Family Farm Ownership Transitions: The Dangers of Sweat Equity

It’s an all-too-common scenario — father farms, a son comes home to farm, other siblings leave the farm.

The generation starting to retire now is really the first generation where it was common for them to seek other employment and not return to the farm. But generally one family member returned and relied on the concept of sweat equity to build his life.

How sweat equity works in family farms

For most of this generation, Dad “retired” at a reasonable age and a son put everything he has into improving the operation, from investing money and time in addition to heart and soul. Formal partnerships are not established, and things are run on trust and short-term concerns.

Son builds the operation up, often under the guise he’ll eventually benefit from it all. Sometimes the equity gained through the son’s work is used to continue to purchase land and equipment in the father’s name. The son doesn’t take a formal wage, but kind of an as-needed distribution from a line of credit. And then something happens — the father dies, perhaps the son dies, or a sibling starts to create a problem and things begin to fall apart.

Strategies for improved family farm ownership transitions

How can all this be prevented? While the risks cannot be entirely avoided, they can be significantly mitigated with:

• Clear and open communication
• Documented arrangements
• Dealing in cash transactions instead of sweat equity

Clear and open communication among farm families

When looking to improve communication, start with these questions:

• Does the next generation rely on real information or assumptions?
• Are they privy to the business finances?
• What if the debt load is so high Dad will never be able to retire and transition?
• If parents want a particular child to take over the business, are the other children aware?
• Are there preconceived expectations that should be addressed in advance of potential problems?

Lay your cards on the table and do it early. Let your children know about the opportunities and risks. For example, assume at age 40, a child goes to his father — who at the time near age 65 — and asks when he’s going to retire. The answer is he’s not and views his child as the “best hired hand he ever had.”

There’s no plan for the son and he didn’t know it. He had plans to expand, to do things differently, and because Dad is in control, he now cannot pursue his dreams. Work with each other to expand the business not as family but as partners with everyone pushing in the same direction but being open to each other’s opinions as equal partners in the business.

Advantages of formal documentation on family farms

Write down the rules! If you are partners, form an actual partnership. Talk about what’s required for a vote. How are decisions made when partners have different opinions?

Children whose parents make decisions for them well into their working years can struggle. Involve your children in decisions and the business structure.

A formal arrangement also requires some capital investment on both parties. Dad should not finance the operation, and the child should have some skin in the game.

The importance of documentation in estate planning

Documentation is extremely important when a parent passes. The operation itself may be owned somewhat by the son, but what if the land is still owned by his parents? What happens if siblings inherited the land equally and want to sell?

Structure it so the farming heir is protected from losing the business due to issues with siblings. Do you want the heir to have the ability to crop share into perpetuity? If siblings are to be bought out, how would payments be structured? Must a land sale require a majority vote greater than 50%? If a sibling wants out, can they take a reduced price? Document all of these factors in an operating agreement.

Sweat equity versus cash — pros and cons in family farming

You cannot spend sweat equity. Nor can you learn to manage it. Working hard for future rights and contributing to building a business without expecting cash is a wonderful and commendable concept —it’s just not practical.

A sweat equity example in family farming

For example, the son comes home and decides to farm “together” with Dad. Dad owns all the equipment and land. The son pays for his half of the inputs but is allowed to use the equipment in exchange for his sweat equity and they work out a crop-share like arrangement.

The son does not take a paycheck. When he needs money, he takes a draw from the farm or a line of credit he and his wife maintain in their own names. The business succeeds and grows and prosper — especially Dad’s financial statement. He trades equipment more often and gets bigger pieces, buys more farms in his own name, and his estate grows while his son essentially lives paycheck-to-paycheck (or line-draw-to-line-draw).

The son has no clue what it’s like to manage his personal finances, has few assets in his own right, and no retirement savings. His family is 100% reliant upon Dad. Dad’s will may say when he passes, his assets are split equally among all his children — and herein lies the problem.

A formal partnership example in family farming

Imagine the alternative where Dad and son form a formal partnership. Dad contributes his equipment and son contributes a nominal amount of cash.

Ownership is unequal at formation. Son does 100% of the work and gets a guaranteed payment every month in a set amount as his wage and a percentage of the profits equal to his ownership interest.

Dad and son agree over time, son will buy additional partnership units from Dad for cash that comes from the guaranteed payment. The partnership agreement documents how the units’ value are determined and gives the son the right of first refusal to purchase additional units and an agreement on the payment terms.

The son and his family must figure out how to live on his monthly paycheck and can also use the excess cash to purchase farmland of their own or save for retirement. At Dad’s passing, the equipment and operation problem is handled and there are many ways to deal with the land issue. The son continues to farm and pass the business on to his children.

How we can help

Formality and open communication are often barriers in production agriculture. Farmers are not fans of paperwork, but they should be, as the lack of it often creates issues at transition and succession. Review how your farm operation is structured and how the next generation is being handled. It may be time to reevaluate and account for the equity being built in a currency other than sweat. CLA works with many family farms and other business owners on succession planning. Explore the many ways we can help provide a smoother transition.