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New Mexico State University

New Mexico State University

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Taxes, Liability Key Issues for Farm Businesses

LAS CRUCES -- Farmers and ranchers should think about taxes and personal liability when deciding whether to operate as sole proprietors, go into partnership or incorporate, a New Mexico State University farm management specialist said.

"Taxes and liability are the major considerations," said Jim Libbin with NMSU's Cooperative Extension Service. "Most people are conscious of both the bottom line and the paperwork involved when it comes to taxes. But in today's litigious society, it also makes sense to think about lawsuits and tax actions that could take away the business you've worked hard to build."

In New Mexico, producers can choose from several organizational structures, depending on their needs, size and preferences. Options include sole proprietorships, partnerships, corporations and limited liability companies, and each has its own particular strengths and drawbacks, Libbin said.

Summaries for each type of business follow.
Sole proprietorships

In New Mexico, most producers are sole proprietors, either operating independently or as a husband and wife team, Libbin said. A selling point of the sole proprietorship is that it doesn't require the consultation with attorneys and accountants that forming a corporation or partnership may.

"As a sole proprietor, you and the business are one, you're the same thing," Libbin said. "That's both the biggest advantage and disadvantage."

At tax time, the proprietor simply fills out a schedule F for the business and attaches it to a personal income tax form. "The major advantage is that there's no business tax on a sole proprietorship," Libbin said. "Income passes through the business to you as an individual, so it is not taxed twice as with a corporation."

However, that simplicity has its drawbacks in a lawsuit or tax action. A producer's personal assets, including a home, car and child's college account, are not protected from lawsuits or tax actions.

"It's easy to form a sole proprietorship, and it's easy to lose in a liability action," Libbin said.

Also, a sole proprietorship ends with the death of a primary owner, meaning that the business does not automatically carry on. However, surviving family members can restart the business as a new sole proprietorship, Libbin said.

Because farms and ranches often involve extended family, business partnerships are common. In most farm partnerships, two related but unmarried people are in business together, such as two brothers, or a parent and son or daughter.

At tax time, partnerships have clear advantages. "For partnerships, tax returns are basically informational," Libbin said. After details are filed on the partnership form, each shareholder fills out a form that's attached to his or her return, where the income is taxed for the first time. "It's a huge advantage in that the partnership itself pays no tax."

While it is possible to share assets with another person without being in partnership, it's difficult, Libbin said. "You can still share some resources, especially machinery, and have separate businesses. But you must split things up carefully, or you will be partners, whether you realize it or not," he said.

Producers are sometimes surprised to find out they're considered legal partners when facing a lawsuit or tax action.

"Either the tax authorities or courts can step in and say you are a partnership, which exposes your personal assets in some legal actions," Libbin said. "At that point, you can lose a home or savings account for something your partner did."

Because it's easier to get into a partnership than to get out of one, even family members may need a formal partnership agreement. Such agreements spell out asset ownership and decision making authority. In New Mexico, partnership agreements are filed with the state corporation commission in Santa Fe.

Incorporating a farm or ranch requires more formal business arrangements than the typical sole proprietorship or partnership. A corporation is "born" when formal documents are filed with the state corporation commission in Santa Fe, Libbin said.

"The concept that you are creating a new legal entity, and to do that you have to file with the state."

The major advantage of incorporation is that it provides protection from personal liability for legal or tax problems.

"If something happens at the business level, individual liability stops at the corporation boundaries," Libbin said. "Personal assets like homes or cars cannot be taken because the shareholder can lose only his investment in the corporation."

While that's certainly an advantage in contentious times, the tax news isn't as simple for a corporation as for a sole proprietorship or partnership.

"The major downfall of a corporation is that it is taxed as a separate entity," Libbin said. "The corporation files a tax return and is taxed at that level. If it passes out dividends to the shareholder, that income is taxed again at the individual level. The biggest knock against corporations is the double taxation issue."

However, tax consequences depend on what kind of corporation is formed. Although New Mexico recognizes only corporations and non-corporations, federal tax law provides for two types: subchapter S and subchapter C corporations.
Subchapter S and Subchapter C Corporations

For federal tax purposes, all corporations are not the same. A subchapter S corporation, named for a section of the Internal Revenue Code, is taxed like a partnership, Libbin said. The corporation files a return, but passes along all tax consequences to its owners.

"In a sole proprietorship, partnership or subchapter S corporation, in essence, the individual pays the taxes," he said.

Most larger companies, on the other hand, are subchapter C corporations that pay corporate income tax. In addition, shareholders pay individual taxes on dividends.

"That makes subchapter C corporations sound unappealing, except that you are only taxed twice if the corporation makes a profit and passes it along to you," Libbin said.

Current tax law provides a way around double taxation for farmers and ranchers, he said. "A properly structured subchapter C corporation can gain advantages that are almost unbelievable on the surface, at least for farms and ranches."

To reduce taxable income, producers can become corporate employees who collect a wage. Another mechanism is keeping land outside the corporation, which leases it from the landowner-shareholder.

"It sounds incredible, but it can be possible to deduct living expenses as an employee required to live on the farm," Libbin said. "A warning, though, Internal Revenue Service regulations are very strict. So you need to consult a knowledgeable tax expert before trying this approach."
Limited Liability Companies

Since 1993, New Mexico farmers and ranchers have had a new option when choosing how to organize their businesses. The limited liability company is an attempt to combine the best features of a partnership and a corporation, while avoiding the drawbacks.

On one hand, sole proprietorships and partnerships have tax advantages, but they don't protect business owners from personal liability. Corporations can provide that liability protection, but their earnings can be taxed at both the corporate and individual level.

"The advantage of the corporation that we want to hold on to is the limited liability, hence its name," Libbin said. "But like a partnership or subchapter S corporation, a limited liability company is taxed only at the individual level, avoiding the double taxation issue."

In addition, a limited liability company has some unique features of its own.

"You can have different types of owners than a subchapter S corporation can," he said. "For example, a non-resident alien can be a stockholder in an LLC. That can't happen in a subchapter S corporation."

Farmers and ranchers always should consult a financial adviser if they have questions about which organizational structure is best for their businesses.