Entity Selection: Tax Advantages and Traps for Farmers & Ranchers

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1 Entity Selection: Tax Advantages and Traps for Farmers & Ranchers Andrea J. Rosholt February 19, 2014

2 Your Questions 1. How does a Family Estate LLC work in transferring of real estate and avoiding probate? 2. Does a farm that operates as a LLC taxed as a partnership subject itself to more liability or risk exposure than a farm that operates as a corporation? 3. Changing from a S-Corp or C-Corp to a LLC. Pros and cons for long term land ownership. 4. Everyone in AG seems to be setting up entities for various reasons. Do you see a time or have experience with the need to unwind/end entities and what issues arise then? 02/19/14 2

3 Entity Selection Scenario One: The Mom and Pop Scenario Scenario Two: The Business Partners 02/19/14 3

4 Business and Succession Planning Goals Scenario One: The Mom & Pop 1. Retain Enough Money for Living Expenses 2. Reduce Liability 3. Reduce Taxable Estate 4. Divide Assets in an Equitable Manner Scenario Two: The Business Partners 1. Make Profit 2. Reduce Liability 3. Reduce Taxes 4. Succession Planning for Business Partners 02/19/14 4

5 Build the Cake GET LIFE INSURANCE OBTAIN LIABILITY COVERAGE PREPARE THE GOVERNING DOCUMENTS SELECT THE ENTITY 02/19/14 5

6 Step 1: Select the Entity Sole Proprietorship General Partnership / Limited Partnership The Family Limited Partnership The C-Corporation / Closely Held Business The S-Corporation The Limited Liability Company 02/19/14 6

7 Challenges Agricultural operations present unique challenges: 1. Land and Equipment usually comprise the majority of the assets. 2. Lenders may require that loans be personally guaranteed. 3. There is liability if you are operating a piece of equipment and cause an accident. You can be sued individually as well as the entity. 02/19/14 7

8 The Family Limited Partnership Two Tiered System: General and Limited Partnership interests Tier One: the limited partners limited liability limited control Tier Two: the general partners liability 100% control and management Ability to gift membership interest succession planning 02/19/14 8

9 The C Corporation / Closely Held Corporation BENEFITS Contributions to corporation are tax free Owners can take larger salary so long as it is reasonable Limited Liability Ability to accumulate value inside the corporation for future generations DRAWBACKS Two levels of taxation Formal reporting and management requirements Difficulty in transitioning to a pass through entity 02/19/14 9

10 The S Corporation BENEFITS Treated as a Corporation but taxed as a pass through entity Same level of limited liability Avoids Self-Employment Tax on Distributions DRAWBACKS Limitations on number of shareholders / type of stock Less flexibility in determining distributions Selling or Distributing appreciated property can cause adverse tax consequences 02/19/14 10

11 The Limited Liability Company Taxed as a partnership Flexibility in ownership and control Can control succession planning through operating agreement Flexibility in distributions Single taxation of income Capital gains tax benefit Favorable and flexible basis 02/19/14 11

12 The LLC / Family LLC Q-1: How does a Family Estate LLC work in transferring of real estate and avoiding probate? An LLC is a hybrid between a corporation and a partnership. An LLC is a separate legal entity. For tax purposes, generally contributions of property (including real estate) are contributed to the LLC tax free in return for membership interests. The LLC is a pass through entity, meaning that income and loss is passed through and reported on the members individual income tax return. Allow for great flexibility with regard to ownership and control. Allows for greater flexibility with regard to allocation of income and loss, distribution of appreciated real property. 02/19/14 12

13 LLC continued Q-2: Does a farm that operates as a LLC taxed as a partnership subject itself to more liability or risk exposure than a farm that operates as a corporation? Answer: No. In general, the limited liability company, and therefore its members liability is capped by the amount of their contribution. But note, this presents a unique challenge in the farm context. 02/19/14 13

14 Step 2: Managing Risk Build the Cake Consider transferring production assets to the LLC and reserving the land, home and other assets. Create an Operating Agreement and/or governing documents that carefully plans for contingencies including death, disability, divorce or simply a falling out. Obtain adequate liability insurance to protect the business from liability not covered by the entity. Consider life insurance as a business succession tool. 02/19/14 14

15 The Governing Documents Governing documents are important to the continuing success of an entity. Some examples of the issues to consider: What each person will contribute to the entity (money, property, services) and how much of the entity each person will own. How to divvy up and distribute the money (also called allocating profits, losses, and draws). Whether each person can be entitled to a regular draw (a withdrawal of allocated profits from the business), or will profits be distributed only at the end of the year? Will the entity pay compensation and benefits to partners for services? How will death, disability or divorce affect the entity? 02/19/14 15

16 Converting to a Pass-Through Q-3: Changing from a S-Corp or C-Corp to a LLC. Pros and cons for long term land ownership? There are two options: conversion to a S-Corp or conversion to a LLC The decision is driven by the tax implications Special consideration needs to be given to the corporation s built in gain, including appreciated property 02/19/14 16

17 Transitioning Out of an Entity Q-4: Everyone in AG seems to be setting up entities for various reasons. Do you see a time or have experience with the need to unwind/end entities and what issues arise then? 02/19/14 17

18 For more information or questions, please contact: Andrea J. Rosholt 101 S. Capitol Blvd., 10 th Floor P.O. Box 829 Boise, ID (208) /19/14 18