Economics: June 2001

Over time, agriculture has experienced many revolutions. A list of all the major events that have affected how we operate today would be long. It would include such things as the moldboard plow, pesticides, hybrid seed corn, mechanization, and cooperatives. More recently, computer technology and an elaborate satellite system have allowed what is called precision agriculture. The latest revolution in agriculture is the development of genetically modified organisms, more commonly referred to as GMOs.

Another revolution that has been quietly taking place is what I will refer to as the business revolution. In my opinion, it started in the early 1980s, shortly after the inflationary and misleading decade of the 1970s, when we thought agriculture would never see another poor day. The price of a bushel of wheat went over $5, and cattle hit record prices in the summer of 1973. Machinery, equipment, and land could be purchased one year and sold the next for more. The whole process didn't require much management expertise, just a good banker. The strategy for success was to borrow and buy. Assets appreciated by the day, and loans could be paid back with cheaper dollars because the inflation rate was higher than the interest rate. Equity on balance sheets was showing gains caused by upward adjustment in asset values rather than retained earnings, a false indication of actual net worth. However, many lenders needed the inflated values to maintain credit quality with bank examiners. All was well until the government decided to slow the economy down. Interest rates shot up as the administration slowed inflation to a single digit, balance sheets went south, and the business revolution began.

As the revolution continues, business organizations get more attention. The most common methods that are used to organize and manage a farm business are sole proprietor, partnership, and corporation. Without a doubt, sole proprietorship is the dominant farm business structure. However, larger businesses tend to be corporations.

The sole proprietorship is popular because it is simple to form and has few governmental regulations and restrictions. The owner is boss, makes all managerial decisions, receives the rewards, and takes the losses. There are two major weaknesses of a sole proprietorship: (1) one person is responsible for a broad range of decisions (the Noble Foundation can help here) and (2) one person is liable for all debts and other claims against the business.

A general partnership is the simplest form of business association involving two or more persons. Like a sole proprietorship, it is easy to create. No written agreement is required, although I strongly recommend that there be one. A general partnership is not a tax-paying entity. However, to allocate partnership profits or losses so each partner can include them in his or her individual returns, tax forms are required. One of the most obvious weaknesses of a general partnership is that each partner is liable for business debts and other claims against the partnership, as in a sole proprietorship.

There are two other forms of partnerships: limited partnership and limited liability partnership. The laws for and even the availability of these two forms vary by state. The underlying principle of these business arrangements is to limit personal liability. However, at least one general partner is required to handle the management of the business, and he or she is liable for all partnership debts and obligations. These forms of business structures enjoy the flow-through tax treatment of the general partnership.

A corporation is different from partnerships in that it is a separate legal and business entity. Its owners are called shareholders because they own shares of interest in the corporation. There are two types of corporations, the regular C corporation and the S corporation. The C corporation is a tax-paying entity, whereas the S corporation pays no income tax. Instead, each shareholder or owner reports his or her share of corporate income for income tax purposes, much like the method used in a partnership. One favorable characteristic of a corporation is the potential for reducing personal liability. The corporation is most widely used with farm businesses grossing $500,000 or more or when income taxes can be substantially reduced.

Another business organization that is fairly new but rapidly gaining popularity is the limited liability company (LLC). It is a hybrid of the corporate and partnership forms of business organizations. As the name implies, it offers owners of the business limited liability like a corporation but is usually taxed like a partnership. LLCs are appealing to many smaller producers wanting to reduce their exposure to personal liability while operating in a fairly simple business environment.

All the business entities discussed here have some disadvantages and limitations. This article is not intended to replace the counsel of an attorney competent in agricultural business organizations. Its intent is to inform you of some of the options you have for creating a business entity that may limit your liability while not complicating doing business.