In Canada more than 90% of farm businesses are family-owned operations; these operations involve about one million people. The total capital value of Canadian farms in 1986 was about $110 billion; the average capital value per farm was $375 000; and, on average, farm real estate was worth more than $375/ha. Because of the economic and social importance of the family farm, the dramatic increase in farm bankruptcies in the last 10-15 years, and the diminishing number of family farms, farm groups have emphasized the importance of establishing the farm business on a sound legal footing, both to protect individual farmers and to maintain the family farm as a viable unit.
Because of its special social and economic problems, the rigid marketing structures that surround it, the high risks attached to it and the more recent consequences of the North American FREE TRADE Agreement, the farming business requires a more sophisticated approach to legal matters than many other businesses do. Regulations relating to marketing vary according to the product, the part of the country in which they are produced and the intended market (eg, domestic or export), etc. Specific cases should always be referred to a lawyer, tax advisor or other professional. A general outline can be drawn, however, of business arrangements and taxation provisions affecting farm businesses.
The 2 broad areas of business relationships in the farm business are between the owner and his or her business and between the owner and his or her family. These kinds of relationships have special implications in farming because the farm family is the major source of farm labour and management. Business arrangements between parents and children are the most frequently encountered in farming, and each party has problems that must be resolved. The parents have accumulated substantial, usually nonliquid, assets (ie, land, buildings, machinery, inventories of grain and livestock), and wish to make an adequate arrangement to assure the continuance of their child or children in the farm business, while maintaining some control of business management and income until their retirement; after retirement they may need some control to protect their remaining capital investment.
Parents desire to assure succession of the business to those children who want to carry on the business themselves, to be paid for the capital they transferred to the children and to provide income and capital for themselves during their lifetimes and perhaps for those children not involved in the business. The children who take over the business desire an adequate income, means of acquiring a controlling (if not total) capital interest in the farm, and eventual guaranteed succession. The parents wish to be fair to the children not involved in the farm business so that they in due course receive their fair shares in the capital or secured debt owned by their father and mother.
All family members must consider certain areas of mutual and separate interest in the agreement outlining how they will carry on the business. This involves the consideration of such matters as the evaluation and ownership of assets (currently and in the future if the parents retain an interest), amount of time each shall contribute to the enterprise, apportionment of income now and in future, regular transfer of capital from parents to child (by gift, purchase or both), agreements regulating purchase and sale of shares in the farm, and the means by which other children may acquire interest in the business.
When considering their estate plan, the parents are faced with the problem of how to divide control of the farm business. Related questions include continuity of management, the effect of either parent's death on the future availability of business credit and funds for the purchase of the business by their children, and the need to make funds available for executors to pay debts and taxes and provide an income for dependants.
A properly thought out estate plan will do much to enable the establishment of adequate credit, create acceptable collateral to secure such control, provide retirement funds, prevent the sale of assets at distress prices, establish the value of the business and achieve continuity in business activity. In most instances, funding for the purchase by the child from the parents is secured by mortgage financing from a bank, the FARM CREDIT CORPORATION, a provincial government credit association or the local credit union.
Any outstanding balance owed to the parents will likely be secured by appropriate documentation that when registered will have to rank second to the aforementioned mortgage obligations. Accordingly, the parents' equity, on which they rely to support themselves during retirement, is at risk and, in difficult times, may be obliterated.
Family Farm Transfer Planning
A number of issues must be addressed so that a farm transfer plan is developed that meets the needs of all parties. This includes the farmer, the spouse, those children who are taking over the farm and operating it, and those children who are also the parents' beneficiaries but will not have an active part in the farm operation or are obliged to sell their interests to those children taking over the farm business.
Of first importance is to collect the necessary data to help the farm family arrive at informed decisions. This data includes developing a net worth statement, calculating income and expenses for the farm, determining how much money is required to retire, reviewing the debt load and anticipated income load, and discussing and agreeing upon immediate and long-term goals.
All parties must also consider, from their own perspectives, other critical issues. These include retirement needs; relevant tax law; the best way of keeping the farm intact and perhaps expanding it if it is going to remain as an economic unit; the maintenance of family good will; and the care of younger children. Above all, everyone must think that what is being done is fair and that every person is being treated fairly.
