Examining Your Farm Business Choices

File C4-41
Updated December, 2007

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The following materials contain several different types of business agreements that can be used in the farm business transfer process. To successfully transfer your business to the next generation, you must select the proper transfer agreement or series of agreements.

Type of operation

The two primary types of business arrangements are the "spin-off' and the "multi-person" arrangements. These can be used in the “commitment” and “established” stages of the transfer process. Either of these types may be chosen after a brief testing stage during which the younger party works for a wage. The type you choose will depend on the type and size of your business and the goals and interpersonal relationships of each of the parties. You also need to examine the various legal arrangements available.

Spin-off arrangement
With a spin-off arrangement the younger party develops a separate farming opertion after a brief trial period with the parents. At least initially, the two parties may exchange labor and machinery. They may operate part of the business together, such as a joint livestock operation but is primarily an arrangement where the younger party builds equity in machinery and other assets in a separate business. If the parents' operation is quite large, it may be divided to create a separate business for the younger party. At the parents' retirement, their farming operation will terminate, with the assets taken over by the younger party.

Advantages of the spin-off arrangement are:

  • fewer goal conflicts;
  • fewer joint decisions;
  • the parties can share management, but each is responsible for individual decisions;
  • each party preserves an independent nature and pride of ownership;
  • the parents' financial security is not jeopardized if the home farm is not large enough to support two families; and,
  • exchange of labor or joint ownership of machinery is still possible.

The key to success is the younger person's ability to develop an independent business that will provide adequate income for living and debt servicing.

When the younger party spins‑off and establishes a separate farming operation, the two parties often continue to share labor and machinery. The older party usually has sufficient machinery but needs additional labor. Conversely, the younger party often has excess labor but does not have sufficient investment in machinery. So an arrangement is developed when the party's trade labor and machinery with each other.

Multi-person arrangement
With a multi-person arrangement, the younger party enters the business and provides labor, capital, and management in return for a share of the income. To be successful, the parties must be compatible and the business income should be adequate for both families. A key concern is how and when to transfer assets and management to the younger party. This arrangement is often used in farm situations with specialized facilities that would be difficult or impossible to divide - such as a dairy or hog operation.

Advantages of the multi-purpose arrangement are:

  • business continuity from one generation to the next;
  • the younger party starts in an established business with less risk and more income;
  • the young person has a chance to grow into the business without incurring substantial debt;
  • both parties are less confined by farm duties; and
  • the older party can retire gradually.

When the younger party joins the business, some form of operating agreement is usually developed. The operating agreement allows the younger party to invest in the business, provide management, and receive a portion of the income from the business. Initially, the younger party may only invest in one enterprise (i.e. hogs, dairy, etc.) while working for a wage on the other enterprises. As the younger party's investment increases, the agreement is changed so his/her share of the income reflects the new investment. If the parties will farm together for several years, a more formal arrangement may be developed, such as a partnership or corporation.

Size of operation

Whether you choose a spin-off or multi-person arrangement may depend on the size of the parents' operation. Farm families with operations of adequate financial size have a wider array of business arrangements from which to choose.

Multi-person
This approach usually works best when the parents' business is of adequate financial size. Fewer problems arise over the division of income when everyone is fully employed.

If the business is not large enough but the parents are near retirement, the parties may enter a holding pattern until the parents retire. When the parents retire, the younger party rents the home farm and buys or leases the personal property.

If the business is not large enough and the two parties will farm together for several years, they may develop a multi‑person arrangement by expanding the business to meet the income needs of both families. Before doing this, the parents must be sure they are financially strong enough to make such a move and that they do not jeopardize their financial security in retirement years.

Spin-off
Even if the parents' business is of adequate size to support both families, the parties may decide to develop separate farming operations. A typical situation would be a cash grain operation where the parents' business is divided into two separate operations.

A spin-off arrangement is often used when the business is not large enough to support both families. In this situation, the younger party creates and develops a separate business and does not draw resources or income from the parent's business.

Legal arrangements

The major legal alternatives available to you are discussed below. The task is to find the one that best fits your situation.

Sole proprietorship
Under a sole proprietorship, the farm is operated by one individual. This legal arrangement continues until the operator quits farming, retires, or dies. Often two or more sole proprietorships are created and linked together with various types of contractual sharing arrangements. Various joint arrangements, such as enterprise and farm operating agreements are examples where two or more proprietorships are used.

Partnership
A partnership is an aggregation of owners. Two or more persons contribute assets to the business and share the management responsibility, profits, and losses. The partnership is not a taxpayer but channels taxable income to the individual partners. A special form of partnership permitted by state law is the limited partnership. A limited partner is an investor and cannot participate in management, but bears no personal risk for the actions of the partnership.

Corporation
The corporation is an artificial entity created under state law. It is a separate business and legal entity, distinct from its owners. There are two types of corporations: (1) the regular C corporation, and (2) the tax-option S corporation. The regular corporation is a separate tax-payer. The tax-option corporation is a corporation in most respects except that it ordinarily pays no income tax.

sole proprietorship- partnership - corporation

Additional information and examples are available in the following files:
Information File C4-42 - Wage and Incentive Agreement
Information File C4-43 - Enterprise Operating Agreement
Information File C4-44 - Farm Business Operating Agreement
Information File C4-45 - Labor and Machinery Sharing Agreement
AgDM Leasing Section

 

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