Farm Table says:
This article introduces the concept of profit interest as a planning tool. The author doesn’t explain the intricacies of a profit interest, but states that it boils down to:
It lets your children earn ownership of the farm through their sweat equity. Many of my clients have worked hard for everything they have, so they like the idea of their children earning the farm while providing a tax efficient way to transfer it to the next generation. The basic premise is that the children earn their ownership by working in the farm business.
How does it work? If you are farming in a partnership (most commonly a limited liability company [LLC]), you can allocate the profits and losses among the members.
The author provides the following example:
- Frank is Nathan’s and Eric’s father.
- when Nathan and Eric decide to return to the farm and help their dad, Frank gives each son a 20 percent profit interest.
- The farm is valued at $1,200,000 and profits are historical $130,000 per year (assume 3 percent growth in profits per year to keep up with inflation).
- Frank takes distributions, but Nathan and Eric only take out enough to cover their tax liability.
- The children will take on a gradually increasing role in the farm.
- However, the children have a choice each year: They can take a distribution of the profits or opt to keep them in the farm partnership.
- If they opt for a distribution, their ownership percentage does not change (they are pulling out the earned equity).
- If they opt to keep the profits in the farm partnership, they effectively contribute money that increases their ownership percentage.