Farming is a tough life, with the benefits of fresh air and being your own boss counter-balanced by a sometimes low income and the illiquidity of assets. A farmer’s net worth is almost entirely tied up in the land.
At retirement that asset can typically be liquidated to fund a pretty comfortable lifestyle—but the plan may be thrown off the rails by one simple and common complication: a child who wants to take over the family business.
In many ways, a family farm is like any other small business, but there is at least one major benefit to earning your living off the land—the tax-free rollover provision. This allows the farmer to pass land on to a spouse or a child without triggering a taxable deemed disposition.
The other great advantage the Canada Revenue Agency bestows on farmers is the enhanced capital gains exemption, which lets them sell their farms and take a $750,000 capital gain before paying tax on the proceeds.
Maximizing these two provisions is at the heart of farm succession planning.
Abe Toews, Stone Creek Financial Group in Regina, Saskatchewan, says he prefers to see the farm structured as a corporation, which not only gives the continuing operations beneficial tax treatment, but also allows for a smoother transition of ownership. Further, it lets the retiring farmer set up an Individual Pension Plan, and buy past service all the way back to 1990.
“A business owner of a corporation is now entitled to the same pension that a civil servant gets,” he says. “We can go back to 1990 and buy back all that past service. What mom and dad need is income, not necessarily a large pool of capital.”
The first step in virtually any succession plan is an estate freeze, which allows the family to estimate the value of the farm at that frozen moment in time. Toews often recommends the corporation be held within a family trust, with preferred shares being issued directly to the retiring generation to provide an income stream. Common shares are issued to the trust, with a value that reflects the adjusted cost base of the farm.
Any future growth in the value of the farm operation is reflected in the value of the common shares, which are shielded from taxation because they’re held in the trust. Dividends from operations are paid into the trust as well.
“If the operation makes a profit, you pay your tax, and the dividends go into the family trust. You can now distribute those dividends to any one of the beneficiaries,” Toews says.
Cash flow can be structured as income, interest, dividends or a return of capital. Toews points out if the farmer flows out about $60,000 to $70,000 as income, he’ll generate substantial RRSP space, as well as CPP benefits.
Should the family decide to get out of the farming business, a third-party buyer would purchase the shares from the family trust at the adjusted cost base. The capital gains would have to be distributed to the trust members, who would then face the tax consequences.
In British Columbia, it remains largely a family affair, according to Malcolm Ross, CFP, Investaflex Financial Group in Vancouver. “You have a really big challenge in trying to create estate equalization for those family members who aren’t going to be part of the farm,” Ross says. “You typically can’t break up a farm easily, or create partial liquidity. It’s very difficult to separate the land from the farming operations.”
Ross works with a network of accountants across BC, who specifically bring him farm clients who need a succession plan. He says a corporate structure can lessen the burden for ongoing operations, as well as smooth succession planning.
“There is an income test that has to be met in order to do the farm rollover,” cautions Ross. “If their income is actually being earned in the corporation, they can still get their capital gains exemption [when the shares are disposed of]. If the income test within the corporation meets that requirement, they can get their exemption. If they were to just hold the interest themselves, it might be more difficult, dependent on what the other source income is, if they are not involved in the farm.”
Ross says the corporate structure is better for children who earn their living through non-farm activities, because there’s an income test to qualify for the higher capital gains exemption available to farmers who sell. If they hold a partial interest in the farm directly, their non-farm income may disqualify them from the provision, but if their stake is held within the corporate structure, it’s the corporation which must meet the income test.
Better still, the corporation shareholders all qualify for the capital gains exemption if the farm is sold to a third party. The typical $750,000 exemption available to farmers is available to each of the shareholders, on the gains realized on the sale. This would allow four shareholders to sell a farm corporation netting capital gains of $3 million, without having to pay capital gains tax.
Share the Land
One client couple had been farming for 40 years and was preparing to retire. They had three children: a son who worked full-time on the farm, another who worked part-time on the farm with a full-time job as well, and a daughter, studying abroad and unlikely to return.
The business was incorporated, and the parents had little in terms of liquid assets. They were able to roll over their shares in the farm to the two sons on a tax-deferred basis in their estate.
The two sons were able to receive their shares under the tax-deferred rollover provision. If the part-time farmer chose to sell his shares, he would be entitled to his own $750,000 capital gains exemption. If his wife was also listed as a co-owner of those shares, Ross says she too would be entitled to the same exemption, allowing them $1.5 million in tax-exempt capital gains.
The daughter is no longer a resident of Canada, so any attempted rollover to her would be a deemed disposition. Her inheritance would be about $2.7 million, but she would face a tax bill that Ross estimates at about $600,000. “Coming up with extra cash flow to pay for insurance would be difficult,” he says, so using insurance to fund that tax liability is not an option.
His suggestion: the parents separate the shares that qualify for the capital gains exemption. Each parent is entitled to a $750,000 capital gains exemption, which would account for $1.5 million in tax-exempt shares.
“We would make sure that the shares that are going to the daughter would have the parents’ capital gains exemption on them, so there would be $1.5 million in preferred shares that would go to the daughter, on which there’d be no tax,” he explains. “Now we only have to fund the tax on $1.2 million, which reduces the tax to about $240,000.”
The parents had some insurance, but it was targeted toward paying off some of the debt. Ross created a holding company to own the insurance policy, as well as the capital dividend account created by the insurance. The cash proceeds were earmarked for debt retirement, while the capital dividend account allowed the company to borrow money back.
This was paid out to the son who was taking over the farm. He in turn used this money to buy back his sister’s preferred shares in the farm, allowing her to fund her tax liability.
A key element of the succession plan is the shareholders’ agreement, which places restrictions on any sibling who wishes to sell his or her stake in the business. In this case, Ross says the set limit was 10% per year, which gave the continuing operation time to secure funding. Further restrictions dictated the farm business must be financially healthy enough to redeem those shares. Without such an arrangement, the son who took over the farm could find himself facing two siblings, demanding their combined two-thirds share of the farm at once.
“A lot of the farm succession issues are actually based around the human side of succession,” says Ross. “As dad gets older, he wants to take less and less risk, but the younger family member may see the need to expand to remain competitive, and he might want to take on more debt to do that. You get this conflict of purpose.”
Farm families are often larger than urban families, which presents its own set of problems. Since the farm is not an easily divisible asset, the family must decide how proceeds should be shared.
In his example, Ross says all three children worked for about 10 years for free on the farm as school kids. Since that would only amount to a part-time job, he divides the 10 years in half, and assigns each child a “service credit” of five. Since the older brother has worked 20 additional years, he receives a credit of 20, for a total of 25. Both parents have worked on the farm full-time for 45 years—together they receive a service credit of 90.
The total number of service credits stands at 125. If the parents choose to leave an equal share as their bequest, each would receive 30 service credits. The eldest son would now hold 55 credits or a 44% stake in the business. The remaining children would each hold 35 credits, for a 28% stake each.
Ross points out that the son who has worked full-time on the farm has received a “below market wage” over the past 20 years, while the son who worked part-time on the farm was paid a market wage for his efforts.
“Fair doesn’t necessarily mean equal,” he says.