USA: Co-op Ownership Compared to Other Arrangements for Dairy Operations

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University of Wisconsin Center for Cooperatives
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     Cooperative Ownership Compared to Other Business Arrangements for
                       Multi-Family Dairy Operations

By Greg Lawless, Dr. Robert Cropp and Dr. Phil Harris (1)

University of Wisconsin Center for Cooperatives
University of Wisconsin - Madison, Wisconsin
April 1996

    Note: This paper is accompanied by a table entitled "Comparison of
Five Business Structure Alternatives for Closely-Held Joint Ventures".

INTRODUCTION

This research project was supported by funding from the Midwest Cooperative
Education, Research and Extension Consortium. The purposes of the study
were (a) to acquire a preliminary understanding of a relatively new
phenomenon in the Wisconsin dairy industry: dairy farm expansion via the
combined resources of related and/or unrelated farm families, and (b) to
evaluate the cooperative model versus alternative business structures for
these multi-family dairy operations (MFDOs).

There was a three-fold approach to this research project. First, contacts
with farm and financial leaders provided a list of MFDOs that have been
established or are under consideration throughout the Upper Midwest, and
interviews with participating farms and/or their advisors resulted in a
number of instructive case studies. Second, a literature review of articles
concerning the related phenomenon of so-called "New Generation
Cooperatives" provided some understandings that were transferable to these
MFDO developments. Finally, a literature review and interviews with "tax
experts" provided insight into the business structure alternatives
available to farm families considering a multi-family dairy operation.

Five business structure alternatives for closely-held joint ventures were
compared: partnerships, limited liability companies, S corporations, C
corporations, and cooperatives. The conclusions offered are meant to give a
general understanding of the issues involved. The strongest conclusion is
that there is no single answer that will fit every situation. The best
business structure, or combination of structures, depends on the particular
situation. It is strongly recommended that families considering a
multi-family dairy operation consult competent legal and financial
professionals before embarking on any joint venture.

Structural Changes In Wisconsin's Dairy Industry

Wisconsin's dairy industry is experiencing major structural chances.
Wisconsin lost 35 percent of its dairy farms between 1985 and 1995.2
Predictions are that Wisconsin could see the number of dairy herds decline
by another 25 to 30 percent over the next five years. Medium-sized dairy
farms, between 50 and 100 milk cows, are decreasing at the fastest rate and
are most vulnerable to the economic forces affecting dairy farmers'
profitability in the midwest. For every two farmers exiting dairying since
1990, only one enters.

Dairying has a major economic impact on the economy of Wisconsin. Gross
farm level milk sales total more than $3 billion annually. When adding milk
processing and marketing, farm inputs and services, the sale of cull dairy
cows, dairy calves and dairy beef Wisconsin's dairy industry generates
about $17 billion of gross state income. Because of this economic
importance, the state of Wisconsin launched in 1993 a special initiative,
Wisconsin dairy 2020, to revitalize the dairy industry.

Not only has Wisconsin lost dairy farm numbers, but also total milk
production. From 1985 to 1994, Wisconsin's total milk production declined
from 24.7 billion pounds to 22.4 billion pounds, a decline of 9.3 percent.3
In fact, Wisconsin's milk production peaked at 25 billion pounds in 1985.
While Wisconsin's milk production declined, U.S. milk production increased
9.3 percent from 143.0 billion pounds in 1985 to 153.6 billion pounds in
1994. As a result, Wisconsin's share of the nation's milk supply declined
from 17.2 percent in 1985 to 14.6 percent in 1994.

Milk production has been shifting from the traditional dairy regions of the
Upper Midwest and Northeast to the West and Southwest. This regional shift
is expected to continue, at least for the next decade.

There are several factors causing the structural changes in Wisconsin's and
the nation's dairy industries. First, a relatively large number of
Wisconsin dairy farm operations are small. In 1994, 21 percent of the dairy
farms had fewer than 30 milk cows, 34.8 percent 30 to 49 cows, 35.2 percent
50 to 99 cows, and only 7.9 percent 100 to 199 cows, and 1.1 percent 200
plus cows. Many of the dairy operations with fewer than 100 cows have
obsolete dairy facilities and milking equipment. The ages of many of the
operators are approaching retirements. The major reason for dairy farmers
exiting the industry is not financial, but rather retirements. Because the
dairy facilities are obsolete or too small to support an adequate family
income, once these dairy farmers exit dairying the facilities are no longer
used for milk production.

Second, profitability in dairying has been under pressure. The federal
dairy price support policy experienced a major change in 1981. From 1950 to
1981, the price of milk to farmers was supported at between 75 and 90
percent of parity. This policy provided a relatively high floor under farm
level milk prices. But because of growing milk surpluses and government
costs to purchase these surpluses, parity support prices were dropped in
1981. In its place, the U.S. congress determines the milk price support
levels based upon the level of anticipated purchases of surplus dairy
products and costs. Further, beginning with 1981/82, assessments were
placed on dairy farmers to offset some of these costs. The support price
was $13.10 per hundredweight in 1981, declined to $10.10 per hundredweight
on January 1,1990 where it remained through 1995.4 The average Wisconsin
farm milk price more than doubled from 1970 to 1980 going from $5.13 per
hundredweight to $12.67 per hundredweight. But with the change in dairy
policy the average milk price since then has been as low as $11.97 per
hundredweight in 1988 to as high as $13.47 in 1990. Predictions are for
fairly flat or declining average milk prices over the next 5 years and
perhaps beyond.

The regional shift in milk production to the West and Southwest has been
partially due to an outdated federal milk marketing order system that has
favored these regions at the expense of the Upper Midwest. But both
population shifts to these regions and new technology enabling these
regions to now produce milk at similar costs or lower costs than the Upper
Midwest are also important factors for this shift in milk production. The
Upper Midwest is no longer the lowest milk production cost region.
Wisconsin dairy farmers must be able to compete with these new low cost
milk production regions.

