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Gravel Extraction

04/07/2011


Lucky you, there is gravel in your farm land worth a lot of money!

Lots of money usually means income tax. What are the income tax consequences?

INCOME

Investment Income

Generally, if the gravel company pays you or your company (if land is company owned) a specific amount per tonnage extracted, the tax man will treat the payments as income – 100% taxable.

For a company receiving the gravel payment, the income will usually be treated as investment income, taxed at the highest corporate tax rate of 44.67% on every dollar received.

Active Business Income

In order to change the gravel receipts from investment income to active income, taxed at the lower corporate tax rate would require some level of activity incurred by your company, for example:

  • Maintaining weigh scale with an employee
  • Operating front end loader to load gravel

However, this simply may not be feasible.

Investment income and active business income will be taxed as earned over the course of the gravel extraction contract.

CAPITAL GAIN

If the Gravel Extraction Contract is structured at the outset as a one-time sale of all gravel for an overall lump sum amount, gravel receipts can be taxed as capital gains – only ½ of taxable gains are taxable.

The result will be a much lower overall tax situation – corporately and personally .

The key is to structure the Gravel Extraction Contract at the outset which provides you or your company with capital gains, and at the same time does not prejudice the gravel company.

This can be accomplished by:

  • Paying lump sum amount over a defined period in equal amounts as gravel is extracted;
  • Including a price adjustment which reduces the overall lump sum amount if less gravel is extracted than estimated.

Unfortunately, for capital gains the entire capital gain will be recognized over a maximum 5 year period with all taxes paid. For example, a 10 year Gravel Extraction Contract for an overall $5M lump sum, all taxes will be paid on the $5M gain over the first 5 years even though the $5M payment will be made over the 10 year contract period.

Therefore, one must be careful to ensure sufficient cash is received to pay income taxes over the first 5 year period. After this 5 year period, future gravel receipts will be received without future tax.

RISKS

Unfortunately, tax law is not black and white. The tax man may disagree and try to reassess any gravel contract as income – not as capital gains.

But there have been successes in dealing with the tax man in the past, yet it may require going to tax court to obtain favorable capital gains treatment.

PLANNING

Upfront planning before entering into a Gravel Extraction Contract is a necessity because the tax results can be dramatically different.

For further information, contact Randall A. Hay, MBA, CA, or your local MNP professional advisors.