Chapter 14 Forms of Business Organization Farm Management Chapter 14 Forms of Business Organization

Chapter Outline Life Cycle Sole Proprietorship Joint Ventures Operating Agreements Partnerships Corporations Limited Liability Companies Cooperatives Transferring the farm business farm management chapter 14

Chapter Objectives To describe the primary forms of business organization To discuss the organization and characteristics of each form To compare their advantages and disadvantages To show the effect on income taxes To summarize the factors to consider when selecting a form of organization To compare the different forms for estate planning farm management chapter 14

Life Cycle Each farm business has a life cycle with four stages: entry growth consolidation exit farm management chapter 14

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

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) farm management chapter 14

Joint Venture Operating agreements Partnerships Corporations Limited liability companies Cooperatives farm management chapter 14

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 farm management chapter 14

Table 14-1 Example Budget for a Cow/Calf Joint Enterprise (One Head) farm management chapter 14

Figure 14-2 Distribution of income from a joint venture farm management chapter 14

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 farm management chapter 14

General Partnerships: Organization and Characteristics Sharing of business profits and losses Shared control of property, with possible shared ownership of some property Shared management of the business farm management chapter 14

Written Partnership Agreements Management: who is responsible for which decisions and how they shall be made Property: list the property each partner will contribute and how it will be owned Share of profits and losses: carefully describe how these will be divided Records: designate who will keep the records farm management chapter 14

Written Partnership Agreements (continued) Taxation: include a detailed account of tax basis of property and copies of the partnership information tax return Termination: state the date of termination if one is known Dissolution: method of division of property in case of dissolution of partnership farm management chapter 14

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 farm management chapter 14

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 farm management chapter 14

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 farm management chapter 14

Partnership Taxation A partnership does not directly pay taxes. It files an information income tax return reporting income and expenses. Each partner’s share of income from the partnership is reported on his or her own tax return. farm management chapter 14

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 farm management chapter 14

Forming a Farm Corporation File a preliminary application, reserving a name for the corporation Draft a pre-incorporation agreement outlining major rights and duties of the parties Prepare and file the articles of incorporation Turn property or cash over to corporation in exchange for shares of stock Shareholders meet to organize and elect directors The directors elect officers, adopt bylaws, and begin business farm management chapter 14

Two Types of Corporations C corporation: a “regular” corporation S corporation: a “tax-option” corporation No more than 75 shareholders Shareholders must be U.S. citizens, estates, or certain types of trusts One class of stock All shareholders must agree to form an S corporation farm management chapter 14

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 farm management chapter 14

Disadvantages of Corporations Costly to form and maintain Legal advice needed Shareholder and director meetings must be held farm management chapter 14

Taxes and C Corporations A C corporation pays taxes on its earnings before dividends are distributed. The shareholders then pay taxes on the dividends, at their individual rates. (“Double taxation”) If shareholders are employees, their salary and benefits (e.g. health insurance) can be charged as expenses to the corporation, but these expenses must be reasonable. farm management chapter 14

Taxes and S Corporations An S corporation is taxed like a partnership. The corporation files an information tax return, but shareholders report their share of income on their own tax returns and are taxed at their own rates. farm management chapter 14

Table 14-2 Personal and Corporate Income Tax Rates (2003) Check current tax rates for changes farm management chapter 14

Table 14-3 Comparison of Forms of Farm Business Organization farm management chapter 14

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 farm management chapter 14

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 farm management chapter 14

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” farm management chapter 14

Transferring the Farm Business Is the business large enough to productively employ another person or family? Is the business profitable enough to support another operator? Can management responsibilities be share? farm management chapter 14

Stages of Transfer Spin-off: separation of operators into individual operations Takeover: older generation retires and rents or sells farm to younger generation Joint operation: both generations wish to continue farming together and either use an operating agreement or form a partnership or a corporation farm management chapter 14

Figure 14-3 Alternatives for farm business transfer farm management chapter 14

Summary A farm or ranch business can be organized as a sole proprietorship, a partnership, a corporation, a limited liability company, or a cooperative. Each form of business organization has advantages and disadvantages. farm management chapter 14