This is part three of a five-part series concerning the authors’ view that agricultural estate planning in this country is broken and needs corrected, particularly in light of “Farm Estate Armageddon” which will happen this decade when ¼ of all farmers retire and 2/3 of all farmers will be over 65. Previous articles can be viewed at farmlegacy.blogspot.com.
Why is farm estate planning so different from other businesses? Well, to answer that question, we have to break it down and compare farming, in general, to other activities. Perhaps one of the most glaring differences between farming and other businesses is that farming is a “high and low income” profession. Two years ago, before grain prices rebounded, I asked a lender what he saw as the rate of return on assets for farmers. The answer was 0.3%. Not three percent, but 1/3 of one percent. Not exactly a comeback that would be the envy of Wall Street. USDA studies show that over the past fifty years, the rate of return on farm assets (excluding land appreciation) was about 3%.
Now let’s look at other professions. Consider a lawyer, accountant, appraiser, or similar white-collar profession. These three professions can easily generate $100,000 in income per year. From an investment perspective (excluding the initial cost of schooling), the scope of assets needed is roughly limited to a desk, telephone, computer, and printer. In fact, a professional in one of these professions could do well with $10,000 or less in investment in hard assets, earning a 10% return on assets.
Consider emotional attachment to the land (I’ve never seen a lawyer, accountant, etc. emotionally attached to their desk, phone, or computer), generational history of the farm, and other factors, succession planning for agriculture is vastly different than for non-farm businesses.
It’s the sheer volume of assets a farm typically has that disrupts succession planning. Historically, farmers have done the following for an estate plan: a) divide all assets among all children equally or b) leave a little more assets/value to the farm heirs, but still leave the heirs not farming a very big slice of the pie. Estate plans most often lead to one of these two outcomes because farmers are looking at the value of what they are leaving to each child, which is incorrect. Farmers should not look at the value of the assets they leave to each child, but rather at the income generated by the asset. I regard this as the fundamental problem of agricultural planning in this country.
Suppose we have three children, Peter, Paul and Mary. Paul is the peasant child. The value of the agricultural estate is six million dollars. Under “option ‘a'” in the last paragraph, the parents leave equal shares for each child, and they think it’s ‘fair’ because each child gets an equal amount. However, Pierre and Marie want to sell their share. Paul wants to continue cultivating. Peter and Mary eventually sell their shares to Paul and each receive $2 million which they put into an investment account earning 6%. Every year they earn $120,000. Paul continues to farm and goes into debt of four million dollars AND has to pay a lender 3-4% or more in interest each year. Who’s the smart investor, the off-farm kids earning huge income from their inheritance, or Paul going into four million dollar debt? From an asset return perspective, Peter and Mary are the smartest investors.
Ok, but what about earth appreciation? After all, it’s been about 40 years since we’ve seen land in this country shrink in any real importance. True, but you can’t eat your balance sheet and Paul only recognizes such a gain in appreciation if he sells. And actually, Paul doesn’t even really inherit two million dollars worth of land. What does he inherit? He inherits the possibility of earning an income from the land he inherits, that is, his yield (average declared by the USDA) of 3%. Worse still, due to the undoubtedly high price at which Paul must buy out his siblings, his return will not be enough to fund the purchase.
The theme is always true under the previously mentioned “b” option. Even if Paul receives, say, 50% of the farm’s assets, he still has to buy out his siblings for three million dollars, go into debt and pay interest to the lender on that debt. On the other hand, the siblings are given three million dollars, or 1.5 million each, and can invest and earn a lifetime of income from the investment. The bottom line is that parents think they are “fair” when looking at asset value, but for those who don’t want to sell, asset value means nothing. Cash is king and the focus should be on cash return.
Let’s take it a step further and really talk about “fair” and in our example, let’s assume that Peter and Mary never helped on the farm, contributed capital or otherwise. How “fair” is it that the person (Paul) who worked on the farm, contributed capital and wants to keep the farm for the next generation, goes into debt while the people who never helped can basically receive a very large 401,000? This situation usually only occurs in agriculture. When you look at a lawyer, a dentist, an accountant, and a host of other professionals, you don’t see an uninvolved brother getting great value from the company. Why? Well, a) often the real value of the business is the professional themselves, b) the son or daughter taking over the business could start their own business and most, if not all, of the volume of business goes with them and c) the company’s liquidity is low. Do you think many professionals or other business owners “reward” non-participating kids with a good chunk of the business? The answer is usually no, but it tends to be a trend that still happens repeatedly in the agriculture industry.
The primary reason current farm estate plans (or lack thereof) are flawed is that it is the value, not the income generation of assets, that is examined and insufficient value is given to the efforts of child farmers. . . It is almost impossible to achieve the “right” without a change of perspective on these two issues.
Need we even mention that with the high price of land, machinery, etc., unless a child farmer receives some level of inheritance (like a very large majority of assets), it is impossible for this child to continue cultivating? Unfortunately, the higher the price of land and equipment, the less likely the continuation of farms simply because it is impossible to redeem non-farming heirs.
So here is. If we are going to fix the way farm estate planning is done in this country, we need farmers to focus on the income, not the asset value, of what they leave to their heirs and give more credit to children who participated in the farm. If that were to happen, it would sustain many, many more farms. In the next article, we’ll start discussing the different ways to make these changes.