farm transition

The Use of Windfall Gain Agreements in Farm Transition Planning

farm transition

By: Jennifer Denchak Wetzel, Esq.

The importance of farm transition planning has become increasingly understood and accepted by the agricultural community.  The topic is regularly discussed in agricultural literature as well as through live seminars.  Yet, despite widespread awareness and adoption of the concept, there can still be a general reluctance, for a number of different reasons, to approach and tackle the issue.

Many times, the topic is ignored because it reminds the parent generation of their mortality.  The parent generation may also have a resistance to losing control and may operate under the assumption that no one could ever run the farm business as well as they have run it.  Sometimes there just is not enough of time to handle the farming obligations, let alone deal with this complex and time-consuming issue.

Another major deterrent is not knowing how to handle the “non-farm child” fairly.  In most farm transitions, the farm child receives the farm assets by gift or through a bargain sale at less than the fair market value.  This arrangement may reflect the sweat equity that has been contributed by the farm child to the farm operation over the years, as well as reflect the maximum price that can be paid by the farm child in order for the business to stay viable.  After the farm assets are transferred, few assets often remain for distribution to the non-farm child.

If your reluctance to approach this topic stems from your uncertainty regarding the treatment of the non-farm child, a possible solution is to add conditions to any transfer to the farm child requiring him/her to share a portion of the “windfall gain” that is recognized by the farm child if he/she sells or transfers all or a portion of the farm assets outside of the ordinary course of the farm business, or discontinues the farming operation, within a set period of time.  For example, for a period of ten (10) years from the date the farm child receives the farm real estate, he/she could be made to share a portion (often a higher amount initially and then decreasing over time) of the net profit he/she receives from the sale of the farm real estate with the parents and/or the non-farm child.  The time period and sharing percentage can be adjusted to fit each family’s circumstances, and parents can provide for exceptions to the windfall gain sharing requirement, such as the leasing of oil and gas rights and/or the sale of agricultural conservation easements, among others.

An agreement to share windfall gain may be part of the solution to guaranteeing fair treatment amongst your children, and may be the peace of mind needed to allow you to begin the farm transition process.

The attorneys at Mette, Evans & Woodside are available to counsel and assist you with the development of an Agreement-Sharing of Windfall Gain, as well as with all other aspects of your farm transition plan.

farm joint ownership

Untangling Joint Ownership of Real Estate

farm joint ownership

By: Ronald L. Finck, Esq.

It is not uncommon in the farm community for real estate to be owned jointly by two or more owners.  Many times, parents will transfer their real estate to more than one child as part of their estate and farm succession plan.  Joint ownership of real estate often presents unique problems for the joint owners.  A co-ownership agreement should be considered to set forth how the joint owners will use the real estate and how the expenses associated with the real estate will be paid.  That agreement could also address what the rights and responsibilities of the owners would be in the event of one of their deaths or if one of the joint owners decides to separate from the joint ownership.

If one or more of the owners decide they no longer want to be joint owners and if the joint owners cannot agree on a sale of the property or how to divide the property among themselves, the Pennsylvania legal system provides a remedy known as partition, which allows joint owners of real property to sever their ties to one another.  In some ways, partition is like the division of property in a divorce.  Two or more parties are splitting their jointly-owned assets and going their separate ways.  Unfortunately, like divorce proceedings, partition can be costly, time-consuming, and full of aggravation.

In Pennsylvania, partition is a two-step process.  First, the court determines whether partition is appropriate.  Second, the court determines how the real property should be divided up so that each joint owner receives a fair payment or distribution.  The first step to partition is relatively simple.  Any party with an ownership interest in real property has a right to have the property partitioned.  Therefore, all that the party seeking partition has to do is show that he or she has an ownership interest in the property.  Partition does not require the consent or permission of the other joint owner(s).

Determining how the property should be equitably divided among the joint owners is often much more difficult.  Frequently the court will employ a special master to assist with the process.  The first thing to be considered is whether the property can be physically divided.  If a court finds that the property can be physically divided, it must physically divide the property and award each joint owner his or her respective share.  This process may be relatively uncomplicated when dealing with large, undeveloped, and unimproved tracts of farmland or woodland.  More often, partition involves property that is improved with buildings or other improvements that are not easily divisible.  Further, factors such as zoning regulations, access to public roads, soil quality, agricultural conservation easements, etc., can prevent or complicate an equitable division of the property.  Thus, the court must find a way to equalize each joint owner’s share.

Equalizing the shares can be an onerous process, rife with potential for disputes.  Sometimes a joint owner will have to pay another joint owner a sum of money in order to equalize the interests.  If the parties are unable to agree on who gets what part of the property, or if there are more joint owners than parts into which the property can be divided, the court may auction off the parts between the joint owners and make awards of money, real estate, or both, to the parties according to their ownership interests.

