of Forms Farm Business Organization
(Chapter 14)
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Objectives
1. Discuss the organization and characteristics of each form of business. 2. Show how income taxes are affected by the form of the business. 3. Discuss the factors to be considered when selecting a form of business organization. 4. Transferring the income, ownership, and management of a farm business from one generation to the next.
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3 Most Common Forms of Farm Business
2002 U.S. Census of Agriculture
1. 2. 3. 4. Sole proprietorship 90% Partnership 6% Corporation (family held) 3% Other 1%
Cooperatives, institutional or non-family corporations, limited liability companies
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Farm Business Organization
Depends On:
Size. Number of people involved. Career stage and age of operators. Owner's desires for passing it on to the next generation. Life cycle.
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Life Cycle
Four Stages:
1. 2. 3. 4. Entry Growth Consolidation Exit
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Life Cycle
Entry Stage:
Choosing farming as a career. Selecting enterprises. Acquiring and organizing resources. Establishing a financial base.
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Life Cycle
Growth Stage:
Expansion by internal growth:
Purchasing and leasing additional land. Increasing the scale of the livestock enterprise.
Merging is another means of growth.
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Life Cycle
Consolidation Stage:
Debt reduction. Increased efficiency is preferred to increased size (when possible). Planning and including the next generation.
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Life Cycle
Exit Stage:
Reducing risk. Liquidating the business. Transferring property to the next generation. Size may decline by selling long term assets. Income taxes and retirement income must be considered. Equitable treatment to all the heirs.
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Sole Proprietorships
Most common. Easy to form. Relatively easy to operate:
Limited rules to create and run.
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Sole Proprietorships
Organization and Characteristics:
Owner = Business:
Owns and manages the business. Assumes all the risks. Receives all profits and losses. Responsible for success or failure.
No legal procedures, permits, or licenses. No legal limit to size or number of employees.
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Sole Proprietorships
Advantages
Simple Freedom All profits belong to owner. Flexible
Disadvantages
All responsibilities Personally liable Limited capital Smaller size Difficult to compete Insufficient time and management skills. Poor continuity
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Sole Proprietorships
Income Taxes:
Owner pays income taxes on any profits. Business profits and capital gains are added to any other taxable income. Income is subject to self-employment taxes (Social Security and Medicare).
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Joint Ventures
Two or more operators combine their abilities: 1. Operating agreements 2. Partnerships 3. Corporations 4. Limited liability companies 5. Cooperatives
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Operating Agreements
Typically informal for a short duration:
Two or more sole proprietors work together on some farming activity. Generally pay their own ownership costs. Operating expenses may be shared:
Usually in the same proportion as fixed costs.
Share income in the same proportion as total resources are contributed.
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Partnerships
A formal association of two or more persons who share the ownership of a business: 1. General partnership 2. Limited partnership
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General Partnerships
Three Basic Characteristics:
1. Shared business profits and losses. 2. Shared control of property, with possible shared ownership of some property. 3. Shared management of the business. Sharing arrangements should be outlined in the written partnership agreement.
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General Partnerships
Oral partnership agreements are legal in most states, but are not recommended: Overlook important points. People forget. Income tax problems.
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General Partnerships
Unless there is a written agreement most courts assume an equal partnership in everything. Written agreements should include:
1. 2. 3. 4. 5. 6. 7. Management Property Ownership and Contribution Sharing of Profits and Losses Records Taxation Termination Dissolution
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General Partnerships
Factors that indicate a particular business arrangement is legally a partnership:
1. 2. 3. 4. 5. 6. Joint ownership of assets. Operation under a firm name. A joint bank account. A single set of business records. Management participation by all parties. Sharing of profits and losses.
A business arrangement may be a legal partnership, even though a partnership was not intended.
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General Partnerships
Advantages
Easier and cheaper than a corporation. Less records than a corporation. Freedom. Flexibility.
Disadvantages
Unlimited liability. Any partner can act for the partnership in legal and financial transactions. Poor continuity.
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General Partnerships
Income Taxes:
File an informational income tax return reporting income and expenses for the business. Income from the partnership is reported by the individual partners on their personal tax returns.
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General Partnerships
Partnership Operation:
Contributed assets should be valued at their current market value. Operating expenses should be paid by the partnership. Labor should be paid fairly by the partnership.
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General Partnerships
Partnership Operation (cont.):
Rent is often paid for the use of land and buildings. Net income can be paid out or left in the partnership account. When the partnership is liquidated, the proceeds should be distributed in the same proportion as the ownership.
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Limited Partnerships
At least one general partner:
Can have many limited partners.
Limited partners:
Cannot participate in management. Financial liability is limited to their investment.
Liability of general partners can extend to personal assets. Common limited partnerships:
Real estate development. Cattle feeding.