With tighter operating margins nearly all Wisconsin dairy farmers are
examining ways to adapt their farming systems to cut costs and protect
future investments and livelihoods. Some farmers in areas where it is
feasible are shifting to rotational grazing methods to achieve lower costs
per hundredweight of milk produced. Others are expanding herd sizes
significantly attempting to achieve the larger-scale efficiencies. A
smaller proportion are turning to niche markets (e.g. organic milk) to
achieve higher prices. Many medium size farms are caught in the middle.
Many do not have access to debt capital or equity capital to expand or are
not in areas conducive to rotational grazing. Dairy cooperatives and supply
cooperatives have instituted programs to assist farmers with expansion
efforts, and they are looking for additional tools to help their medium
sized members continue in business profitably.

New Generation Cooperatives and Multi-Family Dairy Operations

Wisconsin is not the first Midwestern state to experience hard times. Farm
families in North Dakota and Minnesota faced similar problems throughout
the 1980's. By the start of the present decade, however, many farmers in
those two states had begun to take matters into their own hands. They
turned to the old cooperative model of business that had served their
grandfathers so well in the early part of this century, only they were
innovative enough to fit that model to their modern needs. The businesses
they formed have therefore been termed "New Generation Cooperatives"
(NGCs), and the number of NGCs in the Upper Midwest has expanded from two
in 1989 to over fifty today.5

New Generation Cooperatives typically take the raw products of their
members' farms and process them in cooperatively-owned facilities. An NGC
differs from most traditional marketing cooperatives in the following ways:
It is market-driven, in that market demand for the processed end-product
determines the appropriate scale of the business-- and that, in turn,
limits the size of the membership, so that these become "closed"
cooperatives. Furthermore, tradable membership shares not only allocate
rights to deliver units of the farms' raw products, but these shares also
spread "up-front" capitalization responsibilities equitably among members.

This research project was not specifically directed at these New Generation
Cooperatives in North Dakota and Minnesota, but rather at what seems to be
a related phenomenon among a small but growing number of Wisconsin dairy
farms. The multi-family dairy operations (MFDOs) that are the focus of our
research are comparable to the NGCs in the following ways:

  1.  first and foremost, they involve cooperation among farm families,

  2. they are market-driven, in that the farmers involved believe that
     market conditions require expansion of smaller dairies in order to
     benefit from economies of scale,

  3. and, finally, in the sense that dairy products represent end-products
     processed from grain and forage, these MFDOs are "value-adding"
     enterprises.

But the comparison seems to end there. A very important difference between
the New Generation Cooperatives and these multi-family dairy operations is
one of scale. A typical NGC processing plant may have as many as 100
members, each owning one or more "shares" valued at as much as
$2,000/share. The plant itself may have cost hundreds of millions of
dollars to construct, and the gross income that the business brings into
the community may also involve millions of dollars.

The multi-family dairy operations, on the other hand, are comparatively
small businesses. While each of the MFDOs examined was quite different in
many respects, a typical case might involve a collaboration between as many
as four or five families. While these families may have varying degrees of
farming experience, varying levels of equity in their own original farms,
and numerous other differences, they typically share a common belief that
their families will more likely succeed together than apart. If adequate
trust and communication exist between the families, this common belief may
lead them toward a sophisticated joint venture enterprise, together
managing as many as 300, 600, 800 or more cows in commonly-owned,
capital-intensive facilities.

The smaller number of farmers involved in an MFDO, as compared to an NGC,
means that the joint venture is more vulnerable to changes in the
situations of any of the participating families, and also that
administrative costs cannot be spread out as broadly. At the same time,
while NGC members may have invested thousands of dollars in their
cooperative processing plant, each of these NGC farmer's primary focus is
usually their own individual farm. Their investment in the NGC probably
represents a minority share of their total capital investment.

For co-owners of an MFDO, on the other hand, the jointly-owned dairy farm
is probably the primary focus of each participating family. While certain
family assets may be kept out of the joint venture for tax purposes or
other reasons, all of the farms' properties may be practically combined in
a holistic business plan that is geared toward a large-scale milking
operation.

There are business structure options that allow the families to either
combine their appreciable assets into one jointly-owned entity, or to
simply rent certain of those family assets to the MFDO. Either way, the end
result is that co-owners of an MFDO have to think very carefully about how
they structure their joint venture.

While NGCs are, as their name implies, cooperative enterprises, the MFDOs
may involve a number of business structure alternatives, including, but
certainly not limited to the cooperative business model. One of the goals
of this research project was to determine which business structure
alternative, or combinations thereof, is best suited to multi-family
ownership of a capital-intensive dairy enterprise. As mentioned above,
there is no single answer to this question, but the discussion that follows
will highlight some of the fundamental issues that are involved.

Five Business Structure Alternatives

There were five separate business structure alternatives considered. They
were:

   * partnerships,
   * limited liability companies (LLCs),
   * subchapter S corporations,
   * subchapter C corporations, and
   * cooperatives.

 The table entitled "Comparison of Five Business Structure Alternatives
    for Closely-Held Joint Ventures" is presented as one of the main
products of the research effort. It will be referred to in the section
below that compares these different forms with respect to multi-family
dairy operations (MFDOs). Beforehand, the following brief descriptions of
each alternative are offered:

Partnerships, one of the oldest legal forms of closely-held joint ventures,
involve two or more owners, at least one of which is fully liable for the
debts of the venture. The owners, called partners, may pull out at any
time, usually without recognizing capital gain. Income is taxed at the
partner level only.

Limited liability companies (LLCs) are a much newer innovation. In this
case, owners are called "members", and all members enjoy limited liability.
These members may also pull out at anytime without triggering capital gains
tax penalties. And, like partnerships, income is taxed only at the member
level. LLCs, therefore, much resemble partnerships, but, most importantly,
they share the corporate characteristic of limited liability.

S corporations came along sometime before the LLCs, but they also offer a
blend of partnership and corporate characteristics. Like a partnership,
income may only be taxed at the owner (shareholder) level-- as long as
certain ownership criteria are met. However, the S corporation resembles
the C corporation and the cooperative in that distribution of appreciated
assets to original contributors may trigger significant capital gains
taxes.

