Farm tax planning: the basics
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Tax rules are complicated. They vary from one province to another and different accountants may recommend different strategies to minimize your tax liability. So while professional tax advice is vital, it’s also important to understand basic tax principles.
Should your farm be incorporated?
The pros and cons depend on your situation. Corporate tax rates are significantly lower than personal tax rates, particularly up to the $500,000 taxable income level that qualifies for the small business deduction. However, incorporation isn’t always the best approach. It needs to make sense for you and your operation.
The benefits hinge on how much income is generated by the farm and what you need to withdraw personally. If you’re taking out most of the farm’s net income every year, incorporation may not lower your overall tax bill.
There are also additional costs that come with a corporation. It’s considered a separate entity and must file a separate income tax return. It can also have a different fiscal year-end.
If you can leave a large amount of net income within the farm corporation, it can substantially reduce your overall tax bill, at least short-term. But eventually, you may want to get your money out of the corporation, and when you do, you’ll have to pay additional personal taxes. For that reason, the lower corporate tax rate might best be viewed as a tax deferral.
If your farm operates as a sole proprietorship, accountants will often recommend that it becomes an interim partnership, before being switched to a corporation. Rather than selling assets to the corporation and potentially triggering personal income, you can sell your partnership interest to the corporation, creating a capital gain that’s eligible for the Capital Gains Exemption. This sale will, in turn, create a shareholder’s loan that the corporation can then pay you without tax implications, provided you don’t exceed the capital gains exemption limit.
There are several methods to remove retained income from a corporation, including wages, land rental and dividends.
Wages are an expense for the corporation and require you to pay Canada Pension Plan (CPP) contributions. If the farming corporation is renting land that you own personally, the corporation can pay you land rent. In that case, you make no CPP contributions. The corporation can also pay dividends to shareholders. In this case, the corporation and the individual each pay a portion of the tax.
Your accountant will advise which approaches are best for your situation. One of the goals is to maximize the after-tax personal money available.
Capital gain for tax and succession planning
Farmland values have steadily increased, and in many cases so has quota. The increase from when you acquired the asset to when you sell it is a capital gain. And half of a capital gain becomes taxable income, so there can be a significant tax implication.
Farm assets like land and quota, shares in a farm corporation and interest in a qualified family farm partnership can roll over to direct family members on a tax-deferred basis. In other words, these can pass to your children or grandchildren without triggering capital gains tax, but doesn’t apply to nieces and nephews. The rollover provision is a key component in many transition plans.
Note that criteria exist for the rollover provision regarding shares in a farm corporation. You must use at least 90% of the assets in the farm corporation in the farm business. If there are non-farm investments (including cash) above the allowable amount, the farm corporation would have to make changes to be eligible for the rollover.
A Lifetime Capital Gains Exemption of $1 million is available to farmers, and it’s an important tax planning tool that may also have transition planning implications. In many cases, if spouses are joint owners of assets, they can both qualify for the exemption. Corporations don’t, as it only applies to individuals.
There are benefits to retaining personal ownership of farmland and keeping it out of the corporation. If a capital gain is realized on the sale of farmland, the Lifetime Capital Gains Exemption can be used to offset the taxable capital gain.
For purchases of additional land personally, individuals can collect on their shareholder loan owed to them by the company to make the payments. It’s also advantageous for the corporation to purchase additional land from retained earnings. Those earnings will have accumulated at a faster rate within the corporation due to the lower tax rate.
Consider land transfer taxes
Some provinces have lower land transfer taxes and do not end up as a major consideration. In other provinces such as Ontario, the land transfer tax is significant. Exemptions apply to allow families to continue farming the land without paying the tax. It’s essential to know the rules and deadlines involved to avoid unnecessary expenses.
Cash vs. accrual considerations
Farmers can use the cash basis of accounting for income tax purposes. For instance, fertilizer purchased before your fiscal year-end can be used to reduce your farm income, even though it will be used to help grow next year’s crop.
However, financial accounting should be done on an accrual basis matching the appropriate income with the appropriate expenses to provide an accurate financial picture of your farm for a specific time.
The cash-based accounting system allows for tax measures, such as the optional inventory adjustment, whereby a producer can include income in the current year up to the total value of their inventory. As another option, you can claim less than the maximum Capital Cost Allowance (CCA) for machinery depreciation.
The cash basis of accounting is typically more useful for farms operating as a sole proprietorship or partnership where farm income becomes personal income. Balancing out farm income from one year to the next can be important for staying in a lower tax bracket.
With corporations, the tax brackets are much larger, making income balancing less important in most cases. Though many corporate farms likely still file taxes on a cash basis.
A well-developed farm accounting software program such as AgExpert is invaluable for both accurate financial accounting on an accrual basis as well as the calculation of income tax using either cash or accrual.
Your goals and objectives, transition plan (or exit plan) and your financial situation all factor into tax planning. Remember, tax law can be subject to interpretation, so work with an accountant to advise you on how decisions made when preparing income tax statements align with tax laws. While tax avoidance is illegal, structuring your affairs to minimize tax liability is just good business.
Here’s what you can do to make working with your accountant more productive:
- Keep good records
- Explore an accounting software program if you don’t already use one
- Watch for changes in tax laws (often announced as part of federal and provincial budgets)
- Hold regular meetings with your accountant, not just one annual tax meeting
- Tax Plan for the short term and long term