A couple we’ll call Herb and Martha, both 71, have done well with their grain farm, currently 2,800 acres, in south central Manitoba. It has taken them half a century of work to accumulate the land and to build their business, but today, with combined assets of $5 million including $2 million retained earnings inside their farming corporation, their problem is passing on their business to their children.
One son, now 38, has his own farm and equipment but farms co-operatively with his parents. Another son, 36, and his wife have a separate farming corporation not far away. Only their daughter, 39, is working off farm with no wish or plan to be a farmer. The problem is to create a way to transfer the farm, machinery and associated property while minimizing taxes
Farm Financial Planner asked Don Forbes, a farm financial planner with Don Forbes Associates/Armstrong & Quaile Associates Inc. of Carberry, Manitoba, to work with Herb and Martha to structure their retirement income.
Herb and Martha’s immediate goal is to retire with $100,000 pre-tax income extracted from the operating company in a tax-efficient fashion. They also want to devise a way to transfer their estate to their children and grandchildren.
A potential division
Given the size of the farming operation and its substantial value in land and retained earnings, some complexity in the transfer process is inevitable. A potential division of assets which would accomplish the goal of giving each child a fair share of the parents’ farming business could be as follows:
There are two ways to achieve the division of assets: First, by using cash from the farm’s retained surplus or second, by using an estate freeze and reorganization of the farming corporation into common and preferred shares, Mr. Forbes notes.
In the first case, the parents can take $1 million from their retained earnings or have the corporation pay out a taxable dividend this year. This is a good time frame, for Old Age Security begins to be clawed back after net taxable income reaches $70,954 in 2013. When net taxable income hits the 2013 value of $114,640, OAS, $6,660 in 2013, is totally clawed back.
In 2013, the $1 million would be split into several investment accounts. $80,000 would go to Herb’s RRSP, $80,000 to Martha’s RRSP, $25,500 to Herb’s unused TFSA space and $25,500 to Martha’s unused TFSA space. Then $50,000 can be held in trust for grandchildren and $538,000 left in a conventional investment account. If any of this money is needed for farming operations, it could be diverted back to the farming corporation as a shareholder loan, Mr. Forbes suggests. The loan would then be paid back to Herb and Martha on a tax-free basis.
In 2014, money from the $538,000 investment account can be used to purchase additional TFSA investments in the amount of $5,500 for Martha and Herb. The RRSP purchases will, of course, defer taxes, though Herb and Martha must begin taking money from the Registered Retirement Income Funds when they are 72.
The second case is an estate freeze. The operating company is reorganized so that the common share value is converted to an equal value of preferred shares. The new common shares would be sold to the farming children, entitling them to any increase in the value of the farming corporation. The parents’ preferred shares are frozen in value with an option to redeem preferred shares over time. Redemption could be $200,000 per year for five years. It would be important to ensure that 90 per cent of all assets in the operating company be invested to generate active business income, Mr. Forbes cautions. Excess cash would have to be transferred out to meet this requirement.
In future, if this plan is used, corporate salaries would be replaced with dividends. On an after tax basis, this would mean that $135,000 of current salary would be replaced by $200,000 of corporate dividends. In each case, income tax per year would be about $35,000 in the transition years, 2013 and 2014. Then income would subside to retirement levels.
In 2015, Herb and Martha would have substantial retirement income composed of two Canada Pension Plan monthly benefits equaling $24,300 per year, total Old Age Security benefits for Herb and Martha of $13,200 per year, combined Registered Retirement Income Fund payments of $21,417, approximately $2,000 of dividends and $8,800 interest income. The total, $69,717, would be fairly stable for the next eight years and supportable thereafter. The values are in 2013 dollars. After about $4,000 each in tax credits and assuming splitting of pension income and a 10 per cent average tax rate, the couple would have $6,230 per month to spend.
This would be basic retirement income. It could be increased by income from rental of farm land to produce $40,000 per year of pre-tax revenue for the couple. Extracting rent from the farming corporation would reduce retained earnings and thus the potential growth of value of common shares. Taking rental income would thus be a generational transfer issue to be weighed by Martha and Herb and their children.
Evaluating the options
The two plans can produce similar retirement income results for Herb and Faye, but they do it in different ways. Plan 1 is an asset division that leaves a good deal of cash on the table. Plan 2 reorganizes the income of the farming corporation.
Herb and Martha’s retirement income would be fairly stable and partially indexed. Government pensions — OAS and CPP — are guaranteed and rise in concert with the Consumer Price Index. The two benefits would account for 54 per cent of the couple’s retirement income. Dividends paid by the restructured corporation would be dependable, assuming the good financial health of the farms. Required distributions of RRIF capital would start at 7.48 per cent of RRSP/RRIF capital at age 72, rise to eight per cent at 76 and nine per cent at age 80. Taxes would tend to rise. The couple could purchase annuities with some of their RRSP capital. Annuities pay bond interest, some equity investment returns and provide tax-free return of capital
Delaying any purchase of annuities until interest rates have risen, as they will, and buying annuities slowly, with, say, 10 per cent of available RRSP/RRIF capital every five years would preserve most capital in the couple’s hands to do with as they like. Annuities structured to pay on a last to die basis would be a lower tax solution for the couple, would raise after-tax income over time, but would remove some capital from the couple’s eventual estate. The potential use of annuities should be discussed by Herb and Martha. The tax and income advantages need to be weighed with the fact that money once handed over to an insurance company running an annuity is lost to the estate which then receives only income. Moreover, annuity agreements tend not to have ways of compensating for inflation. However, blended into the retirement plan for only a part of their RRSP capital, annuities would both stabilize income and remove some investment risk.
When one partner dies, the other will lose the ability to split income and will therefore lose both one OAS and one CPP benefit. The effect will be to raise the survivor’s personal income and to put him or her in a higher bracket. The tax burden can be covered with a joint and first to die term life insurance policy, essentially paying a modest sum today for a larger sum tomorrow. †