DEFERRING TAX THROUGH A FARM COMPANY

Originally published on August 12, 2004

 

For some of you, the prospects of a decent crop along with old crop deferrals may be causing you to reconsider the option of incorporating in order to defer tax. In our office we are often asked to quantify the tax deferral benefits in order to more clearly communicate the potential benefits of incorporation.

There are two main deferrals that can be realized by incorporating.

Initial tax deferral upon incorporation
To illustrate the initial tax deferral, letís look at the balance sheet of our sample farm that is provided in table 1. What is most noticeable is the difference between the fair market value and adjusted cost base of the farmland. It would appear that the farm has been rolled forward from one previous generation to the next at its original purchase price.

 

 

By incorporating, our farmer could transfer land to his farming company and in the process realize a capital gain of $500,000. Provided that the farmer has access to the $500,000 capital gains exemption, the company would issue in exchange for the farmland, a $500,000 promissory note that the farmer could withdraw tax free.

The creation of this promissory note enables the farmer to replace his salary or dividend income from his farm corporation with tax free note withdrawal which creates what we call an initial tax deferral.

Annual tax deferral
Canadian controlled private corporations pay a much reduced rate of tax on the first $250,000 of active business income. This lower tax rate between 17% and 19% in most provinces Ė leaves the incorporated business with more after-tax dollars, which can be either reinvested back into the business or paid to its shareholders as a salary or dividend.

If you have a corporation and you do not withdraw all of your company profits personally in the form of a salary or dividend but rather reinvest these funds back into your business by either acquiring assets or paying down debt then you will experience what is known as annual tax deferral. By leaving funds in your company, you are essentially deferring the personal income taxes that would have been triggered on these funds had they been paid to you in the form of a salary or dividend.

Letís go back to our sample farm and try and quantify the annual tax deferral. Letís assume that the farm generates a yearly net income of $60,000. After making its $10,000 principal loan payment and $10,000 in capital purchases, all remaining profits are paid out to either the proprietor or shareholder. In table 2, we have Mr. A, who is not incorporated. After income taxes and loan payments, Mr. A is left with $21,266 in his pocket.

In table 3, we have Mr. B, who runs the same farm but through a corporation. For Mr. B after income taxes and loan payments he is left with $25,216 in his pocket. The difference is our annual tax deferral of $3,950.

We can prove the annual tax deferral by applying the formula in table 4. Since the farmís worth or equity rose by $20,000 and Mr. Aís marginal tax rate is approximately 35% we recalculate our annual tax deferral of $3,950.

Quantifying the initial and annual tax deferral is only one small part of the incorporation decision. For this reason, anyone considering incorporation should review their own unique circumstances with their own professional advisors. Hopefully, this column will provide a better understanding of tax deferral.

 

 

Allyn Tastad, certified general accountant, is a partner in the accounting firm of Hounjet Tastad Harpham in Saskatoon at 306-653-5100, e-mail at allyn@hth-accountants.ca or website www.hth-accountants.ca. He is also involved in the family farm near Loreburn, Saskatchewan.  The opinions expressed in this column are for information only.