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Farming Structures Tax and Succession Issues


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Presented by Randall A. ha

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Farming Structures Tax and Succession Issues

  1. 1. MNPFinding the right answer starts here. Farming Structures, Income Tax And Succession IssuesPresented by: Randall A. Hay, MBA, CA Jason VanGarderen, BCom, CA
  2. 2. Overview• Structure Options: • Proprietorship • Partnership • Corporation• Integration & the Power of After Tax Corporate Dollars• Farm Replacement Property Rules• Accessing the Capital Gains Exemption (“CGE”)• Farm Corporations – Advanced Considerations • Family Farm Corporation definition • Accessing multiple Small Business limits • Large Farms - $10M Capital
  3. 3. Overview, cont’d• What is Succession Planning? - The Process - Timing - Effective Family Governance• Estate Planning Issues to be Aware of – Will Update • Example 1 • Example 2 • Example 3
  4. 4. Structure Options
  5. 5. ProprietorshipDescription • One individual in business independently • Assets owned by the proprietor • No separation between proprietor and businessTaxation • Taxable at marginal personal tax rates • Summary of BC Brackets : Salaries: Dividends 1 11,101 - 41,500 ~ 21% ~ 7% 41,501 – 83,100 ~ 34% ~ 20% 83,101 – 128,900 ~ 38% ~ 26% > 128,900 ~ 43.7% ~ 33.71% • Basic personal amount $11,100 • Canada Employment Tax Credit $1,0511 Personal tax on dividends is lower in order to account for corporate tax already paid.
  6. 6. Proprietorship, cont’d Sale of the business • Asset sale is the only option without restructure prior to sale • Tax efficient sale of the farm is difficult • Consider incorporation prior to sale • If time permits (greater than two years), create a partnership prior to the sale • Spread income over a number of years • Purchase price allocation considerations
  7. 7. Proprietorship, cont’dGeneral Comments on the Structure • Very limited liability protection • The only qualifying asset for the capital gain exemption (“CGE”) is land and possibly production quota – may result in wasted CGE • Inventory – taxable on death or on beneficiarys return • Qualifying assets can transfer during one’s life time or on death to a Canadian child tax deferred • Cash basis calculation of taxable farm income, therefore deferral of tax available with year end planning • If possible should avoid the use of this structure.
  8. 8. Description • Two or more individuals (includes corporations) in business together • Assets owned by the partnership • Provincial Partnership Act – but written partnership agreement overrides • Set-up and maintenance structure costs may initially be less than corporationsTaxation • Taxable at the investor (partner’s) level (ie personal tax return/corporate tax return, etc.) • Taxed at partner’s tax rate: • Corporation – Corporate tax rates; • Individual – Personal marginal rates; losses deducted against other income
  9. 9. ’ Sale of the business • Consider asset sale, sale of partnership interests1, or incorporation prior to the sale • Spread income over a number of years • Purchase price allocation considerations • Agri-stability margin stays with the partnership if sold as a going concern1 Income Tax Act considers a partnership interest equivalent to a share in a company.
  10. 10. ’General comments on the Structure • Limited liability protection with individual partners. • A farm partnership interest (“PI”) may qualify for CGE treatment which can result in a significant advantage on incorporation, sale of the business, death, etc. • Much simpler than a proprietorship transfer on death – deal with the partnership interest versus individual assets like inventory. • If “Family Farm Partnership” (“FFP”), PI can transfer during one’s lifetime or upon death, tax deferred to Canadian Child. • Cash basis calculation of taxable farm income
  11. 11. Corporation Description: • Separate legal entity • Corporation owns the assets of the business • Directors make decisions • Investors are shareholders instead of asset owners • Flexibility in the structure • Voting vs non-voting shares • Participating 1 vs non-participating shares 1 Participating means access to dividends and company net assets on Wind-up and dissolution of company.
