Wednesday, August 5, 2020
The Use of the LLC For the Farm or Ranch Business – Practical Application
Overview
Last week I wrote a twopart series on how the singlemember LLC can be utilized as part of a farming or ranching business. A large part of my focus was on the singlemember LLC and what it means to be a disregarded entity. In part two, I noted that the Tax Court has held that while a singlemember LLC is a disregarded entity for federal income tax purposes, it is respected for federal estate and gift tax purposes. As a result, valuation discounts can be available to decrease the taxable value of the owner’s interest in the singlemember LLC.
In today’s post, guest author Marc Vianello, of Vianello Forensic Consulting, provides a practical application of the concepts that I discussed last week. Many thanks to Marc for today’s article.
SingleMember LLCs – Valuation Implications
Assume that Broad Horizon Family Farms is a Kansas farming/ranching family comprised of a father, mother, son, and daughter. The farm/ranch is operated as a unified business under the ownership of a fourpartner general partnership. As an unincorporated entity, this structure allows for four payment limitations for federal farm program payment purposes. The partners of the partnership are four Kansas LLCs that each own an equal 25 percent interest in the partnership—no partner has control, and no family member is a partner.
Also assume that father, mother, son, and daughter each own 100 percent of one of the four LLCs. Each family member, therefore, owns a 100 percent interest in an LLC that owns a 25 percent interest in the partnership. Assuming that the partnership agreement does not limit the partners’ LLC transfer rights, how does this play out for valuation purposes?
To answer that question, we need to know what the partnership owns; its expected future cash flows; and a valuation date. For purposes of the example, assume that the valuation date is June 30, 2020, and that Broad Horizon Family Farms has the following assets and liabilities:
 2,000 acres of farm and ranch land with a real estate valuation of $8,000,000;
 200 cow/calf pairs with an auction value of $300,000;
 $1,000,000 fair market value of equipment;
 $700,000 of harvested grains and in onfarm storage priced at current commodity prices;
 Cash on hand of $150,000.
 Land debt of $3,050,000, with interest accruing at the annual rate of 6.75 percent We will assume that the partner LLCs and their individual owners have guaranteed the debt.
These assumptions result in the following partnership balance sheet stated at fair market value (not cost), and a capital structure that is approximately 30 percent debt and 70 percent equity without regard to builtin gains taxes, and 38.1 percent debt, 61.9 percent equity after deducting the taxes:
Appraised Value 
Tax Basis 
Tax Rate 
AfterTax Value 

Cash 
$ 150,000 
n/a 
n/a 
$ 150,000 
Commodities 
700,000 
 
40% 
420,000 
Cattle 
300,000 
 
20% 
240,000 
Equipment 
1,000,000 
 
40% 
600,000 
Land 
8,000,000 
1,000,000 
20% 
6,600,000 
Total assets 
$10,150,000 
$8,010,000 

