In earlier sections we looked at some of the pros and cons associated with parents selling or giving farm assets to their children. Here we'll look at some of the pros and cons of leasing farm machinery and equipment and farm real estate to children. Let's look first at machinery and equipment leases.
In an earlier section we discussed several potential problems with selling or giving away machinery and equipment. Perhaps the most troublesome is the fact that upon sale the total gain is taxed in the year of sale.
Some families might prefer to lease their machinery and equipment to their children. This eliminates income and gift taxes on a sale or gift. It allows the parents to maintain the financial security of ownership. The lease payments are taxable income to the parents, but since they are unearned, they are not subject to social security tax and do not reduce social security payments. A lease allows the children to control the machinery without tying up a lot of money in machinery.
However, machinery leases are not without problems of their own. Frequently the children don't feel they can pay what the equipment is really worth. Sometimes parents can "help out" and make it work, but other times this is a sign that the children really don't have a financially viable operation. (See Part I)
Machinery repair, replacement, and insurance are major considerations in machinery and equipment leases. Who pays when the engine blows or when the machine wears out and must be replaced? Who pays the insurance? Maintaining a line of equipment is very costly, but not optional, if the business is to continue.
Parents frequently find that after several years of leasing, their machinery and equipment have little value. Sometimes the children face the prospects of replacing a whole line of machinery but again find they cannot afford it. Both families "lived on depreciation," and the children still don't have the financial resources to replace the worn out equipment line.
Usually, the children leasing the machinery assume all of the costs associated with maintaining and replacing it. When an item breaks, the children fix it or have it fixed. When it is time to replace an item, the children purchase the new item. Over time the parents own less and less machinery so the lease payment goes down. The children own more and more machinery.
Sometimes parents are financially able to assist the children at trade-in time by giving them or selling them the old machinery at a low price, prior to trade-in.
A machinery or equipment lease can solve some of the tax problems associated with sales. However, it cannot solve the basic financial problems of an operation that isn't financially viable to start with.
It takes time to establish a reasonable lease value. Usually the annual lease payment will range from 10-25% of the fair market value of the leased property. An equipment dealer or an appraiser may help you determine fair market value. Many factors can come to bear on the lease payment used in a particular situation.
In the past, parents frequently sold their farms to their children. However, we are dealing with higher valuations, higher interest rates, and more complex tax issues than in the past. Families are still looking for ways to transfer the farm from parents to children.
For many families, there comes a time when control of the farm should be turned over to the children. A simple year-to-year lease meets part of the need but provides little security to the children on the farm or their lender. A multi-year lease gives children more security than a one-year lease.
Here we consider how a long-term lease might work as an alternative to selling or giving away farm land, or as a temporary method of operating until the time is right for a sale or gift. When we say "long-term lease," we are thinking of a farm lease that spans 3 to 8 years, although the actual length is somewhat arbitrary.
For our purposes, it makes little difference whether it is a cash lease or share lease. However, the type of lease used may impact self-employment tax payments, Social Security benefits, and federal estate tax options, so consider the type of lease carefully.
A long-term lease usually fits best after the children are on the farm long enough for the parents and children to be reasonably satisfied that the children are going to farm.
Parents and children generally should not enter into a 3 to 8 year lease immediately after the children finish school and start farming full-time. Leases work best when the children have been on the farm for several years, the relationships have stabilized, and the children have acquired substantial chattels.
Normally, the children's financial position has reached the point where there is serious consideration of selling or giving one or more farms to the children. The parents are ready to make a long-term financial commitment to the children, but for whatever reason(s) a transfer isn't appropriate now.
A 3 to 8 year lease encourages stability and encourages children to plan for an ongoing operation. The children leasing the farm can purchase equipment, plan rotations, borrow money, maintain fertility, maintain the farm, and so on, with the expectation of farming it for several years.
