Farming isn’t just a business, it’s a commitment to family values and a different way of life. You work hard to feed your family and others, raise your children, and earn a reasonable living at the same time. And if you’re reading this article, chances are that you’re a farmer and you know this better than me. What you may not know is that your decision not to establish a business entity for your farm can have significant consequences for your farm’s operations and ultimately its success. Handshake deals and informal partnerships are becoming a thing of the past —and for good reason (discussed below). Formal business entities, such as limited liability partnerships, limited liability companies, and corporations, can help protect your personal assets from the hazards of operating a farm, minimize taxes, and ease transition of the farm from one generation to the next.
The Danger with Sole Proprietorships and Informal Partnerships
Many farmers have traditionally operated as sole proprietors or as partners in a general partnership. The sole proprietorship is a common type of business structure among farms and is not a legal entity separate from its owner. A sole proprietorship is an unincorporated business owned and operated by a single individual for profit. In comparison, a general partnership is formed when two or more persons carry on as co-owners of a business for profit. You do not have to file any documents with the Minnesota Secretary of State to establish these types of businesses, nor do you have to draft any organizational documents.
While these business structures are easy to set up and relatively simple to use, both have disadvantages. The first major disadvantage is that these arrangements do not provide any liability protection. The personal assets of a farmer are not shielded from liability arising out of the farming operation.
A second major disadvantage applies to general partnerships. As mentioned above, you do not have to follow many legal formalities to create a general partnership. A general partnership is created under Minnesota law when two or more persons carry on as co-owners of a business for profit. A partnership can even be formed when the parties don’t intend to form a partnership.
Imagine for a minute that the cousin or friend you engage to haul and market grain ends up being treated as your partner under Minnesota law. What are the terms of this implied partnership? What portion of your operation does he receive upon liquidation? How much of your profit will this supposed partner be entitled to claim? Unfortunately, litigation may be necessary to resolve these questions.
Farmers can mitigate these risks by formalizing their partnership with a partnership agreement. At a minimum, a partnership agreement should describe how profits and losses are allocated to the partners, how new partners are admitted to the partnership, how partners may withdraw from the partnership, how and when partners may sell their ownership interests, and how management conflicts are to be resolved between partners. It is also advisable to use written contracts for independent contractors and when leasing farmland.
Entity Types and Structures
In addition to the sole proprietorship and general partnership, several other types of entities can be used in farming operations. Each comes with its own set of positives, negatives, and tax consequences:
Formalized Partnerships. In contrast to a general partnership, farmers can establish a limited partnership by filing a Certificate of Limited Partnership with the Minnesota Secretary of State. Limited partnerships must have at least one general partner and one limited partner. General partners make decisions on behalf of the partnership, but are jointly and severally liable for all obligations of the limited partnership. The limited partners do not have any management rights, but their personal assets are shielded from partnership debts. Limited partnerships are typically governed by a written partnership agreement.
Both general partnerships and limited partnerships can register with the Secretary of State to create a liability shield to protect the general partners’ personal assets. These partnerships are referred to as limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs), respectively.
Corporations. A corporation is the most formal and complex business structure used in farming. A corporation has at least three levels of governance: its board of directors, officers (including CEO and CFO), and shareholders. The corporation’s shareholders elect a board of directors, which is in charge of making all major decisions for the corporation. The board of directors in turn appoints officers to carry out the board’s decisions, sign documents, and take other actions on behalf of the corporation. The rules for how a corporation conducts business and makes decisions
are usually set out in the Articles of Incorporation filed with the Secretary of State and written By-Laws. Corporations offer strong asset protection, but must strictly comply with certain legal formalities, such as holding shareholder and director meetings. Liability protection can be lost when the shareholders fail to observe these formalities.
Corporations can elect to be taxed as a C corporation or S corporation. C corporations are subject to two levels of taxation: one at the corporate level when income is earned and another at the shareholder level when profits are distributed to shareholders in the form of dividends. Items of income and deductions flow through to the individual shareholders of an S corporation, similar to taxation of partnerships. And shareholders of an S corporation typically do not pay a separate income tax on dividends they receive.
Limited Liability Companies. Limited liability companies (LLCs) are now a common operating entity to use in farming. This is due to their strong liability protection and flexibility in governance structure. An LLC’s owners are referred to as “members” under Minnesota statute. The LLC can be operated by its members (similar to a general partnership), by one or more managers (similar to a limited partnership), or by a board of governors (similar to a corporation). The members can also customize any of these three structures by drafting their own, personalized governance rules in a document called an operating agreement. In order to establish a limited liability company, the organizer must file Articles of Organization with the Secretary of State.
