In central Manitoba, a man we’ll call Harry, 81, has retired from a former life actively farming what was four quarters of grain. As Harry’s end of life comes into view, he wants to ensure that his sole heir, a nephew we’ll call Sam, does not wind up with a farm reduced or impoverished by hefty capital gains taxes. The irony in this case is that Harry was more farmer than accountant. He tilled his fields rather than devoted time to his financial books and is, thus, in financial jeopardy.
Harry’s problem, in a broad sense, is letting things go too far and too long. He has taken advice from an expert farm financial planner and realizes that decades of work could be mired in tax issues at his death. And then, quite likely, generate a massive tax bill for his estate. Even cause the forced sale of his farm.
Aware of his need to make arrangements for his passing, Harry went to the farm financial planner Colin Sabourin of Winnipeg Financial Planning. The goal — to devise a way of transitioning from the farm and corporation and non-farm assets to Sam and to avoid unnecessary taxes. He urgently requires a financial package that would provide income, but be free of farm management responsibilities for Harry.
A dozen years ago, the farm was divided so that Sam now owns two-thirds of the farm corporation, while Harry has kept one-third. The farm corporation itself has $600,000 cash, $1 million of land and $60,000 of inventory. His gain on paper of his farm corporate shares is $546,900.
Harry’s personal farmland is two quarters valued at $400,000, with an adjusted cost base of $145,000. He has a $255,000 gain. He has another quarter with his nephew valued at $242,000. His share is 50 per cent or $121,000 with an adjusted cost base (ACB) of $40,000 for a gain of $81,000.
The basic rule for determining if a farm is qualified farm property are as follows:
- Land acquired after June 17, 1987, must be owned by the farming individual for at least two years and the property must have been used principally in a farming business where the gross revenue from the farming business was more than all other income for the year.
- Land acquired before June 17, 1987, must have been used principally in a farming business in the year of sale by the individual, their spouse, child/grandchild, or parent/grandparent, or for at least five years during ownership.
In this case, Harry purchased the farmland before June 17, 1987, and it was used mainly in the business of farming for 30 years. Therefore, it meets the test of qualified farm property, and Harry could therefore use his capital gains exemption when he sells.
Large tax issue
Harry has a large tax issue because his corporation does not meet the test of qualified farm property. His farm is not quite farm enough. The farm has too much cash inside the corporation. CRA requires corporate farm assets to make up 90 per cent or more of total corporate value. In this case, the farm assets are only 65 per cent of total corporate value. The gain on corporate shares can’t be sheltered and will not qualify for the $1 million qualified farm property exemption.
To avoid this outcome, the nephew has to reinvest the cash into more farm assets or withdraw the cash, which could create further problems and potential tax liability, Sabourin notes. It seems like a vise in which a law intended to be reasonable to the farmer or family or their corporation has backfired because the farm is, from a financial point of view, less an active entity than a shell. It would be possible to buy more land or equipment, but that is contrary to the purpose of handing ownership of the farm as is to the next generation. Failure to do this, will make gains taxable as ordinary gains. So, it’s generating two years of active farming or loss of the exemption. Time is still on Harry’s side. Even rental to an active farmer would preserve the exemption. Bringing the corporation into compliance will save Harry’s estate over $100,000 in tax, Sabourin estimates. Harry should not sell his shares to the nephew until they are in compliance with the Qualified Farm Property Exemption rules. Moreover, given that the nephew is Harry’s sole heir, the less tax Harry or his estate have to pay, the more the nephew will get.
Capital gains exemption
Harry is able to use his capital gains exemption to shelter appreciation if he sells or transfers farmland to his nephew. The nephew is not Harry’s child, of course, so Harry has to transfer land at fair market value. This move could trigger the Alternative Minimum Tax (AMT) when taxable income is a small part of high total income. In this case, Harry would have to pay $13,500 in AMT, though it would be recoverable over the next seven years from regular taxes.
There is a catch, however. If Harry dies before the AMT can be used up, it will just be a cost and a diminution of the money Harry’s estate can pass on to the nephew. Furthermore, in the year when income balloons, Harry will lose all of his $7,362 Old Age Security (OAS) to the clawback which starts at about $79,054 these days. All OAS is eaten up by the clawback when net income reaches $128,137. Harry will trigger a $336,000 capital gain, half taxable, and so his $168,000 of net income would be far over the clawback total recovery limit of $128,137.
There is work to be done, Sabourin says. For now, Harry has a gain of $882,900. He has $852,000 of lifetime capital gains exemption remaining. It can be used to shelter part of the lifetime gain. The $30,900 difference will be taxable as a capital gain with a resulting cost of $6,000, Sabourin estimates.
“This is a situation in which a big tax can be avoided by planning, but Harry is alone and does not have a lot of time,” Sabourin explains. “This is a tax and a burden that could have been dealt with a dozen years ago, when there was more time to transition to compliance with the Qualified Farm Property Lifetime Capital Gains Exemption.”
Assuming that Harry can do what is needed by removing cash by buying farm equipment or more land, Harry will avoid a great deal of tax and pay only the recoverable AMT, lose a year of Old Age Security but preserve his right not to be taxed on his homestead and an attached or surrounding acre.
“The irony of the rules is that in an attempt to make a reasonable law, the Government of Canada created a maze of regulations that requires attention to small print and, often, professional expertise,” Sabourin explains. Ultimately, preserving the family farm for future generations becomes a long-term planning process with attendant costs of hiring financial planners, lawyers and accountants to get it all right. There is a cost, but a bill for planning and attendant accounting and legal advice is likely to be a lot less than taxes that, with foresight, do not have to be paid.