An LLC is a separate and distinct legal entity. This means that unlike a sole proprietorship or general partnership, the law recognizes an LLC as separate from the individual(s) that run it.
Increasing popularity of the LLC
The LLC business entity has been gaining popularity over the past 35 years. Wyoming was the first state to create the LLC option way back in 1977. All 50 states and the District of Columbia have now authorized the organization of LLCs by enacting a state LLC statute. It took a while for the LLC to be generally accepted, mainly because it was not clear how the IRS would decide to tax the entity: As a corporation? As a sole proprietorship? Something else entirely? The IRS clarified its rules for LLCs in the late 1990s, allowing LLCs to elect the S corporation tax status. Ever since, the LLC has been gaining traction and is now one of the most popular entity choices for small businesses throughout the country.
The LLC was created to address a growing concern that individuals running sole proprietorships and general partnerships were personally exposed to liabilities related to their business. Before the LLC came about, becoming a corporation (either C corporation or S corporation) was the only option to protect the owner’s personal liabilities. Yet the corporate structure, as we will get into later, is quite inflexible and can have unfavorable tax consequences for small business owners. The solution was to create the hybrid structure: the LLC. The LLC entity carries the same flexibility and tax status as a sole proprietorship or general partnership while providing the same level of protection from personal liabilities as the corporation.
LLCs are now considered very stable business entities. Many of the same legal standards that apply to corporations in court are being applied to LLCs. For example, a concept like “fiduciary duty” (which involves determining whether an LLC owner acted in good faith and should therefore be protected from liability) is being applied to LLC owners the same way it is applied to a director or officer of a corporation. This continuity of legal principles between the comparatively new LLC and the time- tested corporation leaves most legal professionals comfortable recommending LLCs to their clients.
Basic Characteristics of the LLC
LLCs protect personal assets from business liabilities
One fundamental characteristic of the LLC entity is that it protects personal assets from business liabilities. For those who would like peace of mind in keeping the risks of their business separate from their personal assets, this is an advantage. The “members”–which is the LLC term for the business owners–are not at risk
of losing personal assets if another person or business secures a court judgment against the member. The LLC members can, however, lose up to the amount they have invested in the company. The cash, property and other resources members give to the LLC is their investment, or in LLC lingo, their “capital contribution.” Once a member transfers ownership of the cash or property, it is considered a contribution to the LLC. In effect, this capital contribution amount reflects each member’s risk or stake in the business. No more, no less.
We all know that, just like any small business, farm operations may not succeed. One season of unpredictable weather or out-of-control pests could lead to no profit or even a loss. If the farm doesn’t turn a profit and uses up capital in the process, the members won’t even get their capital contribution back. There’s nothing left. Taking it a step further, let’s say the business had taken out a loan to pay for some farm equipment and is no longer able to pay on its debt. It won’t be long before the creditors come knocking on the farm business’s door. However, given the LLC protects members from personal liability, the members do not have to worry so much that creditors will come knocking on their door and snatch up their lake house or their boat if the farm business starts going south. The creditor could still lay claim to any remaining farm LLC assets, but nothing more.
Capital contributions and percentage interest of the members
The capital contribution of each member can be cash, land, equipment, services, etc. However, be sure to see an accountant or your attorney if services are involved as that can lead to tax implications. If the LLC has one member, then that member will own 100 percent of the company. If there are multiple members, the company determines ownership shares or “percentage interest” of each member. The total value of all the capital contributions given by the members divided by the amount of each member’s contribution reveals the individual member’s shares. The percentage interest is significant, as depending on how you decided to structure your LLC, the percentage interest breakdown may determine voting rights and who ultimately has control over the company. See the LLC Operating Agreement Checklist for more details on making capital contributions. See the Story of Sun Sisters Farm, LLC for an example.
Sun Sisters Farm, LLC story: capital contributions and percentage interest
Here at Farm Commons, we like to use stories to help illustrate confusing legal concepts. Throughout this section on LLCs, including the Extensive Farm Operating Agreement for Sun Sisters Farm, LLC, we’ll often be referring to our story of the Sun Sisters Farm, LLC.
