The role of inter vivos financing in the intergenerational transfer of the corporate farm under uncertainty

During the 1970s, the combination of rapidly appreciating land values with the trend toward fewer but larger farms dramatically increased the need for tax management and tax planning. Income and estate tax considerations pose problems for many farm families that want the next generation to continue the farm business. Accordingly, there is an increasing interest in starting the intergenerational transfer process during the parents' lifetimes. Selected equity and nonequity intrafamily financing may or may not facilitate intergenerational transfers. Financing arrangements can create interpersonal conflicts between the objectives of the parents and those of the on-farm heir. This study investigates selected financing arrangements and identifies those which facilitate the intergenerational transfer and those which do not;The Iowa State University Business and Financial Planning Model was used to investigate the financial consequences that selected equity and nonequity financing arrangements have on the parents and the heir. The model incorporated uncertainty as to future events through a Monte Carlo simulation technique which randomly generated nonzero error terms about the expected values of farm revenues and expenses. By recursively running the model a cumulative density function was constructed. First, second, and third degree stochastic dominance theorems were used to compare the cumulative density functions to determine which one (if any) maximized the expected utilities of the parents and the heir;When the farm firm is incorporated as a regularly taxed corporation, all parents and on-farm heirs unanimously prefer corporate income through salaries and director's fees over common stock dividends. If both the parents and the heir are risk averters, both can benefit when the heir converts part of his (her) equity interest in the firm to an investor interest in the form of a loan. Creation of an intrafamily loan to the heir increases the expected utilities both of the parents and the on-farm heir. While intrafamily loans to the heir facilitate intergenerational transfers, the same is not true when the heir converts part of his (her) equity into a bond. The parents increase their expected utilities at the expense of the heir's. An intrafamily bond issued to the heir will never be used to facilitate intergenerational transfers because it is counterproductive and does not facilitate the intergenerational transfer.