By Troy Schneider
There are several different choices of business entities available for farmers to operate their farms. Today, it is becoming increasingly common for a farm to have more than just one business entity to operate the farm business. Although having multiple entities will be more work for the lawyer and accountant (I bet I know what you are thinking), it may be beneficial under the right circumstances.
Types of entities
The four primary business entity choices recommended for farms are the single member limited liability company (single member LLC), the multiple member LLC (multi-member LLC), the S Corporation (S-Corp) and the C Corporation (C-Corp).
The single member LLC has the limited liability protection of a corporation but is taxed like a sole proprietorship. For income tax purposes, all income and expense is identified with the farm owner and reported on his or her schedule F of the farm owner's individual income tax return (IRS Form 1040). For most farm owners, the easiest and usually most recommended form to begin with is the single member LLC.
The multi-member LLC also has the limited liability protection of a corporation but is usually taxed as a partnership. For income tax purposes, all income and expenses of the farm are reported on an IRS Form 1065. Each owner then receives an IRS Form K-1 which shows the farm owner's share of the income and expense. The K-1 Form is then used on the farm owner's individual tax return.
The two types of corporations are the subchapter C and subchapter S (They refer to subchapters of the tax code). The C Corp is taxed separately from its owners. For income tax purposes, the C Corp reports its income and expenses on IRS Form 1120. The S Corp is not itself subject to income tax; rather, shareholders of the S Corporation are subject to tax on their pro rata shares of income and expenses based upon their shareholdings like a partnership. In an S Corp, each shareholder receives an IRS Form K-1, just as in a partnership.
Advantages of each entity
A "pass through" entity for tax purposes like a single member LLC, multi-member LLC or an S-Corp has several advantages over a C-Corp. These advantages include the following:
•IRC section 754 election. When a buyer purchases an interest in an LLC, an IRC Section 754 election can be made to allocate the purchase price to the assets of the entity. This election allows additional depreciation for the benefit of the buyer.
•-Stepped-up basis. A decedent's interest in an LLC will receive a stepped-up basis upon the decedent's death. This allows the decedent's heirs to either sell the farm without tax or will provide the farm's remaining owners additional depreciation.
•No double tax. In a C-Corp, the selling farmer/shareholder will incur a double tax- the corporation income tax when assets are sold to third parties and a personal income tax when the proceeds are distributed from the corporation to the shareholders. An LLC or S-Corp does not have this double tax.
However, a C-Corp does have several advantages over a "pass-through entity." These advantages include the following:
•Lower tax rates. For a C-Corp, $50,000 of taxable earnings can be subject to a 15% federal tax rate. The next $25,000 will be taxed at 25%. This could give a rate savings compared to having that income taxed at higher marginal individual tax rates.
•Deductibility of medical expenses. The C-Corp can deduct 100% of shareholder/employee medical insurance, long-term care insurance and medical expenses.
•Meals and lodging. The C-Corp may provide on the premises meals and lodging to a shareholder/employee. These benefits will be 100% deductible by the C-Corp and non-taxable to the shareholder/employee.
•Avoiding self-employment taxes. The C-Corp can limit employment taxes by paying dividends and commodity wages.
Why consider multiple entities?
In general, most lawyers and accountants prefer that a business with minimal assets and high profits be formed as a corporation and that a business with large amounts of assets and modest profits be formed as an LLC. In a typical farm operation, multiple entities may be created to operate "several businesses" that fit these models. For example, a separate business entity may be created for milk production, cropping, real estate ownership and leasing etc.
A multi-entity structure can address the following issues: 1) Minimizing current income tax; 2) Reducing potential double-tax; and 3) Avoiding gain and increasing depreciation upon a sale or death. When establishing a multi-entity structure, it is important that each entity is engaged in an active business activity. However, greater recordkeeping and more complicated tax reporting are the necessary evils that come with the territory. In summary, "one size doesn't fit all" when it comes to farm business structures.
Schneider is a partner in Twohig, Rietbrock, Schneider and Halbach, S.C., a Chilton law firm that specializes in ag law. Call Schneider at 920-849-4999.