In part one and two of this multi-part series, we stressed the importance of understanding and committing to very clear goals prior to entering into retirement planning. Part two stressed the importance of calculating your financial needs for retirement and outlined your options to generate cash by earning cash with assets or generating cash through the sale of assets.
In this article we will address taxes as a driving factor in your decision making process. We will examine the implications of retiring, and outline the strategies you need to consider to manage this potential tax burden.
In or recent discussions with client, Angus McEarnslot, we quickly realized that his strategy to manage tax through his farming career was to do anything possible not to pay it. There are only two reasons for not paying income tax during your farming career: You have either deferred it through growth and the use of cash accounting; or you haven’t made any money.
Angus McEarnslot has avoided paying tax throughout his farming career by constantly growing and each year he pre-bought a few more inputs and deferred more of his grain sales into the following year. He is now 63 years old, on the verge of retiring and has two years of fertilizer and canola seed on hand and an entire year’s worth of crop inventory to sell. Angus plans to retire soon and will need to be very careful in planning his retirement income. The goal in managing tax should not be to avoid it entirely but rather to pay it at the lowest rate possible through careful planning. If he sells too quickly his income will be extremely high and he will have little for expenses to offset that. His tax burden will be significant. Our advice to McEarnslot was to consider three potential strategies to level out his income.
1. Understand the income stream of his inventory and what it may look like if he were to sell it over two to five years. Spreading out the sale of his crop inventory while he winds down farming may allow him to keep his personal tax liability at a reasonable level. Another consideration for McEarnslot is the fair market value of his machinery line. The difference between his sale price and undepreciated capital cost (UCC) is considered recaptured depreciation and is taxed as income.
2. He can roll his inventory and equipment into a corporation prior to selling. This allows for a more rapid sale of the operating component of the farm without necessarily being immediately accountable for the tax as an individual. The reason for this is that a Canadian small business can have a much higher net income than an individual before it moves up into a higher tax bracket. The company winds down the business more rapidly and the individual pays the personal tax only as he draws income out of the company. This company acts like a dam in the bottom of a riverbed. If an individual stands in the bottom of the riverbed, he will drown. If he sets up a dam with a gated culvert (a company), the dam can hold back more water and he draws water through the gated culvert (the company) at a rate that can be handled personally. There are however legal costs to setting up the company and higher accounting costs associated with preparation of financial statements.
3. Angus has a son that is farming and he intends to transfer the entire farm to him at some point anyway. A smooth way for him to transition out may be to consider a Joint Venture with his son. They agree on an income and expense splitting arrangement that can shift each season allowing son to gradually take over the farm and Angus to gradually exit. This strategy will also require time so it must be planned well in advance.
We also discovered that Angus has been diligent in contributing to RRSPs throughout his farming career and has a significant investment here that will need to be dealt with. Angus will need to convert these to a RRIF at age 71 and will need to plan and understand the income stream from RRSP or RRIF in order to manage his taxable position.
He has used a Tax Free Savings Account which will allow him access to funds without the same tax implications so he can get something nice for the Mrs.
At age 65, Angus will also start that government job. You know the one where he can work hard at reducing coffee supplies and spreading gossip and if he does a good job they will send him a cheque in a brown envelope. This brown cheque also gets added on to what he is claiming from the farm so it needs to be considered.
Is there any way for Angus to avoid paying tax on what he sells? Sort of. As farmers, Angus and his wife both have a capital gains exemption to a limit of $750,000 each. That is to say that they can sell their land for $1.5 million more than what they paid for it before they pay tax on the gain. There is the Alternate minimum tax that is assessed on this sale but as long as Angus is taxable in the future, it is a bit like prepaying tax so not too big of a deal.
Angus has some choices here. He can sell that land arm’s length to his son or a complete stranger and claim his capital gain exemption or he can sell that land to his company. This results in a sizeable shareholders loan for Angus that will allow him to draw cash out of the company without the tax implications of a salary, dividends, or redemption of preferred shares.
This allows Angus a way to draw significant cash out of his company from the sale of his inventory and equipment without giving up control of his land. Going forward, the company is on the hook for any gains in the land if the land is sold but if Angus and his wife haven’t used up all of their capital gains, they could consider selling the shares of the company as opposed to the land and the purchaser of the company then assumes any tax liability from the gain of the land. If the purchaser doesn’t intend on selling, the tax isn’t a concern.
One other consideration for Angus is Old Age Security benefits. Once his income climbs above $66,733, his OAS is gradually clawed back. This calculation is made prior to consideration for the exemption for capital gains so he and his wife will most certainly lose this in the year they sell the land unless it is done prior to age 65.
Stay tuned as we continue down the road to retirement and ultimately decide whether to retire in Texas with the Lexus or if you are stuck in the lodge with the Dodge.
AndrewDeRuyckandMarkSloane managetwofarmingoperationsinsouthern ManitobaandarepartnersinRightChoice ManagementConsulting.Withover25years ofcumulativeexperience,theyoffersupport infarmmanagement,financialmanagement, strategicplanningandmediationservices. Theycanbereachedat [email protected] and [email protected] or204-825- 7392and204-825-8443