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LLCs and Operating Agreements: Should a farmer go to the trouble?

LLCs are easy to form and very flexible. Because of this, writing an operating agreement can help a farmer think through all the details of how to address investments, profits, and losses. Good bookkeeping is also important to optimize a farm’s tax situation.

What’s the situation?

Farmer Espen formed his business as an LLC so he can protect his personal assets from liability. The filing process was pretty easy, and Espen is headed into the farming season with the hope that he won’t have to mess with business entity stuff much longer. He’s hoping to get on with his real business: growing great food.

Where does the law come in?

Filing as an LLC isn’t necessarily the end of the line when it comes to a farm’s business entity. Like we discussed earlier in this blog, a farmer does need to maintain the separation between business and personal in real life, and not just on paper. In addition, Farmer Espen should write and follow an operating agreement and keep good records to optimize his income tax situation.

Details, please:

So what’s this operating agreement and why would Espen need one? An operating agreement is a document that governs how an LLC is run. It can take several pages to lay out how the business makes decisions, who gets how much profit, when the profit is distributed to the members, and when the members will be required to invest in the business. Although some states do not require LLCs to have an operating agreement, the document is highly recommended, particularly for LLCs with more than one member.  

It’s easier to understand an operating agreement if you see one. Check out the two sample operating agreements here. Please note that I can’t assure you these forms meet your state’s legal requirements. Also, the forms are long and complex and I’d hate for that to intimidate blog readers: Please take these forms with a grain of salt.

If you do take a look at the operating agreement above, you might notice that some clauses appear to state the obvious while others are incomprehensible. Why? Is the form all some silly formality? Why go through the process of writing this thing? Why not just make these decisions as you go, depending on how the farming season shakes out? We all know farming is unpredictable and flexibility is key, after all.

There are some good legal reasons why Espen should take the time to write out an operating agreement. First, a farmer’s state law may require the LLC to have one. Second, taking the time to figure out how your farm will run and then sticking to that plan will help you prove to a court that your farm and your personal assets are truly separate. Yes, some of the phrases are formalities. But when you think about it, the separation between farm and business (which Espen is depending on) is itself a mere formality. Formalities can be important.

An operating agreement is wise because an LLC is a flexible business entity. Although we’ll get into corporations in later blog posts, right now I’ll just say that a corporation needs to follow certain laws that define who can receive what kind of profit from the business. With an LLC, the members have to decide. While it’s great that Espen can set up his farm to meet his precise situation, Espen and his partners have to talk each of these issues through and make a lot of decisions. Because of the variability, writing things down is really important if you want those agreements to have any force.

So, Farmer Espen slogs his way through an operating agreement, hammers out a process with his mother, who is investing in the company, and his friend Sally, who is helping him with the farmers’ market side of the business. All the decisions are made and everyone knows what to expect. Great! Is Espen done? Well… no. Soon enough, Espen is going to have to file income taxes for his farm. An LLC can choose to file taxes either as a sole proprietor/partnership (depending on whether Espen is the sole member of the LLC or not) or as an S corporation.

Many farmers struggle with the decision of how to file their taxes. The first and best thing I can say to this topic is that there isn’t a right answer. Neither option is necessarily the best option. Neither is certain to save Espen money compared to the other. The right choice will depend on whether Espen makes a profit, how much profit, what he’d like to do with that profit, how much income he wants to pay himself or other members, and what his ownership and investment situation is on the farm. The best way for Espen to make this decision is probably to sit down with an accountant who can take a close look at Espen’s financial situation. Even if Espen happily keeps his own books and files his own taxes, a few hours with an accountant might be money well spent. If Espen finds can bring neatly organized spreadsheets or workbooks to the meeting, Espen will walk away with a clear understanding of his tax filing options without having to spend much money. It’s more likely the quality of a farmer’s bookkeeping than their choice of tax filing status that will help him or her save money.
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