C corporations are similar to S corporations except for two significant
differences. First, in a C corporation, income is generally taxed at both
the shareholder and entity levels, a real disadvantage for income that is
distributed. However, one advantage over the S corporation, LLC and
partnership is that C corporations can deduct fringe benefits paid to
employee-owners, who can exclude these benefits for tax purposes from their
gross incomes. And, again, gains from distribution of appreciated assets
may trigger significant tax penalties-- at both the shareholder and entity
levels.

Cooperative corporations resemble partnerships and LLCs in that income may
be taxed only at the individual (or member) level-- IF profits are
distributed properly as "patronage refunds". Cooperatives share the
corporate characteristic of limited liability and involve similar capital
gains tax disadvantages. In the United States, the cooperative model was
originally designed to offer farm families the chance to pool resources to
meet common needs. This was achieved through a jointly-owned business that
(a) distributed control equally (one member, one vote), (b) equitably
distributed benefits on the basis of use (rather than on the basis of
investment), and (c) equitably distributed capitalization responsibilities,
also on the basis of use. Agricultural cooperatives typically require that
members be active farmers.

Motivating Rationales, Influencing Factors, and Critical Conditions

The research involved interviews with farmers and with the extension
agents, bankers, and community development specialists who worked along
with them. These interviews provided certain insights into the phenomenon
of multi-family dairy operations. Furthermore, a literature review of the
New Generation Cooperative developments provided certain insights that were
transferable to the MFDO phenomenon. The understandings gained can be
grouped under the following three headings: (a) five rationales motivating
MFDO development, (b) eight factors influencing MFDO development, and (c)
six conditions critical for establishing an MFDO.

Rationales Motivating MFDO Development:

There appear to be as many as five rationales motivating families to pursue
a joint venture together in dairy farming. First, there is the "dairy farm
viability" rationale. This rationale assumes that the best way for a dairy
farm to survive is to expand upwards and beyond a 300-cow operation. Some
families that do not have the capital and cannot acquire the financing to
do it alone are therefore attempting it together. Others see advantages in
combining capital, labor, and management expertise as a means of improving
efficiency and reducing unit production costs.

A related rationale is "the quality of life issue". Some farmers said they
did not want to commit to the 365-day responsibilities of operating a
single family dairy operation. They added that their descendants were even
less likely to make such a commitment. By involving more families in a
larger dairy operation, the workload and management can potentially be
parceled out so that no one individual is unduly over-burdened.

There are also farm families looking to "add value" to their farms' grain
or forage, and who are exploring mutual investment in a commonly-owned,
large-scale dairy operation to enable them to enjoy the additional income
from that value-adding process. This rationale is similar to that
motivating members of the New Generation Cooperatives of North Dakota and
Minnesota.

There is also the "return on investment" rationale. There is at least one
MFDO in which one of the major investors is a non-farmer, and who
presumably hopes to get a fair return from that investment. It was not
clear whether that investor also shared the following, less individualistic
rationale.

In addition to these four rationales motivating families to pursue a MFDO,
three cases were found in which an MFDO was initiated not by farmers but by
non-farmers interested in "community economic development". In one case,
which actually arose in Utah, the non-farmer was a town doctor who was fast
loosing patients after the local sugar beet processing plant closed down,
and area farmers lost the primary market for their farms products. The
doctor led a group of community leaders and farmers to develop a 1400-cow
dairy facility. The facility provided a market for feed grown on twenty
separate farms, employed 17 full-time and 7 part-time employees, and
produces about $3 million dollars worth of milk per year.

Another case in Minnesota was also motivated by a community's desire for
economic development. As part of a broader goal of bringing 4,000 to 5,000
additional dairy cows to the area as a means of securing 30-40 jobs for
workers in the local cheese plant, a community development corporation
built a 500-cow facility. $50,000 in donations were raised from within the
community to leverage the necessary bank loans. However, this community
(multi-family) effort resulted in an arrangement whereby a single farm
family will be renting the facilities, with first option to buy at the end
of a five-year lease.

Another community development approach was taken by leaders of a farm
supply cooperative. The efforts by leaders in the co-op to help start-up a
large-scale dairy operation were cut short when co-op members voted it
down. It had not been decided whether the proposed dairy facilities would
have been leased or owned, or whether one or more families would be
involved.

The five rationales described separately above undoubtedly blend together
for any given family, in the form of "personal expectations". In other
words, the hopes and plans of the various people involved in a multi-family
dairy operation will certainly influence the course of its development, and
its eventual success or failure.

Expectations, along with other factors influencing MFDO development, will
be discussed below. It first must be noted, however, that in all of the
cases studied, there was one common strategy: establishment of a
capital-intensive, large-scale dairy operation. This is noted simply to
acknowledge that there are other strategies that might also achieve such
goals as farm viability, quality of life, value-added income, return on
investment, and community economic development. Rotational grazing of 300
or more cows, as an alternative to capital-intensive dairy operations, and
the processing of milk into special cheeses for "niche markets" are
examples of other strategies that were not included in the research.

Factors Influencing MFDO Development:

Probably the greatest factor affecting multi-family dairy operations are
outside forces, to which the families can only react. The introduction
explained the economic and demographic forces that are impacting the dairy
industry today in Wisconsin. The establishment of MFDOs were ultimately
motivated by reaction to these forces, and the families involved will have
to continue to react to additional changes over which they can hardly
control-- such as changing environmental and tax regulations.

Other factors have more to do with the families themselves. A factor
identified broadly as the families' personal situations would include: the
number of families participating, the number of individuals in each family,
and the health and ages of these individuals will all affect the situation.
Another factor was alluded to above, and is a reflection of these so-called
personal situations, the individuals' expectations. In addition, the
various skills of the key participating individuals will surely have a
great influence throughout the duration of the joint venture. A diversity
of "farm management skills" will allow flexibility when distributing
management and labor tasks. At the same time, "interpersonal skills", such
as abilities to communicate and empathize with others, would best be shared
by all participants.

