Appendix 1
Illustrations of Family Farm
Transfer Arrangements
An Unincorporated Dairy Farm
Situation
Alan is a dairy farmer aged 63 who is contemplating retirement. He has a son, John, who would like to take over the farm and three daughters who have married and moved off the farm. Most of the farm assets were acquired by Alan alone but there is one parcel of land on which his residence is located that is owned jointly with his wife Elaine. This additional parcel is ten acres, most of which is used in the farming business.
John and his wife already live on the main farm.
Virtually all of Alan and Elaine's assets are tied up in the farm. The particulars of these assets are as follows:
Fair
Market
ValueTax
Value(1)Main Farm (50 acres) Land $ 650,000 $ 150,000 Buildings 200,000 100,000 Equipment 150,000 50,000 Livestock 225,000 Nil Quota Additional parcel (10 acres) Land 200,000 50,000 Residence 150,000 100,000
(1) Represents the cost (or depreciated cost) for income tax purposes. Sale proceeds in excess of this amount will result in an income inclusion to Alan and/or Elaine (except for the residence).
What Are the Options?
Well, the first option might be to sell the main farm, equipment, livestock and quota at fair market value. This is not likely to be acceptable, however, because there would be a large tax liability. Alan's capital gains deduction would offset the capital gain on the land but there would still be a substantial income inclusion in respect of the quota and livestock, and the recaptured depreciation on the buildings and equipment.
An alternative would be for Alan to sell his land at fair market value so as to make use of his capital gains deduction, and to sell his buildings, machinery and quota at his tax values. The livestock would have to be sold at fair market value but because Alan reports his income on the cash basis, he wouldn't have to pay tax on this sale until he received the proceeds.
If the transaction were structured on this basis, the sale price would be $1,145,000, calculated as follows:
Fair
Market
ValueSale
PriceMain Farm Land $ 650,000 $ 650,000 Buildings 200,000 100,000 Equipment 150,000 50,000 Livestock 225,000 225,000 Quota 2,000,000 120,000 $ 3,225,000 $ 1,145,000 The problem with this arrangement is that Alan and Elaine would be giving John a very substantial gift by allowing him to acquire the farm at such a large discount. Alan and Elaine would have to consider whether it is appropriate to make this kind of gift at this stage. What happens if John's marriage should fail? Would his equity in the farm ($2,080,000, before tax) be viewed as a family asset that would have to be divided between him and his wife on a 50/50 basis? What happens if John decides to give up farming after three or four years? Will he have received more than he should have done?
It is likely these issues would concern Alan and Elaine and would cause them to reject this option.
A third option would be for Alan to sell his livestock, machinery and quota to John and to rent the main farm. The quota could be sold at a value that would enable Alan to use his capital gains deduction and the equipment could be sold at his tax value. Again, the livestock would have to be sold at fair market value but Alan could defer tax until he received the sale proceeds.
If the transaction were structured on this basis, the sale price would be approximately $895,000, calculated as follows:
Fair
Market
ValueSale
PriceEquipment $ 150,000 $ 50,000 Livestock 225,000 225,000 Quota 2,000,000 620,000(1) (1) The sale price would likely be higher if there was a recapture of previous quota write-offs.
This is likely to be a better arrangement for the family because the gift to John is considerably smaller. It is not necessarily the best option, however, because Alan would have to include in his income the amount of his previous quota write-offs. This could result in a substantial tax liability.
A fourth option that may be more attractive to Alan and Elaine would be to transfer the farm assets to a company on a "rollover" basis. This type of arrangement could be put in place so that:
a) There would be no income tax payable at the time the farm is transferred to the company (except perhaps some refundable minimum tax if Alan sells his land at fair market value - see (b) below). An income tax election would have to be filed with Canada Customs and Revenue Agency.b) Alan might make use of his capital gains deduction by electing to transfer his land to the company at its fair market value of $650,000. As mentioned above, he would have to consider whether there would be a liability for the refundable alternative minimum tax.
c) Alan would avoid tax on his other assets by electing to transfer them at his tax value.
d) On the assumption Alan elects to transfer his land at fair market value,he would receive the following consideration from the company:
Debt (which can be repaid free of tax) $ 920,000 Fixed value, non-voting shares 2,305,000 $ 3,225,000 e) Some or all of the future increase in the value of the farm would accrue to John through his ownership of the growth shares in the company.
f) The company would be controlled by Alan (and Elaine perhaps) through a separate class of voting, fixed-value, non-participating shares.
