Choosing a Business Structure for Your Farm

A business entity is the legal structure under which a farm or any business is organized and operated. Family farm owners can establish their businesses as sole proprietorships, partnerships, or corporations. Whether a family buys, inherits, or receives a farm through gifts, the family must decide on the type of business structure it wants for the farm. Moreover, the selected structure often changes as the farm grows or new individuals enter the business. Individuals who originally owned and operated their business as a sole proprietorship, for example, may choose to shift to a corporation, a partnership, or a multiple business organization.

The sole proprietorship is the most common form of business organization since most small businesses are owned and operated by a single individual. Sole proprietorships have a common law origin and can be easily established and operated because the business structure is an extension of an individual's rights and responsibilities in property ownership and commercial transactions. Partnerships also have a common law origin, and thus have many of the characteristics of a sole proprietorship.

By contrast, incorporation has a statutory origin, which means State laws prescribe a corporation's structure, procedures, and conditions of organization and operation. Hence, incorporating a farm business requires a series of legal steps, and corporate activities are closely regulated.

Choosing an Organizational Structure

Sole Proprietorship. Personal and business objectives help decide the best organization structure fora small business. The sole proprietorship is usually best suited fora beginning business because it is the simplest and least regulated of all business types. No legal papers must be filed to establish and maintain the business. Since the proprietor owns and operates the business as an individual, records and planning are limited to those needed to reach management objectives, to file personal income tax returns, and to comply with laws and regulations common to all business ventures. The major drawback is that sole proprietorships, unlike some types of corporations, do not offer protection from personal liabilities.

Although the sole proprietorship is the simplest business structure, financial management considerations and family objectives may make this structure inappropriate as an enterprise becomes larger and more complex. The advantages of partnerships and corporations over sole proprietorship are too complex to warrant broad generalizations. The decision to shift to a new business structure must be made on a case-by-case basis. Each farm owner must decide if and when to move to a more complex and formal organizational structure.

Multiple Ownership. Increasing capital requirements and the economies of scale available to large operations led to the evolution of multiple ownership of agricultural enterprises. Increased capital requirements make it difficult for young people to start their own enterprises, and many young people enter into the ownership and management of their parents' businesses.

However, parents usually choose not to sell all of their assets at once to the children. In any case, the children usually cannot afford to purchase the entire farm operation at one time. The assets are usually transferred gradually between generations. In these situations, a multiple ownership structure enables the younger generation to move slowly into ownership and management while the older generation gradually withdraws.

Because a sole proprietorship is, by definition, organized and operated by one individual, the intergenerational transfer of a business over time requires a business organization that accommodates multiple owners--either a partnership or a corporation. In some cases, separate proprietorships with joint ownership of equipment and labor exchanges may be established between parties. Separate proprietorships may be more feasible for some enterprises because of their large capital investment in facilities and equipment.

Shared Management

A large business with multiple owners, whether a partnership or a corporation, offers a chance to divide management responsibility among the partners or stockholder employees. Joint management decisionmaking provides excellent on-the-job management training for less experienced managers. Partnership and corporate structures are equally flexible in the development of a management team that meets the needs of each business.

Income Sharing

Multiple ownership and management in a partnership or corporate structure offer many avenues for distributing income among the respective parties. A partnership pays no income tax because the individual partners assume their own tax liabilities; thus, income can be shared through drawing accounts and distribution of residual income. If partners lease assets to the partnership, lease payments can compensate owners for their resources.

The corporate structure can distribute income among stockholder-employees in the form of salaries, dividends, or interest on debentures. Payments to stockholders must be reasonable and based upon services rendered, but there is much flexibility in sharing income among stockholders and employees.

Capital Transfer and Estate Planning

Capital transfer among common property owners in a partnership or corporation is a significant consideration when family members have decided to continue the enterprise as an operating unit beyond the retirement of the present owners. With proper planning, the partnership and corporate structure can be used to reserve resources for retirement, transfer property to family members, and minimize expenses and transfer taxes.

Regardless of the business structure be it sole proprietorship, partnership, or corporation it is possible to develop a sound estate plan. The capital transfer through the estate can be handled with jointly held property ownership, wills, and trust arrangements. Although the partnership or corporate structures do not in themselves solve estate transfer problems, they can make capital transfer somewhat easier.

The costs associated with the transfer of property from one generation to the next include Federal estate and gift taxes and State inheritance taxes. Transfer of property by gift is one way to minimize the death tax burden. Federal gift tax laws allow a person to make $10,000 of outright gifts to each beneficiary each year without paying a Federal gift tax. The annual gift tax exclusion can be doubled to $20,000 if the gifts are made by a married couple to a third person even if only one member of the couple owned the property.

Another advantage of transferring capital as a gift is that gifts are valued at the time they are made. If appreciating assets (such as real estate) are held until death, the value of the asset may have increased, causing an increased death tax liability.

Buy-sell agreements are often used to help transfer capital ownership of a partnership or corporation from one business associate to the next. Such an agreement can establish a market for the business assets when owners desire to withdraw from the business either during their lifetimes, at death, or upon becoming disabled. This is accomplished by requiring the remaining partners or stockholders to purchase the ownership interest of the departing member; likewise, the business associate or the estate is required to sell to the remaining owners. The contract normally specifies either an actual purchase price or a procedure to follow in determining the price.

Attracting Capital

The traditional sources of capital for small farms are the equity provided by family members, reinvestment of retained earnings, lease agreements, and loans. Capital sources are the same regardless of the organization's structure. The sole proprietorship may be the most limited in terms of capital acquisition because only one family is involved in the operation. Multiple ownership through a partnership or corporation allows the combining of funds from more than one family, which results in a larger business.