Feb 25, 2016Best practices for choosing business structure
A poorly structured farm operation, including those that offer farm market and agritainment options but are not properly organized from a business perspective, is a sure recipe for disaster.
Avoiding such risks is the basis for recognizing best practices in choosing the right business structure for your agritourism operation, according to a Conklin, Michigan attorney.
“There are plenty of stories where putting in a cider press saved the farm or deciding to add a packing shed caused everything to unravel,” Barkow said. “A poorly structured operation puts everything at risk, regardless if you risk capital like a riverboat gambler or play it slow and conservative.”
Barkow outlined some of the basic issues to consider when structuring your operation to avoid continual risk.
“You don’t need a law degree to know that it is not a good idea to put all your eggs in one basket,” he said. “If your operation is a sole proprietorship or partnership, you have essentially put all your eggs in one basket. Sole proprietorships and partnerships receive no liability protection under the law; in this situation,
your personal assets can be used to satisfy a judgment resulting from your business liability.
“If you have formed a limited liability entity, you still may be putting all of your eggs in one basket,” he said.
Barkow presented a scenario in which an operation’s land and business are all tied together in one limited liability entity.
“While personal assets are protected in this situation, if the egg cracks, this operation stands to lose both business assets and land,” he said. “For many of our agricultural clients, land is a significant portion of
the client’s net worth. Even though this operation is a limited liability entity, the end result is the same: liability will wipe out a majority of assets.
“As attorneys, our main goal is to keep personal assets and land shielded from business liability,” Barkow said. “The bulk of agritourism liability stems from interacting with the public. Think of all the risk in selling a donut to a customer: an employee uses electrical power to mix batter, puts the batter in oil heated to 375 ̊, scans a credit card, and sells the donut to someone who may or may not have an allergy.
“That operation is one electrical short, third-degree
burn, identity thief, or peanut allergy away from facing tremendous liability,” Barkow said. “Alternatively, owning land is a passive activity and has a lower liability exposure. Using the donut analogy, if your agritourism operation owns both the donut maker and the land the business is operated on, your donut maker and your land could all be used to satisfy liability against you. Instead, separate the land from the donut maker.”
“Ideal” structures are difficult to come by, Barkow said, but “practical” structures can be pursued logically.
“Attorneys would prefer to structure an agritourism business as each parcel of land in a different legal entity, numerous leases and several different entities within the agritourism business itself,” he said. “This complex and cumbersome arrangement – though legally sound – is simply not practical for many small businesses.”
Operations need to adopt a structure that limits liability, protects land and personal assets, and is simple to administer, he said. There is no one-size-fits-all solution for every operation.
“Invariably, we advise clients that are starting agribusinesses differently than those who are looking to modify an existing operation,” he said. “The common thread among all our clients is to separate land from the farming operations.”
For many clients that own land individually or with a spouse, Barkow helps them put a structure together. In this arrangement, land is titled to a revocable trust and separated from the farming operations, which are in a limited liability entity. The operational entity leases the land from the revocable trust and covers expenses, insurance and other costs.
“There is a difference in the size of the organizational eggs and the separation,” he said. “If the operational entity is lost, the client still keeps a large majority of their net worth. We often utilize a revocable trust to keep land out of probate and to achieve a client’s estate planning goals.”
In this scenario, Barkow said, the land could simply be held personally and achieve the same liability protection as being held in a trust. When the land involved in a farming operation is owned by two or more families or multiple generations, the concept of separating the land from the business remains the same but the organizational structure is different.
Barkow used the example of another form of operation in which the land is owned by a limited liability entity and the farming operations are organized as a limited liability entity. The farmland entity leases the land to the operational entity. This protects each owner’s personal assets from liability and the land is still protected from the operation’s liability.
“As stated before, those two examples don’t fit every situation,” he said. “In some cases, land may not be the single most valuable asset. In other cases, there may be different business areas that should be split into different legal entities in order to spread out risk.”
He used the example of a farm market and winemaking endeavor in which the product is sold both at that farm market and others.
“It could be prudent to make your wine as one entity and operate your farm market as another entity,” he said.
Before making any business-structuring decisions, Barkow stressed the importance of obtaining advice from an attorney and accountant.
Limited liability entity
Barkow said there are several types of entities available in most states. S corporations, C corporations, limited liability companies (LLCs), limited liability partnerships (LLPs), family limited partnerships (FLPs), sole proprietorships and partnerships exist in almost every state.
Each type of entity is treated differently under the law and has different advantages and disadvantages.
“Selecting the right entity for your operation requires input from both your attorney and accountant,” he said. “They can best advise you of what works best in your state and fits the way you do business.”
The two main characteristics to consider are: 1) how the entity is taxed; and 2) whether the entity protects the owner from liability.
“For our agricultural clients in Michigan, we mainly work with LLCs and S corporations,” Barkow said. “Both LLCs and S corporations are taxed using a flow-through calculation, which means the company avoids being taxed and all taxes are recognized on the owner’s personal income tax. They also provide excellent liability protection for owners.
“We primarily advise clients to use LLCs because of their flexibility and adaptability,” he said. “LLCs have fewer formal requirements than S corporations. LLCs can also make an election to be taxed as an S corporation in the eyes of the IRS, which can save on self-employment taxes.”
Barkow said to be sure to ask both your attorney and accountant about whether being taxed as an S corporation would be advantageous to your bottom line.
“When going to the time and expense to structure your operation, make sure you use this opportunity to put your estate plan in order,” Barkow said. “Your business and estate planning documents should complement each other to ensure your business interests are protected and your estate planning goals will ultimately be achieved.
“If you are in business with someone other than your spouse, take the time to create a buy-out plan in your operating agreement,” he said. “It is hard to contemplate a break up when your business is in the honeymoon phase, but time spent deciding how to transfer business interests can avoid toxic arguments in the future and protect the business continuity.”
A simple way to transfer your business interest at death in Michigan is a “Transfer on Death” (TOD) designation, Barkow said. Owners of LLCs or S corporations can make TOD designations to direct their ownership interests to automatically pass to another person at death, outside of probate. Although they may be called a different name, TOD designations are available in many other states.
“This planning tool is very, very simple and is a low-cost addition to most operating agreements,” he said.
“You should seek the advice of licensed professionals in your jurisdiction that are familiar with your operation,” Barkow said. “If you need a referral, email or call us and we will try to connect you with someone in your state.”
— Gary Pullano, associate editor