Why Ohio Farmers Should Consider an S Corp Election
A family farm is many things: a labor of love, a legacy from one generation to the next, a source of income and purpose. But it is also a business, and as such, it needs a business structure. Many farmers choose to organize their farm as a limited liability corporation (LLC). Creating an LLC for the family farm confers many benefits; electing S corp tax treatment for your farm LLC can, too.
Farmers choose to create an LLC for their farm for a number of reasons. Farms are inherently dangerous operations, with heavy machinery and large animals, among other hazards; liability protection for the farmer is a must. An LLC offers safeguards the farmer’s personal assets from a potential lawsuit or other creditors of the farm business, as well as from tax liens. It is also possible to have farm assets held in multiple LLCs, which are themselves owned by an operating company LLC. This offers an added layer of asset protection.
In addition, an LLC does not pay corporate tax. It is a pass-through entity, meaning that income of the farm business is reported on the member’s (or multiple members’) tax return(s). This avoids the “double taxation” problem: with a C corp, corporate income is taxed, and then taxed again as income to a shareholder when it is distributed.
LLCs can elect to be taxed as a Subchapter S corporation — and many should be.
Should Your Farm LLC Select S Corp Tax Treatment?
An S corp is a tax entity, not a legal one (like an LLC). A farm that is structured as an LLC (or multiple LLCs with an operating company) can choose the pass-through taxation of an LLC. The farmer reports the LLC’s income on their personal tax return, so there is an incentive to minimize that income. One common way for farmers to do that is to purchase equipment near the end of the tax year and write it off as a business expense. The farm gets new equipment, and the farmer gets a tax write-off. So far, so good.
Ordinary members of an LLC must pay self-employment tax on their full share of the LLC’s net income. By minimizing net income through the purchase of equipment, the member can avoid paying self-employment tax.
But it’s important to think about what is not happening in this scenario. Because the farmer is not paying self-employment tax, he or she is not paying into Social Security. Often, the farmer is not contributing to an individual retirement account, either. When the farmer reaches retirement age, he or she has little to look forward to in terms of Social Security benefits, and often a lot of equipment that the farm no longer needs. What is likely to happen is that the farmer will sell off the equipment. If the equipment is fully depreciated, as is often the case, the proceeds of the sale will be all profit; there is no cost basis. The income from the sale will be taxed at ordinary income tax rates.
What has happened, in effect, is that the farmer simply deferred paying taxes on that income by purchasing the equipment in the first place. Then, when it is sold, the farmer is hit with an income tax bill just when he or she can least afford it. As a result, many farmers are forced to continue farming long after they would prefer to have retired.
How S Corporation Election Can Help Farmers
A farm that elects S corp tax treatment can help to avoid this outcome. With an S corp, the farmer would be compelled to take a “reasonable income” based on the type of work and the location. (A reasonable income for a farmer in Nebraska would probably be lower than for a farmer in California.) And yes, the farmer would have to pay self-employment tax on that income, as well as ordinary income tax. A S corp would also require shareholders to take distributions, which are subject to income tax, but not to self-employment tax.
An S corp is something of a hybrid between a C corp and an LLC. Like a C corp, it can issue stock (while an S corp may issue only one class of stock, some shares can be designated as “voting” and “non-voting.” Like an LLC, it offers pass-through taxation. And, of course, an S corp offers liability protection. All members of an S corp must be U.S. citizens, and it is limited to 100 shareholders or fewer (not a problem for most family farms.
An S corp offers income flexibility and not only allows but requires farmers to contribute to Social Security based on their reasonable salary. That helps to prevent insufficient retirement savings. Let’s take a look at how an S corp election helps farmers save for retirement and, ultimately, save on their overall tax bill.
Farmer Brown and Farmer Green have identical farms across the road from each other. Farmer Brown’s farm is a single-member LLC; Farmer Green has organized her farm as an LLC with an S corp election. In 2021, both farms had net earnings of $180,000.
In 2021, the self-employment tax rate is 15.3 percent (12.4 percent Social Security tax and 2.9 percent Medicare tax). Farmer Brown would pay self-employment tax of $27,540 on that $180,000, in addition to income tax. Farmer Green pays herself a reasonable salary of $50,000, on which she pays income tax and self-employment tax. The self-employment tax on Farmer Green’s salary is $7,650, and she has contributed to her retirement funds. The remaining $130,000 in earnings is considered a distribution. It is taxable as income, but not subject to self-employment tax. In addition, the S corp can deduct the employer portion of Medicare & Social Security taxes.
An S corp election may have other benefits as well. If the farmer decides to sell their interest in the farm, an S corp election makes it easier to do so. With an S corp, a farmer can do a stock sale or an asset sale; with an LLC, only an asset sale is possible. Furthermore, an LLC may need to be terminated if a member with greater than 50% ownership divests his or her interest in the company.
The Bottom Line
If you have questions about the best business entity for your family farm, or the tax implications of your current structure, you should schedule an appointment today with the accounting and tax preparation professionals at Gudorf Tax Group.
