Taxing the farm company

Taxing the farm company
by Perry Pellegrini - 6, 2008

Our local coffee shops have always been a hotspot for discussing a wide range of issues, including tax. One of the common comments I've heard come from these discussions is how expensive it is to "get out of" a farm corporation.

While it can be costly at the time of exit, one must remember that the farm company has provided a deferral benefit over time, which has likely resulted in a much larger farm asset base than would have existed otherwise. So, even though there may be another layer of tax to pay, the farm owners are likely still better off on a "net after tax" basis, having farmed in a corporation versus not.

The benefit of a farm corporation is in the tax rate. As individuals, we pay a third, or more, in tax as income goes above $40,000. An Alberta farm business corporation pays 14.1% tax on income all the way up to $400,000! That is a huge tax saving; or I should say deferral.

The fact is, this low tax rate only applies on income that is retained in the company. If you want to pay the money out to yourself, there will be another level of tax, on dividends. Before you get too upset over this second level of tax, you should note that it is lower than regular income tax rates, to reflect the tax the company has paid. So, in reality you are not being double taxed when the money comes out of the company.

When a farm company sells assets, the method by which tax is applied is pretty much the same as if sold personally. Inventory and recapture are taxed as income, at the low corporate tax rate. Capital gains are only half taxable, but they're taxed at a special "investment" tax rate that is higher than the regular small business rate. The portion of the capital gain that is not taxable creates a notional account, called a Capital Dividend Account (CDA). This portion of the capital gain can be paid out to shareholders as a tax free "capital dividend".

Once all the assets are sold, and corporate taxes have been paid, money can be distributed to shareholders. In addition to the capital dividends noted above, any corporate indebtedness to shareholders can be repaid without personal tax. Such indebtedness is usually referred to as "shareholder loans". Any further distribution to shareholders will be as a "dividend". The dividend is taxed in a somewhat complicated manner, but effectively about one third less than normal income tax.

If you were to sell all corporate assets and distribute the money out to shareholders, the total tax bill will be about the same as if the corporation did not exist. However, this approach would reflect no advanced financial planning. A corporate structure has provided a valuable deferral throughout the farming years. There is no requirement to end the deferral just because you stopped farming.

After the sale, you could retain the company as an investment holding corporation. You would continue to pay some level of accounting and legal expense to maintain the corporation, but they should be less, since ongoing activities in the corporation will be greatly reduced.

Your personal financial planning should accommodate the corporately held investments. Your plan should strategically access cash flow from a combination of personal funds, RRSP funds and corporate funds. Each of the environments in which you hold investments has its own unique tax characteristics, so you want to ensure your investment plan and cash flow plan have taken these characteristics into consideration and positioned assets accordingly.

By retaining investment capital within the corporation you will defer the amount that immediately goes to the government by as much as 25%. It is true, this deferral will likely have to be unwound at the death of both husband and wife, but in the meantime you can enhance your retirement income and backstop your financial security.

The key here is that although liquidating a farm company can be expensive from a tax perspective, there are planning strategies that can lessen the hit and enhance your financial position. You just need to be a little creative in how you look at it.

Please remember many of the strategies we review in these articles are complex, from a tax and legal perspective; make sure you obtain professional advice before you act on any strategy.

Perry is a senior partner with Pellegrini LeBlanc in Red Deer, AB, which focuses on farm sale and financial planning throughout Alberta.