The Mechanics of Legacy Buildingtepap.tamu.edu/wp-content/uploads/2020/01/Ferrell-online.pdf• Farm...

The Mechanics of Legacy Building

Shannon Ferrell Dr. Rodney Jones J. C. Hobbs

OSU Department of Agricultural EconomicsProfessor, Agricultural Law

OSU Department of Agricultural EconomicsProfessor, Agricultural Finance

OSU Department of Agricultural EconomicsAssociate Extension SpecialistAgricultural Taxation

The Mechanics of Legacy Building

$1,000,000,000,000 per year

Tempus fugitFugit inreparabile tempus

FV = PV x (1 + i)t

30%12%

No estate plan

Insufficient capitalization

Failure to prepare next generation

Source: Spafford, 2006

Start, at the beginning

Move consciously, consistently, and constantly

Don’t go it alone, and don’t stop

Start, at the beginning

Mission Statement

Vision StatementCore Values

7%: the words you use

Body language

Non-verbal cues

Mark 6:4 Jesus said to them, "A prophet is not without honor except in his hometown and among his own relatives and in his own household.“

Ferrell’s corollary:You cannot regard someone as an expert if you have changed their diaper.

Entitlement

Opportunityvs.

EQUITABLE≠

The Farm

• Family: Mom, Dad, Farm Kid, City KidEveryone lives on the averages

• Representative Indiana farm derived from KFMA South Central and Southeast Associations

• Targeted $100,000 NFI as estimation of commercial farm for 1.0 FTE operator supported by family labor

The Farm

• 100% of income from crop operations• 33% owned land, 67% leased land• NFI: $100,000• NFI ratio: 15%• Value of farm production: $660,000• Asset turnover ratio: 20%• Family living: $70,000• Off-farm income: $44,165

The Farm Balance Sheet

Assets Liabilities“Operating” assets (None)

Breeding livestock $0

Equipment $500,000

Total “operating” assets $500,000

Buildings $100,000

Land $2,700,000 Owners’ Equity $3,300,000

Total Assets $3,300,000 Liabilities + OE $3,300,000

Farm Kid

City Kid

Mom and Dad bornYear

Farm Kid bornCity Kid born

Mom and Dad’s

“Early Epiphany”

Farm Kid

City Kid

Mom and Dad’s“Average Epiphany”

Dad dies“Early” +36“Average”+18

Mom dies“Early” +41“Average” +23

Farm Kid diesMom dies +21

From calculatin’ to simulatin’

• Each strategy is imposed on model farm and simulated 500 times.

• Each time a strategy violates a criteria, that simulation is deemed a failure.

• Farm asset ratio ≥ 60%

• ≥ 3 consecutive years when operating loan is not cleared

• Only for Strategy 5, if the cash reserves of Mom and Dad ever fall to or below 0

• The total number of successful (i.e. “non-failure”) simulations divided by the total number of simulations gives the probability of success.

Simulated strategies

• Strategy 1: “Split Down the Middle”• Farm Kid and City Kid receive undivided ½ interest in all

assets

• Farm Kid must buy out City Kid

• Strategy 2: “Grow to Equal”• Ma and Pa give all Farm Assets to Farm Kid

• Ma and Pa create financial asset of equal value and give to City Kid

What’ll it cost, man?! What’ll it cost?!

Strategy Who pays Annual expense1a Farm Kid $172,518; $86,8071b Farm Kid $89,1352a Ma & Pa $104,6422b Ma & Pa $64,5033a Ma & Pa $28,8173b Ma & Pa $17,7644a Ma & Pa $14,4094b Ma & Pa $8,882

Remember, annual NFI = $100,000

ResultsTable 2. Alternative Strategies’ Probability of Success Strategy D/A Ratio < 0.60 Op. Debt < 3 years No Op. Debt Cash Reserves >0 1(a) 1% 0% 0% N/A 1(b) 100% 4% 0% N/A 2(a) 100% 0% 0% N/A 2(b) 100% 1% 1% N/A 3(a) 100% 96% 89% N/A 3(b) 100% 100% 97% N/A 4(a) 100% 100% 97% N/A 4(b) 100% 100% 99% N/A 5 100% N/A N/A 99%

1 Corinthians 12:31b

And I show to you a still more excellent way.