This latter factor points to yet another-- mutual trust. The better the
individuals can communicate and work together, the more they may learn to
trust one another over time. Mutual trust may hold the joint venture
together despite outside forces that may work against it. When the families
try to adjust to these outside forces, and to changes in their personal
situations, the complex legal structures they original designed may
stubbornly refuse to bend to meet their new needs. In this future event,
mutual trust among the families may provide the flexibility needed to get
through the periods of change.

Three influencing factors involve financial matters. The business model
structures of the original farms have tax implications that may affect the
choice of the structure for the proposed joint venture. Access to equity
and debt capital will inform the business plan and also the choice of the
legal structure. Finally, the financial resources of the participating
families may limit the families' access to legal and financial assistance
that is necessary to proceed with plans for a multi-family dairy operation.

Critical Conditions for Establishing a MFDO:

The issues presented above were raised by farmers who were either
considering or had already established a multi-family dairy operation.
Bankers, economic development specialists, and extension agents also
contributed valuable insights. From discussions with these individuals,
preliminary conclusions can be offered regarding the conditions critical
for establishing a multi-family dairy operation. None of the MFDO cases
studied had been established long enough to inform conditions for long-term
success. The following "six critical conditions" are therefore offered so
that families contemplating a multi-family dairy operation may have a
better sense of the issues they should consider.

Good Working Relationships Between Families

     Obviously, if the families did not get along well, they probably would
     not consider a joint venture in the first place. The MFDOs that did
     get off the ground involved families with long histories of
     cooperative and friendly relations. It appears it is not necessary to
     share blood ties to enjoy strong inter-family relations. Good
     communication and leadership skills should be shared by all
     participants. Mutual respect and understanding are probably
     fundamental to establishing a joint venture.

     However, it should be noted that families that get along today may not
     get along so well in the future-- whether the families are blood
     related or not. This points to the need for a legal business
     structure, and accompanying by-laws or written operating agreements,
     that help to avoid future disagreements. For instance, it should be
     clear from the start how decision-making "control" will be distributed
     over time. Each family's "estate planning" should also be well thought
     out and accommodated.

Adequate Labor and Competent Management

     Participating families should consider carefully how labor and
     management duties would be distributed in the operation of the joint
     venture. They should look ahead as to how well these duties could be
     transferred to new participants over time. Competency in management
     would include not only farm management skills but the "interpersonal
     skills" described above. Both types of skills will be necessary to
     establishing the joint venture in the first place, as all of the
     various issues are being considered and addressed. Again, the issue of
     present and future decision-making control should be taken into
     account when choosing the appropriate business structure.

Sound Business Plan

     No matter how carefully the legal business structure is designed, no
     matter how competent the participants, and no matter how well the
     families get along, if the business plan is faulty, the venture will
     likely fail. Outside assistance, in the form of a formal feasibility
     study, must be sought. Market analysis and available labor and capital
     should inform the appropriate scale of operations. A strategy for
     managing human and all other resources should be developed. The chosen
     scale of the business will define capital needs, which, in turn, will
     likely inform the best choice of legal business structure. For
     instance, if one family initially invests substantially more than the
     other families, a structure that allows "flexibility in distributions"
     would enable investment to be properly rewarded, while balancing this
     with reward to labor. In addition, tax planning, as a facet of the
     broader business plan, will also have implications that inform the
     best choice of business structure.

Adequate Capitalization and Financing

     The business plan should include considerations of available capital,
     and, since bankers require a sound business plan before lending money,
     it also affects the availability of debt capital. Without sufficient
     funds, the joint venture will never get off the ground. And, as
     mentioned above, the capitalization strategy informs the choice of
     legal business structure.

Proper Business Structure

     Everything above reinforces the reason this research project was
     undertaken in the first place. Issues of capitalization,
     decision-making control, flexibility in distributions, tax
     considerations, and estate planning will all inform the best choice of
     structure. These issues, along with those of liability, family farm
     orientation, administrative costs, long-term stability will be
     discussed at length in the section comparing five alternative business
     structure models.

Access to Sound Advice

     As mentioned above, families should seek out sound advice when
     developing the business plan for their joint venture. They must also
     seek advice when considering the best choice of structure. This report
     is not presented as sufficient input for making that crucial decision.
     The best business structure will ultimately depend on the particular
     situation. Competent legal counsel must be acquired before any final
     decisions are made.

Choosing a Business Structure for a Multi-Family Dairy Operation-- Six
Issues

 This section will go step-by-step through the attached table entitled
    "Comparison of Five Business Structure Alternatives for Closely-Held
Joint Ventures". Again, the alternatives to be examined include:
partnerships, limited liability companies (LLCs), S corporations, C
corporations, and cooperatives. Neither the attached table nor the
accompanying text below is presented as the full and final answer to any of
the issues raised. Rather, this section of the report represents a general
discussion of multi-family dairy operations in light of the advantages and
disadvantages that each structure offers.

(1) Ownership Issues

All of the cases of multi-family dairy operations we studied could fall
under the heading of "closely-held" joint ventures. In other words, the
number of owners involved is rather small, generally three to five
families. The only business structure that involves an upper limit on the
number of owners is the S corporation. The S corporate limit to a maximum
of 35 shareholders, however, would not have affected any of the MFDOs in
our study. S corporations also may not have other corporations or owners as
shareholders. While this may limit the option of multiple-entity, or
multiple-model structure, it need not be an issue.

The cooperative structure, as authorized under the federal Capper-Volstead
Act as well as state cooperative laws, places limitations the return on
investment. This limitation is 8%. Such limitations could affect MFDOs that
wanted to attract significant investment from non-farmers in the community,
in which case the cooperative model may be at a disadvantage. At the same
time, families that did want to limit ownership to farm families could
probably enforce that limitation through by-laws or operating agreements
written into any of the five models of ownership.