An estate plan provides for the equitable transfer of property from one generation to another. This can occur during the person's lifetime or, depending on the circumstances, only on death. Effective estate planning must consider all legal and tax implications, particularly in order to minimize tax liability when these transfers occur. All the considerations made during family farm transfer planning, such as preservation of the family farm and orderly succession of ownership, must form part of the estate plan.
A will must be drawn that is correlated with the farm transfer plan. There are many considerations in planning a will, including the appointment of executors, distribution of particular assets, payment of debts and appointment of guardians for minor children. In addition to properly drawing a last will and testament, other critical decisions have to be made, including what type of business arrangements have been chosen, what transfer mechanisms have been chosen and what types of insurance coverage should be in place. To make these and other decisions, the family farm must seek legal, accounting, insurance and financial advice.
The Farm Business Structure
The farm business involving 2 or more people can be carried on by 2 major methods, the partnership (general or limited) and the limited corporation, each with its own advantages and disadvantages. In certain instances a combination may be warranted.
The Farm Partnership
A partnership is the relationship between persons carrying on a business in common with a view to profit. It is not a legal entity; all rights and obligations accrue to the individuals in the partnership. Each partner is regarded as the agent of the other and is capable of making the other liable for all debts and obligations incurred by the partnership.
A general partnership consists of 2 or more general partners who are jointly and severally liable for the firm's debts, not only to the extent of their investment in the partnership but, if this investment is insufficient to satisfy the creditors, to the extent that their private property is required for this purpose. Each partner has a right of indemnity against the other.
A limited partnership consists of one or more general partners and one or more limited partners. A limited partner is liable for the firm's debts only to the extent of his involvement, but his liabilities increase to those of a general partner if he allows his name to appear in the firm's name and if he publicly helps conduct the business. To be considered a limited partner, one must be so designated in a declaration filed with the government. A limited partnership must be registered and all partners are considered general partners until so registered.
Capital contributions from the different partners may vary, as is often the case in family farm partnerships. In some such cases the partner with the higher capital investment may be paid interest on such excess by the partnership. Such interest is charged as an expense to the partnership; therefore the partner is, in effect, paying part of his own interest. In other instances the partner contributing least capital may contribute most labour. These positions are sometimes equated so that profits are divided equally.
Alternatively, excess labour may be compensated by payment of a wage, leaving the rate of return of profit related to the amount of capital contribution. The cost of labour is charged to the partnership and the partner being paid for his labour contributes personally to his own wages. The division of income from a farm partnership is often difficult. The father needs cash to support and educate other members of the family; the child may also have a growing family and require a maximum amount of income.
In such a case, capital acquisition must either be limited or have payment amortized over a long period to make the maximum amount of cash available. At the same time the goal may have to be towards the immediate expansion of the farm unit. Thus, there may be a most difficult conflict between the capital needs for expansion and the immediate need for cash. To resolve such a conflict the first necessity is to determine whether the existing farm unit can support the partners and, if not, what can be done to alter it to allow it to do so.
The various factors that must be taken into account in the division of income are the amount required by each party for family spending, contributions to labour, management or capital made by each party, and a formula that relates the minimum wage to be earned by each partner, plus a division of surplus, to the growth of the business. The arrangement chosen must be flexible and must recognize the changing needs of each partner.
The Farm Corporation
A corporation is a legal person with the capacity (subject to the Corporations Act), rights, powers and privileges of a natural person. It is an advantageous form of business association because it gives potential income tax advantages, accommodates the many variations of business relationships, can be a vehicle for estate planning, and its liability is usually limited to the assets it owns.
Finally, a corporation has an identity distinct from that of its shareholders and potentially can exist forever. Thus it offers opportunities for investment and management decisions that are largely independent of an individual owner or partner. An individual invests in a corporation by purchasing shares. Shares are allotted for amounts fixed by the directors, and such values, determined at the time of issue, become the paid-up or "stated" capital of those shares.
There may be more than one class of shares, each carrying different rights and restrictions. The directors should determine the nature and attributes of the shares to be issued by considering the nature of the business the corporation will carry on, the relationship between the persons who will be shareholders and the method of securing the repayment of any monies owed by the corporation.
A farmer considering incorporation must consider various aspects of relevant provisions of CORPORATION LAW as they will affect the business. For example, the appointment of directors and the rules governing voting (including the definition of a quorum) will determine who has managing control over farm-business decisions.
