In central Manitoba, a couple we’ll call Nick, 38, and Mary, 37, farm 1,500 acres. They inherited Nick’s family farm eight years ago after his parents died. The farm began with the parents’ two sections. When the parents passed away, the home quarter and associated buildings went to Nick with the neighbouring quarter section going to his sister as her legacy. The sister, not very eager to maintain the property, sold her quarter section to Nick when he started farming. The farm, now a dozen years in operation, has been profitable most years. Nick and Mary have a 10-year old child.
The farm as presently set up consists of the original 320 acres of the parents’ land and another 1,180 acres they later purchased. They have done well with bumper crops and good prices for their grain. However, they want to reduce taxes. Their strategy has been to pre-pay farming expenses to reduce taxable income and to defer selling grain until prices are up and their cash position is down. They have prepaid as much as two years of expenses and they hold two years of inventory.
Tax management has produced personal issues, for the couple has a problem generating enough money to cover living costs. They approached Don Forbes and Erik Forbes of Don Forbes Associates Inc. in Carberry, Manitoba to help them restructure their farm as a corporation. The goal: get cash flow up and taxes down.
The problem is structural, Erik Forbes explains. “Incorporation brings complexity and the costs of professional fees for corporate accounting and legal costs,” he says “Ultimately, incorporation provides the flexibility to expand and grow personal net worth over the long term.”
The larger problem, which incorporation solves, is the question of how long revenue can be deferred and expenses prepaid. The issue, Erik Forbes notes, is earnings management. Farmers can elect to use cash accounting or accrual when filing tax returns. They could potentially defer for many years as long as their reporting is consistent with CRA rules.
The concept of incorporation is to contain the business of the farm under the umbrella of a separate legal entity apart from the personal affairs of the owner. Money held within the corporation and not taken as income can be reinvested in the business, that is, the farm.
After paying salaries and other expenses, the first $450,000 per year of net profit remaining in the company is taxed at an 11 per cent rate rather than the personal rate which, with combined Manitoba and federal tax, can be as much as 46.4 per cent in Manitoba using 2015 rates. The cash flow freed up in the farming corporation, which would otherwise be used to pay a higher tax bill, is retained on the corporation’s books as retained earnings and will become taxable when paid out as dividends sometime in the future. The retained earnings are available to increase the working capital of the farm business, Don Forbes explains.
Moving to a corporation
In Nick and Mary’s case, incorporation allows them to sell grain inventory up to the small business net profit level of $450,000 that they would otherwise defer to another tax year. Any tax-paid equity in farm machinery and /or grain inventory when transferred to the corporation could be liberated as tax-paid principal when it is rolled over into a corporate shareholder loan. That raises cash flow. The shareholder loan reflected in Nick and Mary’s tax-paid equity invested in the corporation can be redeemed in future without tax, Erik Forbes notes.
Moreover, when one incorporates, it is possible to raise the depreciated value of machinery to current market value. That move increases the room for capital cost allowance.
The corporate form of organization allows the business to pay salaries, which allow more structured Registered Retirement Savings Plan contributions, Don Forbes notes.
Both Nick and Mary will be eligible for the qualified farmland capital gains tax exemption when the book value of the personally owned farmland is sold or transferred. However, farmland held within the corporation will not be eligible, so all of their personal land holdings should be kept in their personal names.
In Nick and Mary’s case, farmland with a market value of $2.6 million and a book value of $1.2 million has a nominal capital gain of $1.4 million. Using the $2 million farm land capital gains tax credit based on $1 million per person and allowing $200,000 for the personal residence plus one acre, all capital gains tax liability can be offset. So a potential sale or transfer of the farmland would be tax-free, Don Forbes says. In addition, the residue of $800,000 can be used in future to offset the capital value of the land.
For 2016, the new corporation should realize $450,000 net profits. Some income can be deferred to 2017 to stay under the $450,000 threshold. The extra cash in 2016 can be used to pay off machinery and thus save interest expense, to increase salaries of Nick and Mary to as much as $90,000 each, to top up their child’s RESP, their TFSAs and RRSPs, and, if there is still money left, to pay bonuses for further RRSP contributions of as much as $18,000 for Nick and $14,000 for Mary. If there is still cash leftover, it can be put into a joint non-registered account. The value of this type of account is that the underlying investment in the account can flow to the survivor without tax if one dies. Once the survivor dies, all of the deferred gains become taxable.
Once RRSP space is used up, the next use of cash should be enhancement of the couple’s Tax-Free Savings Accounts. Nick and Mary each have $27,700 in their respective TFSAs. Topping each up to the 2016 maximum of $46,500 this year and taking advantage of the additional $5,500 space for each partner in each successive year with potential indexation will provide a total balance of $583,400 by the time Nick is 65 assuming three per cent annual growth after inflation.
Nick and Mary have a Registered Education Savings Plan for their child with a present balance of $35,000. If they continue to add $2,500 a year and receive the Canada Education Savings Grant of the lesser of $500 or 20 per cent of contributions for eight years including this year, the plan will have $71,814 if it grows at three per cent after inflation. That would cover four years of study at any university in Manitoba for books, tuition and even some room and board. A summer job could provide any additional money, Erik Forbes notes.
Achieving a three per cent after inflation return may seem modest, but it is actually a challenge in today’s low growth, low inflation economy.
The odds of getting three per cent average growth improve if management fees are reduced. A 2.6 per cent mutual fund fee for one year adds up to 26 per cent in 10 years and 52 per cent in 20 years. Rather than use high fee mutual funds, Nick and Mary could use exchange traded funds with average fees of as low as 1/10 of one per cent. Even paying a one per cent advisory fee would leave them ahead. After all, giving up in fees what the couple has struggled to save with a corporate organization would be a waste.