If you use farm expansion as a way to keep taxable income low, eventually it will catch up with you. Incorporation will reduce the tax burden

Al Worknoplay, a modest mid-sized grain farmer on the Canadian Prairies, recently introduced us to his neighbour Johnny Cash. Mr. Cash is a large farmer who has expanded very aggressively, and he has a new problem. Mr. Cash asked to meet with us out of concern for a looming income tax liability that he feared was catching up with him. This is his story and the strategies he is considering.

Mr. Cash has always been an optimist but not a speculator. He has consistently expanded his acres aggressively throughout his career, paying close attention to margin. He prides himself on achieved efficiency goals and leveraging profit into further growth.

His tax management strategies early in his farming career were twofold. First, he would pre-buy inputs for the next crop year thus increasing his cash expenses. Often these pre-bought inputs carried with them a significant discount compared to prices paid later in the production season, but this was not guaranteed — as he saw in the fertilizer market of ’08. Second, he increased his deferred grain sales or simply delayed selling into the following year, which decreased his potential cash income. Since farmers can file income tax on a cash basis, Mr. Cash’s twofold strategy resulted in a reduced tax bill for the near term, but an increased future income tax liability.

Then that strategy caught up with him. Mr. Cash reached a point where he was unable to pre-buy any more inputs for the next year and had sold very little crop from that previous year. So he adopted an expansion strategy, which allowed him to continue increasing pre-buy purchases prior to fiscal year-end. But his opportunities to expand in 2008 and in 2009 have been limited due to potentially lucrative margins in the cropping sector, which has increased competition for land. This limited expansion opportunity combined with an extraordinary crop in 2008 and relatively strong markets have limited his ability to keep his taxable income at a reasonable level.

WHAT TO DO WITH BALLOONING TAXABLE INCOME?

Prior to this year, Mr. And Mrs. Cash were able to keep their taxable income around $31,000 each — a level at which they felt to be reasonable.

If Mr. Cash sells only the ’08 crop he has on hand today, and purchases seed, fertilizer, some pesticide and prepays land rent for 2010 prior to 2009 fiscal year end, his projected net taxable income after depreciation is $300,000. At this level of taxable income, the income tax payable is significant. Huge. That prompted Mr. Cash to discuss the issue with neighbours, Al Worknoplay and Ray Roundmup. They compiled the following list of considerations for our review:

—Expand into additional enterprise

—Pay the tax

—Purchase machinery

—Pay wages to family members —Further dilute the partnership —Purchase RRSPs —Lease capital assets —Incorporate

Mr. Cash has considered expanding into livestock such as cattle, hogs or bison. Purchase of livestock would qualify as a cash expense and thus lower the taxable income. The risk associated with this option is that the new enterprise could actually result in a negative net income. Mr. Cash has no experience in these enterprises and the learning curve would be steep. This option dilutes management into an area of the farm that is not the primary focus or interest, thus negatively impacts the entire operation. This option also may impact potential payments received from government programs such as AgriStability due to good grain margin offsetting livestock losses or vice versa.

Mr. Cash has considered paying the tax bill. This has significant implication in his cash flow. Should Mr. Cash wish to expand in the future, the cash used to pay the tax bill would no longer be available. Mr. Cash has a long, consistent history of profitability and given his present land base, a taxable income greater than what can be managed by a sole proprietor is likely to continue.

Mr. Cash has considered upgrading his combines and 4WD. But the added depreciation would only marginally decrease his taxable income. The purchase would require significant capital with only a small portion of that purchase allowed as a deduction, especially in the first year as only half of the allowable depreciation rate can be used in year one. The other consideration is that if this purchase significantly increases actual depreciation cost, this will negatively impact the efficiency of the business.

Mr. Cash has two sons and two daughters. Two are active in the farm business. He considered paying them a larger salary for the work they perform on the farm. Although justified and completely reasonable, these salaries will not be of magnitude enough to solve his income tax problem.

Johnny Cash considered expanding the partnership for ’09 to include sons and daughters, however two of the children are minors and the other two are not certain about career paths at this point.

Purchasing RRSPs is an option, but since Mr. Cash has never claimed a significant taxable income in the past, his RRSP contribution limit is not large enough to allow this option to solve the income tax problem.

Mr. Cash is anticipating building additional grain storage with steel bins. He has the option to lease these bins with a two-to five-year lease with very minimal residual. This is an excellent option if bins are needed. Essentially this allows the farm to accelerate the depreciation of the assets. There are also opportunities available for producers with significant cash to fund their own leases with minimal administration costs.

The final option that Mr. Cash was considering was to form a corporation including him and his spouse as primary shareholders. Inventory and equipment and existing liabilities would be rolled into the company through a Section 85 Rollover Provision. This should create adequate solvency such that land owned personally could be retained outside of the company. This preserves capital gains exemptions for a future date and thus allows for further appreciation of land equity without sizeable tax implications. This would allow the sale of inventory at the small companies tax rate up to an allowable taxable income of $500,000.

It is Mr. and Mrs. Cash’s intention to continue farming for quite some time, continue to expand as opportunity presents itself, and at some point involve their children in ownership and a succession plan. All of which fit very well with incorporation.

CONCLUSION

Although aggressive expansion can allow for easier tax management in a sole proprietorship, there is also a risk that tax will make management decisions. A business may be forced into purchasing significant inputs or delaying marketing decisions, neither of which may be in favour of the net income of the business. A dollar lost accompanied by a tax savings of 50 still results in a real loss of 50. If you foresee continued income that far exceeds annual needs, incorporation is a good way to reduce current and future tax bills.

Andrew DeRuyck and Mark Sloane operate two farms and a consulting business in southern Manitoba. With over 25 years of cumulative experience, they offer support in farm management, financial management, strategic planning, and mediation services. You can reach Andrew at [email protected]or 204-825-7392 and Mark at [email protected]or 204-825-8443.

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