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Corporations
A separate legal A entity. legal "person," separate and apart from its owners, managers, and employees. A corporation can:
Own property. Borrow money. Enter into contracts. Sue and be sued.
Family farm corporations increasing in popularity.
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Corporations
Basic steps to create:
1. 2. 3. 4. 5. 6. File a preliminary application with the appropriate state official. Draft a pre-incorporation agreement outlining the major rights and duties of the parties. Prepare the articles of incorporation and file with the proper state office. Turn property and/or cash over to the corporation in exchange for shares of stock. Shareholders meet to organize the business and elect directors. Directors meet to elect officers, adopt bylaws, and begin business in the name of the corporation.
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Corporations
Organization and Characteristics:
1. Shareholders 2. Directors 3. Officers Can be the same individuals.
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Corporations
Shareholders:
Own the corporation. Direct affairs through elected directors. Each shareholder has one vote per share of voting stock owned.
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Corporations
Directors:
Elected by shareholders. Manage the business. Set broad management policy.
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Corporations
Officers:
Elected by the board of directors. Responsible for day-to-day operations.
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Corporations
Two Types of Corporations:
1. C Corporation
-Regular corporation.
1. S Corporation
-Tax-option corporation.
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Corporations
Restrictions on S Corporations:
Limited to 100 shareholders. Shareholders can be individuals, estates, certain types of trusts. Other corporations cannot hold stock. Only one class of stock. Voting rights may be different for some shareholders. All shareholders must initially consent to operating as an S corporation. Certain % of "earned" income.
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Corporations
Advantages
Limited liability Pool resources Specialized management Obtaining credit Continuity Transferring ownership Fringe benefits: Vehicles Insurance
Disadvantages
Costly to form and maintain Legal advice Meetings Double taxation:
Remember, Scorporations are taxed like a partnership.
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Corporations
Corporation Operation:
Basically operated similar to a partnership. Number of shares to be issued is decided by the stockholders. Value of each share = (beginning equity by the number of shares to be issued). Net income is distributed in the form of dividends.
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Limited Liability Companies
(LLC)
Resembles a partnership, but offers its members the advantage of limited liability:
Creditors or others can pursue the assets of the LLC, but cannot pursue personal or business assets owned individually by members of the LLC.
Any number of members. Ownership is distributed according to the fair market value of assets contributed. Net farm income is passed on to members in proportion to their shares of ownership.
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Limited Liability Companies
(LLC)
Advantages
Limited liability for investors. Less time to form than a corporation. Simple Flexible
Disadvantages
Can't deduct cost of fringe benefits. Poor continuity. New
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Cooperatives
A special type of corporation formed to:
Obtain inputs or services. Market products jointly. Engage in farm production.
The key is a true desire to cooperate!
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Cooperatives
General Characteristics:
Limited liability. Net income is passed on to members before taxation. Provide tax deductible benefits to owner/members. Maximum return payable is 8%. Remaining net income is distributed to members as "patronage refunds," based on amount of business. All members have one vote.
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Alternative Business Organizational Structures
1. Sole Proprietorship 2. Partnership: - General
- Limited
3. Corporation: - C or Regular Corporation
- S Corporation - Cooperative
4. Limited Liability Company (LLC)
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Transferring the Farm Business
Important Questions for Family Business: Is the business large enough to productively employ another person or family? Is the business profitable enough to support another operator? Can management responsibilities be shared?
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Key Areas to Transfer
1. Income 2. Ownership 3. Management
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Key Areas to Transfer
Income:
Pay the new operator a wage and/or return to asset contribution. Bonus Profit sharing
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Key Areas to Transfer
Ownership:
Saving breeding stock. Investing in machinery. Selling assets. Gifting assets. Careful estate planning.
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Key Areas to Transfer
Management:
Often the most difficult to transfer. Give responsibility one enterprise at a time. Allow younger operators to rent land to gain experience and learn management skills.
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Stages in Transferring the Business
Testing stage of 2-5 years is often a good idea then: 1. Spin-off. 2. Takeover. 3. Joint operation.
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Stages in Transferring the Business
Spin-off:
Operators separate into their own individual operations. Can still trade labor or use of equipment.
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Stages in Transferring the Business
Takeover:
Older generation phases out of active labor and management. Renting or selling to the younger generation.
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Stages in Transferring the Business
Joint operation:
Both generations wish to continue farming together. Often involves expansion. Crucial to have effective personal working and management relationships.
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Alternatives for Farm Business Transfer
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Summary
A farm or ranch business can be organized as a sole proprietorship, partnership, corporation, or LLC. The form of business organization depends on the size of the business, stage of its life-cycle, and the desires of the owners. The right form of business can make transferring farm income, ownership, and management to the next generation easier and increase the chances for a successful transfer.
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