Choice of Business Entity for Farmers
The choice of business entity for a farm is an important decision that can either protect farm owners and their families from the risks inherent in the farming enterprise or expose them to those risks. Farmers employ various forms of business entity, and the choice varies greatly between types of farms and their sizes. Many are operated as sole proprietorships and general partnerships, but these formations pose great risks to their owners. However, Iowa laws restricting corporate farm ownership makes it harder for corporate entities (corporations, LLCs, limited partnerships, etc.) to own or lease farmland. What’s a farmer to do? Thankfully, many of those restrictions can be avoided with appropriate legal advice, and in almost all cases farmers should be able to take advantage of the benefits of corporate entities in running their farming operations.
Sole Proprietorships and General Partnerships
Sole proprietorships are the simplest business entity to “create.” They consist of one owner, and it is the default business entity if a farmer does not file to create another kind. In fact, you automatically become a sole proprietor if you own your own farm and are not on another person’s payroll. There may be some licenses and permits required such as a tax certificate or a filing required for a farmer wanting to name their business something different than their own name, but generally, a sole proprietorship has fewer hoops to jump through to start business.
Unfortunately, this simplicity comes at a cost, as there are significant risks associated with operating as a sole proprietorship. As sole proprietor, your personal assets are not protected from liabilities deriving from business operations. Because the farmer, as a sole proprietor, is not legally distinct from the business, the assets of the farmer can be used to cover any liabilities and debts. While exemptions will protect some assets, if a farm starts facing financial issues, there is a significant threat that creditors will come after the farmer’s personal assets.
These dangers heighten under a general partnership. Under a general partnership, the personal assets of all partners are subject to liability. Moreover, the actions of a partner can create liability for another partner, and every partner can enter into business arrangements that are binding on the whole partnership. Not only is each partner subject to liability as an individual, but each partner can be held fully responsible for the full amount of the partnership’s debt. This creates a situation where one of the partners may be compelled to sue another partner to recover their share of the debt. The partnership can alleviate some of these potential issues by creating a detailed partnership agreement outlining the terms of the relationship, but even with such a written agreement, an alternative business structure would provide more protection. Moreover, a general partnership can be formed unintentionally—all it takes is two people going into business together seeking a profit. If one such partner doesn’t realize they’ve entered into a general partnership, they could face unexpected liability for another partner’s conduct on behalf of the partnership.
Limited Liability Company
The LLC combines the flexibility and favorable tax treatment of a sole proprietorship with the asset protection of a corporation. Understandably, it is a popular choice for a business entity. Farming, like any business, can be unpredictable, and ventures often fail. The LLC provides farmers with greater protection. If the creditors come after the LLC, they can only get LLC assets. This is because when an LLC is created, the LLC becomes its own distinct legal entity. This separation between the owners and the LLC protects a farmer’s personal assets because the farm’s assets are distinct from the farmer’s. Put simply, the risk of the farmer is limited to the amount the farmer invests in the LLC but not more than that. Because the LLC is a separate entity, the farmer must actually separate the assets of the farm from personal assets. In practice, this requires that farmers create separate bank accounts and work to capitalize their farm.
LLCs also give farmers more flexibility when operating their business. LLCs offer broad discretion to owners when deciding who has control in making big decisions for the business. For example, if multiple people are farming together, voting rights in the LLC could be based on an farmers’ percentage of ownership, or each farmer could have one vote regardless of share. Additionally, LLCs do not require that farmers divide profits and losses in proportion with the share of the business owned by each farmer. In a general partnership, if there are two equal partners, then profits and losses would be split equally between them. However, with LLCs, this arrangement can be made however the owners choose. Lastly, LLCs lack the formalities of other business entities like corporations. LLCs do not require positions such as President or Treasurer (though an LLC’s members are free to create such positions), and LLCs do not have to establish annual meetings with elected members. Many farms are owned by a single farmer or very few farmers, so the formalities can be more of an inconvenience than useful guidelines for business governance.
Despite the advantages of an LLC, there is a risk of automatic dissolution of an LLC if the LLC does not report its filings on time or even if there is some change in the business’s structure as the result of a death of an owner or a merger. This does not mean that the LLC can no longer operate, but it can mean the loss of the liability structure that makes the LLC so desirable. It is also worth recognizing that state statutes create LLCs, and every state governs LLCs slightly differently. For example, in Iowa, an LLC must require biennial report with the Secretary of State. These different rules in different states can make interstate business more complicated for LLCs, but it might not be an issue for farmers operating solely within one state. Finally, LLCs are subject to Iowa Code 9H’s restrictions on corporate ownership or leasing of farmland. Thankfully, the statute includes carve-outs for “authorized limited liability companies” and “family farm limited liability companies,” through which most farming operations should be able to qualify, thereby obtaining the benefits of the LLC’s limited liability for members while avoiding the restrictions on corporate farming.
Corporations have some similar benefits as LLCs. There are two main types of corporations: S and C. There is also a B corporation, which is a less popular entity for businesses with a declared social purpose. S corporations act like an LLC for taxation purposes, and the owners are taxed on profits and losses. In contrast, a C corporation is taxed separately from its owners through a corporate income tax. One of the biggest benefits of a C corporation is that they allow profits to remain with the corporation and be dispersed as dividends to the corporation’s shareholders. Also, a C corporation can easily issue shares to raise capital and expand the business.
For farmers, one of the biggest limitations to incorporating is its complexity. Corporations require more paperwork and have to meet many more guidelines than LLCs. For example, corporations have a board of directors, annual meetings, and formal financial statements. There is also a potential issue of being double taxed on the income of the corporation and the tax on the dividends dispersed to shareholders. Ultimately, many farmers decide to use an alternative structure that is simpler to form and gives them more control and flexibility. Similar to LLCs, corporations too are subject to Iowa Code 9H’s restrictions on corporate ownership or leasing of farmland. Again though, the statute includes a carve-out for “family farm corporations” and “authorized farm corporations,” which should cover almost all farming operations that might want to utilize this business entity.
The decision of business entity is a significant choice for farmers. It is often worth taking steps to make an LLC or corporation to protect your farm from future liabilities. Ultimately, it is important to speak with financial advisors and lawyers when making the decision for what’s best for your farm. Ag & Business Legal Strategies can offer its clients advice on choice of business entity and has good relationships with knowledgeable corporate attorneys who can assist with both difficult questions and the logistics of forming and maintaining the best business entity for you and your farm.