Income tax consequences of the division and sale of property is another consideration.  If the division involves two or more properties that are not adjacent to each other, the division may have to be structured as a like-kind exchange under IRC §1031 to defer income tax consequences.

If the court finds that the property cannot be physically divided, it can order that the property be sold.  Such a sale may be limited to the joint owners or open to the public, depending on the circumstances.

The attorneys at Mette, Evans & Woodside can assist you with the various complex issues that can arise from the joint ownership of real property.

Life Insurance Policy

Will Your Whole Life Insurance Expire Before You Do?

By: Gary J. Heim, Esq.

Life Insurance PolicySome farmers have purchased whole life insurance as an integral part of their estate/farm succession plan.  Frequently, the children who are not actively involved in the family farm business (non-farming children) are the intended recipients of those insurance proceeds.  In the parents’ quest to be fair and equitable among the children, the insurance proceeds often pass to the non-farming children to eliminate or reduce the payments that the farming children would otherwise make for the family farm assets they are receiving.  Some of our clients, who have purchased whole life insurance as part of their farm succession plan, however, are discovering, unexpectedly, that their insurance may lapse before their deaths, whether automatically or due to unaffordable premium increases.  If the policy lapses, there are fewer assets to distribute at their deaths.  In the most extreme cases, there are no assets to distribute to the non-farming children.

People expect term insurance (no cash value) to lapse at a certain age.  On the other hand, whole life insurance (any insurance with a cash value such as universal, variable or traditional whole life) is commonly expected to continue until the insured dies… regardless of the age.  But this is a common misconception.

Just as longer life expectancies and reduced investment and interest returns have wreaked havoc in the pension world, these same factors have adversely impacted some (not all) whole life policies.  The most vulnerable policies are those purchased before 2008 when higher investment and interest returns were the norm.

An estate/farm succession plan should be reviewed every five (5) years to evaluate changes in farm/business circumstances, tax laws, Medicaid qualification and assets/debts.  Part of that review should include an insurance company-generated report that projects when the policy will expire under current premium and cash value levels.  The report, commonly referred to as an “in-force illustration,” can be requested from the agent or directly from the issuing company.

If you learn from the report that your policy is projected to expire at a certain age, you can determine whether changes to your estate/farm succession plan are necessary, so all of your children are treated fairly.  The attorneys at Mette, Evans & Woodside are available to counsel and assist you with updates to your estate/farm succession plan, including the interplay of the life insurance component of that plan.

Like-Kind Exchange

How Does a Like-Kind Exchange Work?

By: Gary J. Heim, Esq.

Most farmers and land owners have heard of a like-kind exchange, which goes by several other names, including a 1031 exchange or a tax-free exchange. The primary purpose of an exchange is to reduce the federal income taxes resulting from the sale of real estate.

Although an exchange will not be appropriate in all situations, it should be considered whenever business, farm or investment real estate is being sold.  Projecting the income taxes payable from the sale if an exchange is not used is the starting point.  To qualify for the tax savings, not only must the real estate being sold (relinquished property) be used for farm, business or investment purposes, but also the real estate that is being purchased (replacement property) must be held for farm, business or investment purposes.  It is not an all or nothing requirement, however.  The seller can keep some of the cash from the sale and only invest a portion of the sale proceeds in other real estate, but the income tax savings will only apply to the portion of the proceeds reinvested in qualified real estate.

Farm real estate can be exchanged for an apartment or other commercial property; the replacement property does not have to be a farm.  The like-kind requirement is satisfied as long as real estate is exchanged for real estate (used for farm, business or investment purposes).

Some of the more common situations where our office has assisted PFB members with exchanges include: (1) the sale of agricultural conservation easements; (2) the relocation of a farm operation from one place to another; (3) the sale of a portion of the farm for warehousing or other development purposes; (4) rearranging the ownership of jointly-owned property among siblings or others; and (5) the condemnation of property for highway, school, pipeline or other purposes (there are more lenient IRS rules for reinvestment of condemnation proceeds).

The like-kind exchange process usually involves four advisors or services, including: (1) a tax preparer/advisor; (2) an attorney to prepare the agreements of sale and related documents; (3) a title insurance company to insure title to the property; and (4) a qualified intermediary (QI).  The QI is used to satisfy the IRS condition that the seller cannot actually receive the sale proceeds.  Instead, the QI receives and holds those proceeds until it is directed to release the money to purchase a replacement property.

