Estate Planning In North Dakota

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Asset ownership and business ownership

Owning the assets used in a business is NOT the same as owning the business. For example, a landowner who leases land to a farm business, owns the land (an asset used by the farm business) but does not own the farm business. This page explains the difference between asset ownership and business ownership, and how understanding the distinction clarifies the development of a transition plan.

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Understanding the distinction between asset ownership and business ownership begins with a review of some basic economic theory.

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Traditional Economic Resources

Economic theory traditionally categorizes economic resources and the form of their return, as follows:

  • The owner of land is entitled to rent
  • The owner of labor is entitled to a wage
  • The owner of capital is entitled to interest
  • The owner of entreprenurial ability is entitled to profit

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Revised Economic Resources

It maybe helpful to refine these categories to better understand the challenge of transitioning the ownership of a business.  The first several categories are the same as listed above; it is the last two items that differ from traditional economic theory.

  • The owner of land is entitled to rent
  • The owner of labor (including management) is entitled to a wage
  • The owner of capital is entitled to interest
  • The owner of information is entitled to royalty
  • The person who assumes or accepts risk is entitled to profit

Several examples may help illustrate these categories.

Examples: The owner of land (a landowner) is entitled to a rent payment from a business owner (the tenant) who uses the land.  Likewise, the owner of labor (an employee) is entitled to a wage when the person performs services for the business owner (the employer).  A lender is entitled to interest when the capital is used by a business owner (the borrower). 

These transactions occur many times every day and are well-understood.

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Information as an Economic Resource

Even though information has been developed and used for centuries, the rapid development and extensive use of information and technology deserve further explanation.  A series of examples may help.  If you compose a song, the melody is your property and I am expected to pay you a royalty if I use your property, that is, if I use your melody.  If you write a book, I am expected to pay you a royalty if I use the manuscript or your ideas.  If you study the commodity market and provide me a weekly or daily update and marketing recommendation, I pay you a subscription to receive your information and insight.  If you develop technology, I pay you a royalty to acquire a license to use the technology, as in the case of seed genetics.  If you develop technology and incorporate it into a piece of equipment, the purchase price I pay for the machine is expected to compensate you for your ideas.  

The person with the ideas -- whether a composer, author, geneticist, inventor, commodity consultant, business consultant, lawyer, architect or others -- is entitled to be paid a royalty.  This expectation is based on the legal concept that the originator of an idea owns the idea/information and is entitled to be compensated when someone uses the idea.  This no different than a landowner is entitled to be compensated (i.e., paid rent) when someone else uses their land.

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Assuming Risk as an Economic Resource

The fifth item in the list of economic resources is risk and its associated return of profit.  For example, the person who assumes the risk that a business might fail is entitled to the profit when the business succeeds.

  • The person who assumes the risk that a business may fail is considered the owner of the business and is entitled to control the business as well as receive the profit. 
  • It is often assumed that the person who provides equity capital (as opposed to debt capital from a lender) is entitled to own and control the business and receive the profit.  However, a person can assume the risk associated with owning and operating a business without providing equity capital.  Even though providing equity capital is often associated with business ownership, the real determinant of business ownership is "who has assumed the risk of having to pay the creditors if the business incurs a net operating loss".
  • Risk can be transferred; insurance policies is a common example of someone accepting another person's risk in exchange for a portion of the insured's profit (i.e., a premium payment).
  • To be able to meaningfully assume risk, the person needs both an ability and a willingness to assume risk.
  • To assume risk, the person must agree to assume the risk, even though the agreement to assume risk could be implicit in some situations. 

In developing a transition plan, the business owners must regularly assess who is exposed to the risk of the business incurring a net operating loss and then adjusting the business arrangements to assure that the opportunity to receive the business profit and control the business align with the risk exposure.  This topic is addressed in more detail on another page.

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Business Ownership Differs from Asset Ownership

An individual can own a business without owning any of the business' tangible assets.  For example, a farmer can lease all the land, borrow all the necessary operating capital, hire all the needed labor (including the business manager), and purchase all the necessary technology (in the form of seed, pesticides, and equipment) and still own the farm business.  Likewise, a person can own land, capital and labor but not own a business; instead the asset owner can lease the land to a farmer, work as someone's employee, and deposit the capital with a bank that lends it to a business owner.

Owning a business is not the same as owning the assets used in a business.

This distinction is critical as a family plans to transition the ownership of a business and its assets.

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Compensating the Business and Asset Owners

It is well-understood that if a business uses another person's assets, the asset owner is entitled to be paid.  Employees will be paid wages for their labor, the landowner will be paid rent for the use of their land, the lender will be paid interest for the use of their capital, the information owner will be paid for the use of their ideas (a royalty), and the person that assumes a risk will be paid a premium (i.e., a portion of the insured's profit).