Jema, Ingrid and Marie are sisters who grew up with backyard gardens and an abundance of fresh fruits and vegetables. Each of them individually
has always dreamed of starting a farm. Jema loves everything culinary and wants to cater to the local restaurants with fresh herbs and specialty items including heirloom vegetables, herbs and edible flowers. Ingrid is all about supporting the local community and wants to start a CSA. Marie has a keen business sense and currently runs a successful marketing company. She actually owns a beautiful 10-acre farm that she purchased 10 years ago with a dream of quitting her job and running a farm business. But it just hasn’t happened and she can’t do it herself. The property has a shed, a tiny two- bedroom farmhouse and about a half-acre fruit orchard. The rest of it is overgrown alfalfa.
The sisters meet up for Jema’s birthday and get to talking about their shared dream of starting a farm business. They decide to go in on it together! They decide to form an LLC to provide liability protection. They file their articles of organization and name their entity “Sun Sisters Farm, LLC.” They then start drafting their operating agreement, first by discussing what their capital contributions will be. Marie decides she’ll grant the LLC the title to her farmland as her capital contribution, valued at $45,000. Jema invests $30,000 in cash as her capital contribution. Ingrid offers one year of her farm labor as her capital contribution, which is valued at $25,000. Based on this, Sun Sisters Farm, LLC will have a total of $100,000 in capital. Marie has 45 percent, Jema has 30 percent and Ingrid has 25 percent percentage interest in the company.
With all that said, the LLC’s protection from personal liability is not absolute. Hence the name limited liability company. If the farm business does not follow certain standards, then the courts can go around the LLC’s personal liability shield and allow creditors to access the individual members’ personal assets. Two essential ways to protect the members’ personal assets are to adequately capitalize the LLC and to keep the LLC’s financial affairs separate from the members’ personal financial affairs. However, even if the LLC is properly maintained, some creditors may require members to personally guarantee farm debt. Also of note, the LLC’s liability protection is not a substitute for insurance. We’ll discuss each of these caveats on the LLC’s liability protection in more detail now.
Capitalize the farm operation LLC
Members may lose their personal liability protection if the company is undercapitalized. As a basic rule of thumb, a company is adequately capitalized if it can make due on its debts, or pay its monthly bills, so to speak. Anything less would be undercapitalized. In other words, if you start incurring more debt than you can reasonably pay off based on estimated revenue, your LLC will be considered undercapitalized. As a result, the members may be personally liable to cover the business’s debt. The takeaway message is to be smart about how much debt you allow the LLC to take on. Good business planning and maintaining an accurate profit and loss statement are helpful ways to prevent undercapitalization of your company.
Sun Sisters Farm, LLC story: undercapitalization
For example, let’s say that the members of Sun Sisters Farm, LLC decide they want to buy a brand new tractor with all the bells and whistles. They find one for $45,000. They’ve already blown all but $10,000 of the LLC’s capital—$30,000 in cash—on various tools, a storage shed, seeds and soil amendments. So, they decide to put all of their remaining $10,000 down and take out a three-year loan for $35,000 for the tractor using the farm property as collateral. The monthly payment plus interest works out to be $1,000 per month for the three years.
One month later, Jema and Ingrid decide they really need a greenhouse. They convince Marie to consider the idea. Jema calls up a contractor who is well known for building custom greenhouses. He draws up an elaborate plan. They all love it. He estimates it will cost $40,000 and offers them a flexible, interest-free payment plan for one year, after which he will charge 20 percent interest. They decide to go for it and sign a contract.
As you may have added up, the three sisters have created quite a bind for the LLC. The LLC now has no cash, and at best, they expect to make just $15,000 in annual profits in the first two years. There’s really no way the company will be able to make due on these debts without incurring even more with hefty interest rates. The LLC is hugely undercapitalized as a direct result of the members’ collective poor judgment. If the LLC fails to make its payments in time, the lender for the tractor loan and contractor for the greenhouse could sue to collect on the debt. A court would most likely conclude that Jema, Ingrid and Marie are each personally on the hook for the full amount. You can keep out of trouble by simply following good business judgment. In common sense terms, don’t allow the LLC to bite off more than it can chew!
Astute farmers might realize they could avoid losing any investment in the farm by not investing anything in it. You can’t lose capital if you don’t contribute it, right? The reasoning is sound, but a farmer following that logic may expose his or her personal assets to the business’s liabilities. If the farm needs capital to reasonably function, the members need to provide it to protect themselves.
