Enterprise Operating Agreement

File C4-44
Updated December, 2007

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An Enterprise Operating Agreement is one of your farm business choices. It can be a second step in the farm business transfer process after a Wage and Incentive Agreement. It can also be used as the initial agreement in the transfer process.

In an Enterprise Operating Agreement, the younger party has capital invested in the personal property, operating capital, or livestock of one specific enterprise. Often that enterprise is a livestock enterprise. The younger party also has a portion of the management responsibility for that enterprise. For his/her contribution of capital, labor, and management to the enterprise, the younger party receives a portion of the income from the enterprise.

The parties share the income from the enterprise in the same ratio as they contribute capital, labor, and other resources to the enterprise. An alternative is for the younger party to pay the older party for the feed, use of the facilities, equipment, or pasture, and retain all of the net income from the enterprise.

On the rest of the farming operation the younger party has no capital invested, little or no management responsibility, and receives a wage for labor provided. In addition, the business may provide the younger party with housing and other fringe benefits.

For example, assume the parties are developing an agreement for a hog enterprise. The agreement is for the older party to receive 75 percent and the younger party to receive 25 percent of the gross income. Also, many of the cash operating expenses of the hog enterprise are shared in the same ratio. The younger party purchases a 25 percent ownership interest in the breeding herd so it is now owned 75-25 percent by the two parties. The younger party pays for 25 percent of the operating costs. The older party provides the machinery, equipment, and housing for the hog enterprise. Each party provides a portion of the labor and management with the younger party providing the most.

Contribution of resources

The annual value of the resources contributed by each party must be determined. This includes machinery, equipment, buildings, labor and management. The value of the machinery and equipment includes a rate of return on current market value plus depreciation. A rental rate can be used for the buildings. The breeding herd is not included because this contribution is made in the same ratio as income is divided (75-25 percent).

Home-raised feed is also listed as a contribution in this situation. The older party provides feed that is produced by the cropping enterprise of his/her farming operation. This is valued at current market price.

contributions

As shown in the example above, the older party initially contributes $35,000 and the younger party $18,000. After the home‑raised feed (for example, corn) is added, the older party's total contribution increases to $105,400.

Contribution adjustment

To be equitable, the value of the resources contributed by each party should be in the same ratio as the division of gross income (in this example, 75‑25 percent). If the younger party's contribution does not meet the required percentage, an adjustment can be made by him/her buying home-raised feed from the older party and contributing it to the enterprise. In this example, the younger party only contributes $18,000 and needs to increase his/her contribution by $12,850 to a total of $30,850 in order to make it equal to 25 percent. Conversely, the older party contributes $105,400 but needs to decrease his/her contribution by $12,850 to equal a 75 percent contribution. So, the younger party buys $12,850 of home-raised feed from the older party and contributes the feed to the hog enterprise. Now the resources are contributed in the same ratio as the division of gross income.

adjustment

Income sharing

The income from the sale of market hogs and cull sows is divided 75-25 percent between the two parties. To determine the amount of income each party will receive from the hog enterprise, the cash operating costs (split 75-25) and value of home-raised feed are subtracted from gross income. The value of home-raised feed must be deducted because it is a cost to the hog enterprise and income to the crop enterprise.

None of the costs (such as depreciation or real estate taxes) associated with any of the resources (such as machinery, equipment) contributed to the hog enterprise are deducted here. These costs are borne by the party owning the resource. However, minor repairs may be deducted here if an allowance for repairs was not included in determining the value of the contribution.

net cash income

The younger party's annual income includes income earned from the hog enterprise, in this case $17,735, plus wages earned from work on the other enterprises of the farm and any fringe benefits.

Cash flow

Each party's cash flow from the hog enterprise consists of the net cash income less cash costs and debt payments associated with the ownership of the contributed resources. The remaining cash flow can be used for family living, replacing capital assets, or investing in the business.

cash flow

As shown above, the younger party's net income from the hog enterprise is $17,735. After deducting $500 of interest payments, the younger party has $17,235 to be combined with other income earned on the farm to be used for family living and, possibly, further investment in the business. Additional information and example of dividing business income are available in Information File Dividing Business Income.

 

Don Hofstrand, retired extension value added agriculture specialist, agdm@iastate.edu