One ownership issue that is much more significant involves owner liability.
The major disadvantage of a partnership over any of the other models is
that at least one partner in a partnership must be fully liable for the
debts and other obligations of the business. The LLC differs from the
partnership on this one crucial issue, in that all members of an LLC, like
all corporate shareholders and cooperative members, enjoy the advantage of
limited liability. The disadvantage that this represents for the
partnership is probably enough to exclude it from further discussion. The
remaining comparisons will focus on the LLC and its three corporate
alternatives.6

 (2) Getting Started

There are at least two issues surrounding the task of getting an MFDO off
the ground. One involves having access to qualified outside assistance. The
cost of the assistance will reflect the complexity of the proposed
ownership structure. The degree to which the legal, financial, and other
business development experts are familiar with the proposed structure will
also affect the cost and availability of assistance.

The partnership and C corporation, and to a lesser extent the S
corporation, have all been around long enough, and have been used widely
enough, so that advice on their use is readily available. There are many
cooperative specialists that can offer help with that model. The LLC has
been around the shortest time, and therefore is not so familiar to either
farmers or their advocates. However, the LLC, like the older partnership
model, is a relatively simple structure to construct or establish. It
involves certain rules that must be followed, but not the annual regulatory
reporting, nor the formal board structure of the three corporate models.7

However, it must be realized that any business that is started by more than
one family, especially unrelated families, is going to require thoughtful
consideration of legal and financial matters. The partnership and LLC may
seem deceptively simple on the surface, but certain issues, like tax and
estate planning, require a long-term vision and the appropriate rules to
achieve that vision. But because the LLC will usually involve less total
administrative cost, and because more and more professionals are becoming
familiar with this alternative, it would seem to offer a significant
advantage for closely-held joint ventures in which administrative costs
cannot be widely spread.

A second challenge to starting a multi-family dairy operation is coming up
with the necessary capital. Ultimately, this will depend on the solvency of
the participating farms, the cost and availability of debt capital, and the
feasibility of the business plan. However, each of the business models
involve various rules that could affect capitalization efforts.

Again, because the partnership model requires that all owners participating
in management share liability for the business' obligations, the LCC has a
significant comparative advantage. In other words, an LLC might attract
more investors than a partnership because every investor may enjoy limited
liability. Limited liability is also available in the three corporate
alternatives.

Investment in the form of the contribution of appreciable assets is
discouraged in the three corporate models because of tax penalties
encumbered if and when those assets are ever withdrawn. That alone should
not eliminate the corporate option, because appreciable assets may best be
kept out of joint ownership anyway, and rented to the joint venture
instead. Cooperatives may also limit capitalization options if ownership is
restricted to active farmers, and cooperatives also involve an 8% limit on
dividends paid to capital.

At the same time (and looking ahead to the issue of "control"), limits on
the free transferability of ownership interest in the LLC may limit the
ability to attract minority or "outside" investment. An LLC may require
that disassociating owners gain unanimous approval by remaining members for
a proposed transfer of ownership interest, and could potentially limit the
market, and the resulting price, of that owners' share of the business. Of
course, majority interests in a corporation may also limit minority
transfers, but at least under that model a transfer cannot be vetoed by one
remaining member owning but a small share in the business. While LLCs may
permit "free transferability", by doing so they forego the options of
centralization of management and continuity of life, assuming they choose
limited liability as the second of the four corporate characteristics.

However, the IRS has ruled that unanimous approval for transfers of
ownership may be "reduced" to mere majority approval, and still qualify as
limited (as opposed to free) transferability. Since most closely-held
corporations would involve comparable limitations, then the LLC may not be
at comparative disadvantage in this respect. This issue of transfer of
ownership interests will be discussed in greater detail below.

In summary, then, there will be legal and consultation costs regardless of
the model chosen, while the LLC may have an advantage over the long-run
with lower administrative costs for a closely-held joint venture. And
because the corporate models discourage investment in the form of
contribution of appreciable assets, because cooperatives may discourage
outside investment, and because transferability may be equally limited
under any of the models, it would appear that the LCC has an overall
advantage regarding these various issues involved in getting the business
off the ground.

 (3) Decision-Making and Management

The issues of decision-making and management are essentially issues of
"control", and the different models vary in how they distribute this
control. A cooperative is unique in that, typically, every member is
receives one (and only one) vote to elect a governing board of directors,
and no one member or director may veto the decision of the majority. S and
C corporations and the LLC model, on the other hand, allocate voting rights
in proportion to investment. Unlike any of the three corporate models, most
LLCs do require unanimous consent of members on many important issues, and
members do not usually hand over control to a representative. Like the
cooperative, the S and C corporations do require a board of directors, and
under all corporate forms the board may hire a manager to run the
day-to-day affairs of the business.

Whether or not these differences are advantages or disadvantages will
depend upon the goals and philosophies of the owners, and upon the
particular situation. For instance, the formality of a corporate board may
entail excessive administration costs in a closely-held joint venture,
while some owners may accept these costs and prefer to hand over decisions
to a representative governing board.

While each corporate alternative does require a board of directors, and
while the cooperative model generally does require one member-one vote,
many of the rules regarding control are flexible under each of the
different models. Any of the forms may institute one member-one vote, if
owners prefer equal distribution of control. Furthermore, the LLC may
centralize its decision-making, although not without consequence.

The IRS limits the LLC to two of four corporate characteristics, including
"centralization of management". LLC members may choose to be "member
managed", in which each member formally has a say in every long-term
governing and day-to-day managing decision. This would avoid centralization
of management, with all members essentially sharing the responsibilities
that corporations allocate to their boards and their managers.

Alternatively, the LLC may choose to be "manager-managed", and opt for the
corporate characteristic of centralized management. Under this arrangement,
managers may be elected-- by a majority of the ownership interests-- to
carry out the day-to-day operations of the business.8 The managers elected
and hired need not be members. The latter arrangement is available in any
of the corporate models, but if the LLC selects centralized management and
limited liability, it forfeits the option of free transferability of
interests and continuity of life-- or else loses its favorable status as a
partnership for income tax purposes.

