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Calculating a fairer, smarter farm inheritance: Part One

Can an estate plan be fair both to the family and to the farm business? Merle Good and Greg Gartner see a way forward

I’m supposed to ask the questions, but Merle Good, Alberta farm business advisor and nationally followed succession expert shoots a question my way before I get a chance.

“Suppose you could open all the wills of today’s farmers,” he says. “How many are leaving land to off-farm children?”

I expect the number is big — uncomfortably big, at least a third. So I go bold and offer “Half.”

Good’s answer is swift. “Eighty per cent, in that neighbourhood.”

Tom Button: I’ve heard you’ve got what you’re calling the “million-dollar farm question.”

Merle Good.
photo: Supplied

Merle Good: Yes. It’s this. How do today’s parents meet their objective of continuing and transferring a financially viable farm business to the next farming generation, and yet be fair to their off-farm children?

And it’s important to see it on an industry-wide basis too, because it’s also a multi-billion-dollar question.

As an industry, the family farm is the backbone of our rural economy and culture. Is it financially viable to continue to buy land twice within families?

TB: Buying twice? Who can afford to buy farmland twice?

MG: Welcome to the increasing dilemma facing our farm families and our industry today with exploding land values.

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TB: First, give me your take on why the number of wills leaving land to non-farmers is so high.

MG: The reason is simple but very, very complex. The value of land has exploded. In a typical farm family, if the business has $5 million dollars of grain land assets, the gross revenue will be around $500,000 to $600,000.

Assume I buy a quarter of land for $800,000. The gross revenue from that land in central Alberta would be approximately $80,000. Think of it as $500 per acre times 160 acres. The capital to gross income ratio is therefore 10. It takes $10 dollars of capital to create $1 of gross income.

The ratio explodes when one assumes that net income in agriculture is approximately 20 per cent of gross revenue. David Kohl of Virginia Tech says farmers may target 20 per cent pure net income to gross revenue, but that’s a goal, not necessarily something they’re actually achieving.

In reality, the capital to net income ratio is likely closer to $50 of capital to $1 of net income.

TB: Do your farm clients think in those terms?

MG: It is imperative that all family members understand the capital required in our industry to be successful.

We are not an income-based business but rather an asset equity-based business with enormous capital requirement and debt levels to acquire this capital.

The next farming generation then tries to explain to the parents that to buy land back from their off-farm siblings will require an extreme drain on their future cash flow. It may even be impossible.

The parents of course are perplexed. They understand what the next generation is saying, but they don’t see what they can do.

If they give land to the farm child worth $5 million and they decide to exit the business in the future, then that child and his or her children and grandchildren will be set for life. If the three off-farm siblings only get for example, $500,000 of cash assets apiece, then their children and grandchildren will not receive a share of the wealth that their parents and grandparents created.

Remember, building the farm has been a family effort over the generations. Is it right that only one child should benefit?

TB: But can you be equal and leave a farm that is sustainable?

MG: You have to ask the following questions.

Does the value of all land that is legally the parents’ really belong to the parents?

In other words, is it fair to transfer wealth that maybe the parents have not really created? If the farming child had not come home, would the parents have kept all the land that they had at that time?

But you also have to ask, if land has been purchased by the parents while the farming child was involved in the business, did the child’s contribution not help pay for their parent’s land?

This leads to another interesting way of looking at it.

If Dad had transferred some land 10 years ago as a way of recognizing my contribution to the business, I the farming child would not have to pay today’s outlandish prices to square things up.

I also ask Dad and Mom this question. Can the farm business extract cash now for the off-farm children? Their answer is usually No! Well then how can your farming child raise millions for them after you’re gone?

It’s also important to consider whether to adopt a land valuation freeze.

TB: How do you mean?

MG: In operating companies, we usually freeze the value of the company and transfer all the growth to the next generation. In all my time working with farm families, this only occurred once when the farm wasn’t incorporated.

The parents simply said any land value increase after their son had been home for 10 years belonged to the business, not them personally. Remember: they still owned the land, but they agreed to this plan. I said, “Wow, clarity for once.”

TB: I understand you’ve been thinking about whether we should be transferring the wealth or is it the income generated from that wealth.

MG: That’s the most important question for parents.

Here is an example of one family decision I worked on. The family has 14 quarters of owned land and rents seven quarters. There is one child farming, and three non-farm siblings. Land is worth $500,000 per quarter. Off-farm cash and life insurance at this time add up to $800,000.

Assume we transfer eight quarters of land to the farm business (farm child) and two quarters each to the other children. I always remind families, parents leaving land to a farm child is not because they are the chosen one, in fact they are leaving it to sustain a family business!

Is this fair?

Mathematically, no, because it only considers the land. But perhaps if we analyze this through a different lens it may be. It takes a bit of thinking through, but you may find it worth it.

Start by asking this. If a non-farm child sells the land they inherit, how many years of net income does that work out to? In this example, if the farm quarter produces $10,000 of net income and the land is worth $500,000 the non-farm child has received 50 years of net income. I have not even bothered analyzing the future value of receiving that income all at once compared to making $10,000 over 50 years on a net present value basis.

If a non-farm child receives $266,000, these funds will have a transformational benefit to this family. You drop a quarter-million dollars of tax-free cash into almost any marriage and that family’s personal life is changed considerably. Drop $266,000 of cash into a modern farming business, that is a nice down payment on the equipment loans.

TB: So what do they do?

MG: In this case the parents decided to do this: They left one quarter section to each off-farm child to increase their wealth inheritance BUT with a lease condition that the land had to be leased back to their farming sibling for 15 years after they receive the property. In addition, the farming child has the option to buy back this land at 75 per cent of appraised value during the lease period if their sibling wishes to sell. After the lease period, the farm child has to pay 100 per cent of appraised value.

This means the farming child gets an additional three quarters, but to compensate the non-farming children for those quarters, the farming child must raise $450,000 to pay to the three siblings. Where did the $450,000 come from? It’s cash rent for 15 years. Three quarters times $10,000 per quarter per year for 15 years is $450,000.

The land is transferred on the condition that a payment of $450,000 is forwarded to the non-farming siblings, and the siblings will then receive this income tax free. This is called a conditional bequest.

The net effect is that the farm business secured more land equity, but it has to pay what it could afford to capture that equity based on productive value

It’s a plan that understands the essential difference between income generation and wealth transfer.

TB: But isn’t there a concern that the farming sibling could decide to sell the extra three quarters? They’d have to pay the equivalent of the rental fees to the non-farming children, but that one child would still walk away with maybe $1.5 million. Isn’t that what Mom and Dad were trying to prevent?

MG: Yes, that’s a risk. It’s also true that if the farming sibling wants to maintain the original farm size, they’re either going to have keep paying rent or they’ll have to make a very substantial commitment to buying the single quarters from the siblings. The farm is still paying for that land twice — once when it was originally purchased, and then again when it has to be purchased back from non-farming siblings.

TB: Is there any way not to have the land sold by any child if someone in the family is still farming?

MG: Yes, it is complex, perplexing and separates wealth from income, but if that is an objective that the entire family can wrap their heads around, it can be done. It is called a land capital partnership.

TB: So that’s what we’ll discuss in part two, in the next issue of Country Guide.

About the author

Editor

Tom Button is editor of Country Guide magazine.

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