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Families Struggle to Find Best and Most Fair Formula for Values for Buyout Purposes

Can their problem be solved?

The Problem

Submitted by email from D.T.

My wife and I are trying to figure out what values to use for land, machinery, and sweat equity for future distribution. We’d like to be able to rationalize and explain how we arrived at our fairness and buyout numbers. What are the best formulas to use? 

The Solution

Good news! Your problem can be solved. Why? Because you get to write the formula! The formula should include your cash flow needs, your farming heirs’ farm cash flow capabilities, nonfarm heir equalization, and your intent. Let’s start with land formulas. 

Fair market value: No formulas, just scary for the next generation. 

Percentage of fair market value: What would you sell it to your farming heir for? What is fair market value? Divide the two numbers. This might be your percentage.

Special-use valuation: This is IRS Code 2032A, originally used for reducing estate values. Now, this can be a simple formula for determining land-use value. 

Set a price now for distribution later: Love it or hate it. My simple question is, would you go to an auction today and agree to buy something that will have its price set 20 years later? 

Start selling now: Set the contract price, terms, interest rates, and the heir begins payments now. 

For machinery formulas, things become a little simpler. 

Fair market value: This could be a big range of numbers, but fair sounds good.

Percentage of fair market value: This is common and logical. Start with some quick math. Total value of your machinery divided by 10 (as though on a 10-year lease contract), then divide that number by the number of acres farmed. Could you afford that machinery payment per acre? If not, adjust the percentage. 

Quick note: For 2019, the annual gift limit is $15,000 per person. The federal estate tax limit is $11.4 million. People understand the death tax limit, but for some people there is confusion about using this credit during their lifetime. I had a farmer with $9,000-an-acre ground desiring to sell to his farming heir for $6,000 an acre. This is a $3,000-per-acre discount on his 500 acres, or a $1.5 million gift. He then proceeded to tell me he was told he couldn’t do that. Wrong. He can do that. A 709 gift tax return (no tax due) would be filed now, and the value of that gift would be subtracted from the federal estate tax limit at his death.

What about a sweat equity formula? I have seen sweat formulas attempted for years of service, hours, and all kinds of things. They become very debatable and filled with bullet holes. Sometimes sweat has already been rewarded. In reality, the value of sweat equity will probably be reflected through discounts on land and machinery. The formula for land and machinery will most likely be backed into because it must cash flow for the farming heir. It’s OK if cash flow is a little tight, because ownership has a cost. The difference between fair market value and the value that cash flows must be the value of sweat or risk. Hold it – maybe we just came up with a formula for all three items. What per-acre number cash flows for land and machinery payments? How much do parents need for living? How much should others get? 

Those answers, combined with contracts, financial tools, and legal documents, all coordinated together become your formula. In other words, start with the final answer and make the formula match the answer.

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