Sweat Equity

This is a topic that make a lot of farmers and ranchers uncomfortable, and yet I could talk about it for HOURS. I will try to keep it short and sweet here, but fair warning, if you ask me about this in person-I will get my soapbox and stay there for a while.

In this sweat equity conversation we are specifically talking about situations in which there is an on-farm/ranch heir. An heir is someone that will take or receive from you at your death (kids, grandkids, etc.). The on-farm/ranch heir is usually the child(ren) or grandchild(ren) that comes back to the operation with the intent to work on the operation and continue it on into the future. If you do not have an on-farm/ranch heir then this is not a completely relevant conversation, but it is always good to learn anyways.

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The first rule in this conversation is Fair is NOT Equal.

For some cultural reason, most farm/ranch families think that they must do everything equally in order for it to be fair to the children, and this just isn’t how it works. I am a member of one these families and now have children, so I kind of get it. The best illustration of this I have, I received from one of my favorite social studies teachers in high school. Let’s pretend Hattan got a paper cut and Bowen cut his leg off at the same time (scary this is somewhat plausible with these two). EQUAL would be to give them both a bandaid. FAIRwould be to give Hattan a bandaid and take Bowen to the hospital.

I start with this rule, because it is incredibly important. I have seen it repeatedly from farm and ranch transition plans that mom and dad have their interest divided equally amongst their children, even if only one is the on-farm/ranch heir and is counting on the inheritance to be the successful transition.

The second rule in this conversation is we want successful transition plans.

By successful I mean that it is transitioned and continues on in a SUSTAINABLE manner for the next generation. Not that it is all transitioned logistically and on paper, which almost every estate plan does successfully. This is that we transition the ownership and assets, but also the management in a way that allows the next generation to continue to operate as a farm or ranch well into the future.

This is also important because some families think just transitioning on paper is enough, it isn’t. The agricultural economy and the world today is much different than it was, even 20 years ago. We can debate the how and why for days, we won’t. What we will do is just work with the world as it is in this situation.

The third rule in this conversation is the on-farm/ranch heir owns a majority interest.

In almost all situations, successful transitions mean that the on-farm/ranch heir owns a majority interest in the operations at the parents’ death. Majority ownership is crucial in meeting the second rule, because without a majority interest you can’t manage the operation successfully, you don’t have the necessary control. The on-farm/ranch heir needs to control the organization in order to be able to work. If the on-farm/ranch heir has to rely on the agreement of their siblings to manage the business, it will not work long-term.

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With the rules in mind, now we can talk about sweat equity transitions. As I mentioned in the Free Legal Advice Friday, sweat equity transitions are transitions done before death to the on-farm/ranch heir. I started by just calling this compensation transitions, but sweat equity seemed to fit a little better.

There are a variety of ways that this can actually occur, and I have used different methods for different families, but all are before death using the rules. This is much easier to do logistically if your organization is a corporation or LLC, but it is not required.

[In each of the following option and following example, pretend the family has 4 kids and only 1 on-farm/ranch heir in the situation.]

Option 1 is that the on-farm/ranch heir earns 1% of ownership each year that they work on the operation. If the heir starts at age 25, then by age 50 they will own 25%. If parents both die when the on-farm /ranch heir is 65, the on-farm/ranch heir will already own 40%, then the parents’ ownership can be divided equally among the kids, giving the on-farm/ranch heir a total ownership of 55% a majority of the ownership.

In this option, the parents divide their ownership equally among their kids, allowing them to fall in line with the cultural and familial expectations. This also accurately compensates the on-farm/ranch heir for their work and dedication over four decades. All of this is accomplished, along with a successful transition of the operation.

The math in this situation can be changed to fit the family. If the family is not comfortable with the on-farm/ranch heir receiving ownership and wants to delay it, we can do a scale of transition. An example would be there is no ownership shares transitioned until they have worked 5 years, at year 5 it is 1% ownership. It could continue as 1% forever, or at year 15 we can increase it to 3-5%, it can then increase again at year 30. The math can be changed to fit the family fairly easily.

The basics of this rule are the on-farm/ranch heir earns a percentage each year, over the span of their career, and the parents’ ownership is divided equally among their children at their death.

Option 2 is that the on-farm/ranch heir is allowed buy ownership interest, at a discount, when the off-farm/ranch heirs are not allowed that option. This gives the on-farm/ranch heir the ability to create their own destiny. In this situation it is usually necessary to compensate them at a higher rate than most farmers and ranchers want to compensate employees, or are accustomed to.

Again, the on-farm/ranch heir should own enough that at the death of the parents they will own a majority. If they don’t, it is their fault and then it is fair.

This rule focuses on the on-farm/ranch heir earning the opportunity to buy interest, when off-farm/ranch heirs cannot, with the parents’ ownership being divided equally at death.

Option 3 is a mix of Option 1 and Option 2. The math can be changed depending on what the family wants or needs, but the on-farm/ranch heir would earn a defined percentage each year and then be allowed to purchase more ownership, if they choose, with the parents’ ownership being divided equally among the kids at their death.

There can be limits on how much can be purchased and it can be changed to allow off-farm/ranch heirs to purchase if the on-farm/ranch heir chooses not to.

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The above options are not the only options. This is truly limitless in what we can do, it is about what fits your operation, wishes and family. These are all the basic options I start with for farm and ranch families. Option 1 is probably my favorite for most families, with the math adjusted to fit their needs.

The right attorney will do what is right for your family with these numbers. The reason this is my favorite is that it allows us to successfully transition the operation to the next generation, the parents can fairly compensate the on-farm/ranch heir and also equally divide their ownership at death, making it truly fair.

This may require that your family operation form an entity such as an LLC, but it makes the actual estate plan much simpler and thus cheaper in the end.

If you have questions or ideas about this CALL, TEXT OR EMAIL me, I would love to chat!

Disclaimer: This information is only specific and accurate for the states of Nebraska and Colorado. This information is intended as a general legal foundation and not specific legal advice. SD Law is not responsible for decisions and actions made relying on this document without a specific legal consultation and does not represent you as a result of this post.