Preparing for transition
Transition the Farm Using Profit Interest as a Planning Tool
When I meet a client, one of my first questions is, “How many more years do you want to work?” Typically the answer is a few years, but on occasion I have a client who indicates a longer transition out of farming. As someone who helps farmers transition to the next generation, my eyes light up. It is no secret that the more time you have to transition, the more options are available.
Time is money … and flexibility
Time provides you with the opportunity to think through your upcoming transition and potentially fix past financial sins that might burden your children. For example, I’m meeting with a client today about a transition plan. Unfortunately, the partnership has a substantial negative capital account, so right now the client could not gift (or part sale-part gift) the partnership to the children. Given some time, the client could work through the negative capital account and allow a more tax efficient transfer to the next generation. And as we work through the issue, there is something we can do to immediately start the transition— give the children a profit interest.
Profit interest as a transition planning tool
A profit interest is a planning tool for farmers that begins their transition well in advance of retiring. I could describe the intricacies of a profit interest, but it all boils down to this: It lets your children earn ownership of the farm through their sweat equity. Many of my clients have worked hard for everything they have, so they like the idea of their children earning the farm while providing a tax efficient way to transfer it to the next generation.
Keeping profits in the partnership
So how does a profit interest work? If you are farming in a partnership (most commonly a limited liability company [LLC]), you can allocate the profits and losses among the members as long as the allocation is not a sham. That is, the allocation of profits and losses has to be grounded in reality and not for the purpose of tax avoidance. The reason a profit interest works in a partnership setting is that allocation of profits and losses does not have to be identical to ownership percentage (like in an S corporation). So if a 10 percent equity owner does 50 percent of the work, he may be allocated 50 percent of the profits and losses.
A gradual change of ownership
Here is a tangible example. Frank is Nathan’s and Eric’s father. When Nathan and Eric decide to return to the farm and help their dad, Frank gives each son a 20 percent profit interest. The farm is valued at $1,200,000 and profits are historically $130,000 per year (assume 3 percent growth in profits per year to keep up with inflation). Frank takes distributions, but Nathan and Eric only take out enough to cover their tax liability.
As Frank winds down his level of responsibility in the business over the next 10 years, the children will take on a gradually increasing role in the farm. However, the children have a choice each year: They can take a distribution of the profits or opt to keep them in the farm partnership. If they opt for a distribution, their ownership percentage does not change (they are pulling out the earned equity). If they opt to keep the profits in the farm partnership, they effectively contribute money that increases their ownership percentage. A positive aspect of a profit interest is that if children decide they are not interested in being owners, they can take distributions and not increase their ownership. This benefits the child who wants to be an owner without punishing the child who does not want increased ownership. As you can see in the table below, Nathan and Eric have a combined ownership of 25 percent after 10 years. There are ways to speed up ownership transfer, but the basic premise is that the children earn their ownership by working in the farm business.
|Frank||Nathan||Eric||Frank's Capital Interest||Nathan's Capital Interest||Eric's Capital Interest|
|Year 1||$1.2 million||$17,680||$17,680||97.14%||1.43%||1.43%|
|Year 2||$1.2 million||$35,890||$35,890||94.36%||2.82%||2.82%|
|Year 3||$1.2 million||$54,647||$54,647||91.65%||4.17%||4.17%|
|Year 4||$1.2 million||$73,967||$73,967||89.03%||5.49%||5.49%|
|Year 5||$1.2 million||$93,866||$93,866||86.47%||6.76%||6.76%|
|Year 6||$1.2 million||$114,361||$114,361||83.99%||8%||8%|
|Year 7||$1.2 million||$135,472||$135,472||81.58%||9.21%||9.21%|
|Year 8||$1.2 million||$157,217||$157,217||79.24%||10.38%||10.38%|
|Year 9||$1.2 million||$179,613||$179,613||76.96%||11.52%||11.52%|
|Year 10||$1.2 million||$202,681||$202,681||74.75%||12.63%||12.63%|
How we can help
With enough time, a profit interest can be a useful tool for a tax efficient transfer of a farming partnership. It also provides parents with an opportunity to see if their children are truly interested in owning the family farm. CLA agribusiness professionals understand how difficult decisions about the family farm can be — some of us have been through this transition in our own families. So we understand this situation on a business level, on an industry level, and on a personal level. And we know how to help.