A Saskatchewan farm couple sells their farm and expects to live on easy street. But high taxes and poor fund performance lead them down a different road
In a corner of Saskatchewan, a couple we’ll call Jack and Roberta, both 48, were having trouble making their 1,000 acre grain farm pay. It was 2007 and an offer was on the table for $900,000. They had jobs in town paying them a total of $90,000 per year, so they decided to sell. Today, their jobs are keeping them afloat, for their farm business is a financial shambles caused by their own poor bookkeeping, high administrative fees for services and poor investment returns.
Five years ago, they were offered $900 per acre and, even though the property had been in Jack’s family for generations, they took the money. They bought a new home for $500,000 and still had money left over from the sale of the land and equipment to invest. They signed up for a $500,000 whole life insurance policy with a premium over $7,000 per year. But the force was not with them. They wound up with high tax bills and low performance from their financial assets.
Add that to hefty accounting fees, poor performance of financial assets and those big tax bills and the couple’s problems are clear. Their spending out of personal and corporate accounts exceeds present cash flow. They are sustained by their town jobs, but they are slowly going broke. When they retire from their town jobs, if they have done nothing to stop the flow of cash, the slide into poverty will quicken.
For now, Jack and Roberta have a very reasonable agenda: pay tuition and related costs for their two teenage children at university. That’s $5,200 per year for tuition and books if the kids live at home. They want to buy a vacation home in Arizona in a few years at a cost of perhaps $100,000 to $120,000. And they want to retire fully in 12 years with $5,000 per month after tax in 2012 dollars.
Farm Financial Planner asked Don Forbes, a financial planner with Don Forbes & Associates/Armstrong & Quaile of Carberry, Man., to work with Jack and Roberta.
His analysis is chilling.
“If the couple does nothing to change their current tax, life insurance, investment and spending levels, then their capital will be exhausted by the time they are in their mid-70s,” Mr. Forbes says. “Then, retired, they will be insolvent.”
The problem of having no money for bills has already appeared. Through bookkeeping that is perhaps less transparent than what one would like — they have mixed personal and business accounts. They have kept their farming corporation, however, it contains just investments. The passive investment income inside the corporation is taxed at a higher rate than they need pay on their personal returns, Mr. Forbes notes.
Their life insurance policy is owned by the corporation but it has negative tax consequences. The problem is that life insurance premiums are a taxable shareholder benefit when the corporation is not taxable because of its deficit and if all assets can be transferred out as a return of principal. In this case, the taxable benefit costs $2,622 in extra tax liabilities in their personal returns.
The couple has had to borrow money secured by their personal residence to get money to pay corporate bills.
Jack and Roberta could transfer all of the corporately owned investment assets to their personal names. That would be deemed a return of principal. It would also trigger a $150,000 capital loss if it’s a full transfer. That loss could shelter future investment capital gains, Mr. Forbes notes.
They also need to review how a $313,000 operating deficit could be crystallized when they wind up their farm corporation. An accounting review would be in order, Mr. Forbes suggests. The deficit cannot be transferred but can be applied as a carryback loss for up to the past three years to recapture previous corporate income tax paid. In this case, for 2007 when the farm was sold, the corporation paid $57,000 income tax.
Paying for two children’s university expenses will be feasible if Jack and Roberta do several things to provide approximately $22,000 for four years of study for each child.
Apply to the scholarship trust for tuition for the elder child ($3,000).
The grant should be paid before any return of principal. Then get a return of capital. In the fall, reapply for more money for the second year. Proceeds in the next three years are not known but will be taxed in the hands of the kids.
Another RESP should be taxable to the students in their first years and then should be a non-taxable return of capital to the parents.
Jack and Roberta bought a $500,000 whole life insurance policy. The annual premium, $7,617, would be paid by the farming corporation. Corporate assets can be transferred out as a return of capital without tax. But if the premium is paid by the company, it is taxable benefit to the shareholders and must be declared on their personal income tax returns. At a 34 per cent tax rate, that would add $2,622 to their personal tax liabilities composed of the $7,617 premiums for total insurance cost of $10,239. If the policy were to be terminated now, Jack and Roberta would forfeit $22,000 in premiums paid to date.
Best move? Transfer ownership of the policy from the company to the couple in personal names. The policy will provide a minimum legacy to their two children. Then transfer all investments in the corporation’s name to personal names.
If Jack and Roberta want to buy the vacation home in Arizona, they should budget $12,000 per year for expenses and travel.
They can’t afford it now and, if they want to rent it out for income while they are not using it, they should consider the requirement that they file U.S. returns on that income.
If the couple should stay too long in Arizona, they could become liable for U.S. taxes on all their world income. They could get a Canadian foreign tax credit for those taxes, but the process of filing and recapturing credits would add to the complexity of their affairs.
If they do liquidate their farming corporation, they will have money for the Arizona purchase. But they need to think through the cost of owning that house for the few months of the year they are likely to be in Arizona.
If they want to go ahead, they can put $120,000 obtained from freed up company assets into a bank account for the purchase. Alternatively, they could just rent a house or condo for a few months each year in Arizona and keep their lives simple, Mr. Forbes explains.
Jack and Roberta have 36 different mutual funds in their various accounts. That breaks down to 11 Canadian balanced funds, 15 Canadian equity funds and 10 foreign equity funds. Unfortunately, this mix is not diversification as much as it is costly duplication. The funds are proprietary portfolios sold by mutual fund companies with fees that are typically about 2.8 per cent of net asset value. The funds’ performance, dragged down by fees, has lagged that of peers.
There is a solution — work with a financial advisor or dealer to migrate the funds to specific and desirable stock or to exchange traded funds (ETFs) with desirable holdings. ETF fees are perhaps a tenth of those they are now paying. A professional portfolio manager could also do the job for a fee of one to 1.5 per cent per year of net asset value and create a customized portfolio with appropriate risks and tax characteristics for the couple, Mr. Forbes says.
For the future, it would be important to maximize TFSA contributions for the next 12 years using money from liberated company assets. In a dozen years, the accumulated value of $10,000 annual contributions growing at five per cent per year could add up to $167,000.
They should also maximize RRSP contributions. On top of present RRSP balances of $117,844 for Jack and $113,922 for Roberta, the contributions will build $330,000 for Jack and $300,000 for Roberta. All this will support income from a Registered Retirement Income Fund of $1,500 per month for 30 years for Jack and $1,400 per month for Roberta.
In 2024, when each is 60, Roberta can apply for a company pension that will pay her $685 per month. She can convert a Locked-In Retirement Account to a Life Income Fund for another $1,185 per month. Her RRSPs can be converted to RRIFs that pay $1,400 per month. And she can take an early Canada Pension Plan benefit of $550 per month. Jack, for his part, can convert his RRSPs to RRIFs for $1,500 per month and take $500 from CPP for a reduced benefit at age 60. Their non-registered investments will be about $480,000. If those investments pay five per cent, they will add $2,000 per month to total income, which will then be $7,280 per month. That will cover expected future living expenses of $6,420 per month.
If Jack and Roberta take all of these suggestions, they can retire on $7,280 per month in future dollars at age 60. At 65, they can add Old Age Security benefits, currently $6,480 per person per year. That is much more income than they have now when much of the cash flow has to support bad investments and poorly structured life insurance.
“Jack and Roberta have slipped into a pit of problems which, if not fixed, will leave them broke in the middle of their retirement,” Mr. Forbes explains. “But if they take corrective action as I have suggested, they can retire in comfort and security. Provided that they take the first step of winding up their farm corporation, the rest of their restructuring will follow relatively easily,” Mr. Forbes adds. †