In this article, I will go into more detail on a very important part of the succession process: income tax. (In the February 9 Grainews, page 44, I had listed five basic steps to help start and progress a viable succession plan for your farm business.)
While there may be many years where a farmer will not have income tax to pay, the value of any successful farm will ultimately be taxable some day. In order to best structure a succession plan, it should be set up in the most tax-efficient manner given the circumstances involved.
When discussing your succession plan with your advisors, you should be aware of these five tax issues and concepts.
1. CAPITAL GAINS EXEMPTION (CGE)
This is probably the most commonly used tax tool available for farm succession planning. Some key information about the CGE:
—Every resident in Canada is given a $750,000 exemption on capital gains on qualified small business shares or qualified farm property. Shares in a family farm corporation, as well as farmland and farm equipment would be eligible. Some individuals may have already used $100,000 of this exemption in an earlier year and would now only have $650,000.
—There are restrictions on what defines the shares in a farm corporation as “qualified.” One significant restriction is that if there are too many “non-active” assets in the corporation, then the shares may not meet the definition of “qualified.” Basically, if the farm builds up too much cash, investments, or other assets not needed to actively run the farm, then the shares may not be eligible for exemption.
—The CGE can be used during life or upon death. Corporations cannot claim a CGE.
2. SPOUSAL OR INTER-GENERATIONAL ROLLOVERS
Another commonly used tax tool, these rollovers provide for transferring title of assets or shares to a spouse or child on a tax-free basis. Some key considerations of these rollovers are:
—Any taxpayer has the ability to roll assets over to a spouse on a tax-free basis. Alternatively, one can elect to transfer assets to a spouse at their fair market value in order to utilize their CGE. This way, the cost base on the shares or property transferred would be bumped higher, which has the potential to defer taxes later on for the spouse and other heirs.
—Only qualified farming property can be transferred to a child on a tax-free basis. Any other property will attract capital gains. Again, the property transferred can be elected to have been disposed for an amount between cost and fair market value. (This is subject to an adjustment for actual consideration paid for transfers during the owner’s lifetime.)
A freeze is a very valuable tax tool. The basic mechanism of a freeze is that the principal shareholder exchanges his or her common shares for other “preferred” shares of the corporation, thereby freezing the value of their holdings. The preferred shares would be worth the fair market value of the farm corporation. Now, a successor (perhaps along with the farmer) could buy new common shares of the corporation for a nominal amount. This means that all future growth can accrue to the successor. These shares can then be “redeemed” over time by the corporation, providing a source of cash flow, or a “pension” for the shareholder’s retirement years, while allowing the next generation to participate in growth.
4. HOLDING CORPORATIONS
Using a holding corporation is another way to “freeze” the value of the farm. Basically, instead of exchanging one class of shares for another in the same corporation, the shareholder would transfer his or her shares in the farm corporation to the holding corporation in exchange for shares of the holding corporation. Now the holding corporation would own the shares of the farm. Some of the advantages of this are:
—Dividends on the shares can be paid up to the holding corporation. These dividends would be considered non-taxable, so no taxes would have to be paid by the holding corporation on this income.
—By paying dividends out of the corporation, the farm could eliminate non-active assets that would violate the definition of “qualified shares” for the purpose of utilizing the capital gains exemption. This is called “purifying” the corporation.
—By pooling cash and other investments in a holding corporation, the shareholder could decide when to pay dividends to him or herself. Again, the original shareholders now have a source of “pension” income over their retirement years.
One thing to note under this scenario is that if too many non-active assets accumulate within the holding corporation, it may not qualify for the CGE. So the use of a holding company must be coordinated with CGE planning.
5. LIFE INSURANCE
This can be a very resourceful tool if the situation is conducive to using it. There are a variety of advantages to using life insurance, including:
—Amounts can be provided to spouses and children on a tax-free basis. Using life insurance may be an appropriate method to equalize your estate amongst your farming and non-farming heirs.
—Life insurance proceeds can be used to absorb any tax liability burdens that may arise on the death of the principal shareholder.
This is only a brief overview of these tax concepts. Since each situation is different, how these tools can be used will vary. You should consult your tax and other professional advisors as to how best to qualify and use these tools. Nonetheless, every farming business owner should have a basic awareness of these concepts, so as to ensure they can be utilized.
Shawn Friesen is a senior manager with BDO Dunwoody in Portage la Prairie, Man.