Farm Kid City KidOperating Entity

Land EntityFinancial Asset

Rental payments

Income distributions

Simulated strategies

• Strategy 3: “Estate Balancing”• Land placed in separate entity with equal interests given

to both kids

• Farm Kid given operating assets; City Kid given financial asset of equal value

• Strategy 4: “Sweat Equity Recognition/Discount”• Same as Strategy 3 except City Kid receives financial

asset equal to ½ value of operating assets

And now, I show you an even more excellent way

Strategy 5: “Lifetime Farm Business Transfer”

• Farm operating assets and farm land are placed in separate entities, respectively

• Farm Heir receives annual salary of $42,000

• Farm Heir purchases shares of the operating entity each year

• Farm Heir receives a larger portion of farm income as well as farm debt with each additional share

• In years when Farm Heir has insufficient funds to purchase a full share, Ma and Pa gift the difference

• At the end of the transfer, Farm Heir and Off-Farm Heir receive equal interests in land entity

• Operating entity pays FMV rents to land entity

• Entity distributes income to Farm Heir and Off-Farm Heir

• Any excess funds would then be split between Farm Heir and Off-Farm Heir

• Net any gifts Farm Heir received to help fund this transition

• Operating entity value: $908,784

• Planning horizon: 20 years

• Annual purchase: 5%

• Annual entity payment from Farm Heir: $45,439

• Annual gift to Farm Heir: Variable ($45,439-Entity payment)

ResultsTable 2. Alternative Strategies’ Probability of Success Strategy D/A Ratio < 0.60 Op. Debt < 3 years No Op. Debt Cash Reserves >0 1(a) 1% 0% 0% N/A 1(b) 100% 4% 0% N/A 2(a) 100% 0% 0% N/A 2(b) 100% 1% 1% N/A 3(a) 100% 96% 89% N/A 3(b) 100% 100% 97% N/A 4(a) 100% 100% 97% N/A 4(b) 100% 100% 99% N/A 5 100% N/A N/A 99%

What’ll it cost, man?! What’ll it cost?!

Strategy Who pays Annual expense1a Farm Kid $172,518; $86,8071b Farm Kid $89,1352a Ma & Pa $104,6422b Ma & Pa $64,5033a Ma & Pa $28,8173b Ma & Pa $17,7644a Ma & Pa $14,4094b Ma & Pa $8,882

Remember, annual NFI = $100,000

100% 100% 100% 99%

1a 1b 2a 2b 3a 3b 4a 4b 5

Transition strategy

The value of transition planning

Illustration courtesy Dick Wittman, Wittman Consulting

$4,750,000

Move consciously, consistently, and constantly

The Ballad of Bill and the Gator

Sell it

Lease it

Move it through entity

Transfer at death

Sale forms

Outright sale

Sale with accompanying loan

Installment sale

Financing (or “capital”) “lease”

Lease forms

Financing (or “capital”) “lease”

Operating lease

Year 1 Year 2 Year 3

How unlimited liability works

How joint & several liability works

How partnership liability works

How limited liability works

FounderOn-farm heir

Off-farm heir

Unrelated Successor

OwnershipControl

Participation

Separate Entity

Buy/sell agreements

Disability

Divorce

Deceit

Don’t wanna

To pre-nup or not to pre-nup

Management & decision-making

Taxation

Sole Prop. Gen. Part. Limited Part. C Corp. S Corp. LLC

All to ownerBased upon partnership agreement

Based upon partnership agreement

All to corporation

Pass through to

shareholders

Depends upon tax

filing election (disregarded

entity, partnership, S corp., or C

corp.)

Sources:Ohio State University, “A Comparison of Business Entities”Virginia Cooperative Extension, “Planning the Future of Your Farm”National Association of Tax Professionals, “Entity Comparison”

C corporation taxation under the TCJA

New: 21%, period

Pass-through income deduction

• Applies to pass-through entities (partnerships, S Corps, LLCs taxed as pass-through)

• 20% deduction of “qualified business income”• Say a farm S Corporation makes $150,000 in

income– $50,000 paid in shareholder salaries– $150,000 - $50,000 = $100,000 in qualified business

income– $100,000 qualified business income x 20% qualified

business income deduction = $20,000 reduction in taxable income

BobCo,Inc.

