FARE-talk is to provide an enduring conversation about contemporary topics relevant to food, agricultural, and resource economics.
Farm Succession Planning: Reflections and Suggestions - May 11th, 2012
Brady Deaton Jr.: Welcome to FARE Talk, where we set out to provide enduring discussions on contemporary topics relevant to our economy with particular emphasis on food, agriculture, and the environment. My name is Brady Deaton, Jr. of The Department of Food, Agriculture, and Resource Economics at The University of Guelph. I'll be your host. My guest today is Jennifer Stevenson, she works for The Ontario Ministry of Agriculture, Food, and Rural Affairs as The Business Finance Program Lead. She is very involved in supporting farm tax and business seminars, as well as ongoing efforts to enhance the capacity of farmers to develop succession plans. Jennifer, welcome to FARE Talk.
Jennifer S.: Thank you.
Brady: I recently heard you speak in Fergus about succession planning, particularly as it relates to the agriculture sector, and it was really interesting to me. I hadn't read that much research on it, but I was aware of the issue, and I was hoping that we could explore that in today's conversation. So, just to kind of get the ball rolling, talk to me a little bit about your role with the ministry in looking at succession planning?
Jennifer: Actually it's a recent role that I've taken on, as one of my colleagues went to a different role. But what I'm seeing in talking with producers and producer groups, is that succession planning is definitely top of mind. There's a lot of concerns, and there's concerns most on the technical side, because there's obviously some tax implications, but also on the human dynamics side.
A lot of people have, shall we say, a reluctance to talk about the human dynamics problem. So what I try to do is demystify that, bring it right out on the table, let's talk about it, and having them recognize that they all really share the same kind of problems, and also to find some solutions, maybe sometimes some out of the box solutions, to those problems.
Brady: Breaking down this whole idea of succession planning, when I hear it talked about and when you talked about it, there always seems to be two kind of components to it. The succession planning, which is about the business of farming, and passing that to the next generation, and the estate planning. Are those important or what do I need to understand about those two?
Jennifer: Yeah. I don't know if you remember when I actually gave that seminar, but one of the things I said right off the top is you've got to separate wealth from income, because the thing about farming is that most farmers actually live where they work. So, their wealth is actually tied up into their business, as well as their home, and a lot of that wealth has been accumulated on what I call an emotional basis. Meaning, that's where you've raised your kids, that's home, that's comfort.
So, what you have to do is be able to separate the business assets from those emotional or home type assets. Look at what's really generating income, as opposed to what's accumulating wealth over the course of the business? If you take a look at farm wealth in particular, I mean let's be honest here, we'll talk about land assets. They have tended to appreciate to a higher degree than has the S&P 500. So, there's been a fair accumulation of assets within the agricultural community.
So, you're talking about a substantial amount of wealth that's been accumulated, so when you're looking at the next generation coming in, you have to ask the question, "Are they ready to take over the wealth? Are they capable? Are they able to get financial backing?" Let's say from a traditional source, let's say from a financial institution like a bank or whatever. If they're not, what do you do? Are you able just to gift it? Or, do you have to look at some other scenarios? I think that's the big problem out there.
Brady: Right. So, I mean, and then that probably gets into the emotional sensitivity. If you think about a farmer thinking about a succession plan, but also thinking about how they're going to deal with their estate, or bequest their estate, and they're looking at land as you mentioned, as one of the big, if not the biggest item, they're often dealing with children that are both active potentially on the farm operation, but then often times a lot of children that aren't on the farm.
Jennifer: Well also, what you're talking about is protecting assets, because we take a look at the divorce rate of being 50%, they're also looking at protecting assets from divorce. I mean, let's be honest. If you've built up this emotional capital that you've put a lot of blood, sweat, and tears in over the years, it's really hard to envision that this is going to come apart.
So, you're absolutely right. There's a lot of investment, a lot of thinking, and some people just don't even want to deal with it. They just want to avoid thinking about it. But understanding that avoiding doesn't make the problem go away, so we have to try and think of a way to get people at the table talking about these issues honestly and openly. And also bringing their stakeholders within their family, and the potential stakeholders, so that they can put these issues or ideas in a gentle sort of way, but one that will get everybody not at a perfect result, because I understand that succession planning is not a perfect process, but at least something that a compromise that everyone can live with.
Brady: One of the issues that was brought up there was a great site and I'll provide a link to it. I'll provide a link to your sites on OMAFRA as well, as links to the site I'm about to mention, which is the [Burmont 00:05:43] Extension Program, but they talk about one important aspect of farm succession planning, is these farm business agreements which in one way or another have to account for the five Ds. Death, disaster, disability, divorce, and disagreement.
