For agriculture to prosper in the future, it is important to have a successful transfer from one generation to the next. Tax and other issues must be considered to ensure your farm lives on the way you’ve envisioned.
Some of the items that require discussion when developing a succession plan are:
- Will the parents transfer complete ownership?
- How will management decisions be made?
- If the parents are retiring, what are their income expectations?
- Can the farm afford to pay off any debt the parents take back on the transfer of ownership?
- How will non-farming children be treated?
The following is a review of some of the tax rules relating to farm transfers both before and upon death and we have also looked at family dynamics and how it affects succession planning.
Transferring the farm property prior to death
The basic rule for asset transfers to children for proceeds less than fair market value is that the parent is considered, for tax purposes, to have disposed of the property at fair market value. However, for the transfer of certain farm property (which includes land, depreciable property and eligible capital property such as quota, but does not include inventory) a special rule exists. Providing the farm property was, before the transfer, used principally in the business of farming (usually means more than 50%) and a family member was actively involved, the assets can generally be transferred at cost, fair market value or any value in between. Note that for depreciable property and quota, the cost amount will be the undepreciated capital cost. The ability to transfer at any price up to fair market value results in a great deal of flexibility when trying to maximize the tax position of the parent and the child.
If any capital gains are triggered, the $1,000,000 capital gains exemption may be available to offset the gain. If the exemption is used to increase the cost base of depreciable property or quota, special rules prevent such an increase from being available for future tax depreciation by the child. However, the increased amount or cost will be used to calculate any capital gains the child may have on their own sale or transfer in the future.
Transferring the farm property upon death
In general, a taxpayer, upon death, is deemed to dispose of everything owned immediately before death. However, a number of provisions allow properties to be transferred at cost so that no immediate taxes are owing.
Special rules allow certain farm property to transfer to a child on death at cost, fair market value or any value in between. One of the conditions is that the farm property must “vest indefeasibly” to the child within 36 months of death. This basically means the child must have absolute ownership with no strings attached within 36 months of death.
No special provisions exist to allow farm inventory to pass between parents and children without tax. For transfers to children, often a note is taken by the parent (assuming cash basis reporting is used for tax purposes). Such a note allows the parent to take into income the value of the inventory only as payments on the note are received. This spreads out the income over a number of years.
Capital gains exemption
Access to the $1,000,000 capital gains exemption on qualified farm property for the parents is always a consideration when a transfer is being contemplated. When claiming the capital gains exemption, be mindful of potentially triggering of alternative minimum tax. And although the exemption might reduce or even eliminate the tax liability, the taxable capital gain arising from the sale of farm property is considered income that may affect income tested benefits, such as Old Age Security (OAS). Again, proper planning can reduce or eliminate these adverse consequences.
While tax considerations certainly need to be addressed in any succession plan, one cannot ignore the impact of the family dynamics in this process. Family business advisors indicate that over 80% of family business transition failures can be attributed to the unawareness of and/or inability of business families to adequately address family dynamics.
Working together as a family contains many advantages, such as a shared history, awareness of one another’s strengths and weaknesses, and trust and care for each other. Families who learn to work well together can have a successful business now as well as in the future.
However, there are also challenges. The ability to communicate effectively, resolve conflicts, make decisions and differentiate the family and the business can have a profound effect on the success of the business. The potential for conflict among family members and between generations is most likely to surface during the following three periods:
- During the successor’s entry into the family business;
- During the succession planning process; and
- During the retirement of the founder.
Communication, or lack of it, is a common problem for families in business together. Family members that work together have the added complexity of needing to communicate at three different and distinct levels:
- As family members on an emotional level;
- As owners on a strategic level; and
- As managers on an executive level.
This can be very challenging. Regular family/business meetings can greatly improve communication which in turn will increase productivity and build strong relationships.
In some cases, founders have difficulty in “letting go.” They have difficulty in talking about succession, giving up control and refuse to make contingency plans for the business. The inability to let go can be very harmful to the family, the business and succession.
The following are some reasons founders have given to why they can’t let go:
- “Nobody can run the business as well as I can.”
- “The business is my major source of income – I need to protect it.”
- “I have more than one capable child who can take over and I don’t want to have to choose.”
- “I need someplace to go.”
- “The children want to change the way the business is run.”
- “I don’t know that what I’ll do after – I have no hobbies or other interests.”
- “People don’t live long after retirement.”
In order for the business to succeed during and after succession, founders must accept the fact that it is time to begin transferring the business to the next generation.
Farm family styles
Recognition of different “business styles” can help when two or more individuals are working together. Research has categorized two fundamental approaches to farming: the “expander” and the “conservator.”
The expanders have entrepreneurial drive, high ambition, vision and high need for control. They are greater risk takers, willing to leverage to expand their business. Retirement is not planned.
The conservators tend to achieve success through hard work and a more cautious approach to debt and expansion. They stray from debt thereby usually passing down the farm to the next generation with little or no debt. They tend to plan for retirement making succession much easier.
Recognizing these styles as they apply to parents and children alike will assist the family recognizing the potential hurdles to overcome in the succession planning process.
The transfer of a family farm to the next generation is an issue that most farmers face at some point in time. Your accountant or other tax professional can assist with this process by facilitating discussion, illustrating alternatives, as well as implementing and monitoring any plan that has been put in place.