Keep the LLC’s financial affairs separate from the members’ financial affairs
Courts are also able to access personal assets if the members fail to keep the business separate from their personal affairs. This includes commingling funds such as drawing on business assets to pay for personal expenses or not keeping separate business and individual bank accounts. Farmers accustomed to paying for household groceries and their feed bill with the same checkbook might find it awkward to keep two different payment methods at hand. On the other hand, many farmers benefit from two different bank accounts. The practice can make it easier to assess the finances of the household separately from that of the business.
Of course, personal assets are available for personal liabilities. In other words, you cannot draw on business assets to pay your personal credit card debt, home mortgage or car payments. At the same time, business assets are available for business liabilities. The takeaway is to be sure to develop policies and systems for keeping your business and individual affairs separate, which include at a minimum having separate bank accounts, credit cards and accounting systems. Most importantly, be sure you follow the policies and systems you set in place.
Handling business and personal accounts
Just as business assets are available for business liabilities, personal assets are available for personal liabilities. Keep separate business and individual bank accounts, credit cards and accounting systems. Do not use the business’s assets to pay your personal bills like credit card and rent payments.
LLC members might be required to personally guarantee farm debt
Let’s not forget a few other factors that play out in the real world. First, creditors often require that individual owners of a business entity, in this case LLC members, personally guarantee obligations. Creditors know that if there’s nothing left in the business there will be nothing left for them. This means that creditors may require the members to commit to loan payments as individuals, not just as LLC members. As a result, personal assets will be on the line even though the members took on the obligation to benefit the business. Members have to negotiate whether and to what extent a personal guarantee is required with creditors on a case-by-case basis.
LLCs do not substitute for insurance or reduce the likelihood of business liabilities
Finally, forming an LLC, or any business entity for that matter, is not a substitute for insurance. Some farmers mistakenly believe creating an LLC reduces the likelihood of liability. The name “limited liability” can be a little misleading. Creating an LLC does not change the landscape of a farm’s potential liability. It only limits the assets available to satisfy a claim to business assets. All the farm’s assets are entirely available to anyone with a successful claim against a farm LLC. Good liability insurance provides the farm with a defense in court and a source of funds to pay out on a successful court claim. Farm Commons strongly urges any farm business, no matter what business entity it adopts, to maintain adequate insurance coverage.
LLCs are flexible
The second key characteristic of an LLC is that it allows for a lot of flexibility. Farmers and business owners in general take advantage of flexibility in three main areas: (1) determining voting rights and control, (2) allocating profits and losses, and (3) upholding formalities.
LLCs allow wide latitude in determining who has voting rights or control when big decisions are made. For example, you can establish multiple classes of members and say that some have voting rights and others don’t. You could also determine that voting rights are based on percentage interest in the company, so that if one member has 55 percent percentage interest they will carry a majority in every vote. Or, you could say that every member has one vote regardless of the percentage interest breakdown.
LLC members have flexibility in deciding how to allocate profits and losses. Generally, farmers and business owners will allocate profits and losses in direct proportion to ownership, or “percentage interest” in LLC-speak. If two farmers have equal percentage interests, they split the profit (or loss) down the middle. When it comes to LLC law, you have freedom to set this up pretty much however you want. But when it comes to tax law, anyone looking to allocate losses out of proportion to percentage interest should understand the potential tax effects of the decision. So, if you want a creative arrangement, be sure you check with your accountant or tax attorney for more information.
LLCs allow greater flexibility around formalities. Unlike corporations, state LLC statutes typically do not require LLCs to have elected members or hold annual meetings. Single-member LLCs are especially attracted to this flexibility. There’s no need to hold a meeting and vote yourself in as the president, secretary, and treasurer! With that said, Farm Commons highly recommends that farm operations that form an LLC still follow some level of formality including holding annual meetings, assigning clear responsibilities, documenting decisions in writing, and establishing policies and procedures to ensure regular and clear communication. These procedures serve as evidence that you are, in fact, maintaining your business in a legitimate way, and will help prevent the court from reaching around the entity if allegations of improper play ever arise. In addition to these legal benefits, maintaining these formalities will help you maintain favorable relations with your members and make better business decisions, which will all help lead to a thriving farm business.
Ultimately, the flexibility that an LLC provides is often why farm operations prefer this business entity structure over a corporation. As we’ll see later, a corporation requires a more rigid structure and strict formalities.
