When a shareholder of a family farm wishes to exit the farm operation—whether due to retirement, disagreement with other shareholders, or a desire for a lifestyle change—and there is no shareholders’ agreement in place to dictate the procedures for buyout, negotiations are required between the exiting shareholder and the remaining shareholder(s).
If an agreement is reached, the exiting shareholder typically will want cash on closing when a dispute is involved or if they intend to start a new venture. The remaining shareholder(s) will seek to minimize the cash flow demands on the family farm operation. The parties will need to consider the tax consequences of the deal. Can a compromise be made that satisfies everyone?
Consider, for example, John Farmer and Joe Farmer, two brothers who own equally the shares of Farmco, a family farm operation. The share value to each of John and Joe Farmer is $3 million. A dispute has occurred and John Farmer wishes to have his $3 million in Farmco shares bought out.
Assume that all parties are situated in Ontario and Farmco’s taxable income is taxed at the small business rate of 12.5 per cent. John Farmer has $1 million of his lifetime capital gains exemption available and a cost base of $10 for his shares.
The accountant for the corporation provides the following options for the purchase of John Farmer’s Farmco shares.
Option 1 – Farmco redeems the shares held by John Farmer
Farmco will obtain financing and use the proceeds to redeem John Farmer’s shares for $3 million. John Farmer will report a dividend for tax purposes on the redemption of the shares. Assuming there are no other sources of income in the year, John Farmer will pay $1,384,950 in taxes, leaving net proceeds of $1,615,050.
Farmco will fund the annual loan payments with after-tax corporate dollars. Farmco will need to earn $3,428,500 in net income to fund $3,000,000 in principal payments (ignoring the cost of interest).
Option 2 – Joe Farmer purchases the shares from John Farmer and John Farmer claims his $1 million lifetime capital gains exemption
Joe Farmer will obtain financing and use the proceeds to purchase John Farmer’s shares for $3 million. John Farmer will report a capital gain for tax purposes on the sale of his shares and offset the capital gain with his $1 million lifetime capital gains exemption. Assuming there are no other sources of income in the year, John Farmer will pay $498,500 in taxes, leaving net proceeds of $2,501,500.
Joe Farmer will finance his personal loan with annual taxable dividends from Farmco. For this example, assume that the loan will be repaid over 20 years at $150,000 principal per year (again ignoring interest costs), and that Joe Farmer earns an annual base salary of $50,000. To cover the $150,000 principal payment, Joe Farmer must receive an annual dividend of approximately $250,000 to allow him to fund both the personal tax on the dividend ($100,000) and the principal payment. Farmco will fund the annual dividend payment with after-tax corporate dollars. Farmco will need to earn $285,715 in net income annually for 20 years, or $5,714,300 in aggregate.
Option 3 – Joe Farmer purchases shares from John Farmer and John Farmer does not claim the $1 million lifetime capital gains exemption
Joe Farmer will purchase the shares from John Farmer with a $3 million promissory note. John Farmer will report a capital gain for tax purposes on the sale of his shares and will not claim an offsetting deduction for his lifetime capital gains exemption. Assuming there are no other sources of income in the year, John Farmer will pay $766,000 in taxes, leaving net proceeds of $2,234,000.
Joe Farmer will sell the shares of Farmco purchased from John Farmer to a new corporation, Holdco, for a $3 million promissory note. Holdco will obtain financing and use the proceeds to repay the $3 million promissory note to Joe Farmer, who in turn will repay the promissory note to John Farmer. Holdco can then receive tax-free dividends from Farmco’s future after-tax corporate income to fund the annual loan payments. Farmco will need to earn $3,428,500 in net income to fund $3,000,000 in principal payments (ignoring the cost of interest).
Option 2 provides the best results to the exiting shareholder, John Farmer, but costs Farmco an additional $2,285,800 over option 1 and option 3 to fund the $3 million payment. Option 3 costs the exiting shareholder John Farmer $267,500 but saves Farmco’s farming operation $2,285,800 (less the professional fees involved to implement). Option 3 appears to be a fair compromise to all parties. Option 3 can be even more attractive when the exiting shareholder continues to hold qualified farm property, for example land that was held outside of the family farm corporation, that would use the exiting shareholder’s remaining lifetime capital gains exemption in the future. Additional planning can be incorporated into option 3 to allow the remaining shareholder(s) to amalgamate Holdco and Farmco so that there is only one corporation going forward.
If an agreement between the shareholders cannot be reached, the parties could consider mediation or arbitration, failing which they could face costly and lengthy court proceedings. It is worth noting that all of this can be avoided by ensuring the family farm corporation has a properly executed shareholders’ agreement in place.
A Baker Tilly advisor can help your family farm corporation navigate the buyout of a shareholder.
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