4 ways to structure farm diversification

Before rolling a new enterprise into the main farm, stop, think and talk about how this is going to fit into your operation long term

Maybe it’s something you just want to do. It might be manufacturing a new farm widget or selling birdseed, or producing heritage pork, or grazing sheep.

Or maybe your son or daughter has graduated from agricultural college and they want to come home after a few years working off farm. You know there’s risk with new ventures, but they’re brimming with ideas, they’ve got a plan, and you want to encourage them.

You’ve run the numbers. It looks like the enterprise should eventually contribute to overall profits. But how should you structure it? Should you incorporate the main farm and start a separate sole proprietorship for the secondary business, or incorporate and put it all under one? Or how about keeping both as sole proprietorships under separate names? Or maybe you should go for a partnership? Or a joint venture?

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Set things up right from the beginning with your long-range vision in mind, advises Allan Sawiak, chartered accountant and succession expert with KRP in Edmonton. “What do you see this looking like in 20 years?” Sawiak asks. “Line up the business structure with that future vision.”

The communication involved in this planning process is invaluable. It forces you to think the business through and to prove its value. It also involves figuring out how you want to take profits out of the farm, and it makes you look at who owns what assets, and to define where the startup money is coming from and the value of that venture capital.

The other question you need to answer at the outset is why you want to do it. It might not be all about profits for everyone. Sometimes it’s lifestyle or for the good of the community. In Saskatchewan, a survey of farmers found they diversified mostly to use available management and labour, and to provide full-time, year-round employment for key hired personnel. The survey also found that these farmers used diversification into off-farm ventures or through non-agricultural enterprises to reduce risk exposure to market and production risks.

Of course, a separate category of diversification projects isn’t really designed with profitability in mind. It’s designed to create enjoyment, perhaps, or to provide purpose, but does not contribute financially. “If it’s unprofitable, it’s a hobby,” says Mark Fournier, a professor at Olds College.

Whatever the motive, the project and the way it’s structured should match the farm’s risk tolerance, which means it needs to be talked about with everyone who’s involved. Share up front how much money you want to make, how much you’ll need to start and operate, and exactly where you’re going to get funding.

There are many ways to structure the secondary business without putting it in the main farm, and although there are positives and negatives to each structure, there’s no right answer for everyone. When Country Guide spoke with three experts — Allan Sawiak at KRP, Mark Fournier at Olds, and Ontario farm adviser Carl Moore — each leaned toward a different format, or leaned away from others, all for good reasons.

#1 — Sole proprietorship

Most farms in Canada are still sole proprietorships. It’s the easiest, cheapest way to do the books, and the land is in individual names. But is it still right when you diversify? “If you’re just testing the waters, it’s a lot less tax hassle and legalities. You just do your books and then go see your accountant,” says Fournier. “It’s easier to get started in a sole proprietorship and good for the first couple of years.”

A sole proprietorship doesn’t require a written legal agreement to start a new venture, so one can be launched without a lot of cost. However, once you start dealing with multiple individuals (even parents or siblings), discussing and writing down the logistics become very important.

Since sole proprietorships don’t have written rules of engagement, it’s even more important to communicate expectations and to respect each other. Tell one another what you hope the business will eventually look like, and do take care not to take essential management time and capabilities away from the core business. “Make sure the family has open communication and a method to resolve problems,” adds Fournier.

When starting a new business, a sole proprietorship can be advantageous if you’re going to lose money for the first few years, since those losses can be put against your personal income. However, once your business starts making more money, you start paying at personal marginal tax rates that are much higher than the small business corporate rates.

“Successful farm operations should not be in sole proprietorships,” Sawiak bluntly says.

Carl Moore, farmer and adviser in Woodstock, Ont. is a proponent of keeping it simple, especially with succession. Generally he encourages his clients to not incorporate and to keep land out of a corporation to take advantage of the rollover provisions. In his experience, he’s found that farmers often can buy enough assets and inputs to mitigate some of the extra tax burdens of not incorporating.

Compared with problems that he’s seen with more formal agreements, the cost of paying extra taxes can be a pittance. He warns that small business taxes and rules around incorporation are becoming more complicated with every government budget.

“Every situation is different and will change, so keep it simple to get in and out of,” advises Moore.

Instead of involving children as shareholders in the farm corporation, Moore says it’s often better for them to set up separate sole proprietorships and buy land under their own names with some help from the parents.

A mortgage is the best way to motivate the younger generation, Moore believes. “It puts the responsibility right where it should be. If it’s all split into shares, passed down between several generations, it’s like no one owns anything, no one takes responsibility.”

#2 — Incorporation

As a tax specialist, Sawiak sees many successful, forward-thinking farmers charging ahead with incorporation. They’ll have that structure in place before diversification is considered.

This can work well for diversification projects, especially with pilot projects. Any losses can be put against the corporation’s earnings, and lower corporate tax rates allow for more dollars to put towards debt repayment or diversification.

Corporations allow more ways to split income and to take money out of the businesses with fewer tax implications.

Then, after a year or two, if it looks like the new business will be strong enough to stand alone, and if you are farming with your sibling and both are shareholders, consider splitting it out of the farm corporation right away.

“It becomes difficult and very costly to split it out of the corporation later,” says Sawiak. “Splitting any family farm corporation that involves siblings as shareholders is very costly.”

Every year Fournier sees students go back to the family farm, many with business plans for diversification. The most successful tend to run small pilot projects under the established family farm corporation, much as any business would try a new product line.

