Income Tax – Agriculture Succession & Exit Presented by Vern H. Peters, CPA, CA Tax Partner (2016/10/27)

Agriculture Succession

Share Freeze A share freeze is one of the more common methods to transition the farming operation to the next generation Share sales with the seller utilizing the capital gains deduction are not usually preferred The next generation needs to pay for the shares at the individual level – creates higher income taxes to obtain cash required to pay for the share purchase

Share Freeze Share sales (continued) The next generation is unlikely to sell the shares to an outside party Most purchasers want farmland and do not want an operating company The next generation would be unable to take advantage of the high cost base on the shares

Share Freeze Typically all of the value of the common shares is frozen into fixed value preferred shares Allows the next generation to obtain new common shares at nominal value Future growth will accrue to the next generation Mom and dad gradually redeem the preferred shares in future years

Share Freeze Redemption of preferred shares create taxable dividends for mom and dad Cash for the redemption comes from future after tax income generated in the company Provides protection for matrimonial issues with the next generation as long as mom and dad continue to have significant value in their preferred shares

Share Freeze Allows for gifting of some or all of the preferred shares to the next generation at an appropriate time Shares need to meet the definition of a “share of the capital stock of a family farm corporation”

Land Company One of the goals for retirement is to have non-taxable cash flow The share freeze provides taxable cash flow Many farmers own land outside of their operating company and have not used much of their capital gains deduction Why not benefit from the capital gains deduction during your lifetime?

Land Company Dad Mom 50% 50% Farmer Farms Ltd. FMV of Farmer Farms Ltd. is $2.2 million Dad & Mom own some farmland personally worth $2.2 million and cost of $200,000

Land Company Plan: Create a new company – DM Farms Ltd. (DM) Dad and Mom sell personally owned farmland to DM at fair market value (FMV) creating a tax paid shareholders’ loan account (use capital gains deduction (CGD)) Freeze shares held by Dad and Mom in Farmer Farms Ltd. – exchange existing shares for $2.2 million of preferred shares

Land Company Son obtains common shares in Farmer Farms Ltd. for nominal Transfer the preferred shares owned by Dad and Mom in Farmer Farms Ltd. to DM for preferred shares in DM with the same value on an income tax deferred basis Farmer Farms Ltd. redeems preferred shares held by DM in exchange for a note payable to DM of $2.2 million (Farmer Farms could provide some security)

New Structure Dad Mom Son 50% 50% 100% DM Farms Ltd. Farmer Farms Ltd. Loan owing to DM $2.2 million (secured) Tax paid shareholders’ loan owing to Dad and Mom for $2.2 million from DM Farms Ltd. DM owns farmland with a FMV and cost of $2.2 million

Land Company What have we achieved? Utilized the CGD for Dad and Mom with the result they can withdraw $2.2 million with no personal income tax consequences Farmland owned by DM has a cost equal to the current FMV of $2.2 million Ability to access cash through a note owing to DM by Farmer Farms Ltd. to fund retirement. Son has control over Farmer Farms Ltd.

Land Company What have we achieved (continued)? Dad and Mom have some security on their equity in the farm

Asset Freeze Two children may want to farm Do not recommend having two brothers in the same company Each may want control of their own company May not be able to get along Expensive to split a company with two brothers – could be at least $35,000 for accounting fees

Asset Freeze Set up two new companies – one for each son Parents’ company transfers inventory and equipment to each company on an income tax deferred basis Receive preferred shares Redeem the preferred shares in exchange for promissory notes

Asset Freeze Dad Mom Parent Co Son 1 Son 2 Son 1 Co Son 2 Co Promissory note Promissory note Son 1 Co Son 2 Co Both new companies contain inventory and equipment

Asset Freeze What have we accomplished? Have reduced the cost to split into two companies during the parents’ lifetime The only assets in Parent Co. are the notes receivable. It will be easier and cheaper to split this company between the two sons on the last of the parents to die

Asset Freeze As a twist, we could add land to Parent Co. to create a shareholders’ loan (similar to our Land Company example)

Agriculture Exit

Farm Exit Farmers who operate as a proprietorship may want to consider incorporation prior to the sale of grain and equipment Likely minimal expenses to offset the income Pay tax at 12.5% Gradually withdraw funds over future years to have dividends taxed at lower rates

Incorporation In Saskatchewan, a Canadian-controlled private corporation pays income tax at a rate of 12.5% on the first $500,000 of active taxable income

Incorporation Individuals pay tax at graduated rates. The following are for 2016: First $45,000 – 26% Next $45,000 – 33.5% From 140,389 to 200,000 – 44% Over $200,000 – 48%

Farm Exit Those with corporations will want to plan the timing of auction sales and commodity (grain and cattle) sales to maximize use of the low tax rates on the first $500,000 of taxable income

Companies with Land Becoming more common to sell shares of a company that only contains farmland to another company Would need to remove other assets The seller can access the capital gains deduction on the sale of shares The purchasing company will receive a bump in the value of the land when the companies are amalgamated

Companies With Land It may make sense for many situations to have land owned by a sister company separate from the operating company Will allow for succession of the operating company to the farming child. Non-farming children could be included in the succession for Landco. Easier to sell the shares of Landco without having to remove assets of Opco

Companies With Land May want to sell some land and retain some in the company Could use a hybrid sale Sell some land to a new company at fair market value Transfer some shares of Opco to Landco and utilize the capital gains deduction Sell these shares to the purchaser

Companies With Land If retaining some land in the company, will need to consider future arrangements for income from that land Issues revolve around the taxation of that income and maintaining access to the intergenerational rollover rules and capital gains deduction

Land Income Cash rent will be initially taxed in the company at a rate of 51%. The rate reduces to 20% as dividends are paid to individual shareholders. Crop share likely would be subject to income tax at a rate of 12.5%. The Canada Revenue Agency has stated that they would treat crop share the same as cash rent. A joint venture or custom farming arrangement should qualify for taxation at 12.5%.

Land Income If cash renting land in a company to someone outside of your family, you will lose access to intergenerational rollover and the capital gains deduction (CGD) for the shares if the land is cash rented for longer than it was used actively by family members Cash rent is not active use of the land. Crop share likely is not active enough for rollover and CGD purposes.

Land Income A joint venture arrangement likely would constitute active enough involvement in farming A custom farming arrangement would be active enough

Succession and Exit Three of our senior partners are starting to transition more into consulting for succession and exit Tax Advisory addresses the income tax issues where these are the main factor The other partners would address soft issues and items such as cash flows required by parents and next generation Soft issues would include items such as the possibility of future matrimonial issues