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Untangling the farm tax knots

For a two-generation family actively farming a big spread, transition poses tax issues

In southwestern Manitoba, a couple we’ll call Phil, 63, and Mary, 58, have farmed grain for the last four decades. For Phil, the farm is a continuation of a family tradition with his parents and his brother. For 40 years, they have plowed all profits back into the farm. Today, they farm 4,000 acres they own and another 1,000 they rent. Phil’s son Harold, 33, and son-in-law Fred, 31, work on the farm as well. Phil and Mary are lucky that their children want to continue the operation.

Phil is feeling the effects of 40 years of farming and wants to cut back his work. Harold and Fred want to do more work on the farm. In fact, they have recently bought a $1 million farm with borrowed funds. The family is prosperous, their farms successful. But the very success of their operations has created a web of interlocking interests that has to be deconstructed in order to provide for a smooth and tax-efficient transition of ownership to the new generation.

The problem is to untangle these complicated arrangements so that Phil can enjoy his $8 million net worth in the farming operation. His equity is restricted by the partnership arrangement and the farm’s need for working capital. If Phil were to sell his interest today, it would trigger a huge tax bill of millions of dollars. The problem comes down to getting out without unbearable costs.

Farm Financial Planner asked Don Forbes and Erik Forbes of Don Forbes Associates Inc./Armstrong & Quaile Inc., to work with the family. Don sees the problem as being resolved in stages.

monthly-income-streamsThe best way to unravel the ownership interests in the farm is to terminate the present partnership, Don Forbes suggests. If the partners want to maintain a high level of tax deferability, then each partner should transfer his part of the farm equity to new individual operating companies. Each partner would then receive a mix of common and preferred shares and shareholder loans for the contribution of capital.

After four individual operating companies are created, then the former company owners should negotiate a joint venture agreement to operate the farm and split proceeds according to a pre-arranged plan. Land rent should be paid on all land farmed as a cost of production for the crops which are planted. Note that a joint venture agreement does not have the unlimited liability of a partnership.

Phil and Mary want $100,000 after tax a year in retirement. The farm can’t produce that income and satisfy other obligations. So they will have to charge rent to be extracted from the operation. The ways to do that are complex but, if done right, they are tax efficient.

The rental income plan can be tied to a farm succession plan with a rent-to-own concept for Harold. He would take title to farm land with an agreement that fair market rent be paid to Phil and Mary. That title would be backed by a promissory note take back so that Phil and Mary would not be affected if Harold and his wife have a marital breakdown and division of property. Without the promissory note take-back, Harold’s wife could participate in the appreciation of the land in future and would have to be compensated in any divorce settlement, Erik Forbes points out.

Phil could also cash in his equity in the farming operation. After transition to the individual companies is completed, Phil will have $4 million of equity in machinery, buildings, inventory and working capital. Phil can take $4,000 a month tax-free from his shareholder loan for living expenses. Additional sums can come from arrangements he will make with his three other partners.

The apportionment of land, buildings, working capital and tax planning for all of this should be done by a third party management consultant or an accountant. The interests of each party should be disclosed and divided impartially by the third party to avoid future squabbles, Don Forbes says.

To get $100,000 a year after tax, Phil and Mary will need diverse income streams. The figures shown in the table above are monthly income sources from which they can obtain cash flow.

If Phil takes $4,000 a month from his shareholder loan, he would need only $120,000 before tax to provide $100,000 after tax, Don Forbes says. Corporate retained earnings can be distributed as taxable dividends with substantial tax already paid.

Phil and Mary have significant off-farm investments. Mary has $604,000 in spousal mutual fund RRSPs. She has another $540,000 in a non-registered account. These assets can generate $4,000 a month at a 3.5 per cent annual return. But some tailoring needs to be done. Bonds and bond funds as well as the bank account should be generated from within the RRSP and equities should be held in taxable accounts to make use of the dividend tax credit.

The Farm Land Capital Gains Tax Exemption will help Phil and Mary cut their tax bills. It can be used to raise the book value of the farm to market value when property is transferred to Harold. Phil and Mary will each be eligible for $800,000 of capital gains exclusion for a total value of $1.6 million immune from tax. The effect of the exemption is to lower the total tax cost of the transition dramatically. But there is more involved than just tax management.

Training Harold and Fred to run the farm and giving the incentive of growing equity in the joint venture is vital. As they take over, Phil and Mary will diminish their roles in the farm. Planning for this transition is vital, Don Forbes says. Moreover the joint venture agreement could be amended to free up money which would otherwise be lost in taxes. That money can be used to buy out the equity portion of holdings of Phil and Mary. After all interests are paid, their corporations can be amalgamated with Harold and Fred’s corporations, Don Forbes explains.

“Phil and Mary have done the right thing, that is, anticipating the problems in generational transfer and taking independent advice on how to make it work efficiently,” Don Forbes says. “If they take our advice and obtain independent counsel on farm valuation and asset value and if they take legal advice on asset protection, they can have their retirement with a six figure after tax income, a plan for farm succession, and a continuation of the family farm.”

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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