Most businesses must pay taxes on all income, including accounts receivable and inventory in the year they are created. However, farm businesses are one of the few exceptions, as they are permitted to pay taxes on a cash basis.
Farms have the unique ability to deduct prepaid expenses and push income into future years. Rather than pay tax on inventory, they can wait until this inventory has been sold. While most farmers prefer to take advantage of this deferral opportunity, this is not always the best option.
The problem with deferrals
For most businesses, it seems silly to pay taxes when you don’t have to, but for a farm business, a deferral only postpones your tax burden. In the short term, farmers who defer might feel like these taxes are being eliminated, but when the inventory is sold, the tax needs to be paid. Some farmers who operate as an unincorporated sole proprietorship or partnership mistakenly believe it’s best to postpone paying tax whenever possible, but there are significant advantages to making these payments in smaller increments. For one, this allows you to pay tax in lower tax brackets. In general, I advise farm clients to consider paying taxes in the lower tax brackets every year. The rest of the tax can be deferred, but there’s no reason to delay tax, as the taxable inventory accumulates and eventually pushes you into higher tax brackets. This can become a significant problem as your tax liability grows, and it could potentially reach an unmanageable level.
The future of capital gains tax
Since the government is currently running substantial deficits, there has been speculation among politicians and officials that the capital gains tax rate is likely to increase in the years ahead. As of right now, capital gains are only 50% taxable, which means the other half is tax-free. When the inclusion rate increases, it could go up to 75 or even 100%. If you can trigger a capital gain right now—by selling or transferring a piece of farm property into a corporation—you can avoid being taxed on these gains at a potentially higher inclusion rate in the future. In addition, all farmers can currently access the capital gains exemption, which allows you to shelter $1 million of a capital gain if it’s qualifying farm property. It might make sense to use that now, rather than saving it for later, as there could be changes in the future that make the exemption less attractive or eliminate it altogether.
When deferring is best
I regularly try to convince many clients with a large amount of inventory (which will one day be taxable) to pay low rates every year, rather than put it off and pay tax in higher brackets later. However, it is worth noting that there are some situations where deferring is preferable. If your succession plan is to transfer the farm to a family member and you don’t plan on selling part of the operation, savings in the area of capital gains is not a concern. It’s also worth considering income-tested benefits such as the Canada Child Benefit (CCB), which is based on your family income. If you set your income higher than it needs to be, you might not qualify for certain benefits. With these (and other) issues in mind, every family should consider the complexities of its own situation. This includes the possibility that deferring taxes might not be the most cost-effective option for your business.