Forming an LLC
Now that we’ve provided some basic background and characteristics, we can dive into the process of creating an LLC. This includes filing the articles of organization and creating your operating agreement.
Choosing a name
Before you start the steps in creating an LLC, decide on a name for your farm operation. Choosing a name is a very important step. The name helps create an identity for your business, your product and your entire foodshed. But, it’s also a legal consideration. Most states prohibit two businesses from registering the same business name in that state. In addition, if you choose the same name as another business already in operation, that business may demand that you stop using their name. Indeed, that business could have exclusive rights and protection to use the name under trademark law. If this problem comes up after your operation has been around a few years, changing your name will likely confuse customers. And it’s sad to lose the name you’ve grown to love!
Avoid potential legal problems by choosing a name that isn’t already in use. First, check state and federal databases of trademarks and trade names. Generally, the state’s secretary of state office will maintain a database of business names or “trade names,” which will likely be searchable online. The United States Patent and Trademark Office (USPTO) has a searchable online database for registered federal trademarks. A basic internet search will point you in the direction of these databases. Although a farm should not automatically assume that federally registered names are unavailable, consider it a red flag. Be sure you get more information and even consult a trademark attorney before choosing a name already registered in the federal database. Finally, you may want to check if your preferred website address is available and even register that domain name. You can do a basic internet search for existing businesses with the same name. You can register your preferred domain name on websites like GoDaddy or DreamHost. Also of note, most state LLC statutes require that the name of an LLC include the words “limited liability company” or the abbreviation “LLC” and not have the terms “Corporation” or “Inc.”
Who can create an LLC?
A basic question you may have is who can be a member of an LLC. Again, the LLC is quite flexible in this regard. An LLC can be created by a single person or multiple people. There are no restrictions on how many people may participate. Also of note, another business entity such as a nonprofit, another LLC, a trust or a corporation could be a member of an LLC.
What about married couples?
Married couples who live in specific states may choose to form their LLC with one member—the married couple as a single unit. This option is available to couples in states that adopt “community property” systems. The nature of community property is way beyond the scope of this Guide! To summarize, some married couples may want to form a single-member LLC for tax reasons. Married couples in community property states should talk with their accountant or tax preparer about the best option for their specific situation.
Preparing and filing articles of organization
The first step in formally creating an LLC is filing the “articles of organization.” This is done at the state level, usually through the state’s secretary of state office. Many states provide a form that can be easily downloaded or even filed online. Other states simply list the information required, in which case you can create your own document that includes this information. An internet search for “file an LLC and [your state’s name]” should bring up a form and more information. Each state charges different fees, which vary from $25 to $1,000. Once your articles of organization and fee are filed and processed, you’ll get a confirmation from the filing agency that your LLC is now recognized as an official business entity in your state.
Key terms for LLC articles of organization: registered agent and member- managed or manager-managed
Filing your articles of organization is typically a simple and non-technical process. However, there are a few terms you may not be familiar with. First is the “registered agent.” This is basically the person who will receive “service of process,” which is an official notice that the LLC is being sued. It does not in any way mean this individual is liable or responsible for the outcome. It simply means that the agent is required to pass on the notice to the other members of the LLC so that the LLC is officially on notice. Some businesses select an LLC member to be the agent. Others choose to work with one of the many independent businesses that provide agent of process services for a fee. Second, the articles of organization will generally require you to specify whether your LLC will be “member-managed” or “manager-managed.” Which one is your farm? It depends on who you determine has the authority to make day-to-day management decisions for the business (e.g., decisions related to managing employees, making small purchases, marketing and handling customer relations). If you want all members to make day-to-day decisions, you should designate member-managed. If you want only specific people to make those decisions, the farm must be manager-managed.
Preparing an operating agreement
An operating agreement outlines how the LLC is to operate or run its business. The document usually is not filed with any government office–it is for the business’s own use. As mentioned earlier, a lot of states do not require an LLC to create an operating agreement. However, even if it is not required in your state, Farm Commons strongly recommends that every LLC create an operating agreement. An operating agreement is a great choice for three reasons: (1) it helps safeguard the personal liability protection LLCs provide for individual members, (2) it lets your farm operation take advantage of the flexibility aspects of the LLC, and (3) it allows you to set more favorable ground rules in your relations with third parties. In addition, some lenders will require an operating agreement before making a loan to the farm.
