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Let’s Put the ‘Business’ into Farm Business Structures Part Four: Repairing a Broken Farm Structure

14/12/2015


If you’ve been following my family farming blog series to date, you’ll already have picked up some valuable tips on estate planning, matrimonial breakdowns and goal congruence​. This blog will take a closer look at selecting and refining the best business structure for your farm operation based on more than just the tax benefits.​​
Tax should not be the primary motivation behind a business structure. The tax structure can be determined after the business arrangement is determined. In developing the appropriate structure, the goals of all involved parties should be stated, land ownership should be discussed and the allocation of accrual profits should be negotiated.

Statement of Goals / Objective

Typically, the goals of the parents are:

  • We do not want to quit farming but we do not want to work as hard in the next 20 years as we have in the last 20 years.
  • We want to keep making money! Agriculture is a fast-paced / dynamic industry and, like any business (including law and accounting firms), they run better and are more profitable with smart, hardworking, motivated young people influencing / driving the business to continually improve and keep up with industry advancements.

Typically, the goal of the children is:

  • We want to operate a business we are passionate about and enjoy but we do not have the necessary capital to establish it ourselves.

Land Ownership

One of the first issues in the discussion should be whether land should be viewed as an integral part of the business or as an asset than can be owned outside of the business and rented to the business. 

To provide perspective, please consider the following non-farming scenarios:

Scenario 1:  Son just returned from a three-year contract with a large engineering firm and would like to come back and work with Dad in his small engineering firm.  Dad owns a medium sized office building, 60% of which is used by the engineering firm and 40% of which is rented out to various unrelated tenants.

In this scenario, Dad would probably agree to Son joining the engineering firm because Son’s value lies in improving the business but would likely keep the real estate separate for three main reasons:

  1. While a young, smart, hard-working person would be a very valuable asset in running a busy engineering firm of 15 staff and 10-25 projects underway at any point in time, this same person is not needed in the real estate rental business (essentially cashing rent cheques); 
  2. He would like to keep the building as a stable source of income for a number of year; and 
  3. The building is not integral to the business. The engineering firm could rent space in any building and not be adversely affected. The building would be an asset inherited by all the beneficiaries of Dad’s estate but if his children do sell the building, the Son involved in the engineering business would have a right of first refusal. In certain cases, the Son may be given an option to purchase so that, at the time of passing, he may buy the property at fair market value, even if the other beneficiaries would prefer to continue to hold the property (this is a personal decision and should be left at the parent’s discretion).

Scenario 2:  Dad wants to bring Son into the family construction company. Though concurrently attending post-secondary education, Son has worked in the business for the last 8 years (from the time he was 15 years old). The construction company owns two properties; the main site that houses the majority of the buildings including the specialty equipment and another site directly beside a key client’s operation presently producing about 25 percent of their annual revenue.
In this scenario, the property is not easily replaced by the business nor would it be easy to rent out to a third party.  In that case, the property would likely be included in the entity (or entities) in which the Son would acquire ownership.

Consider, now, the following farming scenarios:
Scenario 1: Dad operates a 7,000 acre grain farm that he wishes to transition to Son.  Dad owns 1,000 acres and the remaining 6,000 acres are rented from long term 3rd parties.
In this situation, generally all but the base of operations (usually the home quarter) would remain outside the operating entity in which Son will acquire ownership. 
Please note that, though from a legal protection perspective, it is generally recommended that the home quarter would remain held personally by Dad, from the perspective of protecting the business, the home quarter would always be included in the operational entity because often the base of operations contains significant infrastructure used by the business (bins, shop, etc).
The decision regarding the home quarter is affected by the value of farm infrastructure compared with the value of the house. If there are bins worth $50,000 and a $700,000 house, the home quarter would be left out of the operating entity.  If there is infrastructure worth $850,000 and a 1940’s bungalow, the home quarter would be owned by the operating entity. If there was a $700,000 house and infrastructure worth $850,000, typically the two would be subdivided so that the land with the infrastructure would be owned by the operating entity and the home would remain personally owned.

Scenario 2: Son is joining Dad in a 700 cow/calf pair ranch with 1,300 acres of deeded grass, 600 acres for silage/grain feed next to the home operation, and 5,000 acres of crown lease land that are all connected.

In this case, the importance of that specific parcel of land is vital to the success of the operation and would, therefore, be included in the operating entity.

