We have found through trial and error over 30 years that there are three fundamental areas of concern in an estate and farm transition plan that each family should independently address — cost of administration, creditor protection and transition plans for land and operating assets.
The purpose of this column will focus on five options to consider for the transition of your land assets.
1. Land to the farmer
The first option in land transition is to get the land to those who are farming it or who have an affinity to own it. Each generation cannot afford to take a step back in equity and expect to compete in today’s marketplace.
Let us assume that Mom and Dad own 400 acres of land and have four children (one who wants to farm). If Dad farms approximately 1,000 acres and owns 400 acres, his ratio of owned/farmed acres is 40%. This is sustainable.
If your family is expecting to farm the same (or more) acres with a land base that has been divided across siblings, each generation will be in a weaker position to complete.
At death, if the farming heir inherits 100 acres and is now planning to farm the same acres, the next generation’s owned/farmed ratio dips to 10%. This may not be sustainable.
The concern in this strategy is finding the balance between a “fair” amount of other assets to go to the non-farm heirs and the amount of cash flow it will require the farm-heir to pay their siblings the difference.
You have earned the right to decide what a “fair price” for your family land should be. If we assume 400 acres would appraise for $15,000/acre, that means that each child’s cash equivalent would be $1.5 million of inheritance ($4.5 million total to the three non-farm heirs).
Four and a half million dollars financed on a 20-year note at 6.5% interest rate (with $1.5 million as inherited down payment) would require an annual debt service payment of $402,000 (or $1,340/acre payment if over purchased acres (3/4 of 400 acres). If dividing the cash flow over all 400 acres (included 100 inherited acres), this would be a payment of $1,005/acre.
There may be additional cash or other assets in the estate or the difference can be paid on a low-interest contract to help for affordability. The process of valuing the assets in your plan for “fairness” of both parties is the most important issue in this particular scenario.
How many times will your family have to pay for the same land? Which generation will eventually lose it due to no fault of their own (other than choosing to carry on the legacy)?
Is it fair that three non-farm heirs get $1.5 million in cash inheritance and the farm heir leverages their $1.5 million of inheritance in an upside-down transaction by borrowing $4.5 million that will not cash flow?
2. Divide the land
Plates, bibles and guns do not divide easily. Land is no different. An undivided ownership in real estate can cause great anxiety for the owners of the land who want to farm it or who want to continue to own it.
Any owner can ultimately force a partition of the land. Historically, this meant that the land would go to auction as default if one owner wanted to sell. It can be maddening to find a reasonable solution with unreasonable people.
There is a greater chance of peace if you divide the land, but also a greater chance it gets away from the family.
After two generations of dividing the land, your family likely will not have the economies of scale to compete and likely will not be farming in the future.
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Unfortunately, we live in a world that takes more acres of equity to compete, not fewer.
3. Leave land in trust
Leaving the land in trust after death seems to be an option for families who cannot afford to get the land to one heir and who do not want to divide their land.
On one hand, leaving the land in a “generation-skipping trust” seems to be a logical option. There could be rules for central management (trustee) to collect rent, pay property tax and insurance and distribute the net rent to the beneficiaries of the trust.
However, the concern with leaving land in a trust for a long period of time is the lack of flexibility to adequately deal with the number of changes that will inevitably be needed to deal for an extended period of time (as long as 100 years) before the trust would be distributed or dissolved.
There are some solid reasons to leave the land in trust for management, including if one or more of your children have marital, money or addiction issues or if one or more of your children are independently wealthy.
More times than not, leaving land in trust gives a false sense of security (short-term solution to a long-term problem) that may ultimately just be a deferral of the problem to the future.
4. Family land entity
A land entity like a Limited Liability Company (LLC) or Family Limited Partnership (FLP) has become popular for a family where the first three options do not fit.
We call this strategy the “Swiss Army Knife” of land transition plan because it can do almost anything or the “boomerang plan” because the rules in the operating agreement of the entity always bring the land back to the family (rental and purchase options).
The entity would have a manager (typically a family member) to collect rent, pay property taxes and maintain the property. The manager also should have direction to lease the property to family members at a family rate.
The LLC can also identify family as permitted owners and set the stage for an immediate call-back option for permitted owners to buy back non-permitted owners (divorce, bankruptcy or poor planning) under family terms.
The LLC should require a super majority vote to change the agreement or to collapse the LLC to protect minority owners who could otherwise get outvoted and lose their options to keep the land together if a simple majority was all that was required.
In addition, the LLC gives the ability to transfer ownership to the next generation to reduce or discount the estate for tax purposes, reduce exposure to future long-term care issues and provide structure to pay rent to the LLC to reduce your self-employment tax (if you are a self-employed Schedule F farmer).
The entity itself is not what protects the farm. The detail in the operating agreement is what makes the “entity” plan work. In my experience, most entity operating agreements are deficient in having adequate detail to deal with the current issues in agriculture.
5. Combination
There is no “one-size fits all” strategy. A combination of multiple options sometimes works best for most families.
As an example, this family with 400 acres may decide it is “fair” to transition the 160-acre home farm plus buildings to the farming heir. The remaining 240 acres would go into an LLC with rules to allow the family to farm the land and to own the land together with rules that will always cash flow.
My hope is that you have the opportunity to explore which option for land transition is the best as your decisions will become the foundation for your family’s future as well as the future of your community.
For 30 years, Steve Bohr has been a partner in the farm continuation firm of Farm Financial Strategies, Inc. For additional information on farm continuation issues or if you have a question, please contact Steve via email at Bohr@FarmEstate.com or by phone at 1-800-375-4180.