Debt (6.75% rate) 
3,050,000 
3,050,000 

Partnership equity 
7,100,000 
_4,960,000 

Total debt and equity 
$10,150,000 
$8,010,000 
On an asset basis, the Partnership equity might have an asset based “as if marketable” value of $4,960,000 as an operational whole, or $1,240,000 per LLC partner. But that is not the fair market value of the LLC partner’s interest in the Partnership, because a hypothetical buyer would be buying into a partnership of which 75% ownership is held be familyrelated parties. Accordingly, a minority discount is appropriate. Let’s assume a 15 percent discount in this case, resulting in a minority discounted value of $1,054,000 per 25 percent Partnership interest.
Now let’s make some assumptions regarding the annual operations of the Partnership. For this discussion, we will make the simplifying assumption of constant results subject to inflationary growth of 1.25 percent annually:
 Because the partnership is comprised of four equal partners, assume that there are no perquisites of control in the manner of operation and the handling of distributions. The projected operations are assumed to continue in all respects as in the past.
 Father, mother, son, and daughter provide all of the labor, and work 50 hours weekly. The LLCs receive periodic distributions equal to 75 percent of book net income. These payments total $554,344 annually ($138,586 to each partner LLC). Let’s also assume that the LLC partners flow the payments directly through to their owners, that is, to father, mother, son, and daughter.
 Valuation requires that the fair market value of the work being performed by related parties be determined. Accordingly, we will assume that the labor provided by father, mother, son, and daughter could be replaced with a threeemployee independent work force at an average hourly rate of $20, with each employee working a 50hour week. Note that the allocation of wages in the valuation scenario would not be equal; some higher paid person would be the manager, and the lowest paid worker may receive just minimum wage. The independent work force payroll on a 50hour week would be $156,000.
 The farm/ranch generates $1,500,000 of annual gross revenues, which is $750 per acre.
 Annual crop inputs are $300,000.
 Annual animal care costs are $95,000
 Annual other operating expenses are $160,000.
 Annual interest of $205,875 (6.75 percent) is paid on the $3,050,000 of debt.
 Net capital expenditures equal to 25% of book net income are incurred. This represents net capital costs of $184,781 annually, for which Section 179 deductions are assumed to be taken.
 A 40 percent effective income tax rate is assumed to impute taxes to the Partnership. This is necessary to equate the Partnership’s income to that of a C corporation, because the cost of equity capital valuation metrics derive from publicly traded C corporations.
 A 20 percent tax rate is assumed to calculate the effect of dividend tax avoidance by the flow through tax nature of the Partnership compared to the nonflow through nature of C corporations from which the cost of equity capital valuation metrics are derived.
These assumptions result in the below operating results. The “adjusted” column is used for further valuation analysis.
Operating Results 

Unadjusted 
Adjusted 

Gross revenues 
$1,500,000 
$1,500,000 
Wages 
 
156,000 
Crop inputs 
300,000 
300,000 
Animal care costs 
95,000 
95,000 
Other operating expenses 
160,000 
160,000 
Total operating expenses 
555,000 
711,000 
Operating profit 
945,000 
789,000 
Interest expense 
(205,875) 
0 
Book net income 
739,125 

Net capital expenditures 
(184,781) 
(184,781) 
Distributions to the LLCs 
(554,344) 
 
Net cash flow from operations 
$  
604,219 
Imputed income taxes at 40% 
(241,688) 

Imputed aftertax cash flow to capital 
$ 362,531 
If an 18 percent cost of equity is assumed as well as a forty percent tax deduction benefit for interest expense, the assumed 38.1 percent/61.9 percent debt/equity capital structure results in a weighted average cost of capital (“WACC”) of 12.688 percent. The assumed growth rate of 1.25 percent therefore results in a capitalization rate of 11.438 percent. Thus, we calculate a capitalized value of $3,169,478. But because the partnership is a flow through entity, it is necessary to make another adjustment to equate it to the financial effects of a C corporation. Assuming a 20 percent qualified dividend tax rate, the value of the avoided shareholder dividend taxes is $792,369. Accordingly, the partnership equity might have cash flow based “as if marketable” value of $3,961,847 as an operational whole  $990,462 per 25 percent Partnership interest. No discount for minority interest applies to this calculation.
Imputed aftertax cash flow to capital 
$ 362,531 