First, the operating agreement helps set the ground rules for how the members will manage and operate the company. When members operate the business in line with the written provisions of the operating agreement, a court is more likely to find that the members have earned the LLC’s protection for personal assets. Also, when a written operating agreement is in place and it explicitly requires practices like maintaining separate bank accounts and accounting records, the members generally take these fundamental requirements of the business more seriously. This helps prevent the commingling of funds and other careless acts that could give a court grounds to go around the LLC and access the individual member’s personal assets.
Second, if you don’t have a thorough operating agreement, the detailed provisions in your state’s LLC statute will step in as the default rules if a dispute arises between the members or with a third party. Your state’s default rules may not be preferable or suitable for your farm operation. In other words, creating a thorough operating agreement gives the farm operation the opportunity to write its own rules. By writing an operating agreement, farmers and business owners can take advantage of the flexibile aspects of the LLC entity that we discussed above.
Third, the operating agreement clarifies and governs relations with third parties. It may not seem to matter much if there are just a few members who all have a close working relationship. They could agree on how the LLC will operate in various conversations and that may seem good enough. However, if it’s not written down in an operating agreement, it won’t govern anyone else who wasn’t a part of that discussion. For example, let’s say one LLC member dies and bequeaths her membership to her daughter. If the prior agreements between the mother and other LLC members are written into an operating agreement, the daughter would have to follow the rules set forth in the operating agreement as well.
To reiterate, the LLC business entity provides business owners or members a lot of flexibility on how they want to structure their operation. When thinking about your operating agreement, use your imagination and really think about what would be ideal given the interests and objectives of your farm operation. One way of thinking about an operating agreement is to imagine all the contingencies or worst-case scenarios and then figure out how you’d want each scenario to be handled.
The Checklist: Preparing for Your Farm’s LLC Operating Agreement, which is in the following section of this chapter, provides a helpful guide in walking you through some of these scenarios. Issues that you can address in your operating agreement include: How are big decisions handled, like whether to buy a major asset or sell the farm operation? How are profits and losses allocated, and who decides? What happens if a member dies? What happens if a member wants to leave? Can members be expelled from the business and, if so, how and under what condition? And so much more.
It can be an uncomfortable and challenging process to think about such bad scenarios. However, talking through these issues now will undoubtedly ease the process if and when such events happen. It helps all the members get on the same page and develop a sense of shared understanding and predictability. In this way, thinking through worst-case scenarios upfront actually helps prevent miscommunication and misunderstandings that may lead to such crises.
Step-by-step process for preparing an operating agreement
- Review the questions in the Checklist: Preparing for Your Farm’s LLC Operating Agreement and think through various contingencies or worst- case scenarios.
- Openly discuss the questions and contingencies with your LLC members.
- Agree on and outline an approach that’s best for your farm operation.
- Start drafting your operating agreement yourself using the Extensive Operating Agreement for Sun Sisters Farm, LLC or the Brief Operating Agreement for Happy Couple Farms, LLC as a guide, or give your outline to your attorney to draft most efficiently.
- Have your attorney review your operating agreement before finalizing it.
- Have all your members thoroughly review and sign your operating agreement to officially adopt it as the governing document.
The operating agreement examples provided in this LLC section include provisions with detailed explanations and stories to help guide you further along the process. Keep in mind that your operating agreement must comply with certain baseline requirements set forth in your state’s LLC statute. Given these statutes vary from state to state, Farm Commons highly recommends that you work with an attorney to help you through the process. You can save costs by working through the step-by-step process above. If you decide to draft the operating agreement yourself, you should have an attorney review it. This will help ensure that all of the provisions are in line with your state’s statute and that none of the provisions contradict each other, which is sometimes hard to spot. Internal contradictions result in confusion, which can lead to disputes. This would defeat the purpose of having an operating agreement.
Implementing Best Business Practices for Your LLC
Now that you’ve formed your LLC (by filing the articles of organization) and have established the governing rules (by finalizing and officially adopting your operating agreement), you must follow through by acting like you have a separate business. This means upholding best business practices by keeping your business affairs separate from your personal affairs, abiding by the provisions of your operating agreement, filing applicable annual maintenance fees with the state and filing your taxes.
