This is part five of a five-part series regarding the authors’ view that agricultural estate planning in this country is broken and needs corrected, particularly in light of “Agricultural Estate Armageddon” which will happen this decade when a quarter of all farmers will retire and two-thirds of all farmers will be over 65. Past articles can be viewed at www.farmlegacy.blogspot.com.
It was 2007. I had been practicing law for two years and once a month my father and I would meet with fellow farmers from a nearby farm to discuss grain marketing. A grain trader, Steve, moderated the meetings. As long as I live, I will never forget one particular meeting where Steve showed up and handed out a packet of information focused on the upcoming ethanol boom and how it would change things. Steve looked at us and said “Boys, be glad you bought some land when you did”. Steve also told us that we would all only grow corn in the future because the demand for ethanol would push corn consumption into the stratosphere.
Well, Steve was half right. For reasons we all know, the demand for ethanol from 2008 to 2012 turned out to be pretty much a one-time stimulus package for the agriculture industry. Although ethanol still accounts for a large amount of annual use, demand can still be easily exceeded by the growing capacity of the American farmer. However, Steve was right to say that we were happy for the land we owned in light of the skyrocketing land prices he correctly predicted.
I often wonder if land prices will really drop. Other than a few minor declines in value over the past 10 years, all of which have been clawed back by the current inflation-driven recovery, farmland really hasn’t declined since the early 1980s. In other words, we haven’t seen farmland in this country shrink significantly in over 40 years. We all know that buying land today does not generate cash. Either you have money in reserve or you borrow money and use other land to generate the income that will help you pay. A recent article reported that even at current grain prices, the average price at which land could bring in cash was around $4,000 per acre in the Midwest.
It’s no wonder that 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 are either unable to farm or spend the rest of their life buying other heirs. Buying the same land twice is not my idea of a good time. If you want your next generation to succeed, you must think long and hard about how you divide your land or the next generation is almost guaranteed not to succeed.
Unfortunately, there are still too many farms that pass to the next generation by 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 appropriate state agency. Why? Well, for starters, you can’t get three people to agree on where to eat breakfast these days, let alone what to do with millions of dollars worth 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 might want to nurture it, Paul might want to develop it, and Mary might want to put it on a conversational program. What usually happens is that the farm is then sold because people can’t get along. Here in Indiana we have a really bad law that was passed in 2014 that basically allows a landlord to force the sale of the whole farm. Also, what happens when Paul goes through a divorce? What happens when Mary is in an accident and sued for millions? What happens if Peter has to declare bankruptcy? All of these scenarios and more will most likely lead to a situation where you can see part of your terrain walking on the road. I could write a book on this subject, but trust me, leaving land to heirs via a joint ownership deed is a bad, bad idea.
Instead of conveying land via a deed, a limited liability company (LLC) should be used instead. Probably the biggest benefit is that the LLC has an operating agreement (i.e., bylaw) that can specify how the land is to be used, who can buy whom, how much a buyout costs, and many other aspects. . Moreover, I believe this is the best way to achieve equity. When considering participation in the LLC, it should be kept in mind that the child farmer will probably never sell the land. So what the farmer’s child really gets when it comes to owning land is the opportunity to earn an income through farming. On the other hand, non-farm children can withdraw money, take the money and go and invest that money earning a good annual return. Compare that to the child farmer who probably has to take on more debt and pay interest on that debt every year.
I would be hard pressed to think of a reason why a child farmer should not receive a larger share of LLC land ownership. If Peter was the child of agriculture and worked for decades on the farm, why should Paul and Mary receive the same share in the LLC? In this situation, it wouldn’t be out of place for Peter to receive 50% of the landed LLC while Paul and Mary receive 25% each. When trying to find a percentage, the income approach discussed above should be helpful in determining percentages. A person simply needs to run some scenarios looking at what the farm child will earn from the land versus what the non-farm children will earn if they cash in and invest.
Another benefit of the LLC is that the operating agreement can set the redemption price of a membership interest. In my operating agreements, it is expected that a commercial appraisal be performed on the LLC land property. A business valuation looks at business assets, revenue, 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 business due to it being a small family business and the fact that there may be a blockage due to the fact that the LLC usually has a small number of members. This discounting is often referred to as an “assessment discounting” and has been authorized by the IRS to reduce overall farm property values for estate tax purposes. Generally, such a business valuation will lower the value of the business between 20% and 40%. This means that the child farmer is able to buy out the non-farm children at less than the current market price. Another mechanism is to cap the value of land owned by the LLC. For example, if the family owns 500 acres, a maximum value of $5,000 per acre is established, capping the value of the LLC at $2.5 million. This not only adds certainty about the buyback price, but also avoids the farm child having to buy back at exorbitant prices.
Sometimes the best thing you can give the farm kid is time. My operating agreements contain a provision that the child of the farm can buy out the other members over a period of 15 years. This protects against situations where the farmer’s child might not be able to obtain financing to buy out the other members. Whichever way you slice it, the LLC’s operating agreement will determine whether or not the estate plan succeeds in terms of passing on the land.
Focusing on the income the land can generate, instead of its value, will greatly increase the ability to achieve equity. Doing this while at the same time using an LLC with the appropriate terms in the operating agreement exponentially increases the equity achieved and with equity 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 that you found some great ideas to implement in your own succession plan. agricultural.