By George Twohig
Parents committed to transferring their farm to the next generation must initially answer the most basic and essential question: What assets are essential for the farm’s continued success, growth and development? Most farmers conclude that the essential assets include both the membership interests (“units”) in the limited liability company (“the company”) which operates their farm business and owns the personal property and often the main building site, and the farm real estate held outside of the company.
An effective succession plan should first focus on the earned transfer of units in the company to the successors, over time, on an “earned basis” as they increasingly assume the farm’s work, management and leadership. Parents usually gift units to the successors to avoid high income tax rates on sales of units. The transfer plan then focuses on the eventual transfer of the farm real estate owned by the parents and other involved family members. During their lives, the parents may transfer at least part of their farm real estate to the successors by gift or in a bargain sale to benefit from low, long-term, capital gains income tax rates.
A member’s transfer of units should be restricted in the company’s operating agreement or a separate buy-sell agreement to assure that the company’s units are held only by active and employed successors. The essential farm real estate should be included in the buy-sell provisions or be subject to options or rights of first refusal.
The parents’ estate plan should provide for the transfer of any of their remaining units in the company and their remaining farm real estate to the successors by earned bequest or under practical terms. The buy-sell provisions and the provisions of the parents’ estate plan must be coordinated.
Buy-sell provisions require careful consideration and shared understanding among the active family members. These provisions must be specific to each farm’s unique circumstances. Unfortunately, many families are operating under existing buy-sell provisions that are now impractical because of the inflated value of farm assets (especially farmland), existing debt, cash flow challenges from today’s difficult farm economy, and evolving personal and business expectations. Here are six questions you should be asking:
1. Should a member be able to transfer units to his or her spouse or descendant who is a full-time and committed employee of the company and has assumed or has the skill, ability and commitment to eventually assume an essential position in the company?
2. Should the senior generation and other successors be required to purchase gifted units from a successor who terminates his or her employment? What is an acceptable retirement age when a successor should be guaranteed a market for his or her units?
3. If there are two or more successors, should each own the same number of units, or should there be different levels of ownership based on individual work, time commitment and responsibility? If two siblings are members, should each sibling’s family maintain the same number of units, or should each future successor be able to acquire equal ownership?
4. Is the current formula for establishing the purchase price of units practical given the farm’s present limited cash flow and ongoing need to also replace depreciation assets, pay existing debt, make improvements and to pay family living? Should the valuation formula be based on the farm’s net worth, its value as an ongoing business or a stipulated value? Should the value of a member’s units be discounted for tax planning purposes or to make a purchase cash flow?
5. Are the present terms for payment practical for the withdrawing member, the continuing members and the farm? Should the interest rate on the installment payment be a fixed rate or a variable rate, such as prime rate? Should the variable rate include a maximum and minimum interest rate?
6. Do the buy-sell provisions or the estate plan assure that the farm real estate will remain available for farm operations? Some planning alternatives include:
- direct transfer, during life or at death, by gift or sale (often bargain sale) to the successors
- options to purchase at a reduced price and favorable payment terms
- options to lease for a substantial term at a favorable rent
- options to purchase during the term of the lease
- rights of first refusal to lease and to purchase
You and the involved family members should annually review the buy-sell provisions, real estate leases, options and rights of first refusal, and the related provisions of any estate plans. You should have your accountant determine what obligations would result under your existing buy-sell provisions in the event of an owner’s death, disability, divorce, retirement or withdrawal. Unfortunately, outdated buy-sell provisions can result in impractical expectations and conflicts between the withdrawing member or his or her estate and the surviving members.
Twohig is a partner in the agricultural law firm of Twohig, Rietbrock, Schneider and Halbach. Call him at 920-849-4999.