Keep your business and personal financial affairs separate
It is essential that you maintain a clear and distinct level of separation between the LLC’s business affairs and each member’s personal affairs. Primarily, this means maintaining separate bank accounts and accounting records. This also includes not paying your personal debts or bills with the business assets. Of course, members can pay for legitimate expenses related to the LLC with their personal funds as long as they account for and properly record these expenses as business expenses. Be sure to keep all the receipts in case of an audit. The member can either write these “business expenses” off on their individual tax return, or they can request to be reimbursed directly by the LLC. If the LLC reimburses the expense, the member cannot also write it off. That would be a sure way of abusing the integrity and separation of the business entity!
Another key requirement for keeping the business affairs separate is to properly allocate assets to the LLC. Any land, equipment or other asset that is contributed to the LLC as a member’s capital contribution needs to be formally transferred over. Officially allocating assets in this way helps make absolutely clear who owns what. It also clarifies the extent of each member’s liability if the farm operation turns sour. Recall that if the LLC upholds best business practices, each member’s liability extends only to the value of his or her capital contribution. If the lines aren’t clear, the courts can go around the LLC and access personal assets.
Sun Sisters Farm, LLC story: allocation of assets
Let’s go back to our Sun Sisters Farm, LLC story as an example. Recall that Marie offered her farmland as her capital contribution. To properly allocate this asset, she needs to transfer the title of the farm to the LLC so that the land is in the LLC’s name. If a member prefers to keep the land in their personal ownership and instead decides to lease the land to the LLC, a written lease needs to be prepared that formalizes this arrangement between the member and the LLC.
Follow your operating agreement
Be sure to follow what your operating agreement says. Legally speaking, this is a contract that all the members are now bound by. You should make copies, or make it available in electronic form, so that every member has it and can refer to it as needed. Following the rules and procedures your operating agreement sets forth gives the business legitimacy in court. It also helps facilitate good relations among the members, as everyone will be on the same page.
For example, if your operating agreement requires an annual meeting, then you need to have one. You should take minutes to record what happened. The minutes don’t have to be elaborate, just enough for the members to recall what was discussed and decided. If you decide to make changes to your operating agreement, you’ll need to follow the procedure it sets for making amendments. Your operating amendment could require unanimous consent, a supermajority (i.e., two-thirds of members), or just majority consent for an amendment, depending on how you set it up. If you properly agree to an amendment, get it in writing and have all the members sign it.
If the business starts turning a profit, the members can agree to take a draw on the profits–or “distribution.” The distribution is generally associated with the member’s ownership share–or “percentage interest” in the company. This reflects each of the member’s potential gain.
You’ll need to follow your operating agreement’s rules about how distributions are made.
It’s a good idea to keep your operating agreement, as well as all meeting minutes and any amendments in one binder so that they are readily available. This also helps prove the legitimacy of your LLC by showing you are taking the separate entity seriously. Whenever you have a doubt about what’s required for making a decision, or how to deal with a specific scenario when it arises, refer to your operating agreement for guidance.
Pay your state’s annual LLC maintenance fees
This is simple, but it’s amazing how many LLCs fail to follow up. Most states require an annual fee to continue to operate as an LLC. Be sure you pay this fee each year, on time. Otherwise, you could incur late fees. Or, at worse, your LLC could be administratively dissolved. You would then have to start the whole process over again, which no farmer has time to do.
Designate your tax status
Recall that the LLC entity arose through state-specific LLC statutes. When states started creating the LLC, the IRS decided not to designate a new LLC category for taxation. Instead, the IRS provides a lot of flexibility and lets the LLC entity chose from among existing business tax options. You can choose to be taxed as a sole proprietorship, a general partnership, a C corporation or an S corporation. While this guide is not intended to provide tax advice, we will provide a brief overview to help with basic understanding as you work with your accountant or tax attorney to decide what designation is best for your LLC.
This Guide is not intended to be relied upon as tax advice. Farm Commons strongly advises any farm operation that decides to form an LLC to consult with an accountant or tax attorney before determining the preferred tax election.
By default, if an LLC has one member (“owner”) it will be taxed as a sole proprietorship. Similarly, if it has two or more members it will be taxed as a partnership, unless you elect otherwise. When taxed as a sole proprietorship or partnership, income and deductions related to the business will flow through to the individual members of the LLC. Such flow-through taxation is often preferred over a corporation because there will be no federal income tax on the company itself. Each member will be required to report the LLC income on his or her personal tax returns.