Allocation of income

All to ownerBased upon partnership agreement

Based upon partnership agreement

All to corporation

Based upon ownership

shares on a per share / per day rule

Depends upon tax filing

election (disregarded

entity, partnership, s

corp., or c corp.)

Salary

Does not apply

Distributions/ guaranteed

payments allowed

Distributions / guaranteed

payments allowed

Required RequiredYes if C/S

Corpelected

Fringe benefits

Most are non-deductible

Most ARE deductible

Most are non-deductible

Depends upon tax filing election

(disregarded entity,

partnership, S corp., or C

corp.)

Who has ownership?

Sole Prop. Gen. Part Limited Part. C Corp. S Corp. LLC

One individual

2 or more general partners

1 or more general

partners plus 1 or more

limited partners

1 or more share-holders

Depends upon selection (single member or multi-

member)

Ease of Formation

Sole Prop. Gen. Part Limited Part. C Corp. S Corp. LLC

Very simple Partnership agreement

Partnership agreement

Articles of incorporation

Operating agreement

Management

Single individual

Managing partner(s)

Managing general

partner(s)

1 or more officers

1 or more members

Directing and control

Single individual

All partners

1 or more officers

1 or more members

Liability

Owner has unlimited liability

Partners have

unlimited liability

General partner has unlimited

liability and limited

partner has limited liability

Limited liability

(must not pierce the

Limited liability

Continuation of life

Owner's death

terminates

Ends upon death or

withdrawal of a partner

Ends upon death or

withdrawal of a general

partner

Perpetual Perpetual

Operating agreement specifies

continuation

Transfer of ownership

Does not apply

May be assigned but

assignee cannot be a

partner

May be assigned but

assignee cannot be a

partner

Stock easily transferred

Operating agreement specifies

transferability of an

ownership interest

Fundamentals

Flexibility is crucial

Someone will go insane

In not choosing, you have chosen

How does the administration of an estate work?

1. Decedent dies2. Inventory / maintain estate3. Handle creditors4. Submit final inventory & accounting5. Close probate / administration

Property acquired after marriage

Property acquired before marriage

The Brady scenario

Intestate succession

Pros Cons

Well, uh… its definitely low-effort up front

Unable to select who handles your affairs (and several people may “volunteer”)

Unable to direct who gets your property – succession rules dictate heirs

No provision for those not specified by rules

Pros ConsLeaves control with testator until death

Must go through probate

Can direct where property goes – almost anywhere

Easily contested

Can select executor Lengthy and public process

Can name guardians State-specificDoes its job then goes away

Cannot operate “long-term” w/o other tools

LIVING TRUSTS

Pros ConsEliminates probate for assets in trust

May have trustee fees

Don’t need guardian to hold assets for minors

Adds complexity to management of assets in life

Not public information Requires coordination with other estate tools

Very difficult to contest Still needs will

Controversial “hot take” by Ferrell

Rigor mortis makes you

an inflexible manager

The new estate tax landscape

$11.58 million personal exemption

$23.16 million combined exemption

Spousal portability retained

Stepped-up basis retained

$15,000 / $30,000 annual gift limit

Sunsets and ABCs

Source: Duft, 2017

Other critical estate planning documents

• Guardian nomination for minor children• Beneficiary designations• Durable (and perhaps “springing”_ powers of

attorney– Business– Healthcare

• Advanced directive for health care• Will• Trust (?)• Life insurance (?)

Don’t go it alone, and don’t stop

Don’t go it alone

The transition team:The Accountant

The transition team:The Attorney

The transition team:The Production Consultant

The transition team:The Investment Advisor

The transition team:The HR Advisor

The transition team:The Referee

Step 5:Deploy your plans / evaluate / revise

The “hit by a ____________” plan

For more information

http://agecon.okstate.edu/farmtransitions

THANKS!

Dr. Shannon L. FerrellOSU Department of Agricultural Economics

shannon.l.ferrell@okstate.edu

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