SUCCESSION PLANNING: TRANSFERRING MACHINERY & EQUIPMENT

Angela M. Gloy, Ph.D.Department of Agricultural Economics

Midwest Women in AgricultureConference – February 2014

Today’s Discussion

• The real challenge with machinery transfer

• Possible transfer options

• Farm example

• Key take-aways

The Value Challenge• Incoming owner’s every dollar is spoken for for the next 30

years given current cost structure

• Goal: structure transfer payments for success

• Coordination of cash flows by new owners critical to cash outlays to current owners

• Current owners want business value back in retirement. Few farmers financially diversified enough to offset the equity they have in operation in retirement

Financial Preparedness

• Financial feasibility

• What is your machinery worth?

• Important to use fair market valuation

• Current farm debt load – is a farmer-financed loan possible?

• Credit score strength of new owners

• Start early building credit worthiness

• Farming debt-free unlikely in the future

DISCLAIMER

More than one strategy

Today: rent to own

General Strategy• Step 1: What can the new owner afford?

• What is new owner’s annual cost of living?• How much equity does the new owner bring to the table in year 1 of

machinery transfer?• What is the new owner’s borrowing capacity?

• Step 2: Structuring the machinery transfer• Type and terms of the lease? • Family vs. non-family: rental rate flexibility

• Step 3: How to handle trade-in/new equipment purchase?• Who gets trade-in value? • Who picks up new machinery expense?

Step 1: What can the new owner afford?• Cost of living calculation

• Net income as starting point • Fixed vs variable costs (worksheet)

• Equity contribution • Where add’l ownership interests exist, sell to buy machinery?• Consider working for salary & “sweat equity” interest until payment structure

feasible. Requires payment structure calculation in advance.

• New owner borrowing capacity• Is a commercial loan an option?• Emphasis on credit worthiness years ahead of buy-in

Step 2: Structuring Machinery Buy-out

• Basic idea: rent-to-own • Buy what is needed and has economic value• Sum fair market value (FMV) on selected equipment

• Rental rate• What is reasonable purchase term?• Family vs non-family situation – add’l flexibility afforded in family transfer

• Review lease agreement terms with accountant

Step 2: Type and terms of Capital Lease

• Capital lease terms to avoid appearance of operating lease

• Present value of lease payments > 90% of FMV • Lease term is > 75% of estimated economic life of equipment• Option to purchase at end of lease at a bargain price• Transfer of ownership at end of lease term

• Minimum structure of financial lease

• 4-year renewable lease term(s). Can have any number of renewable lease terms

• Final buy-out value 10-20% of original machinery value

Step 2: Rent Example

• Annual rental payment: starting point may be 10-13% of value

• Example: $1,000,000 in machinery

At 10%, annual rental rate: $100,000At 13%, annual rental rate: $130,000

• Rental agreement to reflect depreciation of machinery on a capitalized rate

Step 3: Trade-in/new purchase protocol?• Option 1

• New owner trades in equipment; note for trade-in value added to rental agreement

• Balance on new equipment purchase is separate note paid by new owner to equipment dealer

• Option 2• Current owner trades in equipment receiving trade-in value from dealer• Purchase price of new equipment assumed by new owner

• Either way, current owner has secondary, unsecured financial position on equipment debt

Trade-in/Purchase Example

New rental agreement calculation after $200,000 trade-in:

Machinery value $1,000,000Less trade-in value (old tractor) $ 200,000Less annual depreciation adjustment $ 40,000

(0.05)*($1,000,000 - $200,000)Total $ 760,000

Annual payment assuming 10% rental rate:

$760,000 * 10% = $76,000

New Owner Expense Adjustment

• Rental rate following current owner trade-in falls for new owner but cost of new equipment is a new owner expense

• In good years, new owner pays off machinery more quickly

• New owner could trade-in machinery slightly less often

The Land Dilemma

• New owner challenge is to coordinate cash flows given land purchase interests

• New owner equity tied entirely to depreciating assets?• Value in holding onto other, personal assets• Highlights value of building new owner wealth independently of machinery

transfer alone

• New owner’s every dollar is spoken for years out from the start

Benefits

• Current owners able to avoid capital lease/sale issue by structuring agreement as machinery rental

• Allows current owners to avoid all equipment sale income at once

• Current owners able to maintain depreciation benefits

Notes

• Initial cash contribution

Existing equity (cash, land sale, inheritance)Tempers initial machinery value upfront

• The $76,000 Annual Rent

Percentage contribution of new owner’s returns (above salary). Lumpy nature of farm returns – some years able to make larger payments.

Example: Fred Farmwell

• Worksheet

Final Comments

• Structure rental agreement for new owner success & explore alternative scenarios in advance

• Starting capital extremely helpful in facilitating the transfer –value of savings prior to machinery purchase

• The non-family machinery transfer problem is real

• Work with your accountant

WILL A FARM SUCCESSION PLAN BE YOUR LEGACY?

Team Members Jill Andrew-Richards

Jon CainAmanda Dickson

Ed FarrisAngela Gloy

Kelly HeckamanNick HeldJim Luzar

Paul MarcellinoAndrew Martin

Gonzalee MartinLonnie Mason

Alan MillerLindy Miller

Tamera OgleDenise Schroeder

Jenna Smith

Upcoming Topics

• 2013 - Business Structure, Taxes & Valuation

• 2014 - Transferring Ownership: Management, Machinery & Land

• 2015 – Inside Your Farm Succession Plan: The Estate Plan

THANK YOUCOMMENTS - QUESTIONS

Angela M. Gloy - Extension SpecialistDept. of Agricultural EconomicsPurdue University615 Krannert BldgPh: 765-494-4309E-mail: agloy@purdue.edu