Why Use An LLC?
Many farm operations are structured as a corporation (either taxed as a regular corporation or as an S corporation). However, there are certain tax issues with corporations. Two of the primary issues are that if you try to take assets out of a corporation, you create a tax based on the fair market value of the asset. Second, there is no step-up in basis when someone passes away on the assets inside of a corporation.
Let’s look at a couple of examples.
Assume Farmer Ben has a corporation that owns 1,500 acres of land worth $10 million that he only paid $500,000 for many years ago. At retirement, he decides to transfer the land to himself since he no longer wants the corporation. This results in the corporation owing tax on a gain of $9.5 million (about $4 million of federal and state income tax) and he now has a dividend of $10 million that he individually owes about $2.5 million of federal and state income taxes. Just simply transferring the asset out of the corporation to him generates about $6.5 million of tax. Now, if this had been an S corporation, there would be gain of $9.5 million recognized at his level (generating capital gains tax of about $2.5 million), but no corporate tax. The S corporation eliminates the tax at the corporate level, but does not eliminate the gain on the transfer.
Our second example assumes that Farmer Ben does not transfer the land and passes away with it at death and the corporation also owns equipment worth $2 million and has about $2 million of grain on hand at the time of his death. The tax basis in these assets is zero. Since this is a corporation, the corporate stock gets a step-up in basis to about $14 million, but none of the individual assets get any tax basis adjustment. This means the heirs will owe corporate tax when they sell any of the assets.
Now, using an LLC can help solve these issues. It is usually fairly easy to transfer assets into and out of an LLC (assuming it is taxed as a partnership) without creating any income tax liability. Additionally, any assets owned by the LLC at the time of death will get a step-up in basis for the share owned by the decedent and in a community property state, both the decedent and their spouse share will get a full step-up. This can be very powerful tax tool.
Let’s see how this works in our example.
Farmer Ben operated as a partnership with his spouse in Washington state. There would be no tax if they wanted to move the land over to another LLC or into their own name. At the time of Farmer Ben’s death, his spouse would be able to step-up the value of the land to $10 million, the value of the equipment to $2 million (and start depreciating it all over again (Section 179 is not allowed) and the value of the grain to $2 million. She gets a full step-up since Washington is a community property state. The means she can now sell the grain for $2 million and owe no income tax.
As you can see, the LLC has some very good tax features that the corporation does not have. We still like corporations for farmers in certain situations, but overall, we would prefer using an LLC for most farm operations for the above reasons. Also, a properly structured manager-managed LLC should get you similar self-employment tax savings as a corporation. Each farm operation is a little different and you should always discuss this with your tax advisor before many any structure changes.
Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a principal with CliftonLarsonAllen in Walla Walla, Washington, as well as a regular speaker at national conferences and contributor at agweb.com. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally. Paul and his wife purchase an 180 acre ranch in 2016 and enjoy keeping it full of animals.
I see a potential downfall in your LLC scenario at least as far as the self-employment tax is concerned. A one member LLC is a disregarded entity for self-employment and tax purposes. Also a husband and wife are treated as a single member. It would get rid of the double taxation upon liquidation but not the self-employment tax. Even if the disregarded entity issue would be solved, the member-manager would still be liable for the self-employment tax.