One area that many incorporated farm operations commonly overlook is the eligibility of their corporation’s share capital for the $750,000 (now proposed to be $800,000) individual Lifetime Capital Gains Exemption and other certain tax deferrals. The agricultural industry can be plagued by potential hazards, and, unfortunately, a sudden severe injury or death sometimes forces a succession plan earlier than expected. In the case of a severe disability or the death of a shareholder, a farm corporation might be forced to transfer to the next generation before the corporation can be made eligible, resulting in a missed opportunity in significant tax savings lost and the loss of potential tax deferrals.
Even if you have fully utilized your Lifetime Capital Gains Exemption, keeping your family farm corporation eligible is in your best interest. Having a pure and eligible farm corporation could benefit from taking advantage of potential increases in the capital gains deduction such as the proposed $800,000 exemption.
There are two primary issues in determining eligibility for the shares of a corporation that similarly depend on the composition of the farm corporation’s assets. These issues are as follows:
- eligibility of the corporation’s shares for the Capital Gains Exemption, and
- eligibility to elect between the Adjusted Cost Base and the Fair Market Value of the shares when transferring or disposing of the shares to the shareholder’s child.
It is important to understand what non qualifying assets may be for the purposes of determining if the farm is qualifying. Excess cash, marketable securities and other investments such as some intercompany loans and receivables are not considered to be assets actively used in farming. Ineligible loans would include loans made to related companies that are not qualifying family farm corporations. A company may have other operations within the family farm corporation that may not qualify as an active farming business. In such cases, the value of the non-farming business assets need to be determined to ensure that it do not exceed 10% of the value of the total assets of the corporation. Examples of ineligible asset include the following:
- a trucking operation that is used for trucking other farmer’s crops or animals to market. If the trucking assets are used primarily for trucking the corporation’s own commodities they are eligible assets; however, a problem exists if the trucking operation is used for items belonging to others.
- a drying, processing and storage facility where the principal use is to store other farmers’ commodities.
- property owned by the corporation such as rental properties where the rental is not ancillary to the farming operations.
- other non-farm businesses such as equipment repairs, construction etc.
Capital Gains Deduction
The Lifetime Capital Gains Exemption provides an individual a deduction on the capital gain on the sale or transfer of qualifying property.
A transfer or deemed transfer of shares held in a family farm corporation can be eligible for the Capital Gains Deduction if it meets certain criteria. Two of the main tests are as follows:
- 50% or more of the Fair Market Value of assets owned by the corporation were used actively in the business of farming for any 24 month period prior to disposition, and
- 90% or more of the Fair Market Value of assets owned by the corporation were used actively in the business of farming at the time of disposition.
While most established farming corporations should easily be able to satisfy the 50% test, an operation can quickly be offside of the 90% test after several years of profits where accumulated cash is retained within the corporation. If these amounts accumulate to over 10% of the Fair Market Value of the corporation’s assets, a transfer or a deemed disposition of the corporation’s shares will not qualify for the Capital Gains Exemption.
Transfers to a child
The proceeds of disposition on the transfer of a share in a family farm corporation to a shareholder’s child (for certain transfers, child includes grandchildren and great grandchildren) can be elected at any value between the share’s adjusted cost base and its fair market value. The ability to set the proceeds on a transfer offers a great strategy to crystallize or fully utilize an individual’s lifetime capital gains exemption.
The main test in determining the eligibility of the transfer requires that 90% or greater of the Fair Market Value of the corporation’s assets are used actively in a farming operation on a regular and continuous basis.
Similar to satisfying the conditions for the capital gains deduction, inactive assets held by the corporation can put the corporation offside, preventing the transfer of the shares at cost or an elected amount.
Resolutions
Maintaining a pure farm corporation, where substantially all of the assets are used actively in the farming operations, satisfies both the eligibility for the capital gains deduction as well as the deferral of tax on transfer to the next generation. In order to satisfy the above conditions, accumulated assets not actively used in farming operations would typically be removed from the corporation’s balance sheet.
The following are common ways of removing inactive assets from your corporation:
- Shareholder draw – if sufficient shareholder loan room is available
- Corporate Reorganization – through the introduction of a holding company or a sister corporation carrying on non-farming operations.
Under ideal circumstances, your shareholder loan would be built up on an annual basis with shareholder wages or dividends that are reinvested back into the farm corporation all the while utilizing your basic personal tax credits and optimizing your personal tax brackets. Other ways of increasing your shareholder loan could include rolling in any personally owned high cost base farmland used in operations or through declaring a capital dividend if available to your corporation.
In cases, where the shareholder loan is not sufficient to clear the inactive assets or where holding the assets personally is not feasible, a corporate reorganization can assist in clearing the assets from the farming corporation to a holding company where maintaining a pure small business corporation share qualification is not essential. During the reorganization it could even be possible to simultaneously crystallize any outstanding capital gains deduction.
With careful planning and regular review of the farming corporation’s eligibility, a tainted balance sheet could be identified and purified before it is too late. Due to the uncertainty of when a tragedy could occur or a transition be required, it is never too early to take steps in ensuring that your farm corporation qualifies for the capital gains deduction and tax deferrals to the next generation. Your Collins Barrow advisor can assist you in determining your farm corporation’s eligibility and any steps that could be taken to qualify.