The IRS has rigid deadlines that cannot be extended for hardship or other reasons in the like-kind exchange process.  For example, replacement properties need to be identified within 45 days of the closing for the relinquished property.  Similarly, the closing for the replacement property needs to take place within 180 days of the closing for the relinquished property.

The attorneys at Mette, Evans & Woodside have guided and assisted many PFB members through the like-kind exchange process and can assist you in the evaluation and implementation of a like-kind exchange.

Prenuptial/Postnuptial Agreements in Farm Succession Planning

By: Gary J. Heim, Esq.

As part of the succession planning process, most farm owners anticipate the challenge of balancing the older (transferring) and the younger (receiving) generations’ financial needs. And, they know that a difficult decision about the fair distribution of assets among the on-farm and the off-farm children is inevitable. However, equally important in the succession planning process, discussing prenuptial and postnuptial agreements (“marital agreements”) comes as a surprise or is uncomfortable for many from a family or moral perspective.

Marital agreements are used to establish the rights of a married couple in the event of a divorce, and sometimes death. By statute, Pennsylvania provides what the financial rights of spouses are in the event of divorce and also in the event of death. Just as a person has the right to alter the will that Pennsylvania has written for each of its residents (intestacy law), marital agreements can be used to alter the terms that otherwise apply in the event of a divorce of a married couple.

The financial effect of divorce in the farm community is severe due to the high value of farm assets in comparison with the relatively low net farm income. The forced liquidation or distribution of some or all of the family farm assets due to divorce is especially troubling when those family farm assets have been accumulated and preserved over multiple generations at great sacrifice, both in terms of the sweat equity invested and the relatively modest income paid to those farm family members. Further, the involvement of multiple family units in the family farm business means a single divorce can have wide-reaching effects beyond the individual family unit.

While most people think of the younger generation in the farm family business when the topic of marital agreements arises, they also need to be considered by the older generation, particularly with a remarriage following the death of a prior spouse. In one instance with which we were involved, for example, an on-farm child, who was to inherit the farm as a gift from his father, had to pay his step-mother over 30% of the value of the farm. This result could have been avoided through a properly-drafted prenuptial agreement.

It is the farm family members, not the attorneys or other advisors, who need to decide whether marital agreements will be used. However, if you decide that marital agreements are needed in your situation, consider some of the following general rules:

1. A comprehensive disclosure of financial information is required.

2. Each of the two parties to the agreement should be represented by separate attorneys.

3. Without a marital agreement, the income from and appreciation in value of gifted/inherited assets and of pre-marital assets become marital property, subject to equitable distribution in a divorce, even if the assets are only titled in one spouse’s name.

Impact of New Tax Act on Farm Succession Planning

By: Jacob H. Kiessling, Esq.

In the closing days of 2017, the federal Tax Cuts and Jobs Act (“Act”) was enacted. Its impact will be felt by virtually every taxpayer on multiple levels. From a farm succession planning standpoint, the most impactful changes include reduction of individual and corporate tax rates, increases in the federal estate and gift tax exclusion amount, preservation of stepped-up basis and continuation of like-kind exchanges for real estate.

In addition to lower tax rates in general for individuals, the owners of pass-through entities (LLCs, S-corporations, partnerships and sole proprietors) who report business profits on their personal tax returns may be able to take up to a 20% deduction against their pass-through income. Corporations will also benefit with the corporate tax rate being significantly reduced from 35% to 21%.

The Act also doubled the federal estate and gift tax exclusion amount from $5.6 million per person to $11.2 million per person. With portability (the passing of a deceased spouse’s unused federal estate and gift tax exclusion amount to the surviving spouse), a couple will be able to pass up to $22.4 million during life and/or at death tax free.

Another change under the Act impacts like-kind exchanges under I.R.C. §1031, commonly referred to as 1031 exchanges. In the past, taxpayers could defer gain on the sale of property (including, but not limited to, real estate, equipment and livestock) held for productive use in a trade or business if such property, or the proceeds from the sale of such property, was exchanged for like-kind property to be held for productive use in a trade or business. The Act has limited the application of 1031 exchanges (like-kind exchanges) to only real estate for tax years beginning in 2018.

Despite the numerous tax changes under the Act, the guiding principles surrounding farm succession planning will, for most Pennsylvania farm families, remain unchanged. It is not recommended that farmers rush to form or convert to corporations; limited liability companies, taxed as partnerships, will continue to be the entity of choice for most farm businesses. As in the recent past, federal estate and gift taxes will not be a concern for most Pennsylvania farmers. Instead, the impetus for farm succession planning will continue to be: the desire to pass the farm business to the next generation, fair distribution of assets among on-farm and off-farm children, preservation of assets from potential nursing homes costs, the potential impact of divorce, and tax considerations, including stepped-up basis.

