The Alternative Minimum Tax is yet another wrinkle in preparing and paying income taxes. It’s particularly relevant to farmers going through succession planning where capital gains of six figures or more may be realized. The Alternative Minimum Tax (AMT) may apply to you even if you have not reached the limit of your Lifetime Capital Gains Exemption.
The Alternative Minimum Tax (AMT) originated from the optics or perception that some people don’t pay enough tax. There are breaks in the Canadian income tax system that offer lower rates for preferential income like dividends and capital gains, and statutory deductions such as those for lifetime capital gains. The AMT seldom arises for most taxpayers. However, when land owners’ lifetime capital gains are sheltered from income tax via the Qualified Farm Property Lifetime Capital Gains Exemption (CGE), landowners receive a tax break that often triggers the AMT. For farmers doing a deemed disposition (passing land on to the next generation), the GGE can turn the theoretical AMT into something practical and pressing.\
Perception is everything. The AMT, which is calculated alongside the regular personal income tax, is just a kind of threshold. If your regular tax owing is more than the AMT, you pay taxes at the regular rate. If the calculated AMT is more than your regular income tax, you pay the AMT instead. The AMT would seem to ensure that nobody gets away with paying too little tax, but, in fact, there is relief from the AMT. If you have to pay it, then you can recover the federal portion in the next seven years by using your AMT payment as a credit against future federal taxes payable. (The provincial portion of the AMT is not recoverable.)
It is, of course, possible, that your AMT may not be recovered. That can happen if your income in the next seven years is so low that no regular income tax is payable. If you see this coming, you can limit your RRSP contributions and defer your taxes for future years.
The CGE is currently $1 million dollars. The CGE does not apply to equipment, but the shares of a family farm corporation, including equipment, can be structured to avoid a taxable capital gain if the shares are transferred to a blood relative within the first or second generation (son or granddaughter, for example, but no third cousins twice removed) or spouse at book value with no gain.
Other tactics to avoid the AMT bite can be switching to taxable investments that generate a lot of dividends that are sheltered by the dividend tax credit to plain interest investments.
The AMT in action
The goal of the AMT is to calculate what your tax would have been, had there been no preferential rates for certain types of income. Here’s is how it’s done:
- Start with taxable income after all deductions allowed for regular tax.
- Add back deductions not allowed for the AMT. These are: resource-related deductions; losses from any investments which require a tax shelter ID number; interest charges for investments; employee home relocation deductions; and 60 per cent of amounts claimable for employee stock option deductions.
- Add 60 per cent of the untaxed half of capital gains.
- Deduct the dividend gross up.
- Deduct $40,000 as the basic minimum tax exemption
- Calculate federal tax at 15 per cent of taxable income.
- Deduct personal credits such as the basic credits, credits for dependents, old age, disability, EI premiums, tuition, medical and charitable expenses.
- Do not deduct transfers of unused tax credits from a spouse, education and tuition credits transferred from a child or labour-sponsored venture capital credits, pension tax credits and political contribution credits.
Let’s say that a farmer, call him Fred, sells his farmland for a $500,000 capital gain. The gain is exempt under the CGE. We assume that Fred has no other income in the year the gain is realized.
Going through the steps, Fred’s taxable income in Step 1 is $0. He has nothing to add back in Step 2. In Step 3, Fred will need to add 60 per cent of half of his capital gains, or 0.5 x $500,000 x 60 per cent, which is $150,000. Fred had no dividend income, so Step 4 won’t apply. In Step 5 he can subtract the $40,000 basic exemption, leaving $110,000. Calculating federal tax at 15 per cent (Step 6), gives Fred $16,500. This is Fred’s AMT. He must pay this amount, but he can carry the federal portion forward for up to seven years, as a deduction against taxes payable. If he can’t use the deduction in the next seven years, Fred will have lost his AMT payment.
“The need for tax planning to avoid that loss is clear,” says James Doer, managing partner at accounting firm BDO in Winnipeg.
A couple of deductions are not affected by the AMT: deductible interest paid on loans not used for tax shelters and business losses and loss carryforwards. If it makes sense from a business point of view to take these losses, the loss deductions will not trigger the AMT.
Farmers doing a generational shift of farm ownership can avoid the AMT entirely by avoiding the disposition of land. Leasing land to a child or children gives them the operational control of a farm and first crack at income, but it does not avoid the transfer of title at some later time. Transferring land to a family trust at book value could avoid realization of profit. That provides the added advantage that, while the tax liability moves to the trust, eventually, if there is, say, $4 million of value and four beneficiaries of the trust, the CGE would rise to $4 million, notes Don Forbes, a farm financial planner who heads Forbes Wealth Management Ltd. in Carberry, Manitoba.
Whether or not the AMT applies will ultimately depend on the disposition of the farm property. The AMT will be triggered during farm succession if, in the 24-month period immediately preceding disposition of the property, it was owned by one or more of the following:
- an individual, spouse or common law partner of the individual; or,
- a family farm partnership.
In the two years while the property was owned by one of the above persons, that person or farm partnership must have earned most of their revenue from farming, and the property must have been used mainly for farming. The concept is to show that the owner(s) are really farmers. There is no gross revenue test for accessing the CGE.
Rules for using the CGE and applying the AMT are complex. Take advice from a farm tax specialist ensure that money taken for the farm won’t be squandered on avoidable taxes. “If a farmer gets the numbers wrong, not only could the AMT and its related CGE be impaired or even lost, but the farm’s own management could wind up doing less than the best for the farm,” Don Forbes warns. “This is not ‘do it yourself’ accounting.”