Farm Management Chapter 14 Forms of Business Organization.

Farm Management

Chapter 14

Forms of Business Organization

farm management chapter 14

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Chapter Outline

• Life Cycle• Sole Proprietorship• Joint Ventures• Operating Agreements• Partnerships• Corporations• Limited Liability Companies• Cooperatives• Transferring the farm business


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Chapter Objectives

1. To describe the primary forms of business organization

2. To discuss the organization and characteristics of each form

3. To compare their advantages and disadvantages

4. To show the effect on income taxes5. To summarize the factors to consider when

selecting a form of organization6. To compare the different forms for estate

planning


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Life Cycle

Each farm business has a life cyclewith four stages:

1. entry

2. growth

3. consolidation

4. exit


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Figure 14-1Illustration of the life cycle of a farm business


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Sole Proprietorship

• The owner owns and manages the business, assumes all risks, receives all profit

• No special legal permission required• Advantages: simplicity and freedom• Disadvantages: personal liability, size

may be limited, lack of continuity• Taxes on profit paid at tax rate of owner

(individual or joint for couple)


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Joint Venture

• Operating agreements

• Partnerships

• Corporations

• Limited liability companies

• Cooperatives


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Operating Agreements

• Two or more sole proprietors carry on some activities jointly while maintaining individual ownership of resources

• Operating expenses usually shared among the parties in some fixed proportion

• Income is shared in same proportion as fixed assets and expenses are contributed


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Table 14-1Example Budget for a Cow/Calf Joint

Enterprise (One Head)Item Value Party A Party B

Operating expenses

Hay 90.00 90.00

Grain & supplement 56.00 56.00

Salt, minerals 2.40 2.40

Pasture maintenance 22.50 22.50

Veterinary & health expense 10.00 10.00

Livestock facilities 8.00 8.00

Machinery & equipment 5.00 5.00

Breeding expenses 5.00 5.00

Labor 30.00 30.00

Miscellaneous 10.00 10.00

Interest on variable costs 11.95 1.78 10.17

Ownership expenses

Interest on breeding herd 75.00 75.00

Livestock facilities

Depreciation & interest 10.00 10.00

Machinery & equipment

Depreciation & interest 6.50 6.50

Land charge 105.00 105.00

Total expenses 447.35 233.78 213.57

Percent contribution 100% 52% 48%


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Figure 14-2Distribution of income from a joint venture


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Partnerships

• An association of two or more persons who share ownership of a business

• General partners contribute to the management of the business and are exposed to unlimited liability

• Limited partners do not participate in the management and are liable only for what they have contributed to the business


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General Partnerships:Organization and Characteristics

1. Sharing of business profits and losses

2. Shared control of property, with possible shared ownership of some property

3. Shared management of the business


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Written Partnership Agreements

1. Management: who is responsible for which decisions and how they shall be made

2. Property: list the property each partner will contribute and how it will be owned

3. Share of profits and losses: carefully describe how these will be divided

4. Records: designate who will keep the records


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Written Partnership Agreements (continued)

5. Taxation: include a detailed account of tax basis of property and copies of the partnership information tax return

6. Termination: state the date of termination if one is known

7. Dissolution: method of division of property in case of dissolution of partnership


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Termination

• At a particular time, as indicated in written agreement

• Upon the incapacitation or death of a partner, although the partnership may continue if the written agreement contains provisions for passing on the estate and continuing the partnership

• Bankruptcy• Mutual agreement


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Advantages of Partnership

• Easier and cheaper to form than a corporation

• A carefully written agreement can allow the partners to maintain much of their freedom

• Flexible form of business that can accommodate many different situations


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Disadvantages of Partnership

• Unlimited liability of each general partner

• Any partner individually can act for the partnership in legal and financial dealings and the other partners will also be held responsible

• Poor business continuity


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Partnership Taxation

A partnership does not directly pay taxes. It files an information income tax returnreporting income and expenses. Eachpartner’s share of income from the partnership is reported on his or her own tax return.


