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.
What is a business entity?
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.
A formal business entity is considered a person in the eyes of the law
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.
How is a business entity governed?
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.
Do I have to choose an entity?
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.
What are the benefits of forming a formal entity?
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.
How is a formal business entity created?
This can seem daunting at first; there are just too many entities to choose from. However, considering just a few factors will automatically narrow down your options. The following entity comparison chart reviews basic legal issues and implications associated with the various business entities. Turn to Chapter 2 for a user-friendly flowchart. Just answer a few questions and you will identify the best place to start. If you are lucky, the entity will choose you!
Don’t stop at the flowchart. The detailed chapters on each of the entities that follow provide incredibly important, detailed information on the structure and nature of the entity. Read the chapter corresponding to the entity that chooses you in the flowchart exercise. These chapters also contain supplemental materials including checklists and sample organizing documents to help walk you through the steps in forming that particular entity.
Before taking any action, be sure to read chapter 10 on anti-corporate farming laws. Certain Midwestern states have laws that affect a business’s ability to own or control farmland and farm businesses. You’ll need to confirm that your plan doesn’t violate an anti-corporate farming statute if you live in one of these Midwestern states.
We also strongly recommend working with an accountant or tax professional before taking any action. Businesses overall come with very specific tax and accounting issues with varying complexities. These financial issues should not be handled in isolation. While this Guide provides some information about tax issues to get a person started, this Guide does not serve in any way as tax advice. Tax matters are very specific to individual factors, including the farm’s specific operations, the owners’ financial situation and the entity chosen. This Guide does not address state tax issues at all. Obviously, state tax matters are still a vital consideration.
An accountant’s input early on is an investment in later efficiency. An accountant or tax professional can really help with the process of setting up the business, such as creating spreadsheets and financial tracking mechanisms. Good accounting practices and systems can provide insight into the business, help eliminate bad debt, manage cash flow issues, create favorable tax strategies and ease the processes of payroll and maintaining profit and loss statements, to name a few.
Once you’ve confirmed your business entity selection is right for your farm operation and is not counter to any anti-corporate farming statute, you’ll next need to pull the rest of your team together to generate consensus. The team members may include your spouse, business partners and any potential investors.
An attorney can be another key team member. The attorney’s role will be to confirm that your selection of business entity is most suitable for your farm operation based on your state’s business entities laws. Again, each state has a specific statute for each type of entity. These statutes vary from state to state. Each one may have fewer or more restrictions on types of ownership and decision-making power and fewer or more requirements on upholding certain formalities, among other factors. Working with an attorney who is familiar with your state’s business entities statutes provides assurance that your choice is wise and your business organization documents will be upheld.
Deciding on a business entity is just the first step. The next step is actually forming the entity in your state. (Or, if you’ve chosen a default entity, the next step is to do nothing!) This step involves preparing a formation document. The formation document is either called the “articles of incorporation” (C corporation, B corporation, cooperative or nonprofit corporation) or the “articles of organization” (LLC). This document is filed with the state agency responsible for business registration, which is usually the state’s secretary of state office. It typically requires a fee that varies based on both the state and the specific entity. The fee can range anywhere from $40 to $1,000. The filing fee, as well as any required annual maintenance fees, can be a huge factor in which entity to choose. Be sure to look into this thoroughly before filing.
Once the articles are filed and approved, the business entity is recognized as official. The chapters on each of the business entities provide detailed explanations about the formation process.
Federal recognition of distinct business entities for tax purposes
Business entities are traditionally the responsibility of the states. The entity is created at the state level, and the state’s statutes govern baseline operating rules. But, the Internal Revenue Service (IRS) still needs to tax the enterprise. The IRS’ tax classifications may be slightly different than the state’s entity classifications.
For example, an LLC or corporate entity may want to be classified as an S corporation with the IRS. Or, a nonprofit may want classification as a 501(c)(3) nonprofit organization. In addition, certain farmer cooperatives or consumer cooperatives selling agricultural products are eligible to receive special tax benefits if they meet specific IRS requirements outlined in the federal tax code. We provide enough information to help farmers get a sense of the IRS’ expectations for each business entity. But again, farmers will need to work with an accountant or tax preparer for advice on tax matters.
Creating the organizing document
An organizing document defines how the business entity will operate. While the formation document is always required, the organizing document may be optional depending on your entity. In addition, while the formation document must be filed with the state, the organizing document does not. It is a private document that principally serves as a contract between and among the owners.
What’s in an organizing document
The organizing document prescribes the decision-making procedures, roles, responsibilities and other administrative matters for running high-level operations of the business. This includes: How is voting determined? Who has a say on big issues such as selling a significant amount of the business’s assets or closing the business entirely? When are major meetings held? Can new owners be brought on and, if so, what is the process? What happens if a business owner wants to leave or dies suddenly? What happens if the business voluntarily or by force has to close? How is the business valued?
