Wednesday, May 22, 2019
The question often arises with farm and ranch clients that engage in estate, business or succession planning as to what the optimal entity structure is for the business? There’s no easy, one-size-fits-all answer to that question. It simply depends on numerous factors. In fact, the question is best answered by asking a question in return – what do you want the farming or ranching business to look like after you and your spouse are gone? What are your goals and objectives. If planning starts from that standpoint, then it is often much easier to get set on a path for creating an “optimal” entity structure.
Some thoughts on structuring the farming or ranching business – that’s the topic of today’s post
Food For Thought
In many planning scenarios it is useful to create a checklist of points to consider that are relevant in the entity selection decisionmaking process. The next step would then be to apply those points to the goals and objectives of the parties. For starters, consider the following:
C corporations. The following are relevant to C corporations:
- A C corporation can be formed tax free if property is exchanged for stock; the transferors (as a group) hold 80 percent or more of the stock immediately after the exchange of property for stock; and the formation is for a business purpose.
- C corporate income is subject to tax at a flat rate of 21 percent.
- A C corporation is not eligible for the 20 percent qualified business income deduction of I.R.C. §199A that is available to a sole proprietor or the member of a pass-through entity (such as a partnership or S corporation).
- While gain that is realized on the sale of stock of a farming corporation can’t be excluded under the special rules that apply to qualified small business stock (I.R.C. §1202), if the stock is that of a corporation engaged in processing activities, the gain can be excluded. There are other rules that can limit (or eliminate) this capital gain exclusion.
- When a C corporation converts to S corporation status, the built-in gains (BIG) tax applies to the built-in gains on income items. I.R.C. §1374(a). The Tax Cuts and Jobs Act (TCJA) didn’t eliminate the BIG tax, but it did lower it to 21 percent.
- A C corporation has good flexibility in establishing its capitalization structure as well as how it allocates income, losses, deductions and credits.
- A C corporation is potentially subject to additional penalty taxes if too much earnings are accumulated without legitimate, well documented business reasons, or If too much income is passive.
- The alternative minimum tax presently doesn’t apply to C corporate income.
- A corporation for the farming operating entity will limit farm program payment limitations to a single $125,000 limit at the entity level. That amount will then be divided by the number of shareholders. If a pass-through entity is the operating entity, the number of payment limits will be determined by the number of members of the entity.
- A C corporation can deduct state income tax. This should be contrasted with the TCJA limitation on the deduction of such taxes for individuals that is pegged at $10,000 (including real property taxes on property that is not used in the conduct of the taxpayer’s trade or business). I.R.C. §164(b)(6).
- A C corporation can provide employees with the tax-free fringe benefits of meals (limited to 50 percent by I.R.C. §274(n)) and lodging that are supported by legitimate business reasons (and satisfy other conditions). This benefit is not available to sole proprietors and partners in a partnership. See, e.g., Rev. Rul. 69-184, 1969-1 C.B. 256. That is also the result for S corporation employees who own, directly or indirectly, more than 2% of the outstanding stock of the S corporation may not receive certain otherwise tax-free fringe benefits (including meals and lodging). See I.R.C. §1372. Attribution rules apply for determining who is considered to be an S corporation shareholder. I.R.C. §318.
- A farming or ranching C corporation can generally use the cash method of accounting.
- In some states, a C corporation cannot own or operate agricultural land unless members of the same family own a majority of the corporate stock. State laws differ on the specific rules barring C corporations from being involved in agriculture, and some states don’t have such rules.
- A C corporation faces the potential of a double layer of tax upon liquidation.
- The C corporation generally does provide good estate planning opportunities. In other words, it tends to be a good organizational vehicle for transitioning ownership from one generation to the next.
What About Income Tax Basis?
Given the currently high level of the federal estate tax exemption equivalent of the unified credit (11.4 million per decedent for deaths in 2019), income tax basis planning is high on the priority list. Thus, when federal estate tax is not a potential concern, planning generally focuses on making sure that property is included in a decedent’s estate. This raises some basic planning rules that must be considered:
- For property that is included in a decedent’s estate for purposes of federal estate tax, the basis of that property in the hands of the person inherits the property is generally the fair market value (FMV) as of the date of the decedent’s death. I.R.C. §Sec. 1014(a)(1)).