The Difference Between Probate and Non-Probate Assets

By: Jacob H. Kiessling, Esq.

In the typical farm family, the parents’ estate plan is as follows: Farm assets to my farm son, Andrew, and non-farm assets in two (2) equal shares to each of my non-farming children, Susan and Charlie. While the intentions are clear, and while the wills that are prepared are clear, it is not guaranteed that such intent will be carried out. What is not clear is that, in such a situation, the will is often times not enough — it does not dictate where every asset will go in the event of someone’s passing. It is a common misconception that a will dictates where the entire bounty of one’s estate will pass. In reality, a will only provides for the disposition of probate assets, and has no bearing over the disposition of those assets which are considered non-probate assets.

Probate assets are primarily those that are owned solely by a decedent in his or her individual name and contain no beneficiary designation. These assets are subject to Pennsylvania’s intestacy laws (laws which the Commonwealth prescribes for the distribution of assets upon death) and require a will directing distribution in order to avoid such intestacy statutes. Examples of probate assets are business entity interests (e.g. LLC interests) and personal property (e.g. machinery), as well as bank accounts and real estate owned solely by the decedent. Additionally, nonprobate assets (defined below) can be considered probate assets if they name the decedent’s estate as the beneficiary.

Non-probate assets are those which bypass the intestacy laws and the need for a will and go directly to predetermined and designated beneficiaries. These assets include real estate or personal property that is held as joint tenants with the right of survivorship or, in the case of married couples, as tenants by the entirety. Further examples of non-probate assets include retirement accounts, life insurance, jointly owned bank accounts and investment accounts which are either jointly owned or which have payable on death (POD) or transfer on death (TOD) beneficiary designations.

The distinction between probate and non-probate assets requires a comprehensive understanding of an individual’s entire estate and a joint relationship with one’s attorney, accountant and financial advisor to ensure all assets pass as intended upon one’s death. For example, assume a surviving spouse has $2,000,000 of farm assets and $300,000 of non-farm assets held in an investment account, but with the three (3) children named as beneficiaries of that account. Only the farm assets are probate assets, all of which will pass to the farm son, Andrew. Nothing will pass under the will to Susan and Charlie. Each of the three (3) children will receive $100,000 as beneficiaries of the investment account. In the end, Andrew will receive $2,100,000 of assets and Susan and Charlie will each only receive $100,000 instead of the $150,000 they were intended to receive.

estate planning young families

The Importance of Estate Planning for the Younger Generation

estate planning young families

By: Jennifer Denchak Wetzel, Esq.

A successful transition of the family operation and assets to the younger generation is a significant accomplishment, typically marked by a great deal of time and effort. Upon execution of the plan, the older parent generation is generally provided with an estate and elder law plan that, assuming no significant changes, should last for the rest of their lives. Throughout the farm transition planning process, the advisors (being an attorney, tax preparer, lender, financial advisor, etc.) normally represent the parent generation. However, if the transition is successful, the younger generation could definitely benefit from their own assistance, whether involving lending, tax planning and/or estate and business planning matters.

The typical next generation farmer is in his/her 30’s or 40’s, married, with young children, asset rich, cash poor, and in substantial debt. Although it is easy to focus on the needs of the business, of which you are now the owner, it is important to consider whether your family and business will be taken care of in the event of your untimely death. You do not want to lose what you have just worked so hard to obtain.

First, as a young parent, one of the most important things you can do to protect your children is to execute a Will that provides for a guardian in the event of your and your spouse’s deaths. For example, your closest kin may not be the best choice given his/her age, location, marital status, etc., but may be selected by a court if no one else is designated by you.

A properly drafted Will can also provide the guidelines for the preservation of the family operation for the next generation until the time when your children reach majority and can decide for themselves whether they want to continue in the family farm business. Often times this is accomplished through the use of a trust.

Finally, most farm transitions involve an installment sale to the younger generation for some or all of the farm assets. It is important to evaluate what payment alternatives would exist in the event of your untimely death. The purchase of life insurance may be essential so that your spouse and children are not saddled with this debt.

Pennsylvania Inheritance Tax – Ag/Family Business Exemptions

By: Gary J. Heim, Esq.

PA Inheritance Tax

As Benjamin Franklin famously declared, the only things certain in life are death and taxes…but the ag/family business exemptions enacted in recent years are reducing the Pennsylvania inheritance taxes for many farm families. With proper planning and action, both before death and even after death, these inheritance tax savings can be substantial.

