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This guide will help farm owners choose a smart business entity for their unique operation. A wise and thoughtful decision at the outset will help farmers build a strong and resilient farm business that can withstand the test of time. Selecting the right entity is like building the foundation of a house. Without the right foundation, the house will eventually falter. Fortunately, a strong foundation isn’t difficult to build. Thought and attention are all that is required, and sustainable farmers have these qualities in spades. As when farmers turn thoughtful attention to their land and resources, thoughtful attention to legal issues will inspire the best solution for each unique sustainable farm.
A business entity is the legal structure or form that outlines the legal parameters of a business operation. Many business entity options exist, including the C corporation, the LLC, the B corporation, the cooperative and the nonprofit. There’s also an entity known as the S corporation, which actually is a federal tax status that can be applied to a C corporation, the LLC or the B corporation. We’ll call all of these the “formal entities.”
In comparison, we have “default entities.” These include the sole proprietorship, the general partnership and the unincorporated nonprofit association. Default entities are still subject to laws that define business operations that have not formally created an entity. For example, if a farmer is selling crops or livestock, they’ll be considered a sole proprietorship if they haven’t taken any other steps to define the business. If two friends come together to sell a product or service, they will be recognized by the law as a general partnership–even if they don’t file any paperwork.
Every business entity, including the default sole proprietorship and general partnership, carries legal implications. These implications help define tax treatment and answer the questions of who has which rights and privileges, who has the authority to make decisions, when and how owners take a draw on profits, and who’s liable for which decisions and actions. Taxation, rights and privileges, and liability are three driving forces for many farmers in choosing an entity. The purpose or objective of the farm operation may also come into play. Is the farm driven primarily by making profits, or do social or environmental causes play just as much of a guiding role? Succession planning is also key to consider when choosing an entity.
Before the corporation was created, people could only do business under their own personal name. At the same time, they took on the risk of personal liability for any acts or financial issues associated with the business.
This means that, like people, the business entity has rights and duties. Its rights include the ability to enter contracts, possess property, and sue and defend itself—all in the name of the entity. Just like a person, the business entity can lose all its money and file for bankruptcy in its own name. The business entity can also be sued for wrongdoings and illegal action taken by the owners on behalf of the corporation.
The business entity effectively stands in for the people behind it. But, these benefits extend if, and only if, the courts agree that the owners were upholding certain standards. Otherwise, the corporate shield can be knocked down and the owners’ mismanagement or wrongdoings will put them at risk personally. This is called “piercing the corporate veil” in corporate law speak. The takeaway is that a business entity is considered another person that can absorb and protect the owners from personal liability, unless the owners begin exploiting the rights of the entity. If this happens, the reality is that the entity is simply just a shell or a veil over the owners themselves.
State statutes control the way each business entity is created and governed, including the default sole proprietorship and general partnership. When it comes to business decisions and actions, the business entity itself can define its own rules through organizing documents such as the bylaws, a partnership agreement or an operating agreement. The business’s own rules will prevail as long as the rules are in line with the baseline requirements of the state statute. Accordingly, each business entity may have a different baseline in terms of the rights, privileges or responsibilities for the business and its owners. Choosing the entity that matches the farm operation owners’ goals can help bring everything into alignment.
Technically, a farm operation does not have to officially choose an entity. Farmers can certainly start selling their products without officially creating an entity. Of course, certain licenses and registrations may need to be obtained, but that can be done in the name of the owner(s) personally. If a farmer does nothing more, the farm operation will effectively be treated as a default entity–a sole proprietorship if one owner, a general partnership if multiple owners. (Although unlikely, an unincorporated nonprofit may be the default if the primary purpose of the farm operation is a nonprofit, social cause.)
Choosing not to form a formal entity is not necessarily a bad or wrong option. It takes time, money and willingness to follow certain formalities. Farmers unwilling to provide these resources might be better off managing risks in other ways.
Regardless of the ultimate decision, it can be helpful to go through a deliberate decision-making process of fully reviewing and understanding the pros, cons, benefits and risks of officially forming a formal entity or decisively electing to be a default entity. Occasionally, a bank, financial institutions or a regulatory agency may urge a farm operation to become one or another formal entity. It’s good to get the facts up front and to make a conscious decision based on your unique farm operation.
While forming a formal entity, such as a C corporation, LLC, cooperative, or nonprofit, or electing S corporation tax status can take time and money and require certain formalities, these efforts come with privileges. The most significant benefit of a formal business entity is that the owners’ personal assets are protected from the business’s liabilities. This means that if the business incurs debt and is not able to pay its bills, or if it is sued for some wrongdoing, the owners’ personal assets–such as vacation homes, land, boats, wages, individual bank accounts, etc.–cannot be touched by creditors or the courts to pay off the business’s debts. Formal business entities offer business owners a sense of relief. Basically, their risk is limited to the amount that they invested in the company. No more, no less.