- But, the “stepped-up” basis rule (to the date-of-death value) doesn’t apply to property that is income in respect of a decedent (IRD) under §691. R.C. §1014(c). An item is IRD something that decedent was entitled to as gross income but wasn’t’ included in income due to death in accordance with the decedent’s method of accounting. See Treas. Reg. §1.691(a)-1(b). Farmers and ranchers have some common occurrences of IRD such as…
- Deferred gain to be reported from installment sales and deferred sales of crops and livestock;
- The portion (on a pro rata) basis or crop-share rentals due at the time of death;
- Receivables for a cash basis farmer;
- Unpaid wages;
- The value of commodities stored at an elevator (cooperative). Reg. §1.691(a)-2(b), Example 5 (canning factory and processing cooperative).
- Accrued interest income on Series E/EE bonds;
- When a decedent’s estate makes an election under I.R.C. §2032A to value ag land in the estate at its value as ag property (known as the “special use” value) rather than at its fair market value, the basis of the land in the hands of the heir is the special use value. There is no basis “step-up” to fair market value at the time of death. Treas. Reg. §§1014(a)(3); 1.1014-3(a).
- While the income of a pass-through entity is taxed only at the owner level, and the pass-through income increases the owner’s tax basis in the owner’s interest in the pass-through entity, a C corporation pays tax at the corporate level and then tax is also paid at the shareholder level on dividends or proceeds of liquidation. In addition, C corporate income does not increase the shareholder’s stock basis.
Just Starting Out – Creating a New Entity
If an organizational structure is initially being put into place, again there are numerous factors to consider in determining whether the farming or ranching business should operate as a C corporation or a pass-through entity. In addition, to those factors pointed out above, the following factors should also be considered:
- Is it anticipated that the primary or sole shareholder will hold the corporate stock until death?
- Where will the business be incorporated and do business? If the business will be a C corporation, does the state of incorporation or other states in which the corporation will do business have a state income tax?
- What tax bracket(s) will apply to the shareholders?
- If the underlying business of the corporation would qualify for the 20 percent qualified business income deduction of I.R.C. §199A, what’s the differential between the corporate tax rate of 21 percent and the individual rate less the 20 percent deduction? Will that full 20 percent deduction be available if the entity weren’t a C corporation? This can involve a rather complex analysis.
- What type of assets are involved? Will they appreciate in value? If so, the corporate tax rate of 21 percent plus the second layer of tax on gain of the appreciated asset value at the shareholder level upon liquidation (or on a qualified dividend) will exceed the maximum 23.8 percent capital gain rate that applies to an individual (20 percent rate plus an additional 3.8 percent on passive gain under Obamacare. I.R.C. §1411.
- Is it anticipated that the business will retain earnings or pay it out in the form of compensation, rents or other expenses? Growing businesses tend to retain earnings. Paid-out earnings of a C corporation are taxed again at the shareholder level.
- Is income expected to fluctuate widely? If so, remember that the C corporate tax rate is a flat 21 percent.
- Will there be sufficient funds to pay consistent income to the owners of the business? If so, that can mean that (if a C corporation structure is utilized) shareholder-employees can receive tax benefits at the individual level. If a corporate-level loss is incurred in doing so, that loss can be used to offset future taxable income.
- Under the TCJA, losses can offset up to 80 percent of pre-NOL taxable income.
- The loss (for a farming corporation) can be carried back two years. I.R.C. §172(b)(1)(B).
- From an accounting and tax planning standpoint, is a fiscal year desired? A C corporation can have a fiscal year-end and the individual shareholders can have a calendar year-end.
So, what is the best entity structure for your farming or ranching operation? The discussion above merely scratches the surface of a very complex matter. However, if you clearly articulate your goals and objectives for the future of your business to your planners, and provide complete information on assets, liabilities, land ownership, current arrangements, family data and dynamics, cropping and livestock history and tax history, then a good plan can be put in place that can, at least in the short-term satisfy your objectives. Then, there must be a commitment to routinely review and update the plan as necessary. There is no “one-size-fits-all” business plan, and plans aren’t static. There is cost involved, of course, but the successful operations realize that the cost is a small compared to the benefits.