Farm and Ranch Corporations
| Jurisdiction | United States,Federal |
| Citation | Vol. 9 No. 4 Pg. 660 |
| Pages | 660 |
| Publication year | 1980 |
1980, April, Pg. 660. Farm and Ranch Corporations
Nickolas J. Kyser, Denver, is an associate of the firm of Holme, Roberts & Owen.
Like any other business, a farm or ranch can be operated in the form of a sole proprietorship, a partnership or a corporation. This article will examine the advantages and disadvantages of the corporation as opposed to the other forms. It is not intended to deal with the intricacies of farm and ranch taxation, except as they may affect the choice of business organization, and many of the subjects discussed herein are dealt with very briefly. For a much more extensive treatment of the area, the reader is referred to Olsen & Schoaf, Tax Planning for Agriculture, published by ALI-ABA, on which the author has relied heavily.
The corporation has found little favor with agricultural operations,(fn1) and a number of states(fn2) prohibit or restrict farming by corporations, presumably out of a desire to save the "family farm" from encroachment by "agribusiness." The fears of the legislators seem to have little basis in fact; in 1974, only 1,960 farms in the United States were operated by corporations with more than ten shareholders, and 76 percent of all farm corporations were family corporations.(fn3)
Ownership by a single individual is at once the simplest and least flexible form in which to operate a farm or ranch. Income and loss inure directly to the owner and are recognized by him for tax purposes. He provides all of the capital, controls the operations, takes all of the risks and reaps all of the rewards. So long as there is no need to raise outside equity capital or pass the business on to a new generation, the sole proprietorship is well suited to the needs, as well as the inclinations, of most farmers and ranchers. However, farming in the United States is heavily capital-intensive, and for many farmers, equity capital could be an attractive alternative to additional debt as a means of financing expansion.
The need to pass the business on to the next generation must inevitably arise, and this is perhaps the greatest disadvantage of the sole proprietorship for the "typical" small farmer. If the property is in joint tenancy, the estate of the first spouse to die will be greatly overqualified for the marital deduction, creating unnecessarily high estate taxes at the death of the second spouse.(fn4)
Ownership by only one spouse and the use of wills that make optimum use of the marital deduction will alleviate the estate tax problem, but leave other problems in providing for children, some of whom want to be active participants in the business and some of whom do not. Use of a two-trust marital deduction will may lead to an uneasy relationship between a second-generation farmer who doesn't understand trusts and a
trust officer who doesn't understand farms. If a farm or ranch stays in the same family for several generations, the proliferation of tenants in common with small undivided interests can make the ultimate disposition of the property a title examiner's nightmare.
A partnership is probably the most flexible form of ownership. It permits sharing of capital interests in different proportions from those in which income is shared. Different items of income can be shared in different ratios, and profits may be shared differently from losses, depending upon the tax and cash flow needs of the various partners.(fn5) Section 704(e) of the Internal Revenue Code (the "Code") eliminates some of this flexibility for family partnerships. Even with these limitations, a partnership is often the best means to accommodate the divergent interests of active participants, inactive family members and passive investors. Transfers, either lifetime or at death, of fractional interests can be effected by a simple assignment.
Inactive partners can be protected from unlimited liability by using a limited partnership. Limited partners are not individually liable for partnership obligations so long as the statutory requirements for the formation of a limited partnership(fn7) are satisfied and the limited partner does not participate in the conduct of the business.(fn8) The prohibition against participation in management leaves room for limited partners to express their opinions about how the partnership should be managed(fn9) and there are limitations on the general partners' freedom of action.(fn10)
These factors probably give outside investors and outside family members as much protection as they would have as minority shareholders in a corporation, but less than they would have in a corporation if their interest is large enough to carry significant voting power.
The flexibility and tax treatment of partnerships, especially limited partnerships, makes them extremely useful for family tax planning.(fn11) However, there is an inherent conflict between the limited rights given limited partners by the Uniform Limited Partnership Act and the Code's requirements for the recognition of limited partners' ownership of their income interests.(fn12)
This problem is especially severe where some of the limited partners are minors. Although it can usually be solved by holding limited partners' interests in trusts with an independent trustee, this conflict may make the use of a limited partnership impossible or unattractive for some farm and ranch operations. The requirement that the ownership interests and capital contributions of the limited partners be filed in the public record(fn13) may also be a deterrent to some.
Corporations provide much of the flexibility of partnerships, and certain other advantages as well. Shareholders are, of course, not liable for the debts of the corporation except in rare cases where the courts will "pierce the corporate veil." This will ordinarily happen only when the principal shareholder has been careless about maintaining the distinction between himself and the corporation in the conduct of his business.(fn14)
In practice, the limited liability provided by the corporate form is less of an advantage than it may first appear to be. Lenders will often require the personal guarantee of the principal shareholders. When the loan is so well secured by business assets that this is not required, it would probably be possible for a partnership or sole proprietor to arrange a nonrecourse loan. Thus, the limited liability afforded to a sole shareholder protects him only against trade creditors (and then only if he has been careful to deal with them as the corporation and not as an individual) and victims of his employees' torts (for which he will usually have insurance whether he is a sole proprietor or a sole
shareholder), and only to the extent of his unincorporated assets. Where there are multiple active owners, incorporation protects each from personal liability for obligations incurred by the others; owners who are not involved in management could be protected equally well by a limited partnership.
Corporations share with partnerships the advantage of having the assets owned by a single entity, so that a division of beneficial ownership can be accomplished without complicating legal title. Corporations have an advantage over partnerships in that an individual can have both management control and, within the limitations discussed above, limited liability.
Using a corporation may complicate gift-giving for estate planning purposes more than a limited partnership would. In a limited partnership, the first-generation owners can, if they wish, give away virtually all of the equity interest(fn15) without surrendering control. The separation of control from equity ownership may be accomplished in a corporation through the use of two classes of stock, but this, in turn, eliminates the possibility of using a Subchapter S corporation to shift income to the second generation without double taxation.(fn16)
Because a corporation is a separate taxpayer and dividends paid are income to the shareholder and not deductible by the corporation, there is a "double tax" on corporate earnings paid out as dividends. However, a large portion of farm or ranch income is likely to be reinvested in the business rather than taken out by the owners for their consumption. A corporation may pay a lower tax on this reinvested income than a sole proprietor.(fn17) Retention of earnings beyond the "reasonable needs of the business" will subject the corporation to an accumulated earnings tax under §§ 531-537 of the Code, but for most farmers and ranchers the reasonable needs will be quite large. Amounts paid out in compensation will be deductible by the corporation. Thus, the double tax may not often be a genuine problem.
One situation in which double taxation can become a problem arises when the corporation desires to dispose of a part, but not all, of its real estate. Either leasing the property in lieu of selling, or selling the property and investing the proceeds in passive investments, can subject the corporation to the personal holding company provisions, §§ 541-547 of the Code. This will force the corporation to pay dividends to avoid the punitive tax on undistributed personal holding company income.
When the decision is made to incorporate a farm or ranch, care must be taken to comply fully with the formal statutory requirements.(fn18) The initial board of directors should have an organizational...
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