Practically every farm family has, historically, paid Pennsylvania inheritance taxes at some point in time. Unlike the federal estate tax with a current exclusion of over $5 million of assets, Pennsylvania’s death taxes are payable on the first dollar of non-exempt assets. With a tax rate of 4.5% for transfers to direct family members, $45,000.00 of inheritance tax is payable for a farm family with a $1,000,000.00 estate, but the ag/family business exemptions can eliminate all of these taxes.

There are three separate ag/family business exemptions that were enacted in the past five years, which can be described as follows:

1. An ag exemption for immediate family members (lineal descendants and siblings);

2. An ag exemption for extended family members (as distant as second cousins); and

3. A family business exemption that includes ag businesses, but also extends to non-ag businesses.

Each of these exemptions has different qualifications and requirements, which is why an in-depth knowledge of the exemptions by your attorney is essential for proper planning. For example, two of the three exemptions include a seven-year look-back condition, similar to the Clean and Green law for real estate tax purposes. This condition, which you want to try to avoid, is often referred to as a clawback feature that requires the inheritance tax savings to be repaid if certain actions or events occur.

The immediate family ag exemption does not have a clawback provision so there is no need to account to the Department of Revenue for what is done with the exempt assets after a person’s death. It is the most narrow of the ag/family business exemptions in terms of the eligible beneficiaries, the type of farm assets exempted and the manner in which the farm assets need to be owned by the deceased person at death.

The family business exemption, available for both ag and non-ag businesses, is the broadest in scope, but even it has limitations, such as the requirement that the net book value of the family business be less than $5 million. However, there are pre-death planning techniques that can expand the family business value covered by this exemption even though the collective fair market value of the family business may exceed $5 million.

If you are in the planning stages for your estate or farm succession, these ag/family business exemptions are one of many factors that need to be considered in the development and documentation of a complete estate and succession plan. Similarly, if a family member of yours has died within the past four to five years, and the estate attorney or other advisers did not utilize these ag/family business exemptions to reduce the Pennsylvania inheritance taxes, there may still be an opportunity to do that because a refund request can be made for inheritance taxes for a period of up to three years from the date of final payment or determination of tax.

Mette, Evans & Woodside attorneys are knowledgeable about these ag/family business exemptions to Pennsylvania’s inheritance tax, as well as the many other tax and non-tax factors to be considered for your estate and succession plan and to settle the estate of a family member with farm or other family business assets. They are able to assist you with these and other legal matters.

Agricultural Production Contracts

By: Melanie L. Vanderau, Esquire

Agricultural Production Contracts

The use of formal contracts in agricultural production, including crop growing and livestock production arrangements, has been on the rise in recent years. If you find yourself wondering whether it’s worth it to have a formal agreement in place in a production relationship, remember that the purpose of a formal contract is to minimize risk. The more certainty you have in place by clearly agreeing to terms in writing, the easier it becomes for you to manage and plan for risks to your business when entering into the production arrangement.

The best way to minimize risk is considering what you’re expecting out of the production arrangement and evaluating the proposed contract terms accordingly. Ask yourself some questions about how you want the relationship to play out and then consider how, if at all, those terms are treated in a written agreement. For example:

Pricing: How is the price of the product determined? Is the price based on a market price? If so, what market is used? When does the determination of market price occur? Who bears the risk of a fluctuation in market price? Do you want to have a minimum price built into the agreement to limit your risk of market fluctuation?

Payment: How are you expecting to get paid? Upon delivery? Will that be invoiced? How soon to you expect to receive payment after delivery? What happens if the payment is late? If they stop paying you, how do you get out of the agreement?

Quality: What quality standards are in place for the product? Are these standards objective third-party standards, like the USDA or the FDA? What happens if the product delivered does not meet the quality standard?

Delivery: Who is responsible for delivery? Who bears the risk of loss if the property is damaged in transit? If you bear this risk, is this loss covered by an insurance policy?

Cancelation/Termination: Is the term of the Agreement clearly stated? What procedures are in place to terminate the agreement early for each party? What is the impact of such termination? What happens if there is a default by either party?

Catastrophic Events: What party bears the risk for a catastrophic event outside of either party’s control? Avian flu, insect outbreaks, and catastrophic weather are all events that can drastically impact your ability to produce, depending upon the nature of your agreement. Does the agreement contain provisions that relieve you of your obligation to produce upon the occurrence of a catastrophic event?

Agreeing to clear terms like these allow you to manage your risks in connection with the production arrangement. While a written agreement may seem unnecessary at the outset, remember that it’s only when something goes wrong that the existence and terms of a contract become critical. That’s why it’s best to think about and plan for these issues at the beginning, when you can still take the time to manage and minimize your risks.