Similarly, regulations established within the corporation to govern purchase and sale of shares will affect how shares in the farm may be traded within the family or to persons outside the family corporation. The means of repayment to a retiring shareholder or to the estate of a deceased shareholder can influence the continued economic health of the farm corporation. In this connection the importance of insurance on the lives of the principals should be emphasized. A comprehensive shareholders agreement, setting forth all the rules by which shareholders agree to govern themselves and the corporation, as well as all the rules that apply to a buyout of one by the others and sale to a third party, is critical.
Further, a corporation lends itself particularly well to the estate plan. Provided it is adequately established, it can freeze the value of the farmer's estate so that all future growth will go to those persons the farmer wishes it to benefit. It allows the farmer to give nonvoting participating shares during his lifetime, without affecting his control of the corporation, its assets or its income. It permits the farmer to give his heirs specific interests in such proportions as he desires, immediately and in the future. It allows for the maintenance of control by the farmer's executors beyond his death to maintain the farm's value, carry on business and protect the farmer's spouse and dependants.
Finally, it allows a farmer to complete arrangements with those children who wish to operate the farm, so that they share in the income and continued growth of the assets, obtain eventual control and thus stay with the business.
Taxation of the Farm Business
Farmers must make a number of important tax-sensitive choices. First, should income be reported on an "accrual" or on a "cash" basis? Second, should the farm business be incorporated or not?
Cash versus Accrual
Most businesses must compute income on an accrual basis. This means that income is reported as it is earned and expenses are deducted as they accrue. However, farm and fishing businesses have the option of using the cash method. Under the cash method, income is reported when received as cash and expenses are claimed when paid.
Most farm businesses use the cash method because of its flexibility. For example, under the cash method, income for the year can be reduced by paying expenses at the end of the year (eg, feed, fertilizer, livestock inventory) and deducting them against income. The year's income is reduced even though the items purchased are still available at the end of the year for use in the next year. (This practice cannot be used to generate farm losses.)
The second choice is whether or not to incorporate. From a tax perspective, a corporation will be advantageous when the business produces more income than the individual or partners need for their living expenses, and when the corporation is in a lower tax bracket than the individual or partners.
In 1996, the first $200 000 of the active business income of a Canadian-controlled private corporation is taxed at a rate of approximately 23-25%. In 1996, the tax rate for individuals was approximately 30% on income between $8000 and $30 000, 40% to 50% on income between $30 000 and $62 000, and 50% or more on income over $62 000. Tax rates vary from province to province.
A corporation also can provide a number of advantages in tax planning. For example, it is easier to establish a family trust to split income among family members when a corporation is used. Splitting income among family members saves tax because each family member can take advantage of their lowest income-tax brackets and personal deductions.
However, if the farm business experiences periods of losses, then a corporation may be disadvantageous. Shareholders cannot use corporate losses: such losses are "trapped" in the corporation.
Farm losses are subject to limitations. The Income Tax Act distinguishes among 3 categories of farmers. Farmers who are in the "business" of farming can deduct all losses incurred in farming. In 1996, those persons who farm as a sideline with a reasonable expectation of profit can deduct losses up to a maximum of $8750 per year. Persons who farm for enjoyment (ie, hobby farmers) are not entitled to any deductions for losses.
Transfer of Farm Property
Generally, when capital property is transferred (whether by sale or by gift), capital gains or losses are triggered. In some circumstances, the gains on certain farm property are either not triggered or can be sheltered from taxation under the $500 000 "super" capital gains exemption.
In certain circumstances, farm property, interests in family farm partnerships or shares in family farm corporations can be transferred to a spouse or child without triggering the capital gains in the property. This is referred to as a "rollover." The capital gains are triggered if the spouse or child transfers the property in a situation where the rollover does not apply.
In addition to rollovers, the $500 000 super capital gains exemption may provide tax relief should farm property, an interest in a family farm partnership or shares in a family farm corporation be transferred. However, even though the capital gains exemption can be used to eliminate the income tax normally triggered on a transfer of property, some additional tax may still apply. For example, the alternative minimum tax may be payable even though the capital gains exemption applies to the gains triggered on a transfer. Also, in some provinces (eg, Manitoba and Saskatchewan), provincial surtaxes may still be payable on capital gains to which the exemption applies.
The rules respecting family farm rollovers and the capital gains exemption are extremely complex. A tax professional, such as an accountant or a lawyer familiar with taxation, should be consulted before concluding that a rollover or that the capital gains exemption applies to a particular transfer of property.