Jennifer: Absolutely. Farmers have a tradition of, "My handshake is my word" so a lot of it is changing the culture to recognize that, hey, this is a business. You are the CEO of your business, so we have to make things formalized. The nice thing about formalizing an agreement is it takes the emotion out of it. So, putting things on paper, having people sign agreements is a way to be able to secure your assets, in terms of you know exactly what your rights and responsibilities are, as well as the other person's rights and responsibilities. Again, it comes down to getting that culture shift in people's minds.
Brady: Well, let's take a scenario that I imagine is out there where a farmer is in a sole proprietor situation, but they have several children. One of them who may have a handshake or an informal agreement, that they'll get the farm. If that isn't written down, and the person were to die without say a will that guaranteed the land to the individual, then I imagine that person is no longer, despite the fact that there was an informal agreement, that that informal agreement is not the formal agreement that actually occurs, and that person's in a whole heap of trouble.
Jennifer: Oh, yes, yes, yes. When I give any kind of workshop on succession planning, I say, "Hear this. If hear nothing else, hear this, that if you die without a will, what you're doing is handing over control to a person you've never met to make financial decisions on your behalf." So, it's extremely important to have a will. Also, if you're planning on bringing kids into the business, why wait? Bring them in as soon as you possibly can, and bring them into financial discussions. Bring them into the bank, bring them in when you have a discussion with your accountant. It's incredibly important to have that level of commitment and allow them to establish a level of commitment in the business.
Brady: I know land is interesting to us both, and land is so expensive, and in a lot of places in Southern Ontario, its value is not only reflective of its farm productivity, but also of its potential future non-farm activity, which makes it hard for the next generation to actually maybe afford the land at its market price. How do people account for that in their succession planning?
Jennifer: Yeah, I mean you're talking about extrinsic versus intrinsic value, and again, it comes back to wealth versus income. You've got to make sure that you can provide yourself with an income before even looking at your business plan. Make sure that the idea at the end is that there's going to be enough income to be able to provide for your wants and needs. The other thing to remember, too, is that we've been I think lulled into a certain level of complacency that the level of interest rates right now are so low that looking at the future, are they going to be this low in the future? Might not be, right?
Just looking at the past, and in fact, I was talking ... Sorry, I was listening to Dr. David Kohl who had a presentation yesterday about this issue. Said that what he called normal interest rates were only about 6 or 7%. So, if you had for instance, a mortgage at 2%, and it went to 4%, you're actually doubling your interest expense. So, I think a lot of kids coming in, or young adults coming into farming right now have to recognize that these interest rates that we're seeing right now are not "normal" interest rates, and that if they go to refinance in 5-10 years, they have to consider what that interest rate will likely be.
Brady: So, in terms of succession planning, I guess there's two ends to this. The first end is if you're the current owner looking into the future, trying to either asking yourself what you're going to do with your land, whether you're going to give it to your children or whether you're going to sell it, one of the challenging is how are you going to provide for yourself in your retirement? That's the one end, so I'm retiring, what do I do? How do I pass on this farm business? Am I going to get some share of the farm profit? Am I going to get some rent? Am I going just to hand it over? Am I going to get a job off the farm?
But then the other is if you're a child and you're about to inherit this portion of land it's, "Can I really make this farm business operation meet? What is the quality of the assets I'm about to inherit, the non-land assets? Am I going to have to make major investments in barns?" So, I guess when you put that business plan together and the succession, you've really got to have both ends of that worked on, and failure to do that really probably makes it very difficult for the farm operation to continue, and probably leads to a lot of conflict amongst family members.
Jennifer: Well, conflict yes, and that's another thing I say to people is have a disaster plan, or emergency plan in place. Because yes you can plan, put a succession plan in place, or plan to have a succession plan, but what happens if something happens? You have a medical emergency or whatnot, that the person who's currently running the farm is no longer able. So, it's important to have a long term plan, but also have an emergency plan in place, yeah.
Brady: Now, one of the things I noticed on your website, and it seems to me really important when you're dealing with trying to plan for how you're going to pass land down from one generation or own it, what form you want to own it, is a discussion of capital gains taxes. I think you mentioned it's the question you get the most often. What are maybe capital gains 101 and relate that to succession planning, if you wouldn't mind?
Jennifer: Okay. So, again, it comes down to being able to either pass your assets to the next generation or to sell them outside of the family. What you're looking at is the value at which you acquired them, so let's just say you acquired, I don't know, a farm at a million dollars. You sold it for two million dollars, so the capital gain would be the two million dollars at which you sold it for, minus the million dollars that you acquired it for, meaning net a million dollars.