You can set up the lease to provide some continuity through the death of one or both parents. For example, if the lease is binding on the parents' (owners') heirs and the child has a lease with 3 more years remaining when the child's widowed mother dies, the child has at least 3 more years on that farm. That gives time for planning and possible negotiation with brothers and sisters.
An intermediate-term lease can provide the children several years of continuity beyond the parents' deaths. If that seems desirable, consider providing that the lease is binding on the landlord's heirs, executors, administrators, legal representatives, successors or assigns.
The lease might also provide, for example, that at the time of the last parent's death the lease would automatically extend for a period of time. You could write it so it always extends 3 to 8 years into the future until it is terminated. For example, each year when it is renewed, the renewal could extend it for another 3 to 8 years. However, if there are problems or disagreements, both parties would be stuck with one another for several years.
There are some other possible advantages besides providing continuity and stability to the children's operation. Leasing avoids some of the income tax which, as we discussed earlier, may be substantial if the property is sold. It provides a mechanism for children to progress until a sale becomes more appropriate or the parents die.
Leasing has two particularly important advantages for parents planning to retire. Both advantages hinge on farm lease payments not being considered earned income unless the landlord is "materially participating" in the farm operation. "Material participation" is discussed in some detail in the "self-employment" chapter of the Farmer's Tax Guide.
First, lease payments received by a landlord not "materially participating" are not subject to self-employment tax. Secondly, receiving farm lease payments will not reduce a farm landlord's social security benefits, unless the landlord is under age 70, "materially participating" in the farm operation, and has earned income in excess of certain limits.
If non-farming children inherit part of a farm subject to a multi-year lease, they will have some time to get used to the idea of being a landlord. This may help them look more favorably on the possibility of continuing as landlords beyond the term of the existing lease.
Leasing farm property from parents generally requires substantially smaller annual payments than a purchase. This is generally true even when the children pay the customary rates for their area. The smaller payment helps the children's cash flow, which may be important as they start a family and begin building equity in things such as machinery, equipment, livestock, inventories and real estate.
A lease also will generally provide the parents with more financial security than a sale of the farm. They would still own the real estate. They would not have to pay taxes on a sale or be subject to the risks of choosing and managing other investments. The children don't own it so they cannot borrow against it or lose it in a bankruptcy or divorce settlement.
A final advantage that can be very important in some situations is that a multi-year lease must be in writing. This should encourage the persons involved to carefully consider their relationship and to put their wishes in writing. The members of many family businesses would get along much better if they had a written lease. When the inevitable disagreements and irritations arise, a written lease may provide an answer or at least provide a method of seeking a solution.
A lease with a term of more than 1 year cannot be legally enforced unless it is in writing. A lease of 3 years or more can be enforced against persons other than the original parties (such as a new owner) only if it is both written and recorded. An abbreviated memo of lease can be recorded to avoid public disclosure of lease details.
County Extension offices have sample lease forms that may be valuable as a guide. To minimize potential problems, all families should consider what should be in the lease and then work with an attorney to prepare the final written document.
Leases aren't the perfect solution for helping children take over the farm. (There isn't any one perfect solution!) Leases are simply another option.
One of the biggest potential disadvantages of a multi-year lease is that all parties are stuck with the others for what may be a considerable period of time. It can be quite a problem if one party wants out, others will not let him or her out and the lease has another 5 years or so to run.
Try to include all contingencies when drafting a multi-year lease. Unfortunately, to consider everything that might come up is impossible. Ensure the lease is fair. Some leases unduly favor one party over the other.
For those reasons, it may be best to begin with a 1-year or other relatively short lease for the first few years and to gradually lengthen it as it seems appropriate to provide additional security to the parties involved.
At some point the farming children will probably want or need to make a substantial capital improvement on the property owned by the parents. Substantial capital improvements should not be made on the parents' real estate by the children until there is a written agreement clearly spelling out the business arrangement. The lease may specify the terms for making such improvements, or an attorney should prepare a separate legal document.