Assumed capitalization rate 
11.438% 

Capitalized value 
3,169,478 

Adjustment for avoided shareholder dividend taxes 
792,369 

"As if marketable" value based on cash flow 
$3,961,847 
Valuation professionals must reconcile the “as if marketable” values of their different approaches. It is often concluded that the value is not less than the amount that could be realized based on liquidation, but a 25 percent partner would not be able to compel liquidation. Thus, the common conclusion is that the “as if marketable” value of a 25 percent partnership interest is $990,462 based on the partnership’s cash flow. But this is not fair market value. The valuation metrics derive from C corporations whose shares are traded in the public markets—they are liquid, while the 25% partnership interests held by the LLCs are not—they are illiquid. Accordingly, a discount for lack of marketability (“DLOM”) must be subtracted from the “as if marketable” value to arrive at fair market value.
Practitioners use a variety of tools to estimate DLOMs. The most simplistic approaches use the average of various small published studies of the discounts reflected in the prices of (1) restricted stocks compared to their publicly traded versions; and (2) stocks sold before completion of an initial public offering (“IPO”) to their IPO prices. Through 1988, these restricted studies a range of 3035 percent. The implied discounts trended downward thereafter with changes in SEC Rule 144. The preIPO studies suggested larger discounts in the 4045 percent range. Larger databases of restricted stock and preIPO transactions now exist, and are used by many practitioners to estimate DLOM. Nevertheless, relying on restricted stock and/or preIPO transactions for DLOM estimate is problematic and may be unreliable. To support this see Vianello, Empirical Research Regarding Discounts for Lack of Marketability, Chapters 35 (July 2019). Available at https://dlomcalculator.com/wpcontent/uploads/2019/07/EmpiricalResearchRegardingDLOMwithGuide.pdf.
An alternative method of estimating an appropriate DLOM uses the VFC DLOM Calculator, which couples the time and price risks associated with marketing privately held securities to various option pricing formulae. Unlike other methodologies, the VFC DLOM Calculator is a date specific, facts and circumstances tool supported by empirical research. The formula most appropriate for DLOM estimation is the VFC Longstaff formula. You can find the VFC DLOM Calculator and its supporting empirical research at https://dlomcalculator.com/.
Using the partnership’s characteristics (an SIC Code range of 0100 to 0299; Asking Price of $2,000,000 to $4,000,000; 4 Employees; Annual Revenues of $1,000,000 to $2,000,000), a reasonable conclusion is that the average marketing time required by an LLC partner to sell its interest in the Partnership is 232 days, with a standard deviation of 197 days. This compares to an average of 123 days to obtain SEC approval for a public offering by a large business in the 0000 to 0999 SIC Codes. See Vianello, Empirical Research Regarding Discounts for Lack of Marketability, Table 1.1 (July 2019). Available at https://dlomcalculator.com/wpcontent/uploads/2019/07/EmpiricalResearchRegardingDLOMwithGuide.pdf. The VFC DLOM Calculator informs us that we can be 95 percent confident that the average marketing period is between 226 and 239 days based on these statistics.
Using a selection of four publicly traded classified as “Agriculture Production – Crops” (SIC Code 0100) and “Agriculture Production – Livestock & Animal Specialties” (SIC Code 0200), the VFC DLOM Calculator tells us that the longterm average price volatility of the companies’ stocks is 38.1 percent, with a standard deviation of 59.0 percent. The VFC DLOM Calculator informs us that we can be 95 percent confident that the average price volatility is between 37.3 percent and 39.0 percent using the complete set of price data. Using this data and the above marketing period parameters, results in a riskadjusted DLOM estimate of 22.3 percent.
But there has recently been increased price volatility in the stock market because of coronavirus uncertainty. Looking only at the 90 trading days before June 30, 2020, the VFC DLOM Calculator tells us that the average price volatility was 70.2 percent, with a standard deviation of 76.9 percent. The VFC DLOM Calculator informs us that we can be 95 percent confident that the average price volatility is between 62.2 percent and 78.1 percent using the more current set of price data. Using this data and the above marketing period parameters, results in a riskadjusted DLOM estimate of 40.3 percent. The VFC DLOM Calculator informs us that we can be 95 percent certain that the appropriate DLOM based on the more current price data is between 35.0 percent and 45.7 percent. The economic circumstances prevailing as of June 30, 2020, counsel to this higher DLOM estimate.
Using a 40.3 percent DLOM, we might conclude that the fair market value of a 25 percent interest in the partnership held by the partner LLC is $591,306 ($990,462 x (1.403))
However, the family members don’t own interests in the partnership. They instead own 100 percent interests in their respective LLCs. What is the fair market value of these LLCs? It’s something less than $591,306, because the LLC, too, is subject to a lack of marketability. Additional professional consideration must be given to developing the appropriate DLOM. For example, it may be a discount more associated with financial portfolio risks than with agriculture risks.
Conclusion
This use of the singlemember LLC can be a valuable aspect of an intergenerational transfer of the farming or ranching business. Coupled with a general partnership farming entity, the singlemember LLC can also optimize receipt of federal farm program payment limitations. Further structuring of the management form of the LLC can also bring additional income and selfemployment tax savings.
https://lawprofessors.typepad.com/agriculturallaw/2020/08/theuseofthellcforthefarmorranchbusinesspracticalapplication.html