Its July, its hot, and the worry will soon set in on Harvest ‘17. Minus some late season applications, the die has been cast on the crop, and mother nature will be the deciding factor as the crop moves toward maturity. It is time to evaluate where the farm operation is, where it is going, and where it needs to steer clear of in the coming years.
Does your operation have a one year, three year, and five-year plan? Has it reviewed its relationships with its land owners recently? When is the operation going to need more labor? Where will it get that labor, and how will it retain its help when competing with off-farm jobs? Does the estate plan match the business plan? What vendors can you rely upon to grow with you, and which ones are not up to the task? Have you outgrown relationships with vendors and end users of your product? Why do you buy and sell where you do? How could you make it more efficient? How will new federal or state legislation and programs impact your operation? What would a sustained 10% hit to the gross income do to your operation and how would it adjust. Same question at 20%.
These questions need to be asked frequently, and they need to be answered honestly after considering the environment you are operating in.
Consider a couple of the environmental factors farm operations are experiencing right now.
This year has been particularly interesting for farm operators, as lenders are tightening their purse strings, margins seem to be shrinking, and the equity in the once red hot farm land market appears to be receding. Dairy operations are being asked to check with the buying creamery before expanding herds significantly.
Banks are not keen on the slim cash flows. Operators are being asked to consider consolidation, releasing high rental rate ground, and stream lining their operations to be lean in the coming years. Those operators who bought shiny equipment in the last several years are starting to regret aggressive short term note payments and taking accelerated depreciation.
The ever-aging population of farm land owners who are needing high rents to cash flower their health care needs. What does your land owner need from its tenant to meet its own obligations?
While farm operators are used to having to know everything from tire changing, yield monitor calibration, and agronomy, it is highly unlikely to have all the answers yourself. Those involved with professionals like tax preparers, lawyers, appraisers, marketing specialists, and bankers, to accurately assess the question and its costs, will be far better off.
Consider this example of behaving like a professional. A large dairy operation installed a scale and told its suppliers point blank, “we will pay for what goes across the scale on the farm, scale in and scale out.” The operation thinks the scale paid for itself the first year.
Businesses that grow take risks, and balance it with the reward. The opportunities for those with the patience and planning will be many in the coming years. A solid cash base to work from will result in opportunities for capital and equipment purchases in the coming years with good value. Operators who can “do the math”, make cash flows that work, and treat farming operations as business operations, not emotional baggage, will be poised to capitalize and grow.
The world of ag law never stops. Here are some of the recent changes in the law that impact agriculture. Every once in a while, a quick tour is in order.
Within that, the constant is that taxes will change but will always be present.
The likelihood that major tax reform legislation will be introduced and passed in 2017 is high. Some believe that like-kind exchanges remain at a high risk for repeal. Many have used this process to delay capital gains tax by selling farm ground, and instead of taking a check, replacing it with additional farm ground in other areas. As equipment becomes bigger, the value of having adjoining parcels cannot be disputed.
In the local market, pressure in the mid 2000’s came from investors with proceeds from sales near large metropolitan areas. These investors were quick to bid up ground, as they were motivated to delay paying capital gains. As the market tapered off slightly, the investors sold their holdings locally and moved towards Missouri and Kansas where ground was not booming at the same rate.
Land can account for up to 100% of farm operators “retirement”, and is on average, 30% of commercial investments. The statewide average value for an acre of farmland is about 17.5% lower than 2013 peak values, with declining values for the last three years (5.9% in 2016). Prices stay high when demand is high and supply is low. The desire to avoid capital gains tax has been shown to increase demand. The lion’s share of ground in Iowa is held by those who have a high probability of needing expensive nursing home care in the next 20 years. Like-kind exchanges could help keep the market up for land prices, even in the face of additional sales in the coming years.
The House Republican Blueprint for Tax Reform doesn’t address like-kind exchanges, which are disfavored by some. It proposes full expensing for all capital asset acquisitions, excluding the cost of the land. Right now, land improvements of certain types need to be added to the basis of the property, and not deducted as an expense or depreciated. Full depreciation of real property improvements may well face stiff resistance.
The Blueprint proposes a maximum tax rate of 16.5% for capital gains. President Trump has proposed a maximum rate of 20%.
Leases are old news in the U.S. farm community; we have been doing them for a long time. However, how we lease is changing. Landowners are recognizing the value of the data generated by the farm operator in order to make better decisions about what the land value might truly be. Tenants are using the data to determine which farms are truly profitable, and which ones are lemons to be shed or demanded lower rent for.
You can choose from several types of lease arrangements. They all come down to three basic types:
Crop share production, government payments, and crop insurance are shared between the landowner, and the operator who provides the labor. These arrangements also involve sharing crop expenses. The problem is the landowner is still worrying about the weather and the markets. It is a great fit for the first couple of years after a land owner has had to quit farming themselves. It is almost like a half-way house for farm land owners moving to cash rent arrangements.
