CliftonLarsonAllen
March 12, 2012
Using LLCs for the Farm Operating Entity
As tax advisors, we generally turn to an S corporation or C corporation as the entity of choice to limit liability
for a farming business and also to minimize SE tax costs. However, the analysis below suggests that in some
cases an LLC may provide a more flexible entity while also controlling SE tax costs.
Background
We recognize that there are a great variety of structures and entities used for farming businesses. A common
pattern is to retain the land in individual ownership, and lease that real estate to an entity that holds the
operating assets (grain, livestock and machinery). If properly structured, the entity provides liability protection
for the individual owners from high risk farming activities, and also may shelter some of the income from SE
tax. At a minimum, the net rental income from leasing the land to the entity is exempt from SE tax.
In general, our sense is that S corporations and C corporations have more commonly been used to hold the
active business, rather than a partnership form of entity. Historically, much of this probably has to do with the
SE tax costs. For 2012, with a $110,100 base, the lower tier portion of self-employment income triggers
$16,845 of SE tax (ignoring the 2% temporary reduction that is in the law for 2012). Further, the Medicare tax
of 2.9% applies to all additional earnings. That will increase to 3.8% in 2013 and after as a result of an
additional .9% Health Care Act tax on earned income in excess of $200,000 ($250,000 in joint returns).
But a properly structured Limited Liability Company (LLC), relying on the 1997 proposed regulations, can
present a more flexible alternative than a corporate entity in some family farm fact patterns.
The Shortfall of Farm Corporations
In periods of high profitability, the use of a C corporation is problematical. Traditionally, income is extracted
from the corporation using rents to the individual for the use of the land, and then compensation for the
labor. The rent is limited to reasonable fair market rates, and the compensation, if pushed up to extract higher
levels of income, has the added expense of the FICA.
S corporations work better in periods of high profitability, as distributions can be extracted by the owners that
are free of payroll tax costs (assuming a reasonable W-2 amount has been drawn for services). But compared
to partnerships, S corporations do have some limitations. First, the distributions to shareholders must be in
proportion to stock ownership. Secondly, when the death of a stockholder occurs or a sale of stock takes
place, the increased tax basis to the new owner applies to the shares and not to the inside inventory and
depreciable property. And finally, if there ever is a desire to terminate operation without selling the assets
(i.e., distribute the assets to owners), gain must be recognized at the entity level when appreciated property is
distributed from any corporation, whether a C corporation or an S corporation.
On the other hand, partnerships have tremendous flexibility in terms of allocating income and cash
distributions. Allocations of partnership income can differ from the partner capital account percentages. And a
younger individual can be admitted with a profits-only interest, so as to minimize gift reporting or the need
for a purchase transaction. When a death of a partner occurs, or when a partnership interest is sold, a Section
754 election can be made to allocate the outside basis increase to that share of the inside assets. Finally, if a
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termination of the business is to occur without an asset sale, a partnership can distribute appreciated assets
proportionately to its partners without gain recognition.
LLCs That Do Not Reduce SE Income
An LLC formed and owned by a single member, of course, is a disregarded entity. That entity, conducting a
farming activity, will be reportable on Schedule F and all income will be subject to SE tax.
An LLC with more than one member is normally taxed as a partnership. The Internal Revenue Code states that
general partners are subject to SE tax, but limited partners are not subject to SE tax, other than on
guaranteed payments for services [IRC Secs. 1402(a) and 1402(a)(13)]. The 1997 proposed regulations treat
limited liability entity members as the equivalent of general partners and subject to SE tax if they have
management authority, or have extensive personal participation (more than 500 hours within the year) in the
business activities of the entity [Prop. Reg. 1.1402(a)-2(h)(2)].
Under these rules, many family farming operations, even where organized as an LLC or other limited liability
entity, are functionally the equivalent of a general partnership for SE tax. Each owner is involved on a full-time
basis and has management authority under the LLC document, making each owner effectively a general
partner for self-employment tax purposes. Thus, the LLC might be an effective tool for liability protection for
the business operations. But absent special structuring, it will not insulate the typical father-son, brotherbrother, or husband-wife active owners from SE tax.
LLCs that Reduce SE Income
The proposed regulations referred to above have never been finalized, but they constitute substantial
authority and can be relied upon by taxpayers [Reg. 1.6662-4(d)(3)(iii)].
General rule. The proposed regulations provide a definition of “limited partner” for purposes of Section 1402.
