Establishing a legal entity provides protection, options for agriculture familiesWritten by Natasha Wheeler
“The key things we look for in entity creation are limiting individual liability and providing for better management,” notes Max Hansen, referring to the formation of legal entities involving family production operations.
As an attorney and owner of American Equity Exchange, Inc. in Dillon, Mont., Hansen and his firm often work with agricultural families.
“There may be other tax advantages available to business entities that are not available to a sole proprietor or individual, such as no self-employment tax, business expensing, etc.” Hansen says.
Legal entity designations can also simplify succession planning and transfer of assets to other family members or business partners.
“One of the benefits to having a business entity in a family farm or ranch is the role it can play in making it easier for estate planning and transfer of assets to the next generation,” he explains.
It may be complicated for an individual to gift partial ownership interests in land, livestock and equipment, but a business entity allows parents to gift children membership interests or stock ownership.
“They can use the annual exclusion,” Hansen notes, which is currently $14,000 per person per year.
Beyond transferring ownership, becoming a business entity can also be helpful for owners when valuing assets left in an estate at the death of an owner.
“There may be some discounts available from a death tax standpoint,” he states, noting that the value of a deceased owner’s interest in the entity is generally lower than it would be in individual ownership.
Insurance coverage can further simplify the transfer of entity assets.
“For example, if a child is married, and the operation runs smoothly, but the family wants to buy out the surviving spouse when the child dies, key person insurance proceeds can fund that purchase,” Hansen comments.
In a similar situation, key person insurance coverage can provide adequate compensation to the spouse of a deceased partner if an unrelated surviving partner wants to buy out their share or the surviving spouse wants to exit the partnership.
Selection of Entity
When it comes to choice of entity Hansen notes, “The old standby was the C Corporation, but C Corporations have pretty much become a thing of the past.”
“C Corporations sheltered individuals from liability, but if a C Corporation ever sells an asset, it creates a double taxation,” he explains. “The corporation gets taxed, and there is a second tax at the shareholder level.”
Tax Code created the Subchapter S Corporation, a type of “pass-through” entity, which created limited liability for shareholders with only a single layer of taxation.
Evolution of entities
“As business entities evolved, we also began to see more use of limited liability companies (LLCs), which are also pass-through entities with a single layer of taxation,” Hansen continues.
General partnerships, limited partnerships and limited liability partnerships are also examples of pass-through entities.
“By using a family limited partnership, parents can be the general partners, and the kids can have limited partnership interests,” he explains.
This limits the children’s liability, allows a parent to maintain control over the business and gift increasing ownership to the children as they mature and the parents are comfortable in passing the business on to the next generation.
“Be sure of property ownership at the outset in setting up the business entity,” advises Hansen.
He encourages families to determine operational and estate planning goals going forward, which helps in entity selection.
It is also important to consider the evolving roles of other family members, Hansen adds.
“If the kids are minors, for example, their ownership may need to be set up at first under an adult as a trustee until the child becomes an adult,” he notes.
“Even though many forms for creating a business entity are available online, it is always best to consult with attorneys, CPAs, insurance agents and other professionals to make sure all of the ‘I’s are dotted and the ‘T’s are crossed,” he says.
These professionals can help with mundane but important tasks such as applying for an IRS tax identification number
“The accountant is key in setting up the entity books and preparing for the filing of the first tax return,” he comments.
He also advises producers to comply with workers compensation rules, employee withholding, annual dues and fees, annual reports and other state and federal requirements.
“Once the business entity is formed, always observe the formalities,” he states.
If the organizational documents provide for annual business meetings, owners need to meet that requirement.
“Even if it is around the dining room table, owners need to have regular meetings, and they need to keep minutes,” he explains.
As assets are acquired or changed, they need to be documented, and ownership records need to be accurately maintained.
“Even if records are maintained and other formalities observed, the owners must also ensure, as the entity evolves, that it is adequately capitalized,” he advises.
In other words, the business should have significant working assets. If the business is sued and substantial assets are still under individual ownership, anyone with a claim can go after those assets.
“The individuals could still be held liable if the business is found to be a shell entity with no substance,” he explains.
This is where Hansen believes insurance becomes key to the continued viability of the business operation.
“If a business has adequate insurance to protect the entity, it is probably the most cost-effective first line of defense,” he says.
The most important part of business formation is the thoughtful planning and preparation in deciding the best business entity for the operation.
“It is the planning that takes time,” Hansen says.