The chronic cash squeeze that plagues many farmers throughout their working lives can reverse itself at retirement. Suddenly, cash pours in from all directions and tax avoidance becomes the big financial challenge.
About 30% of the 390,000 farm operators counted during the 2001 Canadian census were aged 55 or older. More than half were between 35 and 54 years of age. Since retirement planning should begin in your 40s or 50s, many farmers now need to decide the future of their farms and their personal retirement lifestyles.
Huge amounts of capital get tied up in farm assets such as land, equipment and buildings. For this and other reasons farmers may have to deal with high levels of taxable income when winding down or transferring a farm operation.
A farm operation includes numerous assets - house, land, buildings, machinery and equipment, inventory and perhaps quota. At liquidation, the sale of each asset generates a specific type of income along with its related tax treatment. Strategies are available to lessen the tax impact on these asset sales, but many require long-term planning and guidance from a tax specialist. Here's a summary of tax treatment by asset:
In most cases, sale of principal residences on-farm are exempt from capital gains unless a corporation owns the house.
- Land and buildings
A $750,000 capital gains exemption is available to individuals on the sale of qualified farm property. (If you used the $100,000 personal capital gains exemption available in the early 1990s, you'll have $600,000 remaining.)
Qualified farm property includes farmland and buildings, shares in a family farm corporation, an interest in a family farm partnership and quota that meets certain criteria.
If you no longer have a capital gains exemption available, consider a mechanism called a "reserve" to defer the reporting of gains. With a reserve, the gain is usually spread over a period of no more than 5 years unless the farm is being transferred to children, in which case the gain can be spread over 10 years. A reserve also can be useful when a very large capital gain would expose you to alternative minimum tax (AMT).
- Machinery and equipment
When depreciable capital property is sold, you could have to report recaptured capital cost allowance and/or capital gain. No capital gains exemption is available for machinery and equipment. Any recapture is taxed at your personal rate in the year of sale, and 50% of any capital gain is also added to your income.
If you file your tax on a cash basis, sale of inventory is classed as farm income in the year payment is received. It is taxed at your personal rate if you are a sole proprietor or partner, and at the corporate rate if your farm is incorporated.
An optional inventory adjustment would be available as a deduction if you added inventory value to your income in the previous year. Likewise, a mandatory inventory adjustment reported the previous year could also be deducted in the current year.
Sale of quota can generate both amortization recapture and capital gains. Deemed taxable capital gain on the sale of farm quota is eligible for the $500,000 exemption and not subject to AMT.
Even in this brief outline you can see the need to keep good historical farm records and plan well in advance of selling or transferring farm assets. To minimize taxes at and around retirement, you must also allow for other retirement income, for example Old Age Security (OAS), Canada Pension Plan, investments, and registered savings accounts.
A key consideration is avoiding the OAS clawback. At 65, you become eligible for a taxable OAS benefit of up to $6,481 annually (based on the 2012 basic pension). Depending on your income level, however, a portion could be "clawed back".
The OAS clawback, a kind of surtax, equals 15% of your income over the $69,562 threshold for 2012. At a taxable income above $112,772, your total OAS benefit is eliminated.
To "declaw" the clawback, you might choose income splitting with your spouse; that is, dividing household income so as to lower the higher earner's income. Or for cash needs you might withdraw principal from non-registered investments such as GICs or term deposits.
Withdrawals of "after-tax" dollars are not taxable. You'll also want to consider the clawback in deciding when to start drawing on your RRSPs. If you don't need RRSP income, you can leave it until the year you turn 71, during which the Income Tax Act says you must convert it to some sort of retirement income.
If you don't have other pension income qualifying for the $1,000 pension income credit, however, you should convert part of your RRSP to retirement income at 65 to take advantage of this credit. In collapsing an RRSP, you have these options:
- Withdraw all money in the plan and pay all tax owing in one year
- Transfer funds to an annuity
- Transfer funds to a Registered Retirement Income Fund (RRIF)
- Use a combination of the above
Each option has its own tax implications. But if you're looking for ways to minimize an already heavy tax burden, a RRIF is probably the best choice. It gives you more flexibility with the income stream and investment decisions.
We've just touched the tip of the iceberg, but you can see just how complex and "taxing" a process you face when retiring from a farm business. To retain as much of your farm's equity as possible, first understand the tax issues, then start your tax planning several years (at least) in advance of the actual event.
It's therefore critical that tax-minimization strategies figure prominently in retirement plans. Retirement related tax issues tend to be complex and highly dependent on individual circumstances.
We urge you to consult a retirement/estate planning specialist for guidance toward the best decisions in your specific situation. Our Estate Planning Division can advise you on all of your decisions.