If your family earns enough from off-farm income to live comfortably, you may want to incorporate the farm to shelter farm income from high personal tax rates.
For many Canadian farmers the percentage of income derived from off-farm sources continues to grow. Even farmers who have successful and expanding farm businesses do, in many cases, have substantial off-farm income. At the same time, the gap between small business tax rates and personal tax rates also has continued to widen. So for those producers who have not yet incorporated their businesses, it may be timely to revisit the pros and cons of this type of business structure.
A key benefit to incorporation is the preferential income tax rate. When you operate your business as a sole proprietorship or partnership, you include all of your business expenses and income, including farm and off-farm income, on your personal tax return. Therefore, the sum of your business and personal income is taxed at your personal marginal tax rate. If you incorporate your business, however, your business income will be eligible for preferential tax rates that can offer significant tax deferral and savings.
There is a sizable gap between personal and corporate income tax rates. In some cases, the income tax rate for a small incorporated business is less than half of the personal tax rate the owner would pay operating his business as a sole proprietorship. The 2006 federal budget also includes a proposal to increase the federal small business income limit from $300,000 to $400,000 as of January 1, 2007.
In addition to tax benefits, incorporation offers several other pluses:
Limited liability. As a shareholder of a corporation, your liability in that business is limited to the amount you have invested in it. So to some extent you can protect your personal assets such as your home from creditors should your business ever fail. Many financial institutions do, however, request a pledge against personal assets to secure business loans.
Fiscal year flexibility. You can choose a non-calendar fiscal year for income tax reporting. Depending on the cycles of your specific business, a calendar fiscal year may not be the best for income tax reporting. When you incorporate, you can choose any fiscal year that works for you.
Deferral of income and income taxes. Incorporation may allow you to defer income taxes by delaying when you take payments from the company from one year to the next. Such deferrals could actually become tax savings if your personal tax rate is lower when you do take payments from the business. If your off-farm income tends to be bigger some years than others, this could be a helpful tax-saving feature.
Group insurance and retirement benefits. Corporations can create a registered pension plan and obtain tax-deductible group health and life insurance plans for their employees and family members.
Income splitting flexibility. If your spouse or children are involved in the business as employees, shareholders and/or directors, you can distribute funds to them in a number of ways. These include salaries, consulting fees, dividends, directors’ fees, and even custom farming arrangements.
Additional means of compensation. You can take money out of your incorporated business in various forms, including rent, capital dividends and loans. The company can even pay you a retiring allowance, which could be transferred to your RRSP.
Capital gains exemption. When you hold shares in a business that qualifies as a family farm corporation, you can get a capital gains exemption on the sale of those shares. This means you would pay no tax on the amount your shares have appreciated up to $500,000 at the time you sell them.
Life of its own. An incorporated company can continue as long as the shareholders want to keep it going, long after the founding owners die