But how are asset owners compensated when they use their own assets in their own businesses?  The easy explanation is that the business owner retains the business' earnings or profit.  But are those earnings adequate to compensate the business owners for the use of their land, labor, capital, information, and their ability to assume risk.  A brief review of some basic accounting principles may be helpful.

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Accounting Profit and Compensating the Business Owner

From an accounting perspective, a business' profit or net earnings is the business revenue minus the business costs.  But from a manager's perspective, the question is "does the accounting profit adequately compensate the business owners for their contributions to the business"?

To answer this question, business owners need to consider the value of their contributions to the business and compare the accounting profit to those values.  A simple example is offered.

A farm business generates a revenue of $560,000 in 2011.  Its costs are $420,000.  These cost include fuel, seed, fertilizer, pesticides, repairs and utilities, as well as wages paid to employees, interest paid to the bank, rent paid to the neighboring landowner, subscription to the market consultant, insurance premiums paid to the insurance company, and depreciation.  From an accountant's perspective, the business earned a profit of $140,000.  This is as far as the accountant goes in analyzing the business.  The manager or owner needs to take the analysis the next step.

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Example of a Simple Income Statement



 XYZ Farms

2011 Income Statement

 
Total Revenue $560,000

  Costs

  Fuel

  Seed

  Fertilizer

  Pesticides

  Repairs

  Utilities

  Wages

  Employment taxes

  Insurance

  Depreciation 

 
Total Cost $420,000 
Accounting Profit $140,000

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From a manager's perspective, the question is whether the $140,000 is adequate compensation for the business owner.  To answer this question, the business owners need to identify and value their contributions. 

  • For example, the business owners have $400,000 equity in land; if they want a 5% on their land, they need $20,000. 
  • The two owners each spend about 75% of their time working on the farm.  If they want $40,000 for a full-time job, they need $60,000 for their labor and expertise (40,000 x .75 x 2). 
  • They have another $300,000 equity in the equipment and if they want 8% return on that capital, they need another $24,000. 

Based on these assessments, the owners want $104,000 (20,000 + 60,000 + 24,000) to compensate for the land, labor and capital. 

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Example of an Owner's Additional Thoughts

     
 Total Revenue   $560,000
 Total Cost   $420,000 
 Account Profit    $140,000

Owners' Desired Return for

  Owned Land

  Their Labor

  Their Equity Capital

 

$400,000 x .05

$40,000 x .75 x 2

$300,000 x .08 

 

$20,000

$60,000

$24,000

Return for Remaining Owned Assets     $36,000

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In this situation, the business' financial performance may be acceptable, but only the business owners can make that assessment.  The accounting profit of $140,000 is more than the $104,000 the owners identified as desired return.  The business owners have $36,000 remaining to compensate them for accepting the risk of operating the business. 

It is only by assessing the owner's contributions and comparing them to the business' accounting profit can the owners determine whether they have earned an adequate return.  Should the owners decide they have not earned an adequate return, they can make changes to the business in hopes of increasing the accounting profit, or they can leave the business and invest their resources in an alternative opportunity.

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Another page describes the allocation of accounting profit in more detail, such as dividing accounting profit among the owners who have different contributions.

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Opportunity Cost

The previous example introduces the idea of opportunity cost.  That is, "if I was not using my economic resources or assets in this business, I could be using them in an alternative opportunity.  The income that I could be earning in that alternative opportunity may be one consideration in setting a value on the assets I have invested in my own business."

Opportunity cost -- how much could I earn if the resources were used for an alternative purpose. 

The concept helps value the owners' contributions to their business.  If they each could only earn $25,000 for their labor at an alternative job, it may not be realistic to expect their business to pay them $60,000 for their combined part-time effort in this example.

Another way to think about opportunity cost is "how much do I want to earn to keep me invested in the current business, rather than shift my assets to an alternative use."  As long as the earnings from the current investment meets the asset owner's goals, that asset owner is not likely to change how the assets are being used.  If the current earnings drop below the owner's desired returns, the owner is likely to explore alternative opportunities for the land, labor, capital, information and risk bearing capacity.

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Concluding Thought

Developing a plan to transition ownership of a business and ownership of assets requires careful monitoring of who owns which business assets.

  • Carefully monitoring includes who is providing which economic resource and assessing whether the current business arrangement provides opportunity for the asset owner to receive an appropriate return and to exercise an appropriate level of control. 
  • As the transition proceeds, business arrangements among the owners need to be regularly adjusted so the opportunity for a return and control reflects the changing contributions of the asset and business owners.
  • The transition may occur at once, over several years, or over several decades.  The time period is determined by agreement among the "owners".
  • Agreement among the owners can be reached only if there is careful thinking and open, regular communication.

 

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