Historically, when Dad was ready to retire, he would sell the farm to a son or two, or once in a while, to a son-in-law. Often this transaction occurred at about the time that Dad’s knees, hips or shoulders stopped working properly. Typically, Dad might first sell the cattle and machinery, and once that was paid off, then he sold the real estate. As long as Dad was able, he often worked for the next generation, driving machinery and offering wanted or sometimes unwanted advice. Some farms today still transfer that way, but many don’t anymore.
Today, many farms transfer using a partnership/limited liability company structure. One reason for this is that the milk check doesn’t go as far as it used to, meaning there isn’t as much money available to pay Mom and Dad for the full value of their farm. Another reason is that with the widespread use of milking parlors and more recently, robotic milkers, a bad hip, knee or shoulder doesn’t mean the end of Dad’s career. As such, so long as Dad is feeling useful and bringing value to the farm, he really doesn’t want to “retire." Yet another reason is that mothers, daughters and daughters-in-law are more involved on the farm than ever before.
A fourth reason is that limited liability companies didn’t exist in Wisconsin until 1994. The creation of LLCs allowed a farm or other business to have the pass-through and flexible tax benefits that partnership tax law can provide, and allowed the owners of the LLC to receive limited liability protection in the event of a liability issue that was not covered by insurance or that exceeded the policy limits.
To form an LLC that is taxed like a partnership, you typically transfer all of the livestock, machinery, equipment, feed, growing crops and sometimes the 40-acre building site into the LLC. Also, if there is debt, certain debt is transferred into the LLC. The remaining land owned by the parents, including any land owned by the next generation, is leased to the LLC. Sometimes the next generation has some cattle or machinery to contribute to the LLC, as well. At this point, the parents may look at gifting some initial percentage to the next generation. A typical LLC might start out with parents owning 90% of the LLC and the next generation 10%.
From here, there are three options. The first is to have the parents sell one or more percent a year to the next generation. This often requires the next generation to be paid more from the farm (which that generation pays income tax on) so that the next generation has money to pay the parents. The parents then pay income tax on the money they receive, and most of that income is taxed at the higher ordinary income tax rates.
The second option is to pay the next generation a basic amount for their labor and then gift a certain percentage every year to them. Many times, the next generation is paid a minimum amount so that extra income from the farm can be reinvested into the farm and debt can be paid off. One way to look at this gifting method is as a way to make up for the next generation’s lower pay for their labor as compared to a salary they could make doing something else.
The third option is if you again look at an initial starting percentage of 90% for the parents and 10% for the next generation. Then you can create something called “profits interests,” which means that from that point forward, the yearly profits or losses of the farm and the future growth (or loss) in equity in the farm is split at some other percentage rather than 90%-10%.
For example, let’s say the partnership/LLC had $1 million of equity at its commencement, with $900,000 attributed to the parents and $100,000 attributed to the next generation. From the start of the partnership moving forward, they agree that each side will have 50% of the profit interests, reasoning that each partner is doing half the work. At some later date, as debt in the partnership has been paid down and the farm has grown in size, maybe the partnership is now worth $2 million. Well, the first $1 million gets divided $900,000 to parents and $100,000 to the next generation, but the next $1 million gets divided $500,000 to the parents and $500,000 to the next generation.
In each of these three options, when Mom and Dad really do retire, or perhaps when they expire, there is often some type of sale of assets to set up a stream of income to the parents or the nonfarm kids. Of course, every farm is unique. What works on one farm might not work on your farm.
Halbach is a partner in the ag law firm of Twohig, Rietbrock, Schneider and Halbach S.C. Call Halbach at 920-849-4999.