Day-to-day matters such as budgeting procedures, production standards and quality parameters are not usually included in an organizing document. Most businesses choose to write these issues into separate policy documents, which they write at the same time as the organizing document itself. Policy documents are kept separate, so they are a bit easier to modify as the business evolves. The organizing document is written to be modified rarely, if at all.
What are the benefits of an organizing document?
Most new business owners are optimistic and eager to build their farm business. Even thinking about worst-case scenarios like the death of a partner seems like a waste of valuable time. However, thinking through the worst cases is much better at preventing horror stories from developing than sticking one’s head in the sand.
Going through the process of creating an organizing document helps business owners kindly and judiciously address important matters that can, and indeed have, quickly ruined a farm business. The process of deeply thinking through such matters can really help build trust and understanding between the owners and enhance a relationship built on respect and shared objectives. And, if a dispute were to arise, the organizing agreement can assure a quick resolution if it outlines responsibilities and resolutions. Mediation, arbitration and dispute resolution committees can all help businesses get back on track after a problem develops. But, these mechanisms are much easier to put in place before a problem ever occurs. Putting decisions in writing protects the memories and shared understanding of the founding owners and educates new owners about expectations. Writing it all down also helps to spot inconsistencies and conflicts.
How do you get an organizing document?
The ultimate goal is to get a thorough, affordable and understandable document that addresses your farm’s situation specifically. How is this possible? One option is to pay an attorney to do all of it for you. Getting a standard organizing agreement
drafted will likely cost around $1,000. Of course, the fees could be a lot higher depending on the complexity of the operation and the going legal rates in your region, especially if you are near an urban center. The base amount is for a pretty standard, boilerplate agreement. It may be great and serve many of the beneficial purposes outlined above. On the other hand, you may not really understand what it all means, and at a cost of $1,000, it still may not be affordable for many small farm operations.
Another option would be to get a form from the library, through a quick internet search, or from a friend. This may seem appealing; all you have to do is swap out the names. While this may be the most affordable option, it will certainly not be catered for your specific farm operation. Also, there’s no guarantee of the quality or thoroughness. Most likely, it will simply serve as a bare-bones skeleton and will not provide many of the benefits that a well-thought-out, written agreement can provide as listed above.
A third option, and the one for which this Guide advocates, is to educate yourself on the key aspects of an organizing document. This Guide can help you with that. Checklists and samples of organizing documents are included as tools. The checklists will walk you through a series of questions. Once you have your answers, one option is to start doing some of the legwork yourself by pulling together a draft organizing document. For this step, you can turn to the sample organizing documents included in the Guide, which contain provisions that you can draw from to develop an operating agreement that is best suited for your farm operation. The annotations include alternative provisions for a variety of scenarios. Keep in mind that these sample agreements are not boilerplates, as they were written with a particular farm operation in mind. Yours should be different.
Farm Commons strongly urges you to find an attorney who can help you draft, finalize or review the organizing document. Interview the attorney and let them know you have done your homework. Ask them about their pricing and try to get a sense of their willingness to work with you to keep your costs down. Many attorneys out there are very sensitive to such requests.
Either way, it is very important to have an attorney review and finalize your work. This is primarily because organizing documents must comply with the baseline requirements set forth in the state statutes. The requirements vary from state to state. If your organizing document is in conflict with state law, it may be deemed void and unenforceable if an issue or dispute were to arise. In that case, all your effort would be futile.
Despite many farmers’ inherent skills in problem-solving, it can be challenging to create a consistent organizing document where none of the provisions conflict with each other. If two provisions conflict, it only creates confusion. Which provision applies? All that effort and intention to set clear expectations among the owners goes out the window. An attorney can help assure you that your organizing document has no internal conflicts.
While doing some or all of the legwork yourself takes more time, it will be less expensive than paying an attorney to do it all. In addition, you’ll reap the added benefit of gaining a lot of knowledge throughout the process. You’ll know exactly how your business operates.
Implement good business practices
All formal business entities have to uphold certain formalities and best practices to maintain the entity’s integrity. Otherwise, all the benefits of having an entity, such as special tax treatment and protection of the owners’ personal assets from the business’s liabilities, could be taken away. Primarily, this includes keeping the business’s financial affairs separate from the owners’ financial affairs, including maintaining separate bank accounts, credit cards and accounting systems. In addition, the business entity must not recklessly spend money and incur a lot of debt, otherwise courts could determine that the entity is undercapitalized and use the members’ personal assets to cover the business’s liabilities. Implementing good business practices also includes filing annual fees, obtaining required licenses and registrations, keeping up to date on tax filings and so on. The default entities–the sole proprietorship, general partnership and the unincorporated nonprofit association–must also uphold such good business practices. Each chapter on a specific entity has an Implementing Good Business Practices section that explains each of these requirements and practices in more detail.
How to use this Guide
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.