Why the current method of farm estate and succession planning is not working part five
This is part five of a five-part series regarding the authors’ view that farm estate planning in this country is broken and needs fixed, especially in light of “farm estate Armageddon” that will happen this decade when a quarter of all farmers retire and two thirds of all farmers will be over the age of 65. Past articles can be viewed at www.farmlegacy.blogspot.com.
The year was 2007. I was two years into practicing law and once a month my dad and I would meet with fellow farmers at a neighboring farm to discuss grain marketing. A grain marketer, Steve, would facilitate the meetings. For as long as I live, I will never forget a particular meeting when Steve showed up and passed out a packet of information that centered on the coming ethanol boom and how it would change things. Steve looked at us and said “Boys, be glad you bought ground when you did”. Steve also told us that we would all be raising just corn in the future as the ethanol demand would push corn consumption into the stratosphere.
Well, Steve was half correct. For reasons we all know, ethanol demand from 2008 through 2012 proved to be pretty much a one-time stimulus package to the agriculture industry. Although ethanol still accounts for a large amount of yearly usage, demand still can be easily outpaced by the growing ability of the American farmer. However, Steve was correct that we were glad for the land we owned in light of the surge in land prices that he correctly predicted.
I often contemplate if land prices will ever really subside. Besides some minor dips in value over the past 10 years, which have all been regained by the current inflation driven upswing, farmland really has not decreased since the early 1980s. In other words, we have not seen farmland in this country significantly decrease in over 40 years. We all know that buying land today does not cash flow. You either have cash stored up or borrow the money and use other land to generate the income to help pay. A recent article stated that, even at current grain prices, the average price where land could cash flow was around $4,000 per acre in the Midwest.
It is no wonder why when it comes to farm succession planning, land is the most important element. If the next generation does not receive an adequate share of the land, they either are unable to farm or spend the rest of their life buying out other heirs. Buying the same ground twice is not my idea of a good time. If you want your next generation to succeed, you need to think long and hard how you divvy out your land or it is almost assured the next generation will not succeed.
Unfortunately, there are still too many farms that pass to the next generation via deed. In other words, Jack and Dianne leave their land to Peter, Paul and Mary where all three are on the deed. My position is that this is a form of child abuse warranting investigation by the applicable state agency. Why? Well, for starters, you cannot get three people to agree where to eat breakfast at nowadays, let alone what to do with millions of dollars of land. And, in most states, there are literally no rules as to the use and enjoyment of the land when everyone is on the deed. Peter could want to farm it, Paul could want to develop it and Mary could want to put it in a conversation program. What usually happens is the farm then gets sold because people can’t get along. Here in Indiana, we have a really bad law that was passed in 2014 that basically makes it where one owner can force a sale of the entire farm. Further, what happens when Paul goes through a divorce? What happens when Mary is in an accident and is sued for millions? What happens if Peter has to declare bankruptcy? All of these scenarios and more will very likely lead to a situation where you get to see some portion of your land walk on down the road. I could write a book on this subject, but take it from me, leaving land to heirs via a co-ownership deed is a bad, bad, idea.
Instead of passing land on via a deed, a limited liability company (LLC) should be used instead. Probably the greatest benefit is that the LLC has an operating agreement (i.e. a rulebook) that can spell out how the land is to be used, who gets to buy who out, how much a buyout costs and many other aspects. Further, I believe it is the best way to achieve fairness. When looking at ownership interest in the LLC, it should be remembered that the farming child is likely never going to sell the land. So, what the farm child really receives when it comes to ownership of land is the ability to maybe make income by farming. On the other hand, the non-farm children can cash out, take the money and go invest that money earning a good yearly return. Compare that to the farming child who likely has to go further into debt and pay interest on such debt each year.
I would be hard pressed to think of a reason why a farming child should not receive a larger share in the land holding LLC. If Peter has been the farming child and put in the work over decades on the farm, why should Paul and Mary receive the same share in the LLC? In this situation, it would not be out of line for Peter to receive 50% of the land LLC while Paul and Mary receive 25% each. When trying to come up with a percentage, the income approach discussed above should be helpful in determining percentages. A person merely needs to run some scenarios looking at what the farm child will be earning from the land versus what the non-farm children will be earning if they cash out and invest.
Another benefit of the LLC is that the operating agreement can set the buyout price of a membership interest. In my operating agreements, it calls for a business valuation to be performed on the land holding LLC. A business valuation looks at the assets of the company, income and other factors. Then, the business valuation will discount the value of the LLC based on factors such as the lack of marketability of the company due to it being a small, family held company and the fact that there can be gridlock due to the LLC usually having a small number of members. This discounting is often referred to as “valuation discounting” and has been allowed by the IRS to lower overall farm estate values for estate tax purposes. Generally, such a business valuation will lower the value of the company between 20% to 40%. Meaning, the farming child is able to buy the non-farm children out at an amount below current market price. An alternative mechanism is to cap the value on the land owned by the LLC. For example, if the family owns 500 acres, there is a maximum value of $5,000 per acre established, maxing out the value of the LLC at 2.5 million dollars. This not only adds certainty to what the buyout price will be, but hedges against the farm child having to buy out at sky high land prices.
Sometimes, the best thing that can be given to the farm child is time. My operating agreements have a provision where the farm child can buy out the other members over a fifteen-year time period. This protects for situations where the farm child may not be able to obtain financing to buy out the other members. No matter which way you slice it, the operating agreement for the LLC will drive whether the succession plan is successful or not when it comes to passing on the land.
Focusing on the income the land can generate, instead of its value, will greatly increase the ability of fairness being achieved. Doing such while at the same time utilizing an LLC with the proper terms in the operating agreement, exponentially increases fairness being achieved and, with fairness, comes the likelihood that the next generation can succeed.
In closing, I hope you enjoyed this five-part series on how we can fix the current method of farm estate planning in this country and have found a few good ideas to implement in your own farm succession plan.