A person is a limited partner subject to SE tax under any of three situations:
· The individual has personal liability for the debt of or claims against the partnership by reason of
being an owner;
· The individual has authority under the state statute under which the entity is formed to contract on
behalf of the entity (i.e., the individual has been designated as a manager or holds units that have
management authority); or
· The individual participates in the entity’s business for more than 500 hours during the taxable year
[Prop. Reg. 1.1402(a)-2(h)(2)].
Personal liability. Whether an individual has personal liability is determined by whether that liability arises by
reason of being an owner. That would be determined under state law or the partnership agreement. An LLC
member who guarantees a debt at the request of a lender is not considered to have personal liability “by
reason of being an owner.” In general, this personal liability test will rarely be the cause for imposing SE tax,
because most limited liability entity owners do not have personal liability by reason of their ownership
interest.
Management authority. The authority to bind the limited liability entity is also based on state law. But most
state statutes defining limited liability entities allow control agreements which can specify management
authority. This management authority typically may either be by designation of an individual as a manager, or
by the ownership of interests that confer voting or management rights. If a member has management
authority, the starting point under the regulations is that the income of that member is subject to SE tax.
500 hour test. The 500 hours of participation are not defined in the proposed regulations. However, the
passive activity rules under Section 469 most likely provide guidance on these rules.
Special exception: holder of one class of interest. If an individual works more than 500 hours but otherwise
owns a limited interest (i.e., has no management authority or debt responsibility), the interest in the
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partnership will not be subject to SE tax if other individuals own similar units, those individuals make up at
least 20% of the ownership, and those individuals do not have management authority, personal liability, and
do not participate over 500 hours [Prop. Reg. 1.1402(a)-2(h)(4)]. This exception, for example, would allow a
member of an active farm business who worked over 500 hours to receive a guaranteed payment for services
that was subject to SE tax, but receive non-SE income for a non-manager ownership interest in the LLC,
assuming other investor-owners held at least a 20% interest in the LLC and did not have management
authority or provide over 500 hours of services.
Special exception: holders of two classes of partnership interests. The regulations allow an individual holding
partnership interests that have management rights (and are subject to SE tax) to also hold non-management
units that are not subject to SE tax. To meet this exception, the member’s non-management units must be
identical to those held by other limited members, and those other limited members must hold 20% or more
ownership but not participate in management nor participate more than 500 hours [Prop. Reg. 1.1402(a)2(h)(3)]. In summary, under this exception an individual may hold management units in the entity that are
subject to SE tax, but also hold non-management units that are not subject to SE tax, assuming that other
members who own at least 20% of the entity have similar non-management units, and those holders do not
participate in management nor work more than 500 hours.
Examples of LLCs that Save SE Tax
Example 1: Single class of interest and designated manager
The Jones family operates an active farming LLC and is equally owned by three family members.
Junior is age 40, is the designated manager per the LLC documents, and spends 2,000 hours per year
in active operation of the farming business. Junior’s spouse, Sue, is a non-manager, and spends 600
hours per year in the business. Junior’s dad, Senior, is also a non-manager and is active about 200
hours per year. The LLC has a single class of ownership interest, and its governing documents
designate members as having management or non-management authority.
Senior holds 20% or more of the units and under the general three-pronged test is classified as a
limited partner not subject to SE tax. Sue has the same class of interest, and does not have SE
income on her partnership units because of the single class of interest exception, even though she
spends 600 hours in the enterprise. However, Sue should receive a guaranteed payment for the
reasonable value of her services and this guaranteed payment would be subject to SE tax. Junior, on
the other hand, as manager, is subject to SE tax on all income, including the guaranteed payment for
his services.
Example 2: Two classes of partnership interests with guaranteed payments
Assume the same facts as in the preceding example, except that the Jones LLC documents create two
classes of interests: manager interests and non-manager interests. Sue and Senior both hold 33% of
the interests, which are non-manager interests. Junior also owns a 33% non-manager interest. Junior
also owns, however, a 1% manager interest. The non-manager interests represent the investment in
the LLC. In this example, each member has contributed assets equal in value. Under the two-class of ownership exception, Junior’s 33% non-manager interest is exempt from SE
tax, because at least 20% of the membership interests are held by a non-manager who performs less
than 500 hours (Senior meets this definition). In this situation, Junior should receive a guaranteed
payment for the reasonable value of his services in order to protect this arrangement. He receives
this guaranteed payment for his services as manager, on the 1% manager interest.