g) Alan and Elaine would receive an annual cash flow from the company to meet their living needs. This cash flow might be received in the following manner:
- directors fees
- wages
-interest on the debt owed to Alan
- dividends on the shares owned by Alan or
- debt repaymentsh) Alan and Elaine would retain ownership of the additional parcel of land on which their residence is located. The farm portion of the property could be used by the company. Perhaps the company or John could be given a first right of refusal in the event the property is offered for sale after the death of the survivor of Alan and Elaine, or at the time they vacate the property, if earlier.
i) Alan would have an ability to gift some of the non-voting, fixed value shares to John, either during his lifetime or through his will.
j) Alan and Elaine would have the ability to bequeath the following assets to their three daughters through their wills:
> whatever remains of the $920,000 debt owed by the farm company (the terms of repayment could be specified in the parents' wills);
> the additional parcel of land (if, subsequent to Alan and Elaine's death, this parcel were to be sold by the daughters to John then, depending on the circumstances, any capital gain realized by them might be offset by their capital gains deductions); and
> some of the non-voting, fixed value shares. Depending on the circumstances, these shares would probably transfer to the daughters on a "rollover" basis.Subsequent to the parents' death, these shares would be re-purchased by the company or acquired by John. At that point, there would be income tax consequences to the daughters, or to John, that would have to be evaluated.
To prevent the daughters' shareholdings from de-stabilizing the farm, Alan and Elaine would have to establish before their death the manner in which the daughters would be able to liquidate their investment. This would probably be accomplished through some sort of share repurchase agreement that would be entered into with the company and John.
As part of the overall arrangement, Alan could have the company purchase insurance (on a joint and last survivor basis) on the lives of himself and Elaine. He would have to seek advice from his accountant so that the policy didn't disqualify the company as a family farm corporation.
After the parents' deaths, the company would receive the insurance proceeds and could use them to repurchase the shares inherited by the daughters.
By using insurance, John would be relieved of his obligation to buy-out his siblings. Equally important is the fact that, depending on the circumstances, the daughters could have their shares repurchased without any tax implications. Therefore, the insurance has two benefits.
First, it can fund the buy-out of the non-farming children and second, in the right circumstances, it can eliminate the income tax that would otherwise apply when the non-farming children dispose of their shares.
An Incorporated Nursery Situation
Mark and Diane are aged 62 and are looking to bring their three children into their nursery operation. There are two components to the business. The first is the growing operation which is carried out on five 20 acre parcels and one 10 acre parcel. The product is shipped on a wholesale basis to nurseries located throughout Western Canada as well as to the family's three nurseries located in B.C. The growing operation is supervised by Mark with the help of his son John.
The nursery operation is run by Diane with the help of the other two children, Bob and Mary. Approximately 30% of the nursery's products are grown on the family's property; the remaining 70% are purchased for resale.
The nursery operation is operated by a family company (Nursery Co.) that is owned equally by Mark and Diane. The six parcels of land are also owned by Mark and Diane.
The 10 acre parcel is used almost exclusively by Nursery Co. There is no formal lease arrangement; the land is simply made available to the company. The other five parcels are used exclusively to grow product for the other nurseries.
Mark and Diane would like to bring Bob and Mary into the Nursery Co. and to give John an ownership interest in the growing operation. Unfortunately, Bob's marriage is in difficulties at the moment and there is no certainty it will last very much longer.
Mark and Diane live on a property that is separate from their farm.
Some Preliminary Comments
Nursery Co. is unlikely to be a family farm corporation because a substantial portion of its assets are likely associated with the purchase and resale of nursery products (rather than the sale of products that are grown by the company). If this is the case, the consequences will be as follows:
> the shares of the company will not be eligible for "rollover" to the children
> the shares of the company may qualify as the shares of a small business corporation and, in which case, the capital gains deduction may be available
> the parcel of land that is used by Nursery Co. may not be qualified farm property. If this is the case, it will not be eligible for "rollover" to the children and it may not be eligible for the capital gains deduction either.It is possible Nursery Co. might become a family farm corporation if it were to acquire the parcel on which it grows its products. Whether this is the case would depend on whether more than 90% of the value of Nursery Co.'s assets would then represent property that is used principally in the growing and selling of company-produced product. We will assume the value of purchased inventories is such that the above test would not be met and Nursery Co. would still not qualify as a family farm corporation.
What Are the Options?
