FARM INCORPORATION HAS ADVANTAGES AND DISADVANTAGES
Originally published on October 11, 2001
In law, a corporation is an artificial person having an independent existence, separate and distinct from that of its shareholders.
For farm families, the idea of creating an "artificial person" through the incorporation of their family farm isn't too hard to conceptualize. More than one farm wife has told me that there were three people in their relationship: "him, me and the farm."
Incorporating a farm business has a number of advantages.
Canadian-controlled private corporations pay a much reduced rate of tax on the first $200,000 of active business income.
This lower tax rate — about 20 percent in most provinces — leaves the incorporated farm with more after-tax dollars, which can either be reinvested in the farm or paid to its directors as salary or dividends.
Remember, this is a tax deferral. The accompanying table shows the situation of an unincorporated farmer earning $70,000 and paying $20,889 in personal taxes. If the farm had been incorporated, it would have paid $14,784 in corporate taxes.
The resulting $6,105 tax deferral occurs only if the money remains in the farm company. If the incorporated farm simply paid out a $55,000 dividend, then total tax paid by the company and the individual receiving the dividend would be almost equal to what an unincorporated farmer would have paid in tax on the same $70,000 of earnings.
Notice that if the corporation deferred the payment of the $55,000 dividend to sometime in the future, it would be able to defer $6,105 in tax.
Although unincorporated farmers are permitted to pay their spouses a salary, Canada Customs and Revenue states remuneration must be reasonable. This restriction often limits the full value of income splitting.
To get around this, a husband-wife partnership is often used to enhance income splitting opportunities. Again, Canada Customs requires "reasonableness" and will carefully scrutinize the division of the partnership income by examining each partner's work effort and capital contributions.
Incorporation covers Canada Customs' reasonability tests since income is allocated to shareholders based on their owned shares.
It's always best if unincorporated farmers die after harvest. Those who die early in the calendar year and have been diligent in their deferral of grain may pass a large tax bill to their heirs. This tax bill is the result of deferred grain, no operating expenses and no capital cost allowance in the year of death.
Incorporation solves this problem because incorporated farm businesses continue after the death of the original farmer. It also can be used as a succession tool since a farm that is viable in its present form may not be viable if broken into several pieces. In a recent conversation with an Iowa agronomist, I was told of a growing trend in the U.S. Midwest where non-farming children are continuing with the management of their incorporated farm business on a custom hire or contract basis.
There are some disadvantages in incorporating:
Incorporation is not the answer if a farm business generates a loss and the farmer is using it against other sources of off-farm income. Corporate losses can be carried back three years or carried forward 10 years and they can be applied only against the corporation's business income.
The unincorporated farmer is required to make only one tax instalment equal to two thirds of his income tax liability on Dec. 31 of each year. A corporate farm is required to pay 12 monthly instalments, which in total equal 100 percent of its current year income tax liability.
While the unincorporated farmer must file one statement of farm activity with his personal income tax return, the corporate farm must file a set of financial statements with its corporate tax return. These statements and the tax return cost money to prepare.
It has been my experience that incorporation's intangible benefits are the ones that initially go unnoticed:
■ Incorporating the family farm forces a separation of business and personal activities.
■ Incorporation fosters a business consciousness among family members. This is best illustrated by the following example.
A farmer contacted me a number of years ago about incorporating his operation. The problem was that his three sons were all moving in different directions and weren't getting along. Crops were taken off, not with business objectives in mind, but with the objective of which son needed the money most. The son who had the best job and no kids was forced to wait until late in the harvest season to have his crop harvested.
I told him his farm, with a father and three sons, should operate as efficiently as a single-owner farm of equal size. The best land should be used for the best crops and harvested in the most efficient manner.
Frustrated, the father asked his boys why they couldn't "just ride together in one pick-up."
Eventually, the incorporation forced everyone to set aside personal agendas and focus on overall farm profitability.
Today, their farming company has expanded and shown increased profits in each of their last five years. The father is now retiring and says incorporation was his best business decision in the last five years.