As farms become bigger, they can consistently generate income that pushes earnings into the higher personal income tax rates. As a result, a lot of farms incorporate to take advantage of the lower small-business tax rates.
This article provides a quick review of the reasons to incorporate, highlighting the effect of recent changes to tax rules. Kurt Oelschlagel, farm tax specialist and partner with BDO in Hanover, Ontario, provided guidance for this article.
Reason: Tax deferral
If farm profits put incomes for active members of the operation into a high income tax bracket, incorporation offers an opportunity to pay individuals a wage (taxed in a lower tax bracket) and keep most of the income in the corporation, which is taxed a lower rate. This is particularly beneficial where a corporation is reinvesting proceeds (new equipment, buildings, etc.) or paying down debt.
The small-business tax rate applies to the first $500,000 in profit ($600,000 in Saskatchewan). If not incorporated, the farmer who generated that amount of profit would be in the top income bracket and would pay the personal tax rate of 50 per cent or more (varies by province) for most of that income. If incorporated, farm profits that quality for the small-business tax rate would be taxed at nine to 15 per cent. The actual rate varies by province. (See the table for the Prairie provinces.)
Change: Small-business tax rates dropping. As of January 1, 2019, the federal small business tax rate was reduced by one percentage point across all provinces.
Change: Investment income will reduce the small-business threshold. Effective for taxation years that begin after 2018, corporations earning more than $50,000 in investment income in a year will see their small-business tax exemption threshold clawed back incrementally. With $150,000 or more in investment income in the previous tax year, the exemption is eliminated entirely for the current year.
Change: Income splitting restricted. Income splitting is a way to share income with members of a family who are in lower tax brackets, thus reducing the overall tax owing for the family. As of January 1, 2018, dividends paid to family members from the family farm corporation will be subject to the ‘tax on split income’ (TOSI), which is the highest rate of income tax, unless specific exemptions apply. For example, those who are actively involved in the business at least 20 hours per week on average in the year or any of the five preceding years will not be subject to TOSI.
Change: Restriction on income from sales to other family businesses. For taxation years of corporations ending after March 20, 2017, there are restrictive rules on accessing the small business deduction. These rules could apply, as an example, when a farm corporation sells property or services to another private company that is owned (even just one share) by a parent, sibling or child.
Let’s say you own a farm corporation that sells canola to your brother’s corporation which carries on a small specialty canola oil processing business, and the net income of your company from these sales is more than 10 per cent of its total net income. The net income of your corporation from selling that canola is not eligible for the small business deduction and would be taxed at the standard business rate (see the table). In this situation your brother may agree to have his company assign some of its small business deduction to your company, but there is no certainty to that since your brother’s company may need it all.
Reason: Succession planning
Incorporation can help with succession. “You don’t have to change ownership of any assets, such as equipment and inventory, if they are owned by the corporation. You are usually just changing who owns the issued shares of the corporation, such as introducing a child as a new shareholder.”
Transferring ownership of the farm from one generation to the next can be onerous. Incorporation of a farm, while not necessarily an easy process in itself, can make succession planning a lot easier when that day comes.
“You don’t have to change ownership of any assets, such as equipment and inventory, if they are owned by the corporation. You are usually just changing who owns the issued shares of the corporation, such as introducing a child as a new shareholder,” Oelschlagel says.
Incorporated farms also have tax-saving benefits when it comes to estate planning, which can reduce the tax burden on surviving members of the corporation.
Reason: Liability protection
“In general, the personal assets of a shareholder in a corporation are protected from creditor claims against the corporation,” Oelschlagel says. Incorporation can also protect personal assets when lawsuits are brought against the corporation. There are exceptions in both cases, Oelschlagel notes. “A shareholder who personally guarantees corporate debt is liable for that debt, and directors can be held legally liable for activities of the corporation,” he says.
|Small business tax rate||12%||11%||12%||11%||10%||9%|
|Standard business tax rate||27%||27%||27%||27%||27%||27%|
|Income threshold for small business tax rate||$500,000||$500,000||$500,000||$600,000||$450,000||$500,000|
Downsides to incorporation
Oelschlagel also notes a few downsides to keep in mind. Incorporation does require more record-keeping and tax compliance costs, including a corporate tax return. Incorporation means you can’t use business losses in the corporation to offset personal income. “That is why incorporation can make more sense for farms that are consistently profitable, regularly invest in capital upgrades or expansion, and have debt to service,” he says. A corporation does not have a capital gains exemption, like an individual does. And when farm residences are transferred to the corporation, the house becomes an annual taxable benefit for the person living there and it also means the loss of the personal principal residence exemption for the years it is owned by the company.
Details of the benefits and downsides to incorporating a farm business cannot be covered in a short article, and the best business structure for any one farm will depend on situations specific to that farm. Accounting firms have good information on farm incorporation. As a start, read the farm incorporation factsheets on their websites. When ready to discuss the options, make sure to have an accountant equipped to work through these conversations.
“Despite changes to the tax rules, incorporation is still a very good option for obtaining a tax deferral, succession planning and liability protection for many Canadian farms,” Oelschlagel says.