University of Wisconsin Center for Cooperatives

Cooperative Ownership Compared to Other Business Arrangements for Multi-Family Dairy Operations
By Greg Lawless, Dr. Robert Cropp and Dr. Phil Harris 1
UCC Occasional Paper No. 11, 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: * 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:

 

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.

 


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.
 
 Return to UWCC Homepage