  12. 12. Corporation, cont’d Taxation: 1. Corporate Level • Taxable at corporate rates – active income in BC: • First $500,000 net active income currently taxed at 13.5%; • Greater than $500,000 net active income at 26.5% (2012 – 25%) 2. Investor’s or Shareholder Level • Wages, dividends, director’s fees • Wages taxed at full personal marginal tax rates, deductible in the corporation • Dividends result in dividend tax credit equal to tax paid by the corporation on the income
  13. 13. Corporation, cont’d Sale of the business • Consider asset sale or sale of the shares • Spread income over a number of years • Purchase price allocation considerations • Agri-stability margin stays with the company
  14. 14. Corporation, cont’d General Comments on the Structure: • Liability protection • A farm corporation may qualify for the CGE which can result in a significant tax advantage on sale of the business or death • Much simpler transfer on death – deal with the shares versus individual assets like inventory. • If a “Family Farm Corporation” (“FFC”), shares can transfer during one’s lifetime or upon death, tax deferred to Canadian Child. • Low initial tax rates - ability to reinvest low tax rate dollars • Cash basis calculation of taxable farm income
  15. 15. Integration Canadian tax system is built on the concept that personal and corporate tax should be integrated • Tax paid by the company + tax paid on the dividend to the individual = tax paid as if the individual earned the income directly • Provincial influences – integration is not perfect • Timing considerations – power of after tax corporate dollars Example…
  16. 16. INTEGRATION Greater than First $500,000 $500,000Company $100 $100Corporate Tax 13.5% (13.5) 26.50% (26.5)Retained Earnings 86.5 42.66% 73.5 44.07%Dividend Tax 33.71% (29.16) 23.90% (17.57)After Tax Person Cash $ 57.34 $ 55.93Assumes highest personal tax bracket of 43.7%In theory, corporate tax plus personal dividend tax should equal the personal tax paid on $100 of $43.7.Due to Provinces setting their own provincial tax rate, there is not perfect integration. In BC there isa 1.04% (43.7 - 42.66) tax savings for dividend versus salary if corporate tax rate = 13.5%. If accountfor CPP on salary, difference increases to 2.4%.Dividends do not attract CPP nor create RRSP room.Salary is subject to CPP (possibly EI) and creates RRSP room.
  17. 17. Power of After Tax Corporate Dollars Company Proprietor (tax rate 13.5%) (tax rate 43.7%)Before tax cash $115,600 $178,000Tax paid (15,600) (78,000)Bank Loan repaid $100,000 $ 100,000It takes $62,400 ($78,000 - $15,600) less Corporate cash to repay $100,000bank loan.• best tax shelter in North America• better than RRSP’s• creates corporate wealth
  18. 18. Farm Replacement Property RulesProprietorships, partnerships and corporations can replace farmproperties sold by purchasing replacement farm properties before the endof the following taxation year in which farm properties were sold.July 31st year-end: Sold farm land and buildings December 31, 2011 Must replace farm land and buildings by July 31, 2013Generally, full tax deferral if spend as much on replacement farm asreceived.Must replace land and buildings with land and buildings.Must replace quota with quota.
  19. 19. Accessing the Capital Gains Exemption Assets that can qualify assuming definitions met: • Farmland • Production Quotas • Family Farm Partnership Interests • Family Farm Corporation shares 1 Accessing multiple family exemptions when value exists: • Inter-vivos gift to children, 3 year hold prior to sale • Transfer on death to spouse • Building equity in hands of spouse/child Possible Side-effects of reporting capital gain offset by CGE in personal tax returns: • If over age 65, claw back of OAS • Alternative Minimum Tax • Drug plan and other social programs tested by income, not taxable income 1 A company cannot claim the CGE. Only individuals who own shares of a family farm company can claim CGE.
  20. 20. ACCESS CGE UPON INCORPORATION OF FARM PROPRIETORSHIP IN COMPARISON TO FARM PARTNERSHIPProprietorship FMV Cost Capital GainInventory $ 500,000 $ - $ N/ABuildings and equipment 500,000 500,000 -Land 700,000 100,000 600,000Quota 2,000,000 1,200,000 800,000 $ 1,400,000Ignore depreciation on buildings and quotaBank debt $1,500,000Available $750,000 CGE for proprietorCompany Tax Balance Sheet 1 Do not elect Elect to use $750,000 $750,000CGE CGEInventory $ Nil $ NilBuildings 500,000 500,000Land 100,000 100,000Quota 1,200,000 1,950,000 2 $ 1,800,000 $ 2,550,000Bank Debt $ 1,500,000 $ 1,500,000Due to Shareholder 300,000 1,050,000 3 $ 1,800,000 $ 2,550,0001 Under Income Tax Act, can elect a transfer price on each type of asset which can cause no income tax upon incorporation or can elect a price which triggers a capital gain equal to $750,000 CGE.2 Elected quota transfer price of $1,950,000 which triggered $750,000 capital gain offset by $750,000 CGE.3 Additional $750,000 shareholder loan avoids maximum dividend tax of 33.71% for an undiscounted maximum personal tax savings of $252,825 ($750,000 x .3371)
  21. 21. Partnership - Husband and Wife FMV CostPartnership: Inventory $ 500,000 $ - Buildings and equipment 500,000 500,000 Land 700,000 100,000 Quota 2,000,000 1,200,000 Bank debt (1,500,000)₁ (1,500,000) Partnership Interest $ 2,200,000 $ 300,000Available $1,500,000 CGE ($750,000 per partner)Company Tax Balance SheetElect to use $1,500,000 CGE Inventory $ 500,000 nil inventory cost for tax deduction purposes Buildings 500,000 Land 300,000 Quota 2,000,000 transferred separately from partnership interest, $ 3,300,000 recapture may apply. Tax cost will be adjusted for amortization purposes Bank Debt $ 1,500,000 Due to Shareholders 1,800,000 $ 3,300,000Additional $1,500,000 shareholder loan avoids maximum dividend tax of 33.71% for anundiscounted maximum personal tax savings of $505,650 ($1,500,000 x .3371)1 Partners hip interes t, like a com pany s hare, includes the FMV of all partners hip as s ets - inventory. Sale of directly inventory directly res ults in 100% incom e inclus ion. Sale of partners hip interes t in a capital gain eligible for offs et by the $750,000 CGE.
