My post from yesterday resulted in several comments and questions that I would like to respond to.

One comment is that code section 4975 deals with prohibited transactions regarding you and your pension plan or IRA.  There are severe penalties for not obeying the rules regarding these transactions.  However, if you obey the rules, the penalties do not apply to you.  I sometimes find that other tax advisers are not comfortable with these rules and would rather not have to deal with these types of transactions, however, if you follow the rules and use a company that is extremely familiar with the rules, you should be in compliance.

The majority of these rules do not allow you to sell or rent land, equipment, etc. between your pension plan or IRA and yourself.  However, in my post yesterday, the transaction described involved the purchase of the employer’s stock directly from the employer to the pension plan.  This is one of the transactions allowed by the code as long as you follow the rules.

Another question was whether you can use an IRA to do this.  The general answer is no, however, in most cases, once you set up your 401(k) or other pension plan with your new corporation, you can roll over your IRA to the pension plan and then have it purchase the stock.  This will allow you to use the IRA in an indirect way.  Certain types of IRA rollovers may not work, so like in call cases with my posts regarding tax laws, talk this over with your qualified tax advisor. 

Another question asked if you could purchase farm land using this method.  The answer is yes, no and maybe.  For it to be yes, the corporation would need to purchase the land if you are going to farm it.  If you are simply purchasing the farmland to rent out to a non-related third party, you can use the IRA or pension plan to purchase the land directly.  However, if you fund any of the purchase with debt, there are several rules that come into play.  You can not personally guarantee the debt.  In most cases, it would need to be seller financing for the deal to work.  If you personally are going to farm the land, then you can not have the IRA or pension plan own the land and rent it to you.

I know that many of our readers currently have jobs not related to farming, however, you would like to leave that job and start farming on a full-time basis.   One of the major drawbacks to doing this is the lack of capital.  However, many of you could have a substantial asset that you could tap to create the working capital needed to get started in farming.  This asset is your 401(k) plan.

Here is how it works:

• You will need to create a corporation (generally taxed as a C corporation).
• This corporation will establish a 401(k) plan.
• You will roll over your current 401(k) at the old employer into this new 401(k) plan.
• The new 401(k) plan will then purchase shares in the new corporation and will become an owner of the corporation (this is very similar to an ESOP).
• The money put into the corporation becomes the working capital that the corporation can use to purchase equipment, plant crops, etc.

There is no limit on how much stock the 401(k) can purchase.  This means, that unlike borrowing money from a 401(k) plan which is limited to $50,000 or cashing in the plan and paying taxes and a 10% penalty on the funds received, you are able to maximize the amount of capital you can put into the farm business.

There is a recent article in Bloomberg Businessweek concerning this type of transaction.  The primary topic of the article is that the IRS has noted some abuses in this type of transaction.  Some taxpayers have set up a corporation simply to purchase a motor home, etc.  This will most likely get disallowed on an audit.  However, if you are using the cash to create a farming entity and will be actively farming, there should be no issue with using your 401(k) to fund it.

As in all cases, you need to discuss this with your tax advisor.  Also, the article does refer to a company that has helped do several hundreds of these transactions.

In my post yesterday, I indicated that maximizing your net return per acre was more important than the most yield per acre.  One of our readers wrote a great comment regarding how their operation tries to maximize their yield to achieve the most net revenue per acre.

My post should have stressed that your farm operation should try to maximize your yield up to what I call the point of diminishing returns.  For example, if you can increase your yield by an extra 10 bushels (for corn) by spending $15 on good seed or fertilizer, then your return at $4 corn is $40/$15 or 2.67 to one.  As you do your analysis for your farm, anytime this number is greater than 2, it makes sense to spend the extra money.

If the number is between 1 and 2, then you need to crunch your numbers and get comfortable with your probability of the extra yield happening.  For example, if you think you can make an extra $20 per acre by spending $10, your ratio is 2 to 1, however, if the chance of this happening is 50%, your expected ratio becomes 1 to 1.  At this point, you are simply at the break even point and you are not receiving any extra to cover your overhead related to this extra cost.

If you were to chart your options related to maximizing your yield compared to your input costs, the return yield to cost would look very similar to the horsepower chart on my BMW motorcycle.  As I add RPM, the horsepower output increases at about a 45 degree angle up to about 8,000 RPM.  At this point, as I add more RPM, the horsepower output slightly increases and then as I get near the redline, the horsepower starts to drop off dramatically.

In your farm operation, try to determine where the extra yield maximizes the return to the bottom line.

I was watching Agday yesterday and noted in the business section that Mark Gold of Top-Third Marketing was the guest and had a discussion on how gross revenue per acre was more important than yield per acre.  His insight is that it can be more important to budget for getting top marketing dollars for your crop than to worry about the greatest yield per acre.  With the improvements in technology, a farmer can get great yields on their crops, however, if they end up with the bottom third for their price, they will end up net losers for the crop year.

I believe that you need to take this concept one step further and key in on net revenue per acre, not gross revenue.  My definition of net revenue per acre is to take your gross revenues from crop sales and government payments and then subtract all direct input costs related to this crop.  For example, lets take two farms.  One farmer is able to achieve 175 bushels of corn per acre and sells it for $3.75.  The farmer spends $300 per acre on direct inputs (fertilizer, oil and gas, labor, etc.).  The other farmer only gets 160 bushels per acre, however, they sell it for $4.00 per bushel and only spends $250 per acre on direct input costs.  Which farmer makes the most money?

The answer is the second farmer.  Farmer number 1 has gross revenue of $656.25 per acre and net revenue per acre of $356.25.  Farmer # 2 only has gross revenue per acre of $640.00 per acre, however their net revenue is $390.00 per acre which is about $34 higher than farmer number 1.

As you can see, a farmer needs to key in on maximizing their net revenue per acre, not just the yield per acre.