With that said, the business entity must abide by certain formalities to maintain this protection. This includes keeping the business’s financial affairs separate from the owners’ individual affairs, namely by keeping separate bank accounts and accounting systems. In addition, the owners must ensure that the business is adequately capitalized, which means that the business can’t recklessly spend money and live extravagantly outside its means in hopes that the owners will be protected. Such conduct undermines the integrity of the business entity and, in effect, the courts could use the owners’ personal assets to cover the business’s liabilities.
Another benefit of having a formal business entity is that the formalities themselves actually promote good business practices. For example, by having separate bank accounts, the business may maintain more accurate and diligent accounting, which may save money and identify opportunities for expansion. In addition, a well-thought-out organizing agreement will foster better communication and understanding as everyone will share similar expectations even through challenging times.
A formal business entity can help a business raise funds from outside investors. This includes obtaining loans from banking institutions as well as seeking investments from wealthy individuals like venture capitalists and angel investors. Institutions and investors often prefer a stable entity that carries legal protections. In addition, the formal business structure assures them that the owners are operating the business with integrity, and thus their funding support will be taken seriously and is less likely to be frittered away. Farm owners who anticipate needing a significant amount of funding from the outside should consider this factor when deciding which business entity is right for their goals.
On the other hand, traditional farm lenders such as the USDA Farm Service Agency may occasionally raise concerns about farm businesses organized as LLCs or corporations. These concerns can usually be resolved by working with the lender to show the entity reflects the same fundamental organization as the sole proprietorship or general partnership with the additional benefits of a formal entity.
Finally, a formal business entity can ease the transition process of the farm operation. Succession planning is a huge issue that farmers face. Having a formal business entity provides the opportunity to set clear ground rules and processes for how the transition will take place. A formal entity creates a useful way to transfer the business as a whole rather than individual assets. It can also provide more favorable tax benefits. For example, if the farmland is placed in ownership of a formal business entity such as an LLC or a C corporation, it may be insulated from higher estate taxes if the heirs are properly named as owners of the entity itself.
The objective of this Guide is to help farmers decide which entity is best for their farm operation and to then take steps to actually form and uphold that entity. Ultimately, this Guide encourages farmers to be resourceful and do some of the legwork themselves. Not only will this save money in professional fees for attorneys and accountants,it will also equip the farmer with key knowledge on how to run a successful business. This Guide is organized to help you along the four-step path: Decide, Form, Organize and Implement.
The next chapter provides two tools to help farmers actually decide which business entity is best for their farm operation: Entity Comparison Chart and Choose Your Entity Flowchart. These charts will help farmers narrow down the options based on certain factors or characteristics of the business entity.
Part 2 of this Guide includes chapters on each of the main entities: sole proprietorship and general partnership, LLC, C corporation, S corporation, B corporation, cooperative and nonprofit (incorporated and unincorporated). Once you have narrowed down your choices by using these charts, the next step is to review the entity-specific chapter or chapters (if you’re still narrowing it down from two or three options). These chapters can help you affirm your decision by giving you a more thorough understanding of the characteristics, benefits and drawbacks, and requirements for that particular entity.
Before finalizing a decision, farmers should consult the Special Issues section. Farmers in certain states, farmers with diversified operations and farmers forming a multi-farm venture should review these chapters for additional decision-making considerations.
With an initial decision in hand, farmers need to know what it takes to form their chosen entity. How does a person set up the entity? What documents need to be filed and with whom? Many farmers choose the LLC or the corporation (generally taxed as an S corporation with the IRS). The Going Deeper sections in the LLC and C corporation chapters include even more materials, such as a checklist on creating an LLC and a checklist for creating a C corporation. These checklists walk through a step-by-step process to help farmers form these particular business entities.
The entity-specific chapters also outline the steps required to organize the entity. Primarily, this includes creating the organizing document–or the bylaws, partnership agreement or operating agreement. Again, the Going Deeper sections of the LLC chapter and the C corporation chapters include more extensive tools, including sample organizing documents and checklists for creating an organizing document. The organizing step also includes setting up the management structure, such as appointing a board of directors or managers, depending upon the entity. This step is discussed in the entity-specific chapters. For the LLC and the C corporation, these steps are further detailed in the Creating an LLC Checklist and the Creating a C Corporation Checklist.
Finally, each of the entity-specific chapters includes an Implementing Best Business Practices section, which highlights the requirements and best practices that are specific to that entity.
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