Under a manager-managed system, because "free transferability of interest"
and "continuity of life" could not be instituted (assuming limited
liability is selected), each LLC member would still have a vote in issues
of ownership transfer and continuation of the business upon the death or
withdrawal of another member. In other words, at minimum, majority approval
by remaining membership interests is required for decisions made regarding
a change in the make-up of owners. Most LLCs require unanimous approval for
such decisions.

Most of the multi-family dairy operations in our study would involve every
owner in every major decision. And while day-to-day management tasks might
be distributed according to the owners' various skills, this could probably
be done without crossing the line into centralized management. These
arrangements would probably eliminate the need for a formal representative
board, and would also avoid the loss of the favorable partnership tax
status that is available with an LLC. While not a major advantage, the
lower administration costs of an LLC may be preferable to the formal
corporate board structure.

However, there is another issue of control that offers no simple
conclusions. It is not clear whether one model surpasses another regarding
the complex matter of control "across generations". In other words, it is
not clear which model, if any, could best assure current owners that their
descendants will maintain an appropriate stake and say in the matters of
the joint venture in the unforeseen future. The matter may be less critical
if each family keeps appreciable assets like land under family ownership,
but equity that is invested in the joint venture will raise issues of
future control and ownership. This issue of future concerns will be dealt
with more thoroughly under the heading of "Adjusting to Change" below.

In summary, because of the flexibility of each of the models regarding
issues of present-time decision-making and management, it would seem none
have a great advantage over the other in this regard. In a closely-held
joint venture like a multi-family dairy operation, and with regard to
issues of control, the choice of appropriate business structure may tip
slightly in the direction of the LLC because of its lower administrative
costs and flexibility.

 (4) Flexibility in Distributions

To the extent that all of the capital investors in a joint venture invest
corresponding levels of labor throughout each year, flexibility in
distributions may simply be required for devising tax strategies. For
instance, in a joint venture organized as a C corporation, income may be
distributed as salaries and fringe benefits rather than as dividends in
order to enjoy tax deductions and to avoid a "double tax" on profits. These
and other tax issues will be discussed in the next section, but it may be
said now that flexibility in distributions, for tax purposes, may best be
achieved with a combination of the business structure models.

It is probably more likely that capital investment will not correspond
directly with labor contributions, and this raises another need for
flexibility in distributions. When all owners contribute equal levels of
capital and labor, it may be irrelevant whether income from the joint
venture is distributed as dividends or as salaries. But when one owner--
perhaps an elderly family member-- has invested years of savings but can
contribute little in labor (while for other owners the reverse is true),
flexibility would be needed to fairly "reward" the varying contributions of
capital and labor.

Let it first be said that all of the business structure models are fairly
flexible with regard to distributions. Consider the cooperative model.
Cooperatives typically favor reward to "use" over reward to capital. In one
of the cases studied, the families considered measuring "use" in terms of
labor contributed, and in this sense, the farm would have been creatively
organized as a "worker cooperative". Profits from the joint venture were to
be distributed in proportion to labor contributed each year.

If there was a member of the cooperative that contributed more capital than
labor, the membership as a whole would still have the flexibility to fairly
compensate that member. Cooperative law does allow payment of dividends to
capital investors-- although such dividends are usually limited to 8%.
Beyond that, the cooperative model also retains other distribution options
that would be available under any of the business structure models. For
instance, if owners either lease their land or make loans to the joint
venture, they may be "rewarded" with rent and interest payments. In other
words, income from the joint venture may be distributed to labor as
salaries after capital investors are compensated in any of a variety of
ways.

The freedom to distribute income either in the form of salaries and fringe
benefits, as dividends, as rent, and/or as interest payments is available,
in varying degrees, in each of the business structure alternatives. The
cooperative's 8% limit on dividends may not be very significant. With S
corporations, the IRS limits the temptation to minimize salaries (and
associated employment taxes) and maximize dividends (which are not taxed at
the corporate level). This IRS limitation, together with the limitation to
a single class of stock, would probably make the S corporations the least
flexible of the models. C corporations are also somewhat limited, in that
advantageous tax deductions for fringe benefits are offset by double
taxation on income. The LLC is probably the most flexible model. However,
each of the limitations above may often be side-stepped with creative
distributions in the form of rent and interest payments.

 (5) Tax Issues

It would seem that the greatest efforts are put into devising a business
structure that minimizes the tax burden. Two types of taxation are most
relevant-- income and capital gains taxation. Regarding income taxes, each
of the models except the C corporation may avoid taxation at the entity
level. The other models may pass the tax along to the individual owners,
while under the C corporation both the individuals and the corporation must
pay taxes on income. This may be a significant disadvantage for the C
corporation.

However, the C corporation has the ability to deduct its employees' fringe
benefits. Partnerships, LLCs, and S corporations are not considered
separate employers from their owners-- this is probably related to the
advantageous ruling that these models need only be taxed at the individual
level. But the trade-off is that these employee-owners must pay for their
own fringe benefits without deductions at the entity level. One interesting
question is whether a cooperative could enjoy both single taxation and
deductions for fringe benefits. While cooperatives typically enjoys such
tax deductions, if it is structured as a "worker cooperative" perhaps
employee-owners would be required to pay their own fringe benefits and
forego the entity level deductions.

The deductions for fringe benefits, available for certain under the C
corporation, might be achieved without significant double taxation if
creative distributions and accounting can minimize the income of the
corporation. However, very significant capital gains tax penalties may be
suffered if appreciable assets are put into any of the three corporate
models. Unless owners can be assured that such assets will not be
distributed for a very long time-- and it is difficult to be so assured--
it is generally recommended that assets such as land not be contributed to
a joint venture organized as a closely-held corporation.

A related issue involves "conversion costs". Land that has appreciated in
value and is currently owned under a family corporation may involve serious
capital gains taxes if it is removed from that corporation for contribution
to the joint venture. It would generally be better to keep the land in
family ownership and rent it too the joint venture. If any land or other
appreciable assets are to be contributed to the joint venture, it would be
better put them in a LLC rather than a corporate structure, in order to
avoid future tax penalties. Besides capital gains tax advantages, the LLC,
like the partnership, enjoys favorable adjustments in the basis of its
assets when ownership interests are sold.9 None of the corporate models
enjoy this favorable adjustment.

