Succession of Your Farm: Tax concepts to consider
By Shawn Friesen
Grainews
November 2008
In a previous article, I had listed 5 basic steps to starting and maintaining a viable succession plan for your farm business. In this article, I will provide more detail on a crucial part of the succession process: income tax.
While there are many years where a farm will not incur any income tax, the value of any successful farm will ultimately be taxable some day. A significant amount of tax is incurred upon the passing of the farm from one generation to the next. To best structure a succession plan, it should be set up in the most tax-efficient manner.
When discussing your succession plan with your advisors, you should be aware of these 5 tax issues.
1. Capital Gains Exemption (CGE). This is probably the most commonly used tax tool available for farm succession planning. Here is some key information about the CGE.
- Every resident in Canada is given a $750,000 exemption on capital gains on qualified small business shares or qualified farm property. Shares in a family farm corporation, as well as farm land and farm equipment, would be eligible.
- There are restrictions on what defines the shares in a farm corporation as “qualified”. One significant restriction is that if there are too many “non-active” assets in the corporation, the shares may not meet the definition of “qualified”. Basically, if the farm builds up too much cash, investments, or other assets not needed to actively run the farm, the shares may not be eligible for exemption.
- The CGE can be used during life or upon death. Corporations cannot claim a CGE.
2. Spousal or Inter-generational Rollovers. Another commonly used tax tool, these rollovers provide for transferring title of assets or shares to a spouse or child on a tax-free basis. Some key considerations of these rollovers are:
- Any taxpayer has the ability to roll assets over to a spouse on a tax-free basis. However, one can elect to transfer assets to a spouse at any value between cost and fair market value in order to utilize their CGE. This way, the cost base on the shares or property transferred would be bumped higher, which has the potential to defer taxes later on for the spouse and other heirs; and
- Only qualified farming property can be transferred to a child on a tax-free basis. Any other property will attract capital gains. Again, the property transferred can be elected to have been disposed for an amount between cost and fair market value.
3. Freezes. A very valuable tax tool to use, a freeze occurs when the value of your farming corporation is “frozen” at any particular point. Important points to note about a freeze are:
- The basic mechanism of a freeze is that the principal shareholder would exchange his/her common shares for other “preferred” shares of the corporation. Both the common and preferred shares would be worth the fair market value of the farm. The difference is all of the value of the farm that is owing to you as the principal shareholder is in the preferred shares. A successor could now buy new common shares of the corporation for a nominal amount. This also means that all future growth accrues to the successor; and
- The freeze allows for all value generated by the first shareholder to be recognized as owing to him/her as a return on their investment. These shares can then be “redeemed” over time by the corporation, providing a source of cash flow, or a “pension” for the shareholder’s retirement years.
4. Holding Corporations. Using a holding corporation is another way to “freeze” the value of the farm. Basically, instead of exchanging one class of shares for another in the same corporation, the shareholder would transfer his/her shares in the farm corporation to the holding corporation in exchange for shares of it. The holding corporation would now own the shares of the farm. Some of the advantages include:
- Dividends on the shares can be paid up to the holding corporation. These dividends would be considered non-taxable, so no taxes would have to be paid by the holding corporation on this income;
- By paying dividends out of the corporation, the farm could eliminate non-active assets that would violate the definition of “qualified shares” for the purpose of utilizing the capital gains exemption. This is called “purifying” the corporation; and
- By pooling cash and other investments in a holding corporation, the shareholder could decide when to pay dividends to him or herself. Again, the original shareholders now have a source of “pension” income over their retirement years.
5. Life Insurance. This can be a very resourceful tool if the situation calls for it. The advantages of using life insurance include:
- Life insurance proceeds can be used to absorb tax liability burdens, arising on the death of the principal shareholder;
- Amounts can be provided to spouses, children, etc. on a tax-free basis; and
- Proceeds, if paid to a corporation, will be added to the capital dividend account (CDA). This account allows for the payment of tax-free dividends to the shareholders. By adding into the CDA, life insurance proceeds can be used to redeem the value of shares owned by a shareholder.
This is only a brief overview of these tax concepts. Since each situation is different, how these tools can be used will vary. You should consult your tax and other professional advisors on how best to qualify and use these tools. Nonetheless, every farming business owner should have a basic awareness of these concepts so they can be used to their best advantage.
