By Rachel Armstrong
Chances are, your farm is organized as a sole proprietorship, just like 94% of all farms surveyed in 2007.
Although there is comfort in joining the ranks of other farmers, farmers themselves are being left behind by the vast majority of nonfarm businesses that are choosing the better liability protection offered by other incorporation structures. This article takes a look at the differences between the various business entities, discusses the conversion process, and provides a few additional resources for farmers to move forward in shielding their personal property from farm liabilities.
Choosing the right business structure for your farm operation is an important decision because it determines the scope of the farm’s liability and the farm’s ownership composition. Most business entities are quite simple to establish and operate, although some are easier than others. Further, whether the farm is organized as a Limited Liability Company (an LLC) or a corporation, a farmer can achieve the same effective tax responsibility as if the farm were a sole proprietorship. This makes the choice to convert a little easier by eliminating taxes as one potential factor.
For a busy new farmer, the sole proprietorship offers one important benefit: it’s simple to establish. Unlike a limited liability company or corporation, one piece of paperwork generally does the job. Because it’s generally easier to understand legal issues with a concrete example, I’ll use my fictional farmer, Nell, to explain. If Nell wants to start a sole proprietorship, all she needs to do is register her trade name, generally speaking. In most states, the Secretary of State’s office handles this duty with a convenient online form.
In exchange for its simplicity, the sole proprietorship has a serious drawback. In a sole proprietorship, there is no difference between the business owner and the business. If, for example, a buyer writes a check payable to Nell or to her farm, it’s all the same thing. This lack of distinction comes with a problematic side. If someone has a claim against Nell or the business, then there’s no distinction between the farm’s assets and Nell’s personal assets in that case either. From debt collection to liabilities, such as a school tour on the farm that results in a kid with a broken leg, Nell could end up with a liability judgment satisfied with both the farm’s assets and her personal property.
By contrast, an LLC and a corporation protects personal assets from business liabilities under normal circumstances. Both LLCs and corporations offer the same level of protection. The biggest difference between a corporation and an LLC is that corporations have more formal requirements. The business must elect officers, hold meetings, and comply with specific shareholder requirements. These responsibilities are not particularly burdensome, but they can be difficult to remember.
The LLC is now the small business structure of choice since its creation in the 1990s. State legislators created this option to combine the convenience of sole proprietorship with the protection of a corporation. As a result, the LLC has very few paperwork obligations and offers personal liability protection. However, because it is relatively new, and because farmers tend to learn about starting a business from other farmers, many aren’t familiar with this entity.
Whether or not an LLC is the right choice for a specific farm is a careful decision that can’t be made based on this article alone (the conversion from a corporation to an LLC is a particular caution), but after that decision is made, the process to convert is quite simple. An LLC is created by filing articles of organization with the state. Most states offer forms on their websites. Returning to our fictional farmer, Nell could check her state’s Secretary of State office or ask a librarian at a public or law library for help finding a form. If librarians don’t have a form on file, they certainly know where to download one. Nell’s form should be specific to her state because the articles should follow the requirements of state laws.
Because an LLC is an exceptionally flexible business entity, and a farmer can structure ownership in a variety of ways, it is especially important that someone like Nell write an operating agreement to govern the business. An operating agreement is a document that describes the LLC’s owners, their respective contributions, when and how profits will be distributed, and when and how the business will wrap up operations if that becomes necessary. In fact, a farmer’s state law may require the LLC to have an operating agreement. Regardless, taking the time to figure out how the farm should run and then sticking to that plan creates clarity. Clarity alone can go a long way towards preventing the misunderstandings that trip up a farm business, especially those with more than one owner. In every state an individual may create an LLC, although in that case an operating agreement becomes much less important in terms of clarity.
Creating an LLC (or a corporation) isn’t the only thing required to protect personal assets. The farm needs to follow through by acting as if there is a distinction between business and personal. To take Nell’s example, she shows a distinction between herself and her business by never mixing personal and business accounts. When Nell takes in CSA sales, that money gets posted to her farm business account, not her personal checking account. When Nell wants to buy some personal groceries or new clothes, she pays from her personal account. Nell pays herself a wage or gives herself a distribution of the farm’s profits in a distinct transaction so she knows what is hers and what is the farm’s at all times.
For a farmer used to paying with whatever credit card is handy, the obligation to distinguish between farm and personal assets can be a hassle. It might dissuade some farmers from choosing an LLC or a corporation. But, there is a plus side for the farmer that chooses the extra time and attention that an LLC or corporation might require. An accounting system that distinguishes between person and farm is very helpful in analyzing revenues and expenses or in considering a new crop or food venture. It also might make it easier for the farmer’s accountant to help optimize the farm’s tax situation.
Farmers might want to take a moment this tax season to reevaluate their structure and ponder whether a different entity may better suit the farm’s objectives. The Farm Commons website has more information on several of the most common business entities and details on the LLC conversion process. A sample LLC operating agreement is also available from Farm Commons by request.
Disclaimer: This article does not provide legal advice or establish an attorney-client relationship between the reader and author. Important information may be excluded in the interest of space or clarity. Always consult an attorney regarding your specific situation.
Rachel Armstrong is the Executive Director of Farm Commons, a nonprofit legal organization dedicated to farmers.