Of the trade-off between LLC capital gains tax advantages and C corporation
income tax deduction advantages, it would seem the former is of greater
significance. As long as the joint venture is going to involve appreciable
assets, it seems critical that they be kept out of corporate ownership, and
an LLC would be the best option. If they are already in a family's
corporation, they should be kept there, and perhaps rented to the joint
venture entity. In this case, if no appreciable assets are to be
contributed to the joint venture, a C corporation may be chosen, with its
respective income tax advantages.

It has been suggested that a "multiple-entity model" often may be the best
way to gain the advantages of both the LLC and the C corporation.
Appreciable assets may be jointly owned in the LLC, which would then rent
those assets to a jointly owned C corporation that would cover the
employee-owners' fringe benefits. It has also been said that, given this
option, most farmers choose to forego the advantages of the C corporation's
deductions and, for simplicity's sake, institute the LLC model alone.

 (6) Adjusting to Change

Minimizing the tax burden may be the most common concern of those trying to
establish a closely-held joint venture. However, what should be considered
just as carefully is how the business will endure inevitable change. Each
family's estate planning should be considered when formulating a collective
strategy for bringing subsequent generations into the business.
Furthermore, death, divorce, and irresolvable disagreements are three
events that could bring about an unexpected early withdrawal of one or more
owners. Critical questions that families must carefully consider include:

   * Who should be allowed to hold ownership interests in the joint venture
     in future generations? (An issue of ownership.)

   * How will decision-making authority be allocated among original and
     newer owners? Among farming and non-farming owners? Among more and
     less invested owners? (An issue of control.)

   * How will income be distributed when, over the generations, ownership
     becomes dispersed among a widening circle of individuals, with varying
     levels of investment and involvement in the joint venture? (An issue
     of distribution.)

   * How can remaining owners adjust to the unexpected early withdrawal of
     an owner due to death, divorce, or disagreement? In other words, how
     will equity be distributed to disassociating owners and/or heirs
     without forcing dissolution of the joint venture? (An issue of
     stability.)

There are some differences in the five business structure alternatives that
could be important to answering these questions, but the differences are of
limited relevance. However the families choose to answer the questions
above, there are generally rules and agreements that can be enforced under
any of the five business structures.

If the families choose to restrict ownership and control to active farmers,
they may write that requirement into agreements or by-laws under any
business structure. Agricultural cooperatives typically do restrict
membership to active farmers. The S corporation limit to 35 shareholders
and its exclusion of corporations and non-resident aliens from ownership is
not likely to be an issue.

If the families want control in the future to be distributed equally ("one
member, one vote"), they can do so under any of the models. If they want to
distribute future control in proportion to investment, conversely, then
cooperative law in some states may prohibit that. Another restriction
involves the potential LLC limitation regarding centralized management. If
the LLC is not able to opt for centralized management (because its members
elected two other "corporate characteristics"), then, strictly speaking,
all present and future owners must participate in the management of the
business. This may not be a disadvantage, of course.

Regarding distribution of income in the future, it has already been said
that all of the models are fairly flexible. The LLC and partnership are
more flexible than the corporate alternatives. However, all of the models
may use rent and interest payments to reward its owners, and these
approaches may provide adequate flexibility in distributions in the present
and in the future.

These issues of ownership, control, and distribution are almost always more
complicated in a joint venture business-- as compared to a single family
proprietorship-- and things become even more complicated when trying to
plan for the unknown future. What if the children of only one of four
original families wants to continue farming in the business? Should the
children of the other families be given a say in how the farm is managed in
the future? Should they continue to receive income from the business?
Fortunately, each of the five business structure alternatives are, for the
most part, flexible enough to accommodate answers to these difficult
questions-- if and when the answers are determined.

A final issue involves the stability of the joint venture for remaining
owners when another owner either dies, divorces, or chooses to withdraw
from the business for whatever reason. In any of these cases, early or
unexpected withdrawal of assets could force the liquidation of the entity,
perhaps much to the dismay of remaining owners. Fortunately, there are many
precautions that can be made to help avoid unwanted liquidation.

The choice of business structure has limited relevance to this issue of
stability. It is true that the LLC may lack the corporate characteristic of
"continuity of life", but that only means that a vote of remaining owners
must determine whether the venture will continue after the disassociation
of a fellow owner. What is more relevant is the extent to which owners may
withdraw assets from the joint venture. In a corporation, majority
interests may refuse to allow minority owners to withdraw their assets,
while in an LLC any owner may withdrawal his or her assets at will-- often
without recognizing capital gains. However, while majority control over
withdrawal of assets in a corporation may provide certain stability for
that majority, there are better ways to deal with this issue.

One strategy that is available under any of the business structures is to
put together buy-sell agreements at the start of the new joint venture--
while general consensus still prevails. Buy-sell agreements should
establish (a) the purchase price of ownership interests (which may be
adjusted as appropriate at annual meetings) and (b) the appropriate time
intervals for installment purchases. These agreements may be written so as
to discourage early withdrawal of ownership interests.

In addition, owners may also want to purchase life insurance policies to
cover the death of other owners. This may be quite costly, but it could be
worth it in the event of a tragedy. Finally, the cooperative sector has
developed equity revolvement strategies that could probably be instituted
under any business arrangement. One example is the "base capital plan",
which also provides an innovative capitalization strategy. Equity
revolvement strategies plan for the return of equity to retired owners and
heirs over a time period that balances their needs with those of the
remaining owners in the joint venture.

Perhaps the best way to avoid instability in the event of an owner's
disassociation is to keep appreciable assets out of the joint venture
altogether. For instance, if dairy facilities under joint ownership are
fully depreciated in ten years, then after that time there will be less of
value for an heir to inherit, and it will be easier for remaining owners to
buy out a disgruntled fellow investor. So while tax considerations argued
for keeping appreciable assets out of corporate ownership, this issue of
stability argues for keeping joint ownership of appreciable assets to a
minimum under any business structure. To the extent that it is done,
buy-sell agreements may discourage early withdrawal by an owner, while life
insurance policies and equity revolvement strategies may provide additional
security for remaining owners.

