Farm Management

1. Farm Management Chapter 14 Forms of Business Organization

2. Life Cycle • Each farm business has a life cycle • with four stages: • entry • growth • consolidation • exit

3. Figure 14-1Illustration of the life cycle of a farm business

4. 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)

5. Joint Venture • Operating agreements • Partnerships • Corporations • Limited liability companies • Cooperatives

6. 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

7. Table 14-1Example Budget for a Cow/Calf Joint Enterprise (One Head)

8. Figure 14-2Distribution of income from a joint venture

9. 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

10. General Partnerships:Organization and Characteristics • Sharing of business profits and losses • Shared control of property, with possible shared ownership of some property • Shared management of the business

11. Written Partnership Agreements • Management: who is responsible for which decisions and how they shall be made • Property: list the property each partner will contribute and how it will be owned • Share of profits and losses: carefully describe how these will be divided • Records: designate who will keep the records

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

13. 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

14. 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

15. 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

16. 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.

17. 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

18. Forming a Farm Corporation • File a preliminary application, reserving a name for the corporation • Draft a pre-incorporation agreement outlining major rights and duties of the parties • Prepare and file the articles of incorporation • Turn property or cash over to corporation in exchange for shares of stock • Shareholders meet to organize and elect directors • The directors elect officers, adopt bylaws, and begin business

19. Two Types of Corporations • C corporation: a “regular” corporation • S corporation: a “tax-option” corporation • 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

20. 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

21. Disadvantages of Corporations • Costly to form and maintain • Legal advice needed • Shareholder and director meetings must be held

22. 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.

23. 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.

24. Table 14-2 Personal and Corporate Income Tax Rates (2003) Check current tax rates for changes

25. Table 14-3Comparison of Forms of Farm Business Organization

26. 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

27. 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

28. 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”

29. Transferring the Farm Business • Is the business large enough to productively employ another person or family? • Is the business profitable enough to support another operator? • Can management responsibilities be share?

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

31. Figure 14-3Alternatives for farm business transfer

32. 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.

33. 1. What are the differences among the four stages in the life cycle of a farm business? Think about a farm or ranch with which you are familiar. In which stage is it? • Points of emphasis could include personal and business goals, size and growth of the business, financial management concerns, and attitude toward risk.

34. 2. Why do you think the sole proprietorship is the most common form of farm business organization? • Many farmers prefer to work alone or with close family members, record keeping and legal requirements are simple, and the management decisions can be quite flexible.

35. 3. What general advantages does a joint venture have over a sole proprietorship? Disadvantages? • Advantages include possible economies of scale, specialization of labor and management, and more financial resources. Disadvantages include increased record keeping requirements and a need to coordinate decision making.

36. 4. How does an operating agreement differ from a partnership? • Although two or more people may contribute resources to an operating agreement, generally there is no joint ownership of assets or commingling of funds. Gross income rather than net income is divided, and each party pays his or her own expenses

37. 5. For the operating agreement shown in Table 14-1, how would you divide gross income if party A and party B each owned one-half of the livestock? • The following entries would be changed: • Value Party AParty B • Breeding expense 5.00 2.50 2.50 • Interest on variable costs 11.95 3.78 8.17 • Interest on breeding herd 75.00 37.50 37.50 • Total cost 447.4195.78 251.57 • Percent contribution 100% 44% 56%

38. 6. Explain the importance of putting a partnership agreement in writing. What should be included in a partnership agreement • A written agreement provides a record of how the partnership was formed, documentation for tax questions, and guidelines for dividing income and liquidating the partnership. Points to include are management responsibilities, ownership and contribution of property, procedure for sharing profits and losses, records to keep, tax basis of property, and the process for terminating and dissolving the agreement.

39. 7. Explain the difference between a general partnership and a limited partnership. • In a general partnership, all partners share in management and have unlimited financial liability for partnership actions. In a limited partnership, partners who are not involved in management enjoy limited financial liability.

40. Does a two-person partnership have to be 50-50? Can it be a 30-70 or a 70-30 partnership? How should the division of income be determined? • The ownership shares of a partnership should be determined by the relative value of assets (minus liabilities) contributed by each partner. The shares can be in any proportion. Income is usually divided in the same proportion as ownership, but this does not have to be the case

41. 9. Explain the differences between C and S corporations. When would each be advantageous? • Taxable income from an S corporation is reported on the shareholders' personal tax returns. A C corporation files its own tax return and is taxed at corporation rates. An S corporation is limited to 75 or fewer shareholders, other corporations cannot be shareholders, only one class of stock is issued, and all shareholders must agree to operate as an S corporation. An advantage of an S corporation is that double taxation of income distributed as dividends to shareholders is avoided. However, if most of the corporation income will be retained in the business, a C corporation may provide tax advantages.

42. 10. Why might a partnership or corporation keep more and better records than a sole proprietorship? • Somewhat detailed records are needed to determine how income is to be divided among partners or shareholders, and how the business should be liquidated. Corporations are often required by law to file certain financial reports

43. 12. What special characteristics do limited liability companies and cooperatives have? • Limited liability companies combine the ease of formation and taxation as a partnership with the limited liability of a corporation. Cooperatives are similar to corporations, but distribute net income through patronage refunds. In addition, each member has one vote regardless of ownership share.

44. 13. What form of business organization would you choose if you were just beginning a small farming operation on your own? What advantages would this form have for you? What disadvantages? • Generally a sole proprietorship would be the most satisfactory because of the simple and flexible structure and fewer legal requirements.

45. 14. What form of business organization might be preferable if you had just graduated from college and were joining your parents or another established operator in an existing farm? What advantages and disadvantages would there be to you? To your parents? • The most advantageous organization would depend on the value of assets the student had to offer to the business, the degree of commitment to a farming career, the age of the parents, the skills possessed, and the involvement of other partners or family members.