Do you have your farm set up in the right legal entity category?

If you own a farming operation, you have a decision to make.

What legal entity will you use for ownership? You might use a sole proprietorship, a partnership, an LLC, an S corporation, or a C corporation. While your decision will involve more than just tax consequences, that is what we will focus on here.

What if I said you could choose to pay no income taxes personally for a while? You may have heard some years ago that Warren Buffett, chairman of Berkshire Hathaway, paid a lower income tax rate than his secretary. In fact, billionaires could pay no personal income taxes at all.

Here's how it's done. Let's say you own a farming C corporation with profits of $1 million a year. As the CEO and largest shareholder, you can opt to pay yourself $1 a month in salary, and you could convince the board (you) to pay no dividends out of the corporation. Hence, your personal taxable income from the corporation is $12 a year. Provided you and your spouse are earning under $25,000 a year in interest, dividends, pension, or other income, then you will owe no federal income taxes.

C corporation farms

Who pays tax on the $1 million of profit? The corporation does and currently at a maximum federal rate of 21%. (Corporate and individual tax rates could go up next year.) Why doesn't everyone use the C corporation? The answer is double taxation.

Most people need current cash flow to live. When they pay dividends to themselves out of their C corporation, they owe income tax on those dividends. The dividends are not deductible to the corporation, so the corporation also pays tax on the profit that allowed for those dividends. That works out to15, 20, or even 23.8% federal income tax on dividends at the individual level, plus up to 21% federal tax at the corporate level.

So, if you pay C corporation dividends to yourself for living expenses, you're probably going to pay as much or more in taxes as you would pay running an S corporation, which we'll discuss later.

How might you live for a while without income from your C corporation? You will probably need to set aside at least a few hundred thousand dollars to use for personal expenses that don't run through the corporation. You can keep that in a low-interest savings account. That's the C corporation scenario.

S corp farms

A subchapter S corporation pays no income taxes. The owners pay tax on all the profit earned within the S corporation, and they pay it on their individual income tax returns. Logistically, this happens by way of a schedule K-1, the IRS form that an S corporation uses to transfer information about profit, interest, capital gains, and distributions to its owners' tax records.

Because individual income tax rates start at 10%, many small-business owners use S corporations to operate. They benefit from the graduated federal individual tax brackets of 10% to 37%. The 35% tax bracket ends at $628,300 for 2021. That's where the maximum rate of 37% begins.

One huge point of confusion that I explain to some clients every year pertains to distributions out of S corporations. People assume that if they don't distribute money to themselves, then they don't pay taxes on it. However, that's not how it works for an S corporation. The owner pays tax on the profit earned by the corporation regardless of whether money is distributed out of the corporation.

You can make $1 million in your S corporation and distribute $0, $500,000, or any other number up to $1 million, and you will owe tax on $1 million. You might even distribute more than $1 million in a given year, because you had some already taxed undistributed income from previous years.

Another caveat about S corporations is that the IRS wants you to pay a reasonable salary to yourself for the functions you perform. That's a question for you and your CPA to ponder, but whatever you pay yourself in wages is going to get hit with Social Security and Medicare taxes. They total 15.3% on the first $142,800, considering both the employer and employee portions. That can be a chunk of money, depending on the amount of wages. This issue is the primary tax difference between running an S corporation and running a partnership.

Partnership farms

For a partnership, the partners personally pay tax on the profits earned by the partnership, just like an S corporation. However, by default, all the profit earned by an active partnership is subject to self-employment tax, or Social Security and Medicare taxes by another name. An S corporation owner is paying Social Security and Medicare on wages but not profits. However, the partnership owner cannot receive wages and, hence, is paying self-employment tax on all the available profit. Why can't a partnership owner receive wages? That's just an IRS rule.

Because of this self-employment tax disadvantage, we rarely see active small businesses running as partnerships. Note that passive income running through the partnership is not subject to self-employment tax. Therefore, we do see many partnerships owning rental properties. Also, if you and your partners are going to lose money with an active farm, it's fine to run that through a partnership for tax purposes. Some tax professionals would say it's preferable, considering complex basis limitation rules for S corporations.

Sole proprietor?

If you farm by yourself and don't do anything with legal entities, you are a sole proprietor automatically for tax purposes. Active sole proprietor farmers use Schedule F to report taxable income or loss. Being taxed as a Schedule F is similar to being taxed as a partnership, but there's only one partner. All the profit is subject to individual income tax plus self-employment tax. When your profit is very small or negative, the Schedule F is a fine alternative. If your taxable profit is above $50,000 annually, I believe you should consider other entities.

A passive sole proprietor farmer might be considered a farm landlord. The farm landlord reports income on Form 4835, which is similar to the Schedule E that others might use to report rental income. This is a better way to get taxed than Schedule F because there is no self-employment tax on the profit. For you to be "passive" basically means someone else is planting, harvesting, and milking the cows. You just receive a share of the crop or cash rent.

The limited liability company, or LLC, is basically an empty box for tax purposes. It is a layer of liability protection allowed by a state. The one-member LLC is a sole proprietor by default, which means a Schedule F or Form 4835 for a farmer. The multiple-member LLC is a partnership by default. A one-member or multiple-member LLC can elect with the IRS to be taxed as an S corporation.

There are more considerations than just taxes when determining your ownership structure, so consult with a CPA and a lawyer.