So, the Canadian Revenue Agency has a capital gains exception of $750,000 for qualified farm property, so in this case, there would be an exemption of $750,000. However-
Brady: Now I'm paying capital gains on 250,000, instead of, if I-
Jennifer: Correct. So, but the thing to remember, too, is that is qualified farm property. There's a whole bunch of rules that have to be adhered to, so it's good to talk to someone who's a financial professional or an accountant who's familiar with farm property if you're [crosstalk 00:12:55].
Brady: I guess then there's situations then where the way I put my succession plan or make a farm plan agreement, that could jeopardize the ability of that land to be qualified property?
Jennifer: Absolutely. Cause I'm certainly getting a lot of calls recently from kids of farmers who they think that their parents were farmers, but in fact they were just renting out land on farm property. They're saying, "Well, do I get the capital gains exemption?" And the way that the rules work is renting out farm property's actually not considered farming income. So, in that case, it would not be qualified for the capital gains exemption, so it's pretty important to understand what the criteria is to be able to be eligible for the capital gains exemption.
Brady: Are there any, in terms of choosing the business entity, as we think about a succession plan, so I'm a sole proprietor, I can maybe move into a partnership with my children, I guess there's limited liability relationships, and there's corporations. How does that figure? Have you got any thoughts on how the business ... Is the choice of business entity a key aspect of the succession planning, or?
Jennifer: I wouldn't say it's a key aspect, but it's definitely something you should think about if you're a sole proprietor, and you want to pass the farm onto one of your kids. Certainly you want to think about business strategy or business structure. You want to think, "Well, do I want to bring the child in and perhaps transfer some of the assets to them in a partnership? Do we want to establish a corporation?" The thing to remember is that there's tax implications on each of the business strategies.
For instance, in a partnership, you have to declare all of the income. You have to actually take all the income for the year, whereas in a ... For a corporation, sorry, what you can do is defer some of the income. I'll give you an example. Let's say a farm makes $100,000, okay? And you had two partners, each with 50% partnership. Each of those partners would have to take in $50,000 of income. However, if it was in a corporation, and that corporate farm made $100,000, the farmer would have a choice to take a salary of 0 to $100,000.
So there's a little bit more flexibility in terms of how much income you could recognize in a corporation, as opposed to a partnership. But what I say to farmers thinking about this is don't just look at the business structure, and don't just look at the taxation aspects of it. What you have to look at is what you're trying to do with the land down the road, because in a corporation for instance, it's a lot more difficult to be able to realize those capital gains exemptions, because a corporation is not eligible for the capital gains exemption. Only an individual is.
So, what you actually have to do is sell the shares of the corporation in order to be able to get that capital gains exemption. Again, there's things that people have to be aware of and it's important in your decision-making to bring some of those financial advisors or accountants, bankers, whatever, into the conversation so that you're well aware of all of your opportunities or all your choices out there.
Brady: What are the expertise you want to bring to the table? What are the ingredients of putting together a good succession plan in terms of people? Sounds like an attorney is needed.
Jennifer: Yep. In a lot of cases, an attorney. Certainly if you want to get a will together. You probably want to talk to your accountant, be able to get things like cash flow statements or projected cash flows. You probably want to talk to your banker to see what sort of line of credit, or what sort of credit can be extended to the next generation. Again, you might want to talk to some farm advisors to see if there's any way that you want to look at some of the scalability of your existing farm, and any expansion potential or changing in farming practices, to be able to accommodate the next generation. There's a whole host of people potentially you can bring to the table.
Brady: Now, from your experiences or from talking to people, it seems to me like one big scenario, and we talked about that earlier, is a situation where you have one child who wants to work on the farm, but you have all of these other children who may not, and then you're trying to deal with the ongoing farm business versus selling the land and dividing up the proceeds from that. Are there any kind of ways you've seen people creatively deal with that issue?
Jennifer: Yeah. Well, one of the things I do mention is that you don't have to be equal to be equitable. So, you can look at things like for instance, insurance might be one way. I heard of one farmer in Eastern Ontario who decided that what he would do is give his children who didn't want to participate in the farm each $100,000 as kind of a kick-start to their careers or whatever, and that the child who'd stay on the farm would actually get the farm assets, and they would also get some sort of assets when the parents both died.
So, there's different ways of looking at it. There's also some trusts that could be set up to be able to pass down some of the farm profits to non-participating children. Again, it depends on what the parents want to do, how much the parents want to be equitable or equal. It's also tough when you have the interests of spouses of kids who suddenly come to the table and might not have the same values as the kids or as the farm family.
That's what I talk about, is that a lot of times it comes down to ... How should I say? Accommodating different people's values, and how much you want to be accommodative, how much you want to have peace. Because for a lot of people, having that Sunday dinner with everybody around the table is really important. So what I say is, can you put a price tag on that? Are you prepared to put a price tag on that?
