In northern Alberta, Jack Downey (not his real name) farms 1,280 acres. He has a herd of 200 beef cows. The time has come to pass the operation on to his three children, who are in their mid-50s. There is not much time to waste, for Jack is 79 and his ailing wife Mary is 77. Though healthy, Jack knows that he cannot run the operation forever.
Jack has been so focused on growing his business that he made no plans for retirement. He has no cash reserves and he has not thought through what he will do after he retires. But he knows he has to set the things up for the time when he can’t keep running things.
The ranch was incorporated 30 years ago to take advantage of the low small-business company tax rates. Jack has 68 per cent of shares, his wife has 26 per cent of shares and each child has a two per cent interest in the farming company.
Farm Financial Planner asked Don Forbes, head of Don Forbes &Associate/Armstrong &Quaile Associates of Carberry, Man., to work with Jack to make a transfer of ownership work for all parties.
The problems for the family are to extract $20,000 per year in cash from the farming company for Mary’s care home and other medical expenses. They want to minimize taxes, of course. On the ranch, Jack wants to reduce his workload. That means cutting the heard by half or more and perhaps selling some land in order to raise cash. Finally, Jack wants to leave a legacy for the children.
For now, Jack and Mary have total monthly income of $2,410. Their current expenses are $1,700 per month fees for the care home and $2,000 per month for Jack’s own living expenses. That leaves a monthly deficit of $1,290. Moreover, since 2003 and the BSE crisis, the beef business has not been profitable. All cash reserves, both company and personal, have been used to cover past farming losses, Forbes notes.
Realizing cash from sale of farm assets won’t be easy. The sale of land assets by the family farming corporation will not be eligible for the Qualified Farmland Capital Gains Tax Exemption. The tax credit can only be taken by individuals rather than companies. However, as Forbes notes, small companies can qualify for the $750,000 Small Business Corporation Tax Credit for sale of shares.
For now, Jack has three options. First, liquidate all assets for cash. That should yield $840,000 with potential income tax liability of $124,000. That will leave a nest egg of $716,000. Jack will still need a place to live.
Second, create a seven-year plan to sell the parents’ shares of the farming corporation to the three children; Canada Revenue Agency has strict guidelines on how shares and the small business corporation need to qualify for the $750,000 Small Business Corporation Capital Gains Tax Credit. The sale proceeds of the cow herd will be taxable to the company and dividends taxable to shareholders, the shares sold to the children over the next seven years can be tax free if properly structured and documented, Forbes notes.
Third, combine these two approaches. The couple should carry through with their planned sale of 320 acres of farm land and half of the cow herd. The farmland sale will produce about $180,000. The book value of the land is $36,000, which leaves a taxable capital gain of $144,000. Half of that is taxable and the remaining $72,000 can be paid out as a taxable company dividend.
The 50 per cent cow herd reduction could net $60,000 and is taxable to the farm corporation. Shareholders would have to pay tax on dividends paid to them. By splitting the dividend payment over two years, the tax due would be reduced.
The two transactions will generate a gross return of $240,000 less about $40,000 of income tax payable. The remaining $200,000 is available to the family for personal use. Provincial tax in Alberta will be relatively light. Jack and Mary currently have enough personal tax credits to shelter $20,000 of dividends each year. The remainder of farming corporation shares should be sold to the three children over the next five years. A shareholders agreement would have to be signed by all five shareholders outlining terms.
For the immediate future, Jack and Mary must have a will drafted and enduring powers of attorney must be put in place. Were they to die without wills, sale of all assets regardless of tax consequences would take place.
PROTECTING INCOME FOR LIFE
Assuming that Jack and Mary adopt Forbes’s third suggestion, sell 320 acres of farm land and 100 cows, their retirement incomes will rise dramatically beginning next year. In the first year, Jack and Mary will have total income of $144,100 and pay income tax of $17,264, leaving after tax income of $126,836. That disposable income will decline as taxable sales of property and dividends paid out fall. But their income will not fall below current levels.
Jack and Mary will have difficulty moving their business interests from ranching to managing cash arising from sale of farmland and cows. The temptation may be to accept the risks that go with investing in equity mutual funds or, conversely, to put all their money into a bank account earning approximately nothing.
Neither course is right. Taking on stock market risk late in life must be done sparingly. Accepting just about zilch from a bank account is also not helpful. A middle course would be to find either balanced mutual funds that hold both stocks and bonds and that have management fees below one per cent per year with no sales charges or to buy exchanged traded bond, stock or balanced funds through a fully licensed investment dealer. By buying funds with no sales fees at all from banks and instructing their investment dealer to recommend only funds with no sales charges, they can save a great deal of money upfront and in penalties if they choose to move out of one company’s funds and into another. ETFs are sold on commission by stock brokers but have management fees of half of one per cent or less.
“It is essential that the couple take steps to protect their life’s work and their legacy,” says Forbes. “If they do nothing, much will be lost.”
AndrewAllentuck’sbook,WhenCanIRetire? PlanningYourFinancialLifeAfterWork,was justreleasedbyPenguinasapaperback