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Where do I go from here, Part 2

Iben and Shirley Warken-toohard got a bit of a shock last time we met with them they found out that if they both died tomorrow that the equity they planned to pass on to their children would be $500,000 less than they anticipated.

It quickly became apparent that Iben’s plan to farm until he grew tired of it and then quit was going to greatly compound the existing problem. His strategy throughout his farming career was to defer tax and keep that capital in his business to support the very growth used to defer the tax. Iben and Shirley are now 91 per cent equity with no growth anticipated and the option to simply quit would be very expensive.

Iben and Shirley up to this point have filed their income tax on a partnership basis. For the last five years they have kept their taxable income at the top of the bottom bracket. When Iben and Shirley turn 65 they will begin receiving their Canada Pension Plan and Old Age Security, which will add to their taxable income. This will mean that in the future they will be able to take even less from the farm without paying significant tax. Taking out the RRSPs in addition to claiming the farm income while paying a reasonable amount of tax would be challenging. This is without consideration given to selling any term assets off the farm.

Iben and Shirley did not realize that once their taxable net income reaches $67,000 it starts to reduce their Old Age Security benefits on a prorated basis. This prompted Iben to consider winding down the farm over the next two years to avoid losing his Old Age Security.

The reality of the income stream that would be generated by the current assets alone over the next two years is $250,000 per year ($125,000 each). There may be some minor deductions along the way such as hydro and fuel, insurance and building repair. One thing is for sure. It will generate a significant net income.

After the two years IBen and Shirley would be sitting on significant investment. The interest on this will be taxable, further compounding the problem of taking RRSP’s out. Iben and Shirley can delay taking out RRSP’s but at age 71 these RRSP’s must be converted to a RRIF and they will start to come out as the investment is drawn down.

So what are Iben and Shirley’s options?

Three options

The first and perhaps the simplest is to purchase a $ 500,000 life insurance policy that would payout upon their deaths. The proceeds would pay the tax bill. This way Iben and Shirley could sleep at night knowing that the full value of their estate would be passed on to their 18 children. Although the equity is preserved in the estate, the insurance cost is significant, given their age, and still represents a cash drain out of the farm. In the short run this makes sense to manage risk. However, as a long term solution it is an inefficient means of managing the tax.

The second option is to slowly wind down the farm over 10 years. They would reduce their acres by about 10 per cent each year and, over time, reduce the deferred tax liability in their current assets. They would be exposed to the risk of unexpected death which would derail their plan. They would also be exposed to potential income volatility. Land rent from the acres not farmed would also contribute to income, but would be taxed.

The last option is be to incorporate, either by rolling in a partnership interest including all farm assets or by a section 85 rollover in which assets including inventory, prepaids and equipment are rolled into the company. The advantage to this structure would be that in the event of an untimely death the assets would not all be taxed in one year. In addition, the desired income could be drawn out as required in a much more controlled manner with much less volatility. The disadvantage is the increased cost of accounting and level of complexity.

Now Iben and Shirley now have some thinking to do. †

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