Example 3: Two classes of partnership interest; no guaranteed payment to manager
Assume the same facts as in the prior example, where the Jones LLC documents create two classes of
interests: Manager units and non-manager units. Junior, the active manager, receives a 16% manager
class interest along with a 28% non-manager class interest, for total ownership of 44%. Sue and
Senior each receive a 28% non-manager class interests. Junior will be subject to SE tax only on his
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16% share of income attributable to his manager class interest, and Sue would only be subject to SE
tax on a guaranteed payment for her 600 hours of service. The larger manager interest to Junior is
designed to compensate for his service rendered to the LLC, and eliminates the need to provide for a
guaranteed payment.
Example 4: Corporate manager of LLC
Assume the same family arrangement as in prior examples, with Junior, Junior’s spouse, Sue, and
Senior each at a 1/3 ownership interest, and Junior full-time in the farming business, Sue rendering
600 hours of services, and Senior inactive. In this example, a C or S corporation is formed to serve as
the manager of the LLC, and each individual owns a 1/3 non-manager interest in the LLC. Sue, as in
the other examples, should receive a guaranteed payment for her part-time services to the LLC.
Junior, on the other hand, becomes an employee of the corporation. The LLC pays a management fee
to the corporation, and the corporation in turn compensates Junior for the reasonable value of his
services via a Form W-2; Junior is not working for the LLC. Under this arrangement, all flow-through
income from the LLC is exempt from SE tax.
Observation: In Example 4, with no portion of the LLC income allocable to management units subject
to SE tax, the payments for services to Junior (W-2 from the corporation) and to Sue (guaranteed
payment from the LLC) can essentially be fixed each year. The advantage is that in higher profitability
years, any increased amount of partnership income is not subject to SE tax. Whether the LLC net
income is higher or lower, the compensation and guaranteed payments subject to FICA/SE tax are
essentially consistent from year to year.
Example 5: Husband-wife LLC with wife inactive
Assume an LLC operating an active farm business that is owned by Jack and Jill, spouses. Jill is not
active in the farming operation and receives non-manager units in the LLC. Because Jill does not work
more than 500 hours in the enterprise and holds at least 20% of the ownership, Jack’s membership
interest could be structured as manager and non-manager units. For example, Jack might hold a 2%
manager interest and each spouse hold a 49% non-manager interest. In this case, only the 2% nonmanager interest would be subject to SE tax. Of course, Jack also should receive a guaranteed
payment from the entity to reflect the value of his annual services. Reasonable compensation for
services is important, just as it is in the S corporation context. As in the previous example, the
guaranteed payment essentially can remain stable (assuming Jack’s services are consistent from year
to year), and fluctuations in partnership income will not affect the amount of SE tax (other than the
2% manager interest).
Observation: Although all of the preceding examples represent arrangements where SE tax is limited,
recognize that most of the examples used one of the special exceptions requiring a member that is inactive to
hold at least a 20% ownership interest.
Cautions: Any restructuring of a farming entity also requires consideration of a variety of factors, both tax and
non-tax. On the tax side, partners are generally disallowed the benefit of any tax-free fringes even though
their arrangement of providing services for a guaranteed payment imitates a compensation structure. Also,
LLCs are generally required to use the calendar year for tax reporting.
Another major caution concerns the farming syndicate rules of IRC Sec. 464. If over 35% of losses can be
allocable to an individual who does not participate in the active farming business, it can force the entity into
the accrual method. In the preceding examples, you will note that Senior, who is described as inactive, was a
one-third owner and carefully below this 35% threshold. Further, there are exceptions that eliminate this
inactive taint for those who are a member of the family of an active participant, those who previously
participated in active management, or those whose principal residence is at the farm location. Obviously,
these exceptions solve the problem for many retired family members who might still own an LLC interest,
even over 35%, and therefore not cause an accrual issue.
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Finally, when any entity reconfiguration is under consideration, it is important to consider the impact on Farm
Service Agency (FSA) program subsidies. Our clients would not appreciate an arrangement that saved some SE
tax but caused a significant reduction in farm program payments.
Paul Neiffer and Chris Hesse
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This notice is required by IRS Circular 230, which regulates written communications about federal tax matters between tax advisors and
their clients. To the extent the preceding information and or any attachment is a written tax advice communication, it is not a full
"covered opinion." Accordingly, this advice is not intended and cannot be used for the purpose of avoiding penalties that may be imposed
by the IRS. Such assurances can be granted only by securing a covered opinion letter. Should you wish to explore the option of receiving a
covered opinion letter relating to a tax advice matter, please contact us.
©2012 CliftonLarsonAllen LLP
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Minneapolis, MN 55402
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