Incorporating a farming partnership can be beneficial for several reasons, including the potential to benefit from using the partners’ capital gains exemptions with proper tax planning.
For farmers who operate as sole proprietors, there is no need to worry, as it is often possible to restructure your proprietorship into a partnership with your spouse, a child or a new corporation as the other partner. Restructuring your operations into a partnership can set the foundation for the tax planning opportunity discussed here.
For context, the rules in the Income Tax Act provide that each individual resident in Canada may claim the capital gains exemptions of up to $1 million on the disposition of certain types of eligible farming property. Notably, “an interest in a family farm or fishing partnership” (and no other type of partnership interest) is an eligible type of property for these purposes (an eligible partnership interest).
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On the other hand, farming assets such as inventory and equipment are not eligible types of property for the capital gains exemptions. Therefore, by owning inventory and equipment inside of a partnership, the eligible partnership interest rules effectively allow for the capital gains exemptions to be used on the value of farming inventory and equipment when this would not otherwise be the case.
Farmers in sole proprietorships and partnerships often account for their income on a cash basis, which can allow income to be deferred. Because of that, farmers in these circumstances may not have previously seen the benefits associated with incorporating their operations.
However, income deferral has some operational disadvantages and can create a large tax bill upon the end of the income deferral cycle (which often coincides with retirement or the sale of the farm). Tax planning to use the eligible partnership interest rules can provide a way out of the income deferral cycle without facing the large tax bill.
To qualify as an eligible partnership, the entity must carry on its operations for a least two years. If you are operating as a sole proprietorship, you will need to convert your proprietorship into a partnership and operate as a partnership for at least two years.
It is important to enter a formal partnership agreement to ensure this two-year period begins. Furthermore, your active farming assets, such as inventory and equipment, will need to be transferred into the new partnership before the commencement of its operations.
There are rules in the Income Tax Act that allow for the transfer of your farming assets to a partnership on a tax-deferred basis. The GST and PST rules must also be managed.
Once your partnership has been established, its value will increase as its asset base increases (likely as inventory). Then, when your farming partnership has operated its business for two years or more, your interest in the partnership, along with the interests of your partners, may qualify as an eligible partnership interest.
Remember, each individual in Canada, meaning each of the individual partners of your partnership, would have their own $1 million capital gains exemptions to use. If all the requirements are satisfied such that you and your partners each have an eligible partnership interest, a sale of the eligible partnership interests can be made to a newly incorporated corporation in exchange for a promissory note (or shareholder loan credit). The sales of the eligible partnership interests would result in capital gains, but these capital gains can be sheltered by the capital gains exemptions of the partners.
After such sales, the partnership will wind up and transfer all of its assets to the new corporation as the corporation will be the last remaining partner. The result is that the previous partners of the partnership are now shareholders of the new corporation, and the future earnings of the corporation can repay the promissory notes owing to its shareholders without triggering any tax.
In addition, the corporation should be able to claim the small business deduction with respect to its first $500,000 of taxable income each year. This results in the corporation having a tax rate (in Saskatchewan) of 10 percent. Compare this to a minimum personal tax rate of 25.5 percent and a maximum personal tax rate of 47.5 percent. This planning makes ending the income deferral cycle much less painful.
Garrett Leedahl is a lawyer with Stevenson Hood Thornton Beaubier LLP in Saskatoon. Contact: gleedahl@shtb-law.com. Michael Deobald is a partner with Stevenson Hood Thornton Beaubier LLP in Saskatoon. Contact: mdeobald@shtb-law.com.
