In the not-so-distant past, economics played a lesser role in farm succession planning. Let’s face it, with $7 corn and $15 beans, there generally was ample money to bring the next generation into the farming operation and/or have the next generation buy out the older generation.
Now, with prices that are break-even or below, economics play a much greater role. The question becomes, how do we ensure the next generation can financially afford to take over the farm?
I was recently asked how does a farm family pass on the farm if the next generation cannot afford it? We all know it is next to impossible for someone to break into farming due to the capital costs of land, machinery, and so forth. So, how do we expect the next generation to do the same?
In many instances, for the older generation, economics and the need for income is so important that succession plans do not get established because the older generation is fearful if the farm is transferred, so is their income. Conversely, the younger generation looks at the cost to “buy in” or the inability for them to receive the necessary income from the farm as a major impediment.
There needs to be a convergence between the income needs of the older generation and that of the younger generation. After all, there is only so much of an income pie for a farm to feed two generations.
I have found it helpful to first start by analyzing what the older generation needs for income. Then, a plan can be put in place as to where that income comes from.
Often, such income can come from renting of the farmland to the younger generation. Or, if the younger generation can afford it, they purchase some of the farm assets, which will provide income to the older generation. I have also seen where the older generation is hired by the younger generation and thus earns income.
I have yet to meet a client who wants to transfer the farm and live in the poorhouse. So, starting with the economic needs of the older generation and having a plan that meets their needs allows us to back into the economic needs of the younger generation and what they are able to afford.
And, a serious look needs to be given toward what is realistic for the younger generation to financially take on. The following offers some suggestions that I have seen work well over the years.
•The farm operation: I find it useful to set the farm operation up as an LLC. The operation does not own land or machinery, but has farm inventory, leases with landlords, accounts, and so forth. From an estate standpoint, leaving the farm operation to the farming child(ren) does not add much to any estate imbalance. After all, the farm operation itself is not the main source of asset value, unlike land and machinery.
However, to the farming child(ren), there is great deal of intrinsic value. From a succession standpoint, using an LLC allows the older generation to orderly transfer ownership of the farming operation to the next generation via membership shares.
Most important, the older generation can transfer a vast amount of the farm operating LLC and still receive the necessary amount of income from the farm operating LLC.
•Farm machinery: The value of farm machinery to the farming child(ren) is not the dollar amount of the equipment; rather, the true value of farm machinery to them is the income the machinery helps create. After all, the farming child(ren) is not going to sell the farm machinery.
So, if you leave $1 million of farm machinery to a farming child(ren), you’ve really only left them the amount of income the machinery generates. Plus, clients seem to forget that machinery depreciates each year. Thus, that $1 million in machinery they are leaving will be worth half that in a matter of years.
From an estate standpoint, it is important for the older generation to properly value the machinery when factoring in fair distribution to heirs. One time I saw a family actually value the machinery off the income it produced, not the fair market value.
No matter how you slice it, without the machinery the next generation likely will be in the NFL (aka Not Farming Long).
From a succession standpoint, I’ve seen where the older generation gradually sells to the next generation or transfers shares of the LLC owning the machinery. This can provide income to the older generation, while at the same time setting a payment structure that is palatable to the younger generation.
Depreciation recapture on the machinery can be a factor, however, so tax advice should be sought.
•Farm real estate: I also like to see farm real estate held by an LLC. The benefits are many, and using an LLC provides a lot of flexibility. From a succession planning standpoint, I have seen many instances where the older generation leases the land to the younger generation.
Again, if a necessary income level for the older generation can be established, then we can back into what amount of rent needs to be paid by the younger generation. Often the older generation will charge a lesser rental amount to the younger generation in order to assist them.
From an estate planning standpoint, the obvious problem is the sheer cost confronting the younger generation in purchasing the land. Even if the farm child(ren) receives more of the landholding LLC, they still could be looking at millions of dollars in buying out non-farm siblings.
Here is where the LLC really shines. The sky is the limit in what the buy-sell provisions in the LLC operating agreement can spell out that ensure fairness, but enable the farming child(ren) to buy out non-farm siblings.
I have written buy-sell provisions that allow for the purchase to be made over several years, akin to a land contract. I have written buy-sell agreements that set the price per acre of the land. I have also written buy-sell provisions that allow the buyout price to be a percentage of the land value.
The point is, there is much that can be done to set up a mechanism that enables an affordable transfer of the land to the next-generation farmer.
Succession planning is now, more than ever, dependent on economics. You can have the best intentions and desires to pass the farm on to the next generation, but if the economics are not there, the outcome you want likely won’t be, either.
Figuring out what is economically feasible will greatly enhance the chances of a successful transfer the farm to the next generation. In the end, balancing the income needs of the respective parties and setting up an affordable structure for the next generation to take on the operation is paramount.
These articles are for general informational purposes only and do not constitute an attorney-client relationship. John J. Schwarz, II, is a lifelong farmer in northeastern Indiana and has been an agricultural law attorney for 12 years. He can be reached at 260-351-4440, email@example.com, or visit him at www.farmlegacy.com