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Tax advantages of LLCs in farm operations.

The use of limited liability companies (LLCs) to own real estate used by farm operations provides self-employed farmers with significant opportunities to save taxes. Specifically, the use of passthrough entities in tax planning for self-employed individuals provides opportunities for (but not limited to) lowering self-employment (SE) tax; limiting personal liability; estate planning; and preserving Social Security benefits.

Example: A farmer, F, is currently filing Schedule F and reporting a $50,000 net farm profit. The farm consists of land and fully depreciated outbuildings, and has incurred a reasonable debt load that could be attributable to operating capital. F forms an LLC with (at least) two members and transfers the real estate to it, which begins to charge F rent for use of the real estate. Further, the lease is a triple net lease; the farm operation will continue to bear the real estate tax, insurance and cost of minor repairs. The fair market value (FMV) of the real estate approximates $500,000, with a reasonable annual rent of $40,000.

F has effectively transferred $40,000 of SE income from Schedule F to passive income reported on Schedule E, and reduced his SE tax by $5,652. The decrease in SE tax will decrease the deduction from adjusted gross income of 50% of the SE tax, thereby increasing income tax by approximately $600 (depending on F's specific incremental tax rate). If F uses some of the tax savings to purchase an individual retirement account (IRA) or a simplified employee pension-IRA; the increase in income tax is mitigated and he has secured a source of future retirement benefits to replace those lost from the reduction in future Social Security benefits.

Another benefit of this plan is that, if F is between ages 63 and 70 and receiving Social Security benefits, the lower farm income may not exceed the earnings limit (SE earnings test) that can trigger repayment of Social Security benefits. The potential savings of Social Security benefits could exceed the savings from the SE tax. Together, they provide the older farmer with an excellent tax savings opportunity.

This course of action, however, may have adverse consequences. For example, if a farmer transfers relatively new buildings (with depreciation expense) and significant acquisition debt (with related interest expense) to an LLC, a net rental loss may be created, while simultaneously increasing farm profit. In addition, young farmers with families will want to consider options for disability and survivor benefits available from Social Security that may be reduced if the above plan is implemented.

There have been many cases fought over the true nature of rental operations. In William E. Davis & Sons, Inc., TC Memo 1981-178, the court ruled that rental payments to shareholders were deductible when the amounts paid as rent were required to be paid under the terms of the lease and the lease was fair and reasonable when executed. Sec. 482 specifically allows the IRS to apportion or allocate income when the same interests own or control two or more businesses. Accordingly, single-member LLCs and unincorporated activities are at risk of the Service ignoring a rental agreement. Publication 225, "Farmers Tax Guide" specifically states that farm rental income is subject to SE tax if the landowner materially participates in the production, or management of production, of the farm products on the land. Once the landowner and the farmer are two distinct entities (preferably with different ownership interests), rentals are allowed as long as a fair market rent is charged. According to Letter Ruling (TAM) 9637004, a rental arrangement for farm land between a corporation and landowner would be disregarded, and the rental income subject to SE tax. In this ruling, there were employment contracts between the corporation and the landowners that required them to undertake the farming operations, as well as other factors that caused the IRS to rule that the landowners materially participated in the farming activity. Accordingly, any anticipated arrangements should not provide for employment contracts, nor should the rental agreement include any obligations by either party to produce agricultural products. In addition, no arrangements should be planned without considering the potential ramifications of Letter Ruling 9637004.

Depending on the size of the farm and the farmer's other assets, an LLC may provide an excellent opportunity for gifting assets (and ultimately, lowering estate taxes). An LLC agreement can provide for a limited ability to transfer member interests and for a limited opportunity to manage the operations. These factors have supported reductions in the FMV of LLC member interests when compared to the underlying assets; see Bernard Mandelbaum, TC Memo 1995-255, aff'd, 91 F3rd 124 (3rd Cir. 1996). The ability to adjust a property's FMV provides an opportunity to annually transfer a greater share of an individual's net worth than would have been available if the real estate was personally owned. In addition, LLC membership interests provide a medium to accomplish a gradual real estate transfer.

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Article Details
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Title Annotation:limited liability companies
Author:Shrader, Dwight
Publication:The Tax Adviser
Geographic Code:1USA
Date:Apr 1, 1999
Previous Article:Recent developments in farm taxation.
Next Article:CRTs in unique planning situations.

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