Once it’s big enough, the students might run it as a sole proprietorship or another corporation, or as a division within the farm corporation.

Regardless of the structure, expectations need to be communicated and understood, and all parties must respect each other, says Fournier.

By their very nature, corporations have better records, plus preplanned and written structures for transitions. It’s also easy to run several different enterprises under one corporation, which means that as the farm diversifies it can still operate under one set of books.

Something to keep in mind is what the farm will look like in the future, and if the rules may change. From a tax perspective, farm corporations set up before 1985 missed out on using today’s farm tax advantages such as capital gains exemptions,” says Sawiak. The capital gains exemption came into law in 1985 but before this farmland was typically owned by the farm corporations.

Dealing with a corporation can become more difficult as more people become involved, especially for future generations. “In my opinion, many farm corporations formed in the ’60s and ’70s are now a disaster area for the third generation,” says Moore. “Now with all the sons and daughters, spouses and children involved, there are too many voices.”

Worldwide, about 90 per cent of businesses do not survive through the third generation, says Moore. “Why are we not planning for this rather than setting up business structures that will not exist for the grandchildren?”

#3 — Partnership

With farms, business formats tend to be based on the tax level, says Sawiak. In his experience, it is usually tax planning that triggers changes to structures. “Farmers have deferred, deferred and deferred and pre-bought, pre-bought, and pre-bought, and have run out of options,” he says.

When a farm is at this point, Sawiak tries to move it to a partnership for two years minimum and then into a corporation. This interim step allows them some time to do some strong tax planning and it helps set up the family with future tax savings to grow the farm.

Partnerships that have proper partnership agreements can also help avoid some of the tax problems triggered on death for family farms, says Sawiak.

Before Fournier was a professor, he worked in loans and saw both failures and successes play out. “I’m not a big fan of partnerships,” he says. “When I was a lender there was a saying that was often true: The only ship that’s destined to sink is a partnership.”

Fournier says the problems arise with partnerships if there’s no set agreement ahead of time to deal with problems. Most partnerships are still handshake deals and they can sound like a good idea at the beginning, but then the real world sets in. Things like spouses, splitting income or disability complicate the situation and cause problems.

At least with a corporation you have to talk about it. It’s long term and formal. You’ve paid a lawyer to work out the logistics if something happens, and before you get into it, you have a buy-sell agreement and a way to deal with spouses.

#4 — Joint venture

Part of the problem and a serious limitation for diversifying today is the massive expense to start a secondary farming business that has the scale to compete. This is an even bigger issue for younger farmers.

Joint ventures are a way to maximize resources, diversify, or try something new. Joint ventures allow the younger generation to start farming or diversify a farm at a competitive scale with relatively little capital. Older farmers often use joint ventures so they have more time off and can ease toward retirement.

Carl Moore says although the risk is spread out, usually one individual loses in a joint venture. And usually that’s the more established party.

The individuals involved own the assets and share net revenues, and joint ventures can be set up for whole farms, a portion of the farm, or even just a specific component, such as a combine.

Joint ventures tend to be short-term operating structures and, unlike partnerships or corporations, they don’t require a business number, own anything, or pay income taxes.

The joint venture legal agreement is simply the framework for the parties to work together, but it is vital, says Fournier. “Lawyers get the hard discussion done in advance. It’s cheaper to get them involved at the beginning of business than at the end.”

Fewer farms diversifying

Over the last few years, Allan Sawiak of KRP in Edmonton has noticed a trend toward less diversification. Most of his farm clients are expanding or trying to improve their productivity in the sectors they already do well in, unless of course they’re landlocked, in which case the diversification tends to be directly related to their core production, for example a grain farmer growing or selling certified seed or growing other crops that complement the land and grain operation.

Typically more money can be made by getting better first at the base enterprise before diverting attention and resources to a new enterprise. In the past, sometimes when farms have tried to start a new enterprise, they have taken their eye off the ball and it has resulted not only in the failure of the new enterprise, but damage to the main business too.

Sawiak thinks this becomes more of a factor as farming has become more complicated, specialized and asset heavy. There’s no room for messing up, and there’s more risk getting into a new product range, he says. With the steep learning curve and huge dollars to enter at a competitive scale, diversifying has too many risks.

The success rate of farm diversification efforts is probably not much different from any small business venture; the majority fail in the first five years and many don’t even make it past the first year. Based on the survival rate of other business ventures, only one in five will contribute positively to the financial health of the farm.

With succession planning and adding another family, farming tends to be about doing it bigger and better, and today, successful single or double family farms are doing so much more and are hiring people, says Sawiak

“These farmers are looking for potential access to more profits and, even with higher land prices, are just waiting for the opportunity to expand,” says Sawiak. “There’s little hesitation.”

Sawiak does see mixed farms making little adjustments for their children coming back to the farm, but staying in the same stream. “Heritage is alive and well,” he says.

As farm assets increase in value, diversifying has become less popular, agrees Mark Fournier at Olds College. “It’s too risky to try new things and there’s big dollars at stake. Young farmers trying to make mortgage payments know that they need to make payments from Day 1, they don’t have time to mess around,” says Fournier.

One interesting way to allocate diversification risk is for the senior generation to transfer the base farm to their children and then start a new enterprise as their semi-retirement project. The retiring generation is typically financially established and can put the time and patience into developing something new. Risk becomes less of a factor because they’re not necessarily relying on it for a living. As a result, they’re willing and able to experiment and be creative.

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Maggie Van Camp

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