Farm Management Chapter 14 Forms of Business Organization

Farm Management Chapter 14 Forms of Business Organization farm management chapter 14

Chapter Outline • • • Life Cycle Sole Proprietorship Joint Ventures Operating Agreements Partnerships Corporations Limited Liability Companies Cooperatives Transferring the farm business farm management chapter 14 2

Chapter Objectives 1. To describe the primary forms of business organization 2. To discuss the organization and characteristics of each form 3. To compare their advantages and disadvantages 4. To show the effect on income taxes 5. To summarize the factors to consider when selecting a form of organization 6. To compare the different forms for estate planning farm management chapter 14 3

Life Cycle Each farm business has a life cycle with four stages: 1. entry 2. growth 3. consolidation 4. exit farm management chapter 14 4

Figure 14 -1 Illustration of the life cycle of a farm business farm management chapter 14 5

Sole Proprietorship • The owner owns and manages the business, assumes all risks, receives all profit • No special legal permission required • Advantages: simplicity and freedom • Disadvantages: personal liability, size may be limited, lack of continuity • Taxes on profit paid at tax rate of owner (individual or joint for couple) farm management chapter 14 6

Joint Venture • • • Operating agreements Partnerships Corporations Limited liability companies Cooperatives farm management chapter 14 7

Operating Agreements • Two or more sole proprietors carry on some activities jointly while maintaining individual ownership of resources • Operating expenses usually shared among the parties in some fixed proportion • Income is shared in same proportion as fixed assets and expenses are contributed farm management chapter 14 8

Table 14 -1 Example Budget for a Cow/Calf Joint Enterprise (One Head) farm management chapter 14 9

Figure 14 -2 Distribution of income from a joint venture farm management chapter 14 10

Partnerships • An association of two or more persons who share ownership of a business • General partners contribute to the management of the business and are exposed to unlimited liability • Limited partners do not participate in the management and are liable only for what they have contributed to the business farm management chapter 14 11

General Partnerships: Organization and Characteristics 1. Sharing of business profits and losses 2. Shared control of property, with possible shared ownership of some property 3. Shared management of the business farm management chapter 14 12

Written Partnership Agreements 1. Management: who is responsible for which decisions and how they shall be made 2. Property: list the property each partner will contribute and how it will be owned 3. Share of profits and losses: carefully describe how these will be divided 4. Records: designate who will keep the records farm management chapter 14 13

Written Partnership Agreements (continued) 5. Taxation: include a detailed account of tax basis of property and copies of the partnership information tax return 6. Termination: state the date of termination if one is known 7. Dissolution: method of division of property in case of dissolution of partnership farm management chapter 14 14

Termination • At a particular time, as indicated in written agreement • Upon the incapacitation or death of a partner, although the partnership may continue if the written agreement contains provisions for passing on the estate and continuing the partnership • Bankruptcy • Mutual agreement farm management chapter 14 15

Advantages of Partnership • Easier and cheaper to form than a corporation • A carefully written agreement can allow the partners to maintain much of their freedom • Flexible form of business that can accommodate many different situations farm management chapter 14 16

Disadvantages of Partnership • Unlimited liability of each general partner • Any partner individually can act for the partnership in legal and financial dealings and the other partners will also be held responsible • Poor business continuity farm management chapter 14 17

Partnership Taxation A partnership does not directly pay taxes. It files an information income tax return reporting income and expenses. Each partner’s share of income from the partnership is reported on his or her own tax return. farm management chapter 14 18

Corporations • A corporation is a separate legal entity • It is formed and operated in accordance with laws of the state in which it is organized • Shareholders in a corporation are liable only to the extent of their investment farm management chapter 14 19

Forming a Farm Corporation 1. File a preliminary application, reserving a name for the corporation 2. Draft a pre-incorporation agreement outlining major rights and duties of the parties 3. Prepare and file the articles of incorporation 4. Turn property or cash over to corporation in exchange for shares of stock 5. Shareholders meet to organize and elect directors 6. The directors elect officers, adopt bylaws, and begin business farm management chapter 14 20

Two Types of Corporations • C corporation: a “regular” corporation • S corporation: a “tax-option” corporation 1. 2. 3. 3. 4. 5. No more than 75 shareholders Shareholders must be U. S. citizens, estates, or certain types of trusts One class of stock All shareholders must agree to form an S corporation farm management chapter 14 21

Advantages of Corporations • Limited liability for shareholders • This advantage may be negated if a shareholder is required to personally sign a note to borrow funds • The corporation, like a partnership, allows for several individuals to pool resources • Business continuity farm management chapter 14 22

Disadvantages of Corporations • Costly to form and maintain • Legal advice needed • Shareholder and director meetings must be held farm management chapter 14 23

Taxes and C Corporations A C corporation pays taxes on its earnings before dividends are distributed. The shareholders then pay taxes on the dividends, at their individual rates. (“Double taxation”) If shareholders are employees, their salary and benefits (e. g. health insurance) can be charged as expenses to the corporation, but these expenses must be reasonable. farm management chapter 14 24

Taxes and S Corporations An S corporation is taxed like a partnership. The corporation files an information tax return, but shareholders report their share of income on their own tax returns and are taxed at their own rates. farm management chapter 14 25

Table 14 -2 Personal and Corporate Income Tax Rates (2003) Check current tax rates for changes farm management chapter 14 26

Table 14 -3 Comparison of Forms of Farm Business Organization farm management chapter 14 27

Limited Liability Companies • A limited liability company (LLC) resembles a partnership but offers members the advantages of a corporation • Liability is limited to the assets of the LLC, not the individually owned assets of members • An LLC can have any number of members, all of whom can participate in management farm management chapter 14 28

Limited Liability Companies (continued) • Ownership distributed according to fair market value of contributed assets • Net farm income from an LLC passed to members, who pay taxes at their individual rates (no “double taxation”) • An LLC does not automatically continue in the event of a death of a member farm management chapter 14 29

Cooperatives • Cooperatives are a special type of corporation • They require articles, bylaws, and detailed records • Members who contribute capital enjoy limited liability • Net income is passed to members and taxed at their individual rates • Return to members cannot exceed 8%, with remaining profits distributed as “patronage refunds” farm management chapter 14 30

Transferring the Farm Business 1. Is the business large enough to productively employ another person or family? 2. Is the business profitable enough to support another operator? 3. Can management responsibilities be share? farm management chapter 14 31

Stages of Transfer 1. Spin-off: separation of operators into individual operations 2. Takeover: older generation retires and rents or sells farm to younger generation 3. Joint operation: both generations wish to continue farming together and either use an operating agreement or form a partnership or a corporation farm management chapter 14 32

Figure 14 -3 Alternatives for farm business transfer farm management chapter 14 33

Summary A farm or ranch business can be organized as a sole proprietorship, a partnership, a corporation, a limited liability company, or a cooperative. Each form of business organization has advantages and disadvantages. farm management chapter 14 34