Using partnerships and corporations to transfer farm assets

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.

1. Partnerships

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.