Does your LLC need an Employment Identification Number (EIN)?
An EIN is the identification number that the IRS uses to identify the tax accounts of employers and certain other business entities. Not all LLCs need an EIN. Again, this is because the IRS does not formally recognize LLCs as a separate entity for tax purposes, and instead allows LLCs to choose how they wish to be taxed. LLCs can select to be taxed
as corporations (either as a C corporation or S corporation, both of which are discussed in upcoming chapters), general partnerships, or sole proprietorships. LLCs choosing to be taxed as corporations or general partnerships need an EIN. Single-member LLCs need an EIN only if they have employees or if they choose a corporation tax treatment. Otherwise, a single-member LLC will handle all of the LLC’s tax issues by filing an individual tax return using the member’s Social Security Number. So basically, you’ll need an EIN unless you are a single-member LLC that has no employees. You can get an EIN immediately by applying online through the IRS website. If you prefer, you can download the Form SS-4 on the IRS website and fax your completed form to the service center for your state, and they will respond with a return fax in about one week. Some banks will refuse to issue bank accounts without an EIN, even if the IRS does not require the business to have one. In those cases, it can be easier to simply get the EIN than to argue with the bank about the necessity of the EIN.
An LLC can be taxed as a corporation by filling out the IRS Form 8832, “Entity Classification Election,” and electing corporation tax status. Once you do this, the default is that you will be taxed as a C corporation. Basically, the LLC will be taxed separately from the owners and profit remaining in the LLC at the end of its tax year will be taxed at corporate tax rates. This may be an option to consider if certain LLC members prefer privacy and do not want to report their business income on their individual tax returns. Also, with corporation tax status you can choose a fiscal year rather than a calendar year. For example, you can designate that your tax year ends on March 31 and begins on April 1. This might be preferable for farm operations that want to pay taxes more in tune with your particular farm operation season.
Another option is to be taxed as an S corporation. After choosing the corporation election on Form 8832, the LLC would then need to file the IRS tax Form 2553, “Election by a Small Business Corporation.” The S corporation handles self- employment taxes slightly differently. Basically, in addition to a “reasonable” salary that can be paid to the member(s) or owner(s) of the farm operation, the members can also receive income in the form of “distributions.” Distributions are taxed at a lower rate and are free from self-employment taxes including Social Security and Medicare taxation. This can equate to about 15 percent savings in federal taxes. Distributions can of course only be made if there are sufficient profits in your farm operation. Otherwise, your company will be considered undercapitalized. Recall that if this happens, the members may be personally liable to cover the business’s debt.
Two more points of clarification. First, while you will be designated as an S corporation for federal tax purposes, your entity is still considered an LLC in the eyes of your state. Second, to be an S corporation, you must follow additional formalities including holding annual meetings and annually filing IRS Form 1120S. This informational tax document is used to report the income, losses and dividends of S corporation shareholders (i.e., members, if you are an LLC with S corporation tax status).
Deciding on salaries of members
Farmers may be motivated to keep their salary as low as possible so that the remainder is taxed at a lower rate. If you designate the LLC as an S corporation for tax status, keep in mind that the IRS does not look fondly on artificially low salaries and can reclassify dividends as salary. The IRS will look at many different factors in determining what a reasonable salary should be. Anything above that could be reclassified and taxed as dividends. Factors the IRS will consider include the following:
- training and experience
- duties and responsibilities
- time and effort devoted to the business
- dividend history
- payments to non-shareholder employees
- timing and manner of paying bonuses to key people
- what comparable businesses pay for similar services
- compensation agreements
- the use of a formula to determine compensation
This begs the question, what is a reasonable salary for a farmer? Where do we draw the line? According to the Bureau of Labor Statistics, in 2014, the average annual income for farm supervisors and farmworkers was $47,540. If you own and run your own farm operation, which includes supervisory duties, the IRS may consider this as the baseline. Let’s say a member of an LLC with net annual income of $50,000 tried to claim that just $20,000 of that was a reasonable salary in hopes of getting a tax break on the remaining $30,000. You might have an uphill battle convincing the IRS that a farmer of similar skill and responsibilities could only reasonably expect $20,000.