Cash rent really needs little explanation. The key is setting the price and the timing of when the payments are due.
Flexible lease arrangements provide a base cash rent, plus a bonus, which represents a share of gross revenue in excess of a base value. This allows the landowner to have a set price, but still capture some of the good year’s prices. It also ensures that in bad years, tenants aren’t paying for a tuxedo when all they needed was flip flops and a bathing suit.
If you have ever bought a pie, you know buying the whole pie is the only way to decide if it makes it Thanksgiving dinner or if you eat it alone in the dark. Consider this, you buy a pie for $10.00. Then If someone gave you 1/4th of a second, exactly the same pie but told you that the pie can’t be eaten until the other owner says so and they get to store the pie, that second pie’s ¼ interest should be worth less than the $2.50 that simple math would suggest. Not if you work for the government.
The IRS released proposed regulations in August that would enhance code sections regarding valuation of privately-held, minority interests that are controlled by the same family. This means LLCs, corporations and partnerships that many farm and small business operators use. It wasn’t out of the blue that the IRS decided to adjust the code, they lost in court and see a potential loss in revenue, so they are changing the rules.
This will impact intra-family interest transfers like when an elder generation gifts a portion of the farm via LLC membership interest to the next generation. The prevailing theory is giving Junior 1/8 of the farm isn’t really worth 1/8 of the total value of the operation because Junior probably still takes orders from Ma and Pa and can’t control the company in any meaningful way and the company is not something that Junior could turn around and sell for 1/8th of the total value to a disinterested party. Think about that pie again.
Valuation principles have long been established showing that Junior interests in privately-held businesses like that are worth less than controlling (Ma and Pa) interests or similar interests in publicly-held companies like Target, IBM and the like . It makes sense that certain adjustments are made when valuing Junior interests in family contexts.
The two most common adjustments are discount for lack of control and the discount for lack of marketability. A discount for lack of control discounts the value of a business interest because Junior does not have the ability to manage the operations of the business and also does not have the ability to control the business. The discount for lack of marketability discounts value of a business interest because the interest cannot be sold and converted to cash as quickly as a publicly traded stock. Many take a 10-20% discount for these impairments.
The IRS has had some leeway in calling out sham discounts however, the latest set of amendments look pretty grim.
They include special valuation rules for such as:
Disregarding Restrictions – No discount for a buy sell restriction on who you can sell your interest to.
•Elimination of Assignee Interest – No discount for the situations where the stock doesn’t have full rights, like when a spouse ends up with the family stock but doesn’t get voting rights.
Three Year Lookback – Makes transfers made within three years of death not eligible for a discount.
Assumed Put Option –Assumes that the junior holder in a family-owned business can sell back at full price within six months. Family owned business do not grant put provisions as they cause liquidity problems which would cripple the operations of the company, when owners can withdraw and demand cash at any time.
Family-owned businesses will lose lose an estate planning tool for families that a valid business purpose for junior interest, like running a farm and separating off farm heirs from on farm decisions.
This is a big change from the ways accepted by the IRS and tax court in years past. It invites a court challenge, which could create uncertainty for an extended period of time.
The regulations are subject to a 90-day public comment through November 2, 2016. Those interested in posting public comments should look at at: https://www.federalregister.gov/articles/2016/08/04/2016-18370/estate-gift-and-generation-skipping-transfer-taxes-restrictions-on-liquidation-of-an-interest
If placed into effect gifts made before the actual implementation will not be subject to the new restrictions (unles the IRS forgets about the Consitutional provision on ex post facto laws). If entities are formed now but gifted after the change they will be subject to the new view. The new rules could be in effect before the end of the year, as early as Dec 2016.
Sumner, Iowa Attorney practicing in Iowa primarily in Ag Law, Bankruptcy, Estate Planning, Real Estate Law, Family Law & Criminal Defense. Lawyers at the Dillon Law P.C. are dedicated to serve Iowa, including but not limited to the cities of Allison, Charles City, Cresco, Decorah, Des Moines, Dubuque, Elkader, Grundy Center, Independence, Manchester, New Hampton, Waterloo, Waverly, Waukon, West Union & Vinton, and the communities that make up Allamakee, Benton, Black Hawk, Bremer, Buchanan, Butler, Chickasaw, Clayton, Delaware, Dubuque, Fayette, Floyd, Grundy, Howard, Polk, Winneshiek, counties. © 2017 Dillon Law P.C. Sumner Location | 209 E. 1st Street, Sumner, IA 50674 Directions Volga City Location | 502 Washington St, Volga City, IA, 52077. We are there most Fridays 10-3 and by appointment. Directions Telephone: (563) 578-1850 Email: firstname.lastname@example.org Home | Attorneys | Blog | Ag Law | Bankruptcy | Estate Planning | Real Estate Law | Family Law | Criminal Defense | Contact | Iowa Ag Law Attorney Sumner Taxation Commercial Transactions Production Contracts Labor Hobby Farm Liability Bremer Fayette County Lawyer