INCORPORATE BEFORE SELLING FARM
Originally published on May 18, 2006
One of the little-known tax advantages available to farmers lies within the farm partnership.
Typically the $500,000 capital gains exemption is used at the end of a farmer's lifetime when bequesting his farmland to his beneficiaries.
More recently, however, we have seen a growing number of farmers structure their operations into partnerships because farm partnerships qualify for the capital gains exemption. Let me explain.
Mr. and Mrs. Farmer have established a successful mixed farm partnership. They are getting out of farming and are in the process of moving to the city.
They plan to keep their land on a cash rental basis but will sell their livestock, commodities, buildings and equipment. These are valued at $1.025 million, but there is a $200,000 loan outstanding.
In the first example shown in the table, we see that selling the farm assets with no planning triggers a tax bill of $311,000. Ouch.
How do we get around this? What if we were to incorporate the farm partnership before the sale?
Through proper planning and advice, we are able to transfer the farm assets through the farm partnership into a farming corporation, triggering a promissory note of $600,500 and non-taxable capital gain of $510,500.
Following the tax-free dissolution of the partnership interest within the company, the sale of the corporate-owned assets over one year triggers a combined tax bill of $224,500.
By further planning to allocate the sale over two years, the total tax bill is reduced to $155,000, as shown in the third column of the table.
Mr. and Mrs. Farmer can then withdraw the proceeds from the sale of these assets by having the company repay the promissory note tax-free. There are a few things to watch for:
■ A valid partnership has to be in existence for at least two years.
■ Prepaid alternative minimum tax may apply in the year of rollover.
■ If you have a history of investment losses, your capital gains could be partially taxable.
The establishment of a valid farm partnership is often the first step in a flexible farm succession plan.
A written farm partnership agreement goes even further, especially if it allows for the continuation of the farm partnership after the death of one partner.
For example, if Mr. Farmer dies before incorporating, then a properly written partnership agreement will allow his estate to incorporate his partnership interest after his death, giving his beneficiaries the same tax advantage he would have had himself.
A farmer's ability to use his capital gains exemption sooner will put him in an enviable position and leave him with a bigger bulge in his wallet.