A simple technique to multiply your capital gains exemption is to set up a valid partnership.
Clients often call upon us to determine whether their sale of farm assets, including partnership interests and shares of corporations, qualify for the capital gains exemption. The rules for “qualified farm property” are quite technical, but at the same time generous, particularly with respect to farm real estate. In many cases, the sale does qualify.
In this article we will look at how to access more than one capital gains exemption limit. We will assume the property being sold or transferred qualifies for the capital gains exemption as qualified farm property.
SET UP A PARTNERSHIP
A simple technique to multiply your capital gains exemption is to set up a valid partnership, where the parties contribute their time and effort to the farm operation. When the farm partnership sells real estate it used in the farming operation, partners can split the capital gain and each partner can use their capital gains exemption. The partnership must exist for a minimum of two years prior to the disposition.
Many farm families across the country operate in partnership — spouses, children, etc. With a family partnership, we must be cautious of an income tax rule that requires allocations of income from the partnership be “reasonable” in relation to the capital invested or work performed.
Now let’s look at a farmer who is operating as a proprietor and owns farm real estate. He is thinking about selling the farm. He may think the transfer of the farm, either in whole or in part, to his spouse will allow for access to another capital gains exemption. This planning is fraught with problems. When a person transfers capital property to a spouse, there is an automatic rollover “at cost,” which avoids triggering the capital gain. However, when the spouse sells the farm and has a capital gain, the “spousal attribution” rules require that the capital gain be reported on his tax return and not on his spouse’s return.
Another thought might be to transfer all or partial ownership of farm real estate to your children to allow access to their capital gains exemption on eventual sale. The tax rules do provide that farm real estate used in your farming business can be transferred to your children “at cost.” The children then could sell the farm and access their capital gains exemption. However, if there is a plan to sell the property or an arrangement to sell the property within three years after you transferred it to the children, then this plan will not work. You would be considered to have transferred the property to your children at fair market value and as such, the full capital gain would be triggered and would have to be reported on your tax return in the year your transferred it to the children.
The use of a family farm corporation can allow for income splitting and multiply access to the capital gains exemption. If properly structured, other family members such as a spouse and children can own shares of the family farm corporation. If their shares are sold for a gain, they would be able to use their capital gains exemption.
FORM A FAMILY TRUST
A family trust, established while you are alive, is another common technique for multiplying access to the capital gains exemption. A properly structured trust will allow you to control the property owned by the trust, while at the same time, the income and capital gain on the property will belong to the beneficiaries, which could include your spouse, children and grandchildren.
For example, let’s say you plan to transfer your farm operation to a corporation. One option would be to establish a family trust where you and your spouse could be the trustees (control the trust and trust property) and the beneficiaries include you, your spouse and your three children. The common shares of your new family farm corporation are issued to the family trust. These are the shares that grow in value.
After many years, the shares held by the trust have a significant capital gain — the capital gain exceeds $3,750,000. The shares are sold and the trust has a significant capital gain. The trust then pays or makes legally payable the taxable portion of the capital gain (50 per cent of the capital gain) to each beneficiary such that we use each beneficiary’s full $750,000 capital gains exemption. As such, we have sheltered $3,750,000 of capital gain from regular income tax. However, other income tax consequences could result, such as alternative minimum tax, which must be reviewed.
Another option is to have a family trust purchase and own the farm real estate used in your farm operation. If properly structured, when the farm real estate is sold, the taxable capital gain can be allocated to the beneficiaries and they would be eligible to use their capital gains exemption.
The above is a very cursory overview and there are many technical details that must be adhered to if the plan is to be successful. Proper tax advice from an experienced tax practitioner is a must.
Kurt Oelschlagel, CA, TEP is a tax partner in the Hanover, Ontario office of BDO. A significant part of his practice is agriculture and related businesses.