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Corporations

• A corporation is a separate legal entity

• It is formed and operated in accordance with laws of the state in which it is organized

• Shareholders in a corporation are liable only to the extent of their investment


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Forming a Farm Corporation1. File a preliminary application, reserving a

name for the corporation2. Draft a pre-incorporation agreement outlining

major rights and duties of the parties3. Prepare and file the articles of incorporation4. Turn property or cash over to corporation in

exchange for shares of stock5. Shareholders meet to organize and elect

directors6. The directors elect officers, adopt bylaws,

and begin business


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Two Types of Corporations• C corporation: a “regular” corporation

• S corporation: a “tax-option” corporation

1. No more than 75 shareholders2. Shareholders must be U.S. citizens, estates, or certain types of trusts3. One class of stock4. All shareholders must agree to form an S corporation


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Advantages of Corporations

• Limited liability for shareholders

• This advantage may be negated if a shareholder is required to personally sign a note to borrow funds

• The corporation, like a partnership, allows for several individuals to pool resources

• Business continuity


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Disadvantages of Corporations

• Costly to form and maintain

• Legal advice needed

• Shareholder and director meetings must be held


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Taxes and C Corporations

A C corporation pays taxes on its earningsbefore dividends are distributed. The shareholders then pay taxes on the dividends, at their individual rates. (“Double taxation”)

If shareholders are employees, their salary andbenefits (e.g. health insurance) can be charged as expenses to the corporation, butthese expenses must be reasonable.


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Taxes and S Corporations

An S corporation is taxed like a partnership.The corporation files an information taxreturn, but shareholders report their shareof income on their own tax returns and are taxed at their own rates.


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Table 14-2 Personal and Corporate Income Tax Rates

(2003)

Marginal Marginal

tax rate (%) tax rate (%)

Single Married filing jointly

$0 to $6000 $0 to $12,000 10 15$6,000 to $28,400 $12,000 to $47,450 15 25$28,400 to $68,800 $47,450 to $114,650 27 34$68,800 to $143,500 $114,650 to $174,700 30 39$143,500 to $311,950 $174,700 to $311,950 35 34 to 38Over $311,950 Over $311,950 38.6

$75,000 to $100,000$100,000 to $335,000Over $335,000

Up to $50,000$50,000 to $75,000

Personal

Taxable Income Taxable Income

Corporate

Check current tax rates for changes


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Table 14-3Comparison of Forms of Farm Business

OrganizationCategory Sole Proprietor Partnership Corporation

Ownership Single Individual Two or more individuals A separate legal entity that isowned by its shareholders

Life of business Terminates on death Agreed on term or Forever, unless fixed byat death of partner agreement; in case of death

stock passes to heirs

Liability Proprietor is liable Each partner is liable for all Stockholders are not liable forpartnership obligations even corporate obligations; in some to personal assets (except cases, individual stockholderslimtied partners) may be asked to co-sign

corporate notes

Sources of capital Personal investments, Partnership contributions, Shareholders' contributions,loans loans sale of stock, sale of bonds,

and loans

Management Proprietor Agreement of partners Shareholders elect directors decisions who manage the business or

hire a manager

Income taxes Business income is Partnership files IRS information Regular C corporation:combined with other report; each partner's share Corproration files a tax returnincome on individual of partnership income is and pays income tax; salariestax return added to individual taxable to shareholders are dedcutible;

income shareholders pay tax ondividends receivedTax-option (S) corporation:Shareholders report theirshare of income, operating loss and long-term capital gain on individual returns;IRS information report filedby corporation


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Limited Liability Companies

• A limited liability company (LLC) resembles a partnership but offers members the advantages of a corporation

• Liability is limited to the assets of the LLC, not the individually owned assets of members

• An LLC can have any number of members, all of whom can participate in management


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Limited Liability Companies(continued)

• Ownership distributed according to fair market value of contributed assets

• Net farm income from an LLC passed to members, who pay taxes at their individual rates (no “double taxation”)

• An LLC does not automatically continue in the event of a death of a member


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Cooperatives• Cooperatives are a special type of corporation• They require articles, bylaws, and detailed

records• Members who contribute capital enjoy limited

liability• Net income is passed to members and taxed at

their individual rates• Return to members cannot exceed 8%, with

remaining profits distributed as “patronage refunds”


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Transferring the Farm Business

1. Is the business large enough to productively employ another person or family?

2. Is the business profitable enough to support another operator?

3. Can management responsibilities be share?


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Stages of Transfer

1. Spin-off: separation of operators into individual operations

2. Takeover: older generation retires and rents or sells farm to younger generation

3. Joint operation: both generations wish to continue farming together and either use an operating agreement or form a partnership or a corporation


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Figure 14-3Alternatives for farm business transfer


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Summary

A farm or ranch business can be organizedas a sole proprietorship, a partnership, a corporation, a limited liability company,or a cooperative. Each form of businessorganization has advantages and disadvantages.

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Farm Management Chapter 14 Forms of Business Organization.

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