When it comes to farming, one of the most frequent questions we get has to do with whether it makes sense to incorporate a farming proprietorship or partnership. While every case is unique, in many cases the advantages of incorporation far outweigh the disadvantages.
In order to understand the advantages of incorporation, you first have to understand that a corporation is a separate legal entity from the person(s) who own it. This separation in itself provides our first advantage, creditor protection.
Creditor protection
Because a corporation is considered a separate entity from the farmer who owns the corporation, the non-farming assets owned by the farmer outside of the corporation are generally protected from the creditors of the corporation. This means that if something were to happen on the farm, an uninsured accident for example, the only assets that would be at risk would be those assets inside the corporation. Without the corporation all of the farmer's assets, including their principal residence, could be at risk.
Absolute tax savings
One of the cornerstones of the Income Tax Act is the idea of integration. Integration is simply the concept that a person should pay the same amount of tax regardless of whether they choose to operate their business personally or through a corporation. While this is the goal of the Income Tax Act, in the majority of the provinces in Canada integration is not perfect and there is actually an advantage to operating your farm business through a corporation. In some provinces, the savings are over 3% and this advantage will continue to grow as the corporate tax rates decrease through to the year 2011. This means that by simply operating your farm through a corporation you can save over 3% tax depending on your province.
Access to sunk costs
In many instances, a farmer will have a great deal of their wealth tied up in the value of their land and equipment. By incorporating, the farmer can gain access to the sunk costs of these assets through the use of a tax-free rollover.
For example, suppose a farmer had land and equipment that had a fair market value of $1,000,000 that they had paid $650,000 for. If that farmer were to incorporate, it is possible to roll those assets into a corporation on a tax-free basis. In exchange for the land and equipment, the farmer would receive shares of the corporation with a fair market value equal to $350,000 (the difference between the cost and fair market value) and a shareholder loan equal to $650,000. The farmer can then withdraw the $650,000 loan proceeds from the corporation tax free when funds become available to the corporation.
Combining shareholder loan repayments with other forms of remuneration can significantly reduce the overall tax burden on both the farm and the farmer.
Income Splitting
With proper planning, a corporation can be structured so that the farmer can split income by way of dividends with their spouse and adult children. Splitting income allows the farmer to take advantage of the low marginal tax brackets of their spouse and adult children to reduce the overall tax paid by the farm.
Without the corporation, the only way to accomplish income splitting is to pay a wage to family members. The problem with wages is that they are subject to a reasonableness test that may not always be easily met. Dividends from an active farm corporation are not subject to a reasonableness test.
Income deferral
It is also not uncommon that a farmer may have been building up their inventory over a number of years. Due to their ability to file their taxes on a cash basis, these inventories have never been taxed however they present a large tax problem once they have to be liquidated. One way to deal with this problem is through the use of inventory notes.
A farmer with a large inventory can incorporate their farming operation and sell their inventory to the corporation. Provided both the farmer and the corporation file their taxes on the cash basis, there is an opportunity to defer tax on the sale of the inventory and smooth out the tax burden. Because the farmer is reporting their farm revenue on a cash basis, this sale is not taxable to the farmer until they receive payment from the corporation.
Another income deferral advantage is simply not paying out all of the income earned by the corporation to the owners of the corporation. If a farmer is able to save some of the earnings of the corporation inside the corporation, they can defer some of the tax on that income. Generally, the income tax paid by a corporation is less than that paid by an individual farmer. Any income invested in the corporation can be paid to the farmer at a later date (similar to an RRSP) when the farmer may be in a lower tax bracket. If this is possible, not only will the farmer have deferred tax, there will be an absolute tax savings.
Corporate dollar financing
Finally, a corporation provides the farmer with the opportunity to take advantage of corporate dollar financing. Corporate dollar financing is simply using corporate money to pay for expenses instead of using personal money. Depending on your province, a dollar earned in the corporation attracts tax of between 14.37% and 21.12% where the same dollar earned personally attracts tax at between 39% and 48.64% (in the highest tax bracket).
A good example of the savings from corporate dollar financing is a farm purchase. Suppose a farmer in Ontario wants to purchase a new farm to expand their farming operations and suppose they finance that purchase so that each year the principal repayment on the loan is $25,000.
By paying that $25,000 out of the corporation instead of personally, they would save $6,950 in tax annually.
This is because without a corporation they would need to pay the personal tax of 46.4% on the $25,000. However, with the corporation they only pay 18.6% tax. The difference in the tax rates of 27.8% generates the absolute tax savings of $6,950.
While these are some of the advantages of incorporation, these are by no means all of the advantages. Of course, there are also disadvantages to incorporation. As with any major business decision, we strongly urge you to consult with your lawyer and your Collins Barrow tax advisor to be sure that incorporation is right for your particular situation.