  22. 22. Advanced $750,000 CGE Company StrategyUse $750,000 CGEForm parent company (Parentco) for estate planning purposes.Transfer on a tax free basis all "hard" farm assets - land, buildings and equipment - from Farmco to Parentco.Result maybe adding to shareholder loan $750,000 plus without personal income tax (subjectto CRA denying tax benefit) Mr & Mrs A Parentco Buildings, equipment and land Farmco Herd & quota
  23. 23. Family Farm Corporations and Family FarmPartnerships– Is the definition met? • Family Farm Corporation (“FFC”) and Family Farm Partnership (“FFP”) – all or substantially all of the assets used in a farming business operated by a family member • Watch for custom work division, trucking division, investment assets, other non-farming assets mixed in with the company – if they exceed 10% of the Corporation’s total assets the definition may not be met • Penalty may be that the ability to gift shares to children during lifetime or on death eliminated. • May result in costly restructuring requirement – put a structure in place that can deal with this issue • You may be exposing farm assets to a non-farming business liability and vice versa.
  24. 24. NON-QUALIFYING FAMILY FARM CORPORATION - EXAMPLE FMV %Inventory $ 500,000Buildings and equipment 500,000Land 700,000Quota 2,000,000 3,700,000 64Trucking division 1,500,000Rental property 600,000 2,100,000 36 $ 5,800,000 100Bank debt $ 1,500,000Due to shareholder 300,000Share value 4,000,000 $ 5,800,000Tax on deemed disposition, on death of surviving spouse: $4,000,000 x 21.85% = $874,000If purify Family Farm company with two other companies each own Truckingdivision and Rental property:$2,100,000 x 21.85% = $460,000 Recommended Structure: Mr & Mrs A FarmcoFarmco Rentalco Truckingco
  25. 25. Accessing Multiple $500,000 Small BusinessLimits Taxed at 13.5% • If you plan on growing to a size that will generate significant income, plan for this ahead of time • Consider joint venture or corporate partnership structures to increase access • Need to review cost/benefit analysis in 2012 when high corporate tax rate is 25% in comparison to low corporate tax rate of 13.5%. Benefit on an additional $500,000 x (.25 - .135) = $57,500 p.a. must be compared to increased complexity, cost and risk of CRA denial additional $500,000 taxed at 13.5%.
  26. 26. Larger Farm Corporations - $10M Capital• At $10M, access to 13.5% low corporate tax rate on $500,000 grind starts.• At $15M, access to 13.5% low corporate tax rate on $500,000 is nil.• Calculated on a combined bases with associated companies.• Starting to become a more prevalent issue in the farm sector – large dairy farmers with costly quota, grain farmers with large inventories, land and equipment.• Be aware of the issue – if you plan on growing, make sure your structure allows for the growth without this issue.• Example of only one planning option (there are other planning options) – keep investors in the farm in separate, non-associated entities.