So, those are the kinds of questions you have to ask, because again, there's an emotional component to it that you can't necessarily integrate as you would with other types of businesses.
Brady: So, you mean that the harmony that whatever your decision has to be, if there's not harmony there, then it can really come back to bite you and you may not be having Easter dinner in a year or two together. That's quite a challenge, isn't it?
Jennifer: It is.
Brady: I guess the temptation would be just to put it off.
Jennifer: Well again, that's a huge temptation, right? But the temptation of putting it off can be offset by saying, "You know what? If you don't control it, somebody else will control it." So, it's a good idea that at least you try to work it out, and no, it's not going to be perfect, and yes, it's probably going to take a lot of time. It might even take a few iterations, but it's worth the effort.
The important thing is to get people around the table as soon as possible. Meaning that at least people, if they feel like their voice is heard right from the start, and they feel like they have a stake in it, they're less likely to jump in afterwards and say, "I hate what you're doing" or, "I really don't agree with what you're doing." They're less likely to do so, so it's really important to get people started, get them involved, get them invested right from the beginning.
Brady: Jen, for the last time we spoke, we talked about some ideas that you were percolating and thinking about that might not be so well known, but might enhance succession planning for farmers. I wonder if you can just talk to them a little bit?
Jennifer: Okay. So, what it really comes down to is having a big enough pool of money such that it can support the ongoing business as well as the exiting parents. So, one of the ideas that I've been talking to farmers about is bringing in potentially a local investor from outside the family. So, maybe you've got let's say a family who've they've got a job outside. They're not a farming family, but they're really interested in farming. They'd like to make an investment in farming, and hey, maybe they even have some management expertise.
So, they might be brought in to make an investment in the farm so that it would ease the burden on the incoming farmers to be able to raise enough capital to be able to pay the parents for the assets of the farm. So, I'll just give you an example. Let's say the parents need a million dollars in order to get what they need to be able to retire, and that the incoming, the new generation, goes to the bank and they can only get funding for $250,000.
That leaves a deficit of $750,000, but let's say that there's, I don't know, a doctor and his wife who happen to live on the next concession over, who are really interested in farming, really believe what the family's doing, and really believe in what their goals and aspirations are, and want to invest in that farm. Maybe what they'll do is invest $750,000 into that farm, and it allows the outgoing generation to have enough money to retire, and as well, it puts less of a financial burden on the incoming generation. Because they have some liquidity, plus they have some potential management expertise coming onboard.
Another idea is the use of long term leases. Typically we think of leases, we think of, I don't know, one, two, three years. What happens in the farming community the lease rate tends to be tied to the price of commodity. So, we see commodity prices go up, and then all of a sudden you see, "Oh, these prices go up." So, one of the ideas that I've been talking to farmers about is don't just look at it as a one, two, three year event. Look at it as maybe a 20 year event, a 40 year event, and then tie the escalator clause to something absolutely unbiased, like for instance, core CPI.
Meaning that when food prices increase, then the CPI would increase, which means that they would have potentially a bit more money coming in because the food prices increase, therefore their profitability would increase, so it helps both parties. But also, the interesting thing about having a longer term lease means that you can actually bequeath it to the next generation, so you would have land rights potentially for a 40 year period. Meaning that you would have a better understanding of the land, you'd have more ties to the land, better potential for good water and land stewardship, because that effectively becomes your land without owning it. So, separating ownership of land and the control of land.
Brady: It's interesting because in some ways, these leasing ... Already a good portion of land, of course, is being leased. So, what you're recommending in order to create greater surety, I guess, and for people that are actively using the land, is to explore the option of longer leases.
Jennifer: Exactly, because it's almost like owning the land. If you know that you have access and control of that land for 20 years, I mean, it's as good as owning it. What you're also taking out of it is that speculative value. What you're saying is you're basically having surety of the intrinsic or the farming value, as opposed to the speculative value.
Brady: Do you think landowners, there are landowners out there that would be willing to do that, to make these long term leases?
Jennifer: I've certainly spoke to landowners who are open to that, because what it does is actually provides them an annuity effectively that's tied to inflation. So, it works for both parties.
Brady: That's great. So that would do two things, I guess. It potentially could provide liquidity to the people who were retiring, some kind of payment. Then, it brings expertise and I guess some ability to deal with any debt or new investments that had to be made on the farm. That's interesting. Okay, Jennifer. Thank you so much for joining us today. We will make all the links that we've discussed available and on our website, and thanks so much for joining us.
Jennifer: Thank you so much. It's been great being here.
Brady: Thanks for joining us at FARE Talk. We hope that you will continue to check our website for updates and the latest podcasts.
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