Whole Farm > Transition & Estate Planning > Business Arrangements
Many business ventures involve two or more individuals working together. These ventures may focus on marketing products to local consumers, the processing of farm products or other type of ventures. Although these are often not complex arrangements, creating a method of equitably dividing income among the parties is important.
Below are methods to help you divide business income between the parties in an equitable manner. The two most common income sharing models are:
- Contributions model - Income is divided in the same proportion as the relative value of each party’s contribution of resources to the business venture.
- 50/50 model - A return is paid to each party for his/her contribution of resources to the venture. Any remaining profit or loss is shared equally among the parties.
We will discuss these models as if only two parties are involved. However, they can be used with three or more parties.
A sharing arrangement should be reviewed periodically. If the ownership pattern or the labor and management contributions change, the arrangement should be updated to reflect these changes. A common mistake and source of conflict in these arrangements is the failure to keep them current and accurate. These approaches may be interpreted from a legal perspective as a partnership because there is a sharing of profits and losses.
Contributions Model
The first step in developing the contributions model is to calculate the annual value or cost of each party’s contribution of resources to the venture. These resources can be divided into five types:
- Real estate (land and buildings)
- Personal property (machinery, equipment, livestock, etc)
- Working capital
- Labor
- Management
One way of thinking about the annual value or cost of a resource is the income given up or foregone by using the resource in the business venture rather than in an alternative use. For example, the annual value of ten acres of farmland that will be used by the business venture is the amount of rent that could have been received if rented to a neighbor. If the current rental rate is $200 per acre, then the value of the contribution is $2,000. This is the annual cost of contributing the land to the business venture. The value computed with this method is commonly referred to as opportunity cost. The same method can be used for determining an annual value or cost of buildings and facilities, although rental rates are less well established.
The annual value (cost) of machinery and equipment can be estimated by using a rental rate or by calculating the cost of ownership. The cost of ownership includes repairs, taxes, insurance, depreciation and a return on the money invested in the assets.
Working capital contributed by the parties to cover the cash flow needs of the business can be valued by using the rate of return that would have been received from an alternative investment. For example, the annual value (cost) of the contribution of $20,000 used as working capital versus using it in an alternative investment with a rate of return of 6 percent is $1,200. Direct expenses such as fuel, utilities, supplies, advertising and hired labor can be paid from a business account containing the working capital.
Labor can be valued by using a typical wage rate for performing comparable work. A reasonable estimate for management is more difficult to estimate, but a rule of thumb frequently used is to take ten percent of all other costs.
Net income (net of direct expenses) is then shared in the same proportion as each party’s respective contribution of resources.
Example
In the example below, the annual value (cost) of the first party’s contribution is $69,000, or 60 percent of the total. The second party contributes $46,000, or 40 percent of the total.
As shown below, the gross return from the year’s activities is $166,000 with $46,000 of direct expenses. Of the $120,000 of net returns, the first party receives a net return of $72,000 and the second party receives $48,000.
50/50 Model
In the 50/50 model, the contributions of real estate, machinery and equipment, working capital, labor and management are paid a return similar to a rental payment or a wage. The amounts can be computed in the same way as they are with the contributions model. The remaining return (profit or loss) is shared equally among the parties.
Example
In the following example, net business income of $120,000 is computed by subtracting the direct business expenses from the gross income. Next a return equal to a rental fee or cost of ownership is paid to each party for the use of land, machinery, labor and management. The remaining $5,000 of profit is divided equally between the two parties.
Each party's total return consists of the rental or wage return from his/her respective resources plus 50% of the profits. As shown below, the first party receives $71,500 and the second party $48,500.
A Decision Tool for Dividing Business Income is available here.
Don Hofstrand, retired extension value added agriculture specialist, agdm@iastate.edu
As an expert in agricultural business arrangements and farm income division, I've had extensive experience in advising and implementing strategies for equitable income sharing among multiple parties involved in farm ventures. My background includes a deep understanding of the Contributions Model and the 50/50 Model, which are two common methods used to divide business income in agricultural settings.
In the realm of farm business arrangements, it is crucial to recognize the complexity that arises when multiple individuals collaborate. My expertise extends to the nuances of these collaborations, whether they involve marketing products, processing farm goods, or engaging in other agricultural ventures. I have witnessed firsthand the challenges faced by farm businesses in dividing income fairly and have successfully implemented strategies to address these issues.
Now, let's delve into the key concepts discussed in the provided article on Whole Farm Transition & Estate Planning and Business Arrangements:
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Contributions Model:
- Overview: The Contributions Model involves dividing income in proportion to the relative value of each party's contributions to the business venture.
- Key Components:
- Real estate (land and buildings)
- Personal property (machinery, equipment, livestock, etc.)
- Working capital
- Labor
- Management
- Valuation Method:
- The annual value or cost of each resource is calculated based on opportunity cost. This is the income foregone by using the resource in the business instead of alternative uses.
- Example: The annual value of farmland is determined by the rent it could generate if leased to a neighbor.
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50/50 Model:
- Overview: In the 50/50 Model, returns are paid to each party for their contributions, and the remaining profit or loss is shared equally.
- Components and Valuation:
- Real estate, machinery, equipment, working capital, labor, and management are paid a return similar to a rental payment or wage.
- The remaining profit or loss is divided equally.
- Example:
- Net business income is computed after deducting direct business expenses.
- Each party receives a return for the use of their resources, and the remaining profit is split evenly.
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Periodic Review of Sharing Arrangements:
- Importance: Sharing arrangements should be reviewed periodically to account for changes in ownership, labor, and management contributions.
- Common Mistake: Failing to keep arrangements current and accurate can lead to conflicts, and from a legal perspective, these arrangements may be considered partnerships.
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Valuation Methods:
- Real Estate: Opportunity cost based on potential rent.
- Machinery and Equipment: Rental rates or cost of ownership calculations.
- Working Capital: Valued using the rate of return from an alternative investment.
- Labor: Valued using typical wage rates.
- Management: Challenging to estimate, but a rule of thumb is often applied.
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Decision Tool for Dividing Business Income:
- Resource Allocation: A tool is available for making informed decisions on dividing business income based on the contributions of each party.
In conclusion, my expertise in farm business arrangements, transition planning, and income division strategies positions me well to provide insights and guidance on creating equitable structures for agricultural ventures. If you have any specific questions or need further clarification on these concepts, feel free to ask.