Tax designation choices for an LLC
- Do nothing. The default will apply, which is a sole proprietorship (single- member LLC) or general partnership (two or more members).
- File IRS Form 8832, “Entity Classification Election,” and elect corporation. You will be taxed as a C corporation.
- File IRS Form 8832, “Entity Classification Election,” and elect corporation, and then file IRS tax Form 2553, “Election by a Small Business Corporation.” You will be taxed as an S corporation.
Note that this is simply for federal tax status. You will still be considered an LLC in the eyes of your state!
Fulfill your tax obligations
Once you decide on your tax designation and file the appropriate forms, you’ll then need to be sure the entity and each of its members fulfill the annual tax obligations. This includes distributing forms, filing forms, and, of course, paying taxes when due. The following provides a basic breakdown of what’s required based on the tax status you choose for your farm operation LLC. Again, Farm Commons strongly recommends that you seek guidance from your accountant or tax attorney come tax season. Tax law is very particular. Working with a tax expert will help guarantee you’re doing everything properly; it could also end up saving you money by finding ways to minimize your tax burden.
If you choose the default status and are taxed as a sole proprietorship or general partnership, then the LLC itself does not have to file a separate annual income tax return. Rather, each member will report income from the LLC on their individual tax returns (i.e., Form 1040, Schedule C, E or F). If the LLC has more than one member and is thus taxed as a general partnership, it will need to distribute Form 1065 to each member. This is purely an informational form that provides each member the necessary profit and loss information of the LLC to report on his or her individual tax return. Each member must include Form 1065 when filing his or her tax return.
If you elect to be taxed as a C corporation, the LLC will have to file Form 1120, “U.S. Corporation Income Tax Return,” and pay its own taxes. In addition, the members of the LLC will each have to individually report and pay taxes on any LLC income they receive (i.e., salary and distribution of profits).
Double taxation of LLC with C corporation tax status
In effect, the farm operation LLC members pay double taxes. First, the entity pays and then the individual members pay. This double taxation dilemma is why business owners often prefer the LLC structure, as it provides the option to be taxed as a pass-through entity (i.e., sole proprietorship, general partnership or S corporation). It would be a very unusual circumstance for a farm operation LLC to choose to be taxed as a C corporation. Be sure to confirm with your tax attorney or accountant on whether this would be the ideal option for you.
If your LLC elects to be taxed as an S corporation, you’ll have to file the annual Form 1120S with the IRS. This is an informational tax document used to report the income, losses and dividends of S corporation shareholders (i.e., members of an LLC with S corporation tax status). The entity itself will not have to pay taxes, as it passes through to the individual members. In addition, an LLC that elects S corporation status will have to provide each of the LLC’s members with a Schedule K-1. The Schedule K-1 is similar to a W-2, the end-of-the-year wage statement that employees receive from their employers. The Schedule K-1 shows the self- employment income each of the members receives from the company. The LLC must also submit a copy of Schedule K-1 to the IRS for each member. This allows the IRS to be sure that each member is properly reporting any self-employment income he or she receives from an LLC that’s being taxed as an S corporation.
Tax forms that an LLC must file and distribute based on tax status
- LLC with sole proprietorship tax status (default for single-member LLC): None. The individual member reports LLC income and profit or loss allocations on his or her individual tax return (or Form 1040, Schedule C, E or F).
- LLC with general partnership tax status (default for multi-member LLC): Distribute Form 1065 to each member. Each member reports LLC income and profit or loss allocations on his or her individual tax return and must include the Form 1065.
- LLC with C corporation status: File Form 1120, “U.S. Corporation Income Tax Return,” with the IRS and pay taxes as a corporation. Each member will report and pay taxes on any income (e.g., salary and distribution of profits) he or she received from the entity on his or her individual income tax return.
- LLC with S corporation tax status: File Form 1120S with the IRS, which is purely informational. Distribute Schedule K-1 to each member and file Schedule K-1 for each member with the IRS. Each member reports LLC income and profit or loss allocations on his or her individual tax return.
Maintain accurate accounting records
Finally, the business and all members need to keep good records of the business’s financial affairs, including all receipts of business expenses in case of an audit. It’s also advisable that you use a reliable accounting system such as QuickBooks or hire an accountant to handle your accounting and taxes for you.