September 4, 2019 by Bud Arnold

Five tips for navigating tax deferrals as a farm business

Special tax rules apply to farmers and fishermen, including the ability to report taxable income on a cash basis, rather than an accrual basis. Using the cash basis approach, there are three ways farmers can defer taxes by reducing their taxable income in the current year:

1. If they make a sale, but haven’t been paid yet, they don’t have to include that in their income.

2. If they pay for seed or other inputs within a year, they can deduct the prepaid expense in the year when they made the cash payment even if they haven’t received the inputs yet.

3. Whereas most businesses must value their inventory at the lesser of cost or net realizable value, farmers have an option to include a value of inventory up to net realizable value in their income.

While it’s generally better to pay tax later, and farmers can use deferrals to smooth their income (avoiding spikes in income that would result in a higher tax rate in a particular year), all cash deferrals have to be reported as income at some point in the future. If farmers aren’t careful, these deferrals can destabilize their business. The best way to keep negative impacts to a minimum is to understand the risks they're facing, as well as the solutions available.

1. Understand the risks

Some profitable farms find themselves in a situation where they exclude all accounts receivable from income and prepay as many expenses as they can. They pay all of the next year’s expenses (seed, chemicals, etc.) and exclude all or most of their inventory value from income. As a result, they find there’s no more cash basis deferral available to them. If their income increases in a future year, there are no opportunities available to reduce their taxable income, and they can find themselves with an increased tax burden.

2. Consider incorporating

When farmers run out of opportunities to reduce their taxable income, they should explore the possibility of incorporating their business. From a tax perspective, there is a clear benefit to incorporating in this context: the corporation pays a low rate of tax on its first $500,000 of income. Farmers can pay this low rate on any income in their corporation and reinvest after-tax corporate profits in the farm operation.

3. Know your limitations

Prepaid expenses can become an issue when a business is trying to incorporate. Farmers can’t transfer these expenses into their corporation and realize the income, which can lead to some transitional challenges. They can transfer inventory and realize the income in the corporation, but they can’t transfer prepaid expenses or accounts receivable and shift the income into the corporation. As a result, there may still be a major personal tax liability on income that has been deferred personally.

4. Seize new opportunity

In November, the federal government announced an accelerated capital cost allowance opportunity. If a farmer buys a piece of equipment any time after November 2018, they can deduct one and a half times the normal amount of capital cost allowance, which is the depreciation of the asset for tax purposes. Before November, they could only deduct half the normal amount of depreciation. For example, buying a combine falls into a tax class that is deducted at 30 per cent per year. Farmers used to be able to only deduct half of that (15 per cent) in the first year. Now they receive one and a half times the normal amount of depreciation, which results in a 45 per cent deduction of the original cost in the first year.

5. Get over the wall

For clients with a big wall of deferrals, accelerated capital cost allowance could be the solution. If you spend $1 million on drivable farm equipment, you can now get a $450,000 deduction for that purchase in the first year. This can help offset a big chunk of the tax deferrals and allow you to transfer into a corporation without major tax complications. It will also help offset a significant portion of your personal income if you’re trying to move from a personally owned farm to a corporately owned farm. Buying the asset personally and transferring it into a corporation the following year could help you get over the wall of deferrals.

Meet the Author

Bud Arnold Bud Arnold
Guelph, Ontario
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