An Alberta grain farmer we’ll call Bill and his wife, who we’ll call Marilyn, both in their early 40s, have two teenagers. They are part of a family tradition that has seen his dad cultivate 3,000 acres of dry land. Now the question of succession has arisen.
Bill’s dad, now in his 80s, has a fairly simple will in which all assets are to be sold and divided equally in three ways so that Bill and his two siblings get equal shares. Trouble is, Bill would like to maintain the farm. Indeed, he has a three-year crop share lease with his father and a right to use farm machinery as needed subject to a requirement that he maintain and repair it.
Bill has a right of first refusal to buy the land. But the will, as drafted, is a poor succession device. It fails to spell out how the transfer of ownership will take place, how valuations will be done and what the role of each family member may be in the business.
The assets in question are not just the 3,000 acres, but $1 million of machinery that pushes the total value of the operation, including land, to $4.6 million. All the assets are free of encumbrances — no debts, no liens. There is unsold grain in bins and an investment account that is composed mainly of bank GICs.
The farm currently produces net income of $300,000 to $400,000 per year. Bill has a job in town as well that pays him $100,000 per year. His employer would let him off for five months of farm work. The other seven months would produce $56,000 income from employment.
Farm Financial Planner asked Don Forbes, head of Don Forbes & Associates/Armstrong & Quaile of Carberry, Man., to work with Bill to develop a succession plan. As Don says, “Bill is correct in identifying his relationship with his siblings as the most important obstacle to his succession to the family farm. The siblings have 4.6 million reasons not to cooperate in settling the estate in his favour.”
Family issues notwithstanding, Bill has two ways to handle the succession problem.
BILL’S TWO OPTIONS
One: Give up the idea of farming. He could continue with his town job, earn $100,000 a year before tax, continue to live in his new $500,000 house and get a legacy of $1 million or more after his father’s passing. Some of the legacy would pay off his existing $300,000 residential mortgage. Were Bill to maximize his RRSP contributions cach year for the next two decades, he would accumulate $1.1 million. That sum would produce $80,000 permanent income from a Registered Retirement Income Fund at his age 63 onward.
Two: Get the farm and take on its business risks. Only about 30 per cent of all businesses survive a generational transfer, Mr. Forbes notes. If the succession were to be successful, then by the time he is 63, he would have farmland worth $6.1 million, assuming a three per cent real annual return after inflation.
In order to improve the odds that the succession will work, Bill should first keep his town job. That’s ironic, but it will help as a negotiating tool with the siblings. With that town income, he can argue from a position of strength. The income flow will also help his personal household cash flow, Mr. Forbes says.
Bill should also work with his accountant and lawyer to prepare to buy 640 acres that his father owns. He should aim for a closing by January 2010.
Assuming that the current market value of this acreage is $1,200 per acre, then the parcel would be worth $768,000. The first $250,000 of the price would be a gift from his father.
The next $500,000 would be financed with a mortgage with the proceeds to be divided equally between his two siblings.
The $750,000 Qualifying Farm Property Capital Gains Tax Exemption will enable this transaction to be tax-free.
An option to buy another 640 acres should be included in the deal.
It is vital to get Bill’s father and his siblings to agree to this proposal and to have the property shift agreed to in writing by January 2010. If they cannot do it while Dad is alive, it will be much harder after he passes away, Forbes says.
The schedule of transfers would thus make it possible for Bill to buy the land and related equipment in five stages:
1. 640 acres in 2010
2. 640 acres in 2011
3. 640 acres in 2012
4. 1,080 acres in 2013
5. Farm machinery in 2014.
GET MORE INSURANCE
Taking on more assets with related liabilities will increase Bill’s financial risks. Right now, he has $350,000 of term insurance. In the event that the property and equipment purchases do take place, he will have to cover the lender’s interest of $3 million. He can either buy mortgage life from the lending institution or from an independent agent.
Mortgage life sold by banks is not the most desirable coverage, Forbes says. The insurance underwriting is usually done after a claim, that is, death, and it is done to exclude claims that may be for such things as preexisting medical conditions. The problem of this type of deferred underwriting is that the buyers of the coverage often do not understand the technical language of the applications and the medical disclosures and thus may put their heirs in the position of losing the property on which the loans were issued. Moreover, mortgage life covers only the interests of the lender. As the debt is paid down, a value gap opens that should accrue to other beneficiaries, but does not.
It is far better and often cheaper to buy ordinary term coverage with flat premiums that are reset every 10 years. Bill’s mortgages on the property would run for no more than 20 years, so that the property would be paid off by the time he retires in his mid-60s.
On that basis, coverage for Bill and his wife, assuming that they own and owe equal amounts and that they are non-smokers, using a first to die policy would be $4,200 for the couple in total.
If the farm generates net income of $300,000 to $400,000 per year, the insurance premiums would be about one per cent of cash flow, a relatively small amount. What’s more, over time, as the amount owed declines, named beneficiaries, who might be his children, would have their own financial interests secured, Forbes explains.
LOOKING AHEAD TO RETIREMENT
If Bill and his wife make the farm their life, then their capital invested in their land and equipment will be their futures. They could start with investing in a Tax-Free Savings Account and build up balances at a rate of $5,000 per year per person. When they have paid off their debts and their incomes have risen into higher brackets, they can then start investing in Registered Retirement Savings Plans, the planner explains. Eventually, they could build up six or seven figure balances.
Looking far ahead into the future, Bill would like his own children to take over the farm one day. He could sell or lease the farm to them, but his decision could be flexible if he has an RRSP for income independent of the farm, Forbes suggests.
He should therefore seek to