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Tax Issues with Farm Proprietorships

28/08/2012


Farmers may not want to spend the time and effort or are hesitant to form a partnership with their spouse or another individual they are farming with. The same farmers may also be hesitant to think of operating their farm inside a company. In actuality, the time and effort to restructure your operations from a proprietorship to a partnership and eventually to a corporation does not require too much effort on the part of the farmer and the benefits always outweigh the costs.

A proprietorship is the carrying on of a business by one individual on his or her own account. The profits or losses of the business are taxed solely in the proprietor’s hands. A farm proprietorship, in fact any farm business, also benefits from the cash basis of reporting income from the farming business. This means that generally sales are only included in income when the cash is received and expenses are only deducted from income when paid.

Many farmers that are operating as a proprietorship will manage their taxable income by deferring the receipt of the proceeds from the sale of grain to the following year (“deferrals”). Or alternatively, the farmer may retain a large quantity of inventory on hand. Not only does this force the farmer to sometimes not sell when it makes sense from a business perspective to sell (for example when prices are high) for fear of paying too much income tax, these deferrals can also cause income tax pain if the proprietor passes away.

When a farm proprietor passes away, there are specific income tax rules for deferrals and inventory on hand. Inventory and deferrals at the time of death are known as “rights or things”. The income from rights or things can be reported in one of three ways:

  1. On the farmer’s final return up to the date of death;
  2. On a separate tax return, called a rights or things return; or
  3. The rights or things can be transferred to one or more beneficiaries with the result that the beneficiary will report the income and pay tax on the income when the right or thing is disposed of.

If option 1 is implemented, all the rights or things must be reported on the final income tax return of the farmer to the date of death. The executor cannot choose to report some of the rights or things on the final return and then choose to report the remainder under options 2 or 3. However, if the executor decides to report the rights or things under option 2, they can also choose to report some of the rights or things under option 3. Note that there are deadlines for electing to report the rights or things under either option 2 or 3 that the executor must be aware of.

So one might think that with all these options, the tax burden should be manageable when a farmer passes away with deferrals or inventory. The issue arises when the farmer passes away with a large amount of deferrals and inventory, for example $1,000,000. The beneficiaries will likely want to sell the inventory as soon as possible and will have very little to no expenses to offset against the income.

Assume that after taxing an appropriate amount of rights or things on the rights or things return there is still $1,000,000 of inventory remaining, which is transferred to the beneficiary. Assume the beneficiary sells the inventory over two years to reduce the tax burden. This will equal approximately $500,000 of taxable income in each year. In Saskatchewan, the taxes owing over the two years could be as high as $440,000.

As an alternative to operating as a sole proprietor, if the farmer had been operating the business as a partnership, more planning could have been undertaken to reduce the tax burden. The partnership could have been wound-up into a corporation during the lifetime of the farmer, or, following the death of the farmer. The corporation could have sold the inventory over two years. In Saskatchewan, the company would have paid taxes of approximately $130,000 if taxed in 2012 and 2013. Under the right circumstances and with the proper advice from advisors, the personal tax on the funds when removed from the company could be avoided completely. By having the partnership in place, there could have been a tax savings as high as $310,000.

A reader may be asking: why not have the beneficiary transfer the inventory to the company? Under the Canadian Income Tax Act a taxpayer can transfer certain assets to a company on a tax-deferred basis, with most types of inventories qualifying for the transfer. However, when you read the tax-deferred transfer rules along with the transferring of rights or things to a beneficiary rules, as soon as the beneficiary receives an amount on the disposition of the rights or things it is included in income. On a tax-deferred transfer to a corporation, generally preferred shares with certain characteristics are taken back as consideration with a value equal to the assets transferred. This avoids immediate tax consequences. When the beneficiary transfers, i.e. disposes of, the rights or things to a company and receives these preferred shares as consideration, the result is that the beneficiary will be taxed on the full fair market value of the rights or things. There is no tax-deferred transfer to a company allowed under these circumstances.

With proper planning, there may be a way to substantially reduce the tax consequences on the death of a farmer.

Please consult with your local MNP Tax advisor to discuss how this type of planning would work in your personal situation.