  27. 27. What is Succession Planning?Succession is: Succession is not:• A process • An event• About family, people and • One person’s problem relationships • About minimizing taxes• About ownership and • About equality management • Driven by technical issues that• About what is fair are handled by lawyers and• Driven by the family values, accountants wants and concerns
  28. 28. The Process• I want to retire• Do I sell? Who to? – Third party – Family – Management• Or do I keep the business? – For my family – For myself
  29. 29. The Process, cont’d • What is it worth? • Who will buy it? • How will they pay? • Business plans and planning for the business • Ongoing process and monitoring • Closure – moving on
  30. 30. Timing• The sooner the better• Family inputs and delays• Most important – START!• Get right team together at outset
  31. 31. Effective Family Governance Maximize consensus around protocols Clarify objectives, process, authority, Encourage “fair process” – valuing responsibilities consistency Avoid overlap between structures but Build clear supervisory system for encourage discussion each body Be prepared to revise any mandate Have a process to make revisions Maximize openness of communication. and have process for doing so Provide for appropriate and timely Use non-family advisors to increase communication between the family, effectiveness and efficiency of family directors and management governance bodies Create a process to allow question Search for opportunities to learn from workings of any body other families.
  32. 32. “Hagar the Horrible”
  33. 33. Estate Planning Issue To Be Aware Of1. Will Last time updated? Result: All children – active and non-active – inherit all and business/farm no longer remains in family. • “Fair is not always equal” • Insurance to create fairness?2. Irreversible Estate Freeze Too Early Result: “Windfall” appreciation – quota – and split in the family.
  34. 34. Estate Planning Issues To Be Aware Of, cont’d3. Losing the Ability to Transfer Assets on a Tax- Free Basis • 10% threshold non-qualifying passive investment type assets exceeded. • No Ongoing Purification – Small Business Corp/Family Farm Corp • Lose access to $750,000 Capital Gains Exemption • Lose access to tax-free intergenerational transfer family farm corporation • Farmland transferred 50-50 to siblings
  35. 35. Estate Planning Issues To Be Aware Of, cont’d4. Breaking Up Is Hard To Do When Parents Gone Parents Alive – Relatively easy to carve off company assets into several companies with no immediate tax consequences. Parents Not Alive – Into much more restrictive “butterfly” rules. Professional Costs can exceed $100,000.
  36. 36. Will Update – Ongoing Process and CriticalExample #1Will never updated – simply states estate assets to surviving spouse.If no surviving spouse, split equally amongst all my children.No insurance in place.Farmco estate asset value - Shareholder loan – nil - Share value - $19M.Parents own all shares of Farmco.Both parents die in plane crash.
  37. 37. Will Update – Ongoing Process and Critical(cont’d)Example #1: (cont’d)Six Siblings:Farm ChildDarryl - operated dairy farm for 30 years and lives with his family on farm.Non-farm Children – all live in various towns with own career and families.LacyLarryBerthaBettyBobbyAs per the outdated Will, all six (6) children each inherit $3.167M of Farmcoshares. Farmco sold to pay out children.
  38. 38. Example #2Parents Will updated for the undernoted Farmco share distributionNo company insurance on lives of childrenFarmco estate asset value - Shareholder Loan – nil - Shares $19MSix Siblings Will DistributionDarryl $14MLacy 1MLarry 1MBertha 1MBetty 1MBobby 1M $19M
  39. 39. Example #2 (cont’d)Company redeems shares owned by non-farm children with 3% dividendrate over 20 years. Annual payment - $ 326,290 Total payment - 6,525,797Payments to non-farm children taxable dividends in their hands.Interest paid on company bank loan to redeem shares may not be fullytax deductible.
  40. 40. Example #3Company Insurance in place to buyout Non-Farm ChildrenCompany acquires $5M T100 Life Insurance on parents lives.Parents – 50 years old - 32 years remaining lifeAnnual Premium (estimate) - $51,435Total Premiums paid over 32 years - $1,645,920IRR1 Company Owned Life Insurance Policy Before Tax – 15%+Caveats and Other Issues:• BC Wills Variation Act• Voting vs non-voting shares• Maximum amount of shares owned by non-farm children to be bought back by company each year defined• Accessing non-farm children’s $750,000 CGE.1 Internal Rate of Return before tax that is required to grow annual insurance premium of $51,430 paid over 32 years to $5M. This IRR includes tax benefit of company ownership and discounted tax benefit of Capital Dividend account.
  41. 41. What To Do?? DO NOT HESITATE TO CONTACT A SPECIALIST AT MNP WE CAN ASSIST IN ALL AREAS INCLUDING, but not limited to: -Year ends - Tax planning - Estate and Succession Planning - Family Governance Model - Choosing insurance brokers and dealing with insurance brokers onyour behalf to review appropriateness of amount and type of insurance
  42. 42. Thank you.Questions?