An important element of any plan that Mark and Diane might put in place should be to arrange for the parcel of land used by Nursery Co. to qualify as farm property for purposes of the "rollover" rules and the capital gains deduction. In the circumstances, the most appropriate way of doing this might be for Mark and Diane to proceed as follows:
a) Transfer the six parcels of land to a new company (Grower Inc.) that will be operated as a family farm corporation for income tax purposes. This company will grow products for sale to Nursery Co. and the arm's length nurseries. (Mark and Diane would continue to own their residence.)
b) The parcel used to supply product to Nursery Co. would be "rolled" to the new company in exchange for debt and non-voting fixed value shares. An election would have to be filed with Canada Customs and Revenue Agency.
c) The parcels used to grow produce for other nurseries might be transferred at or near fair market value so as to make use of a portion of Mark and Diane's capital gains deduction. If this were to happen, the consideration to Mark and Diane might consist entirely of debt that can be paid to them free of tax.
In deciding this matter, Mark and Diane would want to take into account that the accrued gain on their investment in Nursery Co. will be taxed at some point (see below). This being the case, they may want to set aside a portion of their capital gains deduction to offset this future gain.
Mark and Diane would have to receive advice on the application of the refundable alternative minimum tax.
d) The company would be controlled by Mark and Diane but some of the growth shares would be issued to John.
e) Ultimately, all of the growth shares would likely be inherited by John. The additional shares could be gifted or bequeathed to him in the future, without income tax consequences, provided Grower Inc. remains a family farm corporation.
f) If necessary, to make the inheritances equitable, Bob and Mary could acquire some of the non-voting shares of Grower Inc. There would have to be an arrangement entered into beforehand setting out how these shares are to be repurchased by the company. This repurchase might be funded with life insurance on the lives of Mark and Diane.
g) Grower Inc. would maintain its family farm status by using all of its land to grow products for resale and by ensuring Mark, Diane or John are actively involved on a regular and continuous basis.
h) At some point, Mark and Diane might be prepared to give up their voting interest in Grower Inc. or Nursery Co. so that the two companies would no longer be associated for income tax purposes and each of them would be entitled to the low rate of tax on the first $200,000 of active business income.
In regard to Nursery Co., Mark and Diane need to recognize that because the entity is not a family farm corporation, they will not have the ability to transfer their shares to their children on a "rollover" basis. If the company is still owned on their deaths, the survivor of them will be deemed to dispose of their shares at fair market value and there may be a tax liability on the capital gain resulting therefrom. Whether a tax liability will exist will depend to some extent on whether the shares of the company qualify as "shares of a small business corporation" and, as such, are eligible for the capital gains deduction. It also depends on whether this deduction still exists at the time of death. Because of this, Mark and Diane may want to consider the following:
a) A freeze of their interest in the nursery company under which they would exchange their voting common shares for non-voting fixed-value shares.
b) Depending on the circumstances, it may be advantageous to structure the "freeze" so that Mark and Diane are treated for income tax purposes as having disposed of their shares to the company at or near fair market value. The resulting capital gain would be offset by claiming the capital gains deduction (provided the shares qualify as shares of a small business corporation).
As an alternative, Mark and Diane might choose to use all of their capital gains deduction on the transfer of land to Grower Inc. (see above) and deal with the accrued liability on their shares in Nursery Co. in another manner. They could, for instance, decide to gradually redeem their freeze shares over their retirement years (perhaps in lieu of receiving a salary) so that on their death, the tax liability would be substantially eliminated. Professional advice would be essential because there are several issues to be considered.
An election may have to be filed with Canada Customs and Revenue Agency.
c) Mark and Diane would control the company through a separate class of voting, fixed-value shares.
d) A family trust might be created to acquire some or all of the growth shares. Because these shares would have no value when issued, they would be issued for a nominal price. The beneficiaries of the trust might be limited to Bob and Mary and, in which case, the trustees would be Mark and Diane.
Because the trust would be discretionary, Bob would not have any entitlement to the trust's property until Mark and Diane exercise their discretion and distribute it to him. Accordingly, his future interest should not be exposed to a claim from his wife if their marriage should fail.
Mark and Diane would have to realize that because trusts (other than spouse trusts) are generally treated as having disposed of their assets at 21 year intervals, this trust would have to be wound-up before the end of the 21 year period.
e) Mark and Diane would continue to receive an annual cash flow from the company in the form of:
> dividends on their freeze shares;
> directors fees;
> wages; or
> a repurchase of their freeze shares.f) The trust would be wound up within 21 years and, at that point, Bob and Mary would acquire the shares owned by the trust. The distribution from the trust would not result in income tax.
g) Mark and Diane could bequeath the remainder of their non-voting fixed-value shares to Bob and Mary. If they made use of their capital gains deduction on the estate freeze, there may be little or no tax liability in respect of this asset on their death.
h) To the extent there is an accrued tax liability on the shares of Nursery Co., Mark and Diane's will would provide that this liability is to be borne by Bob and Mary.
