10/18/2024
𝐓𝐨 𝐅𝐚𝐫𝐦 𝐨𝐫 𝐍𝐨𝐭 𝐭𝐨 𝐅𝐚𝐫𝐦? 𝐀 𝐐𝐮𝐞𝐬𝐭𝐢𝐨𝐧 𝐟𝐨𝐫 𝐭𝐡𝐞 𝐍𝐞𝐱𝐭 𝐆𝐞𝐧𝐞𝐫𝐚𝐭𝐢𝐨𝐧.
The family farming business has been carried on by the family for generations. Now, the current generation operating the farm is starting to think about retiring. There are some tax efficient strategies to pass the farm on to the next generation but a key question to ask early on is: “Does the next generation intend to run the farm?” What if only some of the next generation wants to be involved in the farm? How do you plan your estate transfer to accommodate those active in the farm and those that are not? Is equal always fair? The latter is often an important question in farming situations, since often the farming business is asset rich and cash poor. Can estate equalization be achieved without jeopardizing the farming operation?
An oft-used strategy to pass the family farm from one generation to the next is ensuring that the farm property qualifies for the intergenerational farm rollover. Upon their death, this rollover allows farmers to defer the tax on the transfer of certain types of farm property to their children, such as land, buildings, quotas, and machinery and equipment, as well as “shares of the capital stock of a family farm or fishing corporation” and an “interest in a family farm or fishing partnership” as defined in the Income Tax Act. The rollover is a valuable tool for deferring the tax liability that usually occurs on death.
If the intergenerational rollover strategy is not used, capital gains tax rules will apply. These rules state that when someone dies, they are deemed to dispose of their capital assets at their fair market value immediately before death (unless the spousal rollover is used which allows the transfer to a spouse on a tax deferred basis). If this amount exceeds the taxpayer’s cost of the asset, then they will have a taxable capital gain. Considering that the capital gains inclusion rate is proposed to increase from 1/2 to 2/3 on net capital gains* for dispositions occurring on or after June 25, 2024, the tax liability on death just got even larger – using a 50% tax rate, the increase would result in $83,333 extra tax on a $1 million capital gain.
The issue that often arises for farms that have been passed down from generation to generation, is that the deferred tax liability has grown to a significant number. Farm values have increased exponentially, and many farmers don’t realize how large a capital gain they are sitting on. The cost base for many farms is very low unless planning had been done by prior generations to increase the cost base, for instance using the lifetime capital gains exemption (“LCGE”) on “qualified farm and fishing property”, which is proposed to increase to $1,250,000 on June 25, 2024. While it is true that taxes can be deferred and the cost base of property can be bumped using the LCGE through the generations, there may come a time when property may no longer meet the conditions to qualify for such preferential tax treatment and taxes must be paid. Let’s look at an example.
The Smiths’ family farm has been passed down for generations. Mr. Smith has farmed the land since it was transferred from his father, who also farmed the land. Mr. Smith’s wife has predeceased him. His son, John, has never shown an interest in farming and will sell the farm once Mr. Smith passes away. We will assume that the farmland meets the requirements for the intergenerational rollover and the LCGE and Mr. Smith has the full $1,250,000 LCGE available. The cost base of the farmland is $50,000 but the value of the land is now $10 million! Mr. Smith passes away in November 2024. If no planning is done, using a 50% tax rate and the 2/3 inclusion rate*, the tax liability would be $3,316,667!
Since Mr. Smith has actively farmed the land and John is resident in Canada, planning could be completed to use the intergenerational rollover and the LCGE on death. By using the LCGE, the cost base of the land to John would increase to $1,300,000 ($50,000 original cost + $1,250,000) which would reduce the future tax liability (assuming no increase in the value of the land) to $2,900,000. Still a significant amount of tax to pay!**
Now, what if Mr. Smith had two children and one wants to farm but one does not? How will Mr. Smith equalize the value of his estate between the two children? Does he have other assets that can be left to the non-active farming child? Would productive assets used in the farm have to be sold to provide funds to the non-active farming child or would some of these assets be left to the non-farming child but leased back to the active farming child? These are questions that Mr. Smith needs to consider and discuss with his children. One option that would provide Mr. Smith the liquidity to equalize his estate is to purchase life insurance so the farm operations are not affected.
Farmers, like all business owners, need to have a succession plan that achieves their estate planning and retirement goals. Insurance can play a meaningful role in their succession plan. It can be used to fund the deferred tax liability that may have been growing significantly over multiple generations, and to equalize the farmer’s estate if the farm is being passed to some children and not others.
References
*Federal Budget 2024 increased the capital gains inclusion rate from 50% to 2/3 effective June 25, 2024, for amounts over $250,000 for individuals. For simplicity, the 2/3 inclusion was applied to the full gain. At time of writing, this change was not yet law.
** It may be possible on the future sale for John to use his $1,250,000 LCGE since his father had been actively engaged in farming on the property, but it is important that all other conditions required to claim the LCGE at that time have been satisfied.