Conclusions and Questions

Remember that conclusions were offered regarding the conditions critical
for establishing a multi-family dairy operation. In short, the following
six conditions were identified:

  1. good working relationships between the families
  2. a feasible business plan
  3. adequate capitalization and financing
  4. adequate labor and competent management
  5. an appropriate business structure
  6. access to competent outside advice

This paper focused on the fifth condition regarding the appropriate
business structure for an MFDO. The comparison of five alternatives-- the
partnership, the limited liability company, the S corporation, the C
corporation, and the cooperative-- led to the conclusion that the LLC
offers the most advantages. Lower administration costs, limited liability,
flexibility in distributions, single taxation of income, capital gains tax
benefits, and favorable adjustments in the basis in assets are among the
reasons why the LLC may often be the best choice of business structure for
a closely-held joint venture.

The partnership, which is similar in many respects to the LLC, was ruled
out simply because it did not offer limited liability to all owners. In a
closely-held joint venture, "cooperative principles" of equal control,
equitable distributions, and equitable capitalization can probably be
accomplished in any carefully structured model-- through by-laws, operating
agreements, or more informal means.

However, things become more complicated if appreciable assets are already
in corporate ownership, because of conversion costs associated with
liquidating a corporation. C corporations and cooperatives also have the
advantage of tax deductions for fringe benefits paid to employee-owners.
Conversion costs and fringe benefit deductions may be reason enough to
develop a "multiple entity model" that includes both an LLC and a
corporation. The best choice for that corporate structure may be the S
corporation, the C corporation, or perhaps even the cooperative, depending
upon the situation.

The S corporation may be used to postpone taxation on built-in gains when
transitioning from a C corporation to an eventual LLC. More often, a C
corporation would be best because of its deductions for fringe benefits
paid to employee-owners. It is not clear whether the cooperative could be
used in place of the C corporation in this multiple-entity model in order
to get both deductions for fringe and single taxation of income that is
returned as patronage refunds. This would be a question for the IRS.

While these options should be considered, many families may choose to
forego a multiple entity model (and associated deductions for fringe) and
simply select an LLC in order to keep things simple. Even if an LLC is
chosen, it is probably best to keep appreciable assets out of joint
ownership in order to avoid unforeseen conflicts in the future. In order to
ensure stability of the joint venure and deal with unexpected early
withdrawals by an owner, it is highly advised that buy-sell agreements be
put into writing at the outset, while there is still general consensus
among the families.

It must be said that all of the conclusions offered in this report would
benefit from a a careful review by colleagues in academia, by legal and
financial professionals, and, most importantly, by farm families
themselves. Any conclusions regarding the comparison of business structure
models should be taken as the researchers best interpretations of some very
complicated laws. Any family considering a closely-held joint venture like
a multi-family dairy operation is strongly encouraged to seek out
additional legal and financial assistance. There is no single "correct"
approach that can be applied across every situation.

While the cooperative business form, by itself, may not be the best way to
organize a multi-family dairy operation, there is an underlying "spirit of
cooperation" that was perhaps the most encouraging discovery of this
research project. This cooperative spirit is undoubtedly essential if
Wisconsin dairy farm families are going to overcome the challenges facing
their industry. Further research would help direct this cooperative spirit
along paths of rationale business planning, particularly with respect to
issues of scale, capitalization, tax planning, and related business
structure issues.

It's been almost a year since interviews were conducted. At the time, many
of the families had not yet settled on a business structure for their
proposed joint ventures. It would be good to re-examine each case to see
how they have developed. It would be worthwhile to study more cases like
those in Gunnison, Utah and Towner, Minnesota, where community investment
was used to help finance capital-intensive dairy operations. Further
research might help determine which business structure model might be best
at attracting community support through outside investment, while still
maintaining farm family control over the operation.

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Endnotes:

  1. Greg Lawless is an outreach specialist for the University of Wisconsin
     Center for Cooperatives; Robert Cropp is the Director of the
     University of Wisconsin Center for Cooperatives and Professor and
     Extension Specialist, Department of Agricultural Economics; Phil
     Harris is Professor and Extension Specialist, Department of
     Agricultural Economics; all at the University of Wisconsin, Madison,
     Wisconsin.
  2. Wisconsin Department of Agriculture, Trade and Consumer Protection,
     Wisconsin Agricultural Statistics, 1995, pp. 69; and Wisconsin
     Agricultural Statistics Service special report.
  3.  _Wisconsin Agricultural Statistics_, pp 64, and _Wisconsin 1994 Dairy
     Facts_, pp 5
  4.  _Wisconsin Agricultural Statistics_, pp 65, and _Wisconsin 1994 Dairy
     Facts_, pp 29.
  5. Dennis Johnson, et. al., _Year in Cooperation_, Fall 1994.
  6. It should be noted that cooperatives are corporations. They must be
     formally incorporated under state statutes, and they involve the
     similar formal structure of corporate boards elected by the
     corporation's owners. However, there are significant differences
     between cooperatives and other corporations, as will be discussed
     further.
  7. For an LLC to qualify for partnership (pass-through) tax status, it
     may possess no more than two of the following "corporate
     characteristics": (a) continuity of life, (b) centralized management,
     (c) limited liability, and (d) free transferability of interests.
     Since limited liability is almost always present, if the LLC opts for
     centralized management, for example, no other corporate
     characteristics may be present without forfeiting pass-through tax
     benefits. These issues will be discussed below.
  8. Under certain state laws, at least two managers must be identified-- a
     chief manager and a treasurer.
  9. I.R.C. Section 751 allows the LLC/partnership to increase its basis in
     its assets for purposes of calculating depreciation and gain or loss
     for a new member/partner. This increase allows the new member/partner
     to report bigger depreciation deductions and/or less gain when assets
     are sold.