An LLC with only one member is treated as a “disregarded entity” for tax purposes, unless the LLC elects to be taxed as an S corporation. A disregarded entity is totally ignored for tax purposes; all items of income and deductions of the LLC are reported directly on the member’s individual tax return. If the LLC has more than one member, it can elect to be taxed as a partnership or S corporation.
The Benefits of Farming with an Entity
When a farmer forms a business entity, the farmer transfers farm assets out of his or her name and into the name of the business entity. In exchange for this contribution, the farmer receives ownership interests in the business entity, such as shares of stock, membership interests, or partnership interests.
As mentioned above, one of the primary benefits of using a formalized entity is the liability protection afforded to the company’s individual owners. The company is a separate legal entity. Generally speaking, the debts, obligations, and liabilities arising from the operation of the farm belong to the company and not its owners. For example, if an employee of the company is injured while operating the company’s tractor, the employee is normally limited to recovering against the company’s assets. The employee (at least in most cases) cannot recover from the farmer’s personal assets held outside of the company.
Business entities also provide an effective way to transfer the farming business from one generation to the next. Rather than splitting up the farmland among children who farm and those who do not, a farmer can gift ownership interests in the entity to all children during his life or at his death. The benefit of this arrangement is that the farmland is kept together, while the “non-farming children” still receive some benefit in the form of future profit distributions. To the extent that the farmer needs income in retirement, the farmer can sell some of his ownership interest in the entity to children or other family members.
Using business entities in farm-succession planning can also minimize gift and estate tax. As a general rule, for gift and estate tax purposes, transfers of interests in closely-held businesses like family farms are valued at their fair market value. Unlike shares in a public corporation, there is no readily available market for the sale of interests in closelyheld business entities. Consequently, the value of the interest is often discounted for this lack of marketability. Discounts may also be applied for non-controlling or minority interests.
Minnesota Corporate Farm Law
If you’re going to farm through a business entity, the entity must be eligible to farm in Minnesota. In the early 1970s, Minnesota passed a law that is commonly referred to as the Minnesota Corporate Farm Law (the “Law”). LLCs, corporations, most types of trusts, and other business entities cannot own agricultural land or engage in specified farming activities within the state of Minnesota unless they meet the Law’s requirements. The Law is fairly long and complex, and its requirements vary based on the type of entity used to farm. However, to generalize broadly, there
are two categories of entities that may farm in Minnesota—Family Farm Entities and Authorized Farm Entities.
A Family Farm Entity is a company formed for the purpose of farming and owning agricultural land. A majority of the ownership interest in the entity must be held by persons within three degrees of kinship—think grandparents, parents, children, siblings, nieces and nephews. At least one of those persons must be residing on the farm or actively operating the farm; or, in the case of LLCs and LPs, one of the persons must have owned the agricultural land for a period of at least five years prior to transferring the land to the entity.
An Authorized Farm Entity must comply with even stricter requirements. An Authorized Farm Entity can only have one class of ownership interests and up to five owners, although married couples are counted as one owner. Its revenue from rent, royalties, dividends, interest, and annuities cannot exceed 20 percent of its gross receipts. And the Authorized Farming Entity cannot own more than 1,500 acres. There are additional requirements, but these are some of the more important restrictions to keep in mind when deciding between the two categories of farm entities.
Family Farm Entities and Authorized Farm Entities must file a corporate farm application with the Minnesota Department of Agriculture. The cost of filing the application is $15.00. Annual renewal forms are sent out every February via U.S. mail. The renewal must be processed every year to remain compliant with the Law. Failure to file a required corporate farm report is a gross misdemeanor and can be punished with a $500 civil penalty. The Law also authorizes the Attorney General to seek a court order forcing a business entity or trust owning agricultural land in violation of the Law to divest itself of the land within five years.
It should be noted that the Law only restricts the farming activities of corporations, limited liability companies, pension or investment funds, most types of trusts, and limited partnerships. Sole proprietorships, general partnerships, limited liability partnerships, qualifying revocable trusts, and certain grandfathered entities are entirely exempt from the Law and do not have to register with the Minnesota Department of Agriculture.
It is important to treat your family farm like a business. The extra burden associated with formalizing your family farm is minor in comparison to the benefits offered by using entities such as LLPs, LLCs, and corporations. What entity works best for you will ultimately depend on the size of your operation and the activities it engages in, among other things. Farmers should consult with their attorney or CPA to help determine which option is best for them.