amounts. Doing so will reduce or eliminate any estate tax.
Justification for the discount is based upon lack of marketability of the assets due to a fractional ownership interest.
One disadvantage of discounting is that you have artificially lowered the basis of the assets in the entity. This can be a problem if the entity is discontinued and the assets are sold as a result. This could result in a tax obligation. If the assets are replaced due to use, this is not an issue.
Assets being discounted and placed into an entity should be appraised. If, at a future date, the entity is audited by the IRS, you can document the value of the assets placed into the entity. For machinery and equipment, simply take the depreciation schedule to the local implement or equipment dealer and ask them to put a value on all machinery. Have them put the values in writing on their dealership letterhead along with a signature and date. For livestock you can take a list to a livestock auction facility or someone who deals in livestock and would have a grasp of the values. The values should be put in writing and listed on their letterhead with a signature and date. For land, seek the help of a realtor who deals with ag land. Simply have them do an estimate or appraisal of the land, put it in writing on their letterhead, with a signature and date.
Note: In late 2016, the Internal Revenue Service and the US Treasury Department enacted 2704 rules which drastically changed discounting rules and during which situations they may apply. If assets are transferred and then sold, discounting will definitely not apply. If you are contemplating discounting any assets seek legal and accounting assistance to make sure you are in compliance with 2704 rules.
Business entities and maintaining homestead classification
When using a business entity for ag land ownership, caution must be used in order to maintain eligibility for the Minnesota Qualified Small Business Property Qualified Farm Business Property estate exclusion. In addition, utilizing limited liability companies (LLCs) as a business entity have new rules to comply with due to passage of the Minnesota Revised Uniform Limited Liability Company Act of 2015. The law states the land-owning LLC and its members must be the ones farming the land on behalf of the owner LLC. If the owner LLC rents the land to someone else, even another member of the LLC who then farms it personally, homestead classification is lost and therefore the qualified farm property estate exclusion is also lost. New LLCs must have complied with the new law as of August 1, 2015. Existing LLCs must have complied with the new law by January 1, 2018.
Ag land held in any trust, except a revocable living trust, as well as land in limited partnerships, limited liability limited partnerships, S and C corporations and LLCs must file documentation with the Minnesota Department of Agriculture under the Minnesota Corporate Farm Law in order to be eligible for the qualified farm property exclusion. The application must be done annually and there is a filing fee of $15 per application.
For more details on the Minnesota Homestead Classification requirements see maintaining farm land homestead classification and qualification. This is a complex area and there is a lot at stake regarding the qualified farm property estate exclusion so seek legal advice specific to your situation when establishing any entity that owns ag land.
Farm Service Agency (FSA) payments and business entities
Under the current farm bill, there are some restrictions regarding commodity program payments made to individuals versus entities. Entities that limit member’s liability exposure (all entities except the general partnership) are limited to one maximum payment limit regarding FSA commodity program payments.
This is a complicated issue. If you have any questions or concerns related to your situation, check with your FSA office for details of the program.
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