Selection of an entity is important for any type of business, but for the farming industry it’s particularly important. There are many options depending upon the needs of the farmer, and the decision to file as one type of company may not necessarily be tax motivated.
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Here’s what farmers need to know:
Sole Proprietorship. This is the easiest way to go: Taxes are filed on Schedule F of the individual income tax return, and the recordkeeping is pretty straightforward. However, the farmer should maintain a separate bank account for the farming enterprise. Closing the business is as easy as walking away from it, and profit is subject to self-employment tax. If the farmer wants to bring children into the business, it may be advantageous to entertain another entity structure that more easily accommodates the continuity of the business.
C Corporation. With this structure, you enjoy limited liability, but the paperwork requirements are much more stringent and it can be difficult to pull money out of the business. The owner must be on payroll, and if you have a large farming enterprise, you may be required to report income and expenses on the accrual basis, which may not be advantageous.
S Corporation. An S Corporation is exempt from the accrual requirements, which may make it a tempting filing choice. Advances against profit are allowed, but you should make sure you aren’t taking advances in excess of your basis in the corporation. The owner must also be on payroll.
Profits flow from the S Corporation via Schedule K-1 to the farmer’s individual income tax return, and these profits are not subject to self-employment tax. Oftentimes farmers will create multiple S Corporations and partnerships with other farmers to deal with various aspects of the farming operation. Be aware of the hobby loss rules and also the material participation rules or the IRS may disallow losses.
Family Limited Partnership. This is one of the more popular ways to structure a farm enterprise as it works especially well as an estate planning tool. It’s a great way to transfer assets, such as land, from one generation to the next. Essentially, you set up the partnership, and the farmer maintains a small percentage general interest and gifts limited interests to his children and grandchildren. The interest is in the partnership itself, not in the assets of the partnership. The partnership interests that are gifted can be substantially discounted (20%-50%) and valued less than the value of the assets thus reducing or eliminating the impact of the gift tax. Be sure to consult with an estate planning attorney and your tax pro to ensure that it is set up properly.
Trusts. Another estate planning tool is the use of a trust as the legal form of the business. The tax rate for trusts is much higher, but continuity can be achieved through the use of beneficiaries. A simple grantor trust (living trust) is treated as a sole proprietorship for tax purposes – no separate tax return is filed. The other common trust form is the simple trust. Income from a simple trust passes through on a Schedule K-1 to the beneficiaries but operating losses are held within the trust.
Limited Liability Partnerships (LLPs) and Limited Liability Companies (LLCs). This is a newer form of business entity and provides coverage for liability issues. It’s a “check the box” tax return, which means there is no federal tax form that is filed for an LLP or an LLC. You decide if the operation will be treated as a sole proprietorship (Schedule F , Form 1040) or partnership (Form 1065) a C Corporation (Form 1120) or an S Corporation (Form 1120S). In order to protect assets, oftentimes separate LLCs or LLPs are created – one for the holding of assets which are then leased to another LLC or LLP which governs the operations of the farm.
As you can see, there are advantages and disadvantages to every legal form, and jumping from one legal form to another requires a tax impact analysis. There could be taxable events on distributions and liquidations of prior entity structures like when a corporation decides to become an LLC, or a sole proprietorship goes to the trust level.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitterat BLTaxpertise and at Facebook.