Allocation of Profits​

Once the decision regarding land ownership is settled, the last significant issue is determining the appropriate allocation of profit. This allocation should be based on three components:

  1. Capital contributed (this includes equity in the operation as well as the cost of using land where land is held outside the joint operating entity),
  2. Labour contributed, and
  3. Ownership/residual profit after the first two components have been addressed.

This process is foreign to most farm owners who, though they need guidance through the process, fundamentally need to determine the arrangement themselves.

Rules of Thumb for Negotiating Allocation of Profits:

  • While capital is important to a farm operation, once the base capital is in place, management is more important. Farming operations run by a senior partner together with a smart, hardworking junior partner are generally more profitable than those without that younger tier of management with a new level of enthusiasm, energy, and new ideas.

  • It is not recommended that a fixed return for capital (i.e. land rent or interest on money invested in operations) be implemented because, typically, the junior partner does not have the equity to contribute in the case of an unprofitable year (a guarantee from a young entrepreneur is no guarantee at all without the capital to support it).

  • Even if contributed labor is paid monthly/hourly (which is not the norm for management of most farms) and the equity receives a fixed rate of return, there is still negotiation required as to how the residual profit should be split. For that reason, rather than breaking down the split of profit into its individual components (rent, interest, labor, profits), the parties just agree to split the net profit as one overall percentage reflecting all relevant components. As the arrangements and the junior partners mature and (hopefully) build equity, the land rent and interest on equity components can be added to the formula.

  • Profit should not be allocated based on the number of acres owned. This can encourage poor decisions such as Son leveraging far beyond his ability to buy land in order to share in more of the profit. Rather, Dad should buy land and rent it to the operation for a reasonable rate of return and then labor is left as the driving force behind farm profitability.

  • Remember this is a business transaction and, as such, both parties should be thinking about achieving their goals while maximizing their profitability. This means that the senior partners need to offer enough to encourage their junior partners to join the business and help them manage the farm and the junior partners want to make sure that the senior partners are motivated to leave their equity in the business. That way, both can reap the rewards from the farm business rather than selling the farm, investing the proceeds, and renting out the land to the neighbour for cash rent. Simply stated, greed should be the driving force in negotiations - but in order for one side to win, the other side must win also.

Farm Structure Rules of Thumb:

  • Always put Mom and Dad on a fixed withdrawal rather than the children.

    One problem with a regular payment to the children is that it has the potential to cause them to feel as though they are the hired hands, receiving the same $5,000 (for example) every month, regardless of whether the farm had a great year or a poor year.

    A second problem is that the children do not learn the important skill of managing cashflow to ensure the operation runs smoothly. This includes when payments are due, how much machinery to buy, and when to sell grain. If the goal of the parents is to gradually reduce their role in the day to day management, they need to transition the business end of operations. The longer it is delayed, the less likely it is that the transition will be successful.

    Therefore, rather than Son receiving a fixed monthly distribution, Mom and Dad receive one. Typically, it should be a fixed automatic transfer from the farm account to Mom and Dad’s account. Otherwise, Son will always have something else the farm needs to purchase and parents are traditionally poor at collecting from their children. This discipline is great training for the children and provides comfort to the parents that the farm is being managed well.
  • Ensure that the farm produce a full accrual financial statement (regardless of whether it is required for tax purposes or not) for two reasons:
    1. To allow the parents to see the profitability of the farm and to ensure that the child is managing it well, and

    2. To track each of the stakeholder’s equity in the farm resulting from their share of profit and their withdrawals and contributions.

  • Do not start with the details but rather begin with the big picture and then work down to the details in order of importance.

  • Approach the discussion as though the arrangement was with the neighbour’s child that was joining the operation rather than a family member. This provides clarity in distinguishing what a child should receive as an inheritance and what he or she may or may not earn (depending on profitability) as a junior partner in the business.

Once the business arrangement is finalized, operation of the farm moves forward with all parties involved trying to maximize the farm’s profit so that all may benefit. This is not the end of planning. The parties must still figure out how to communicate, determine each individual’s roles and responsibilities, develop an effective decision-making process and address operational and corporate ​governance. Even so, it is a good start!

​To learn more about business and tax structures for your agriculture operation, contact Dean Klippenstine, CPA, CA, Director, Primary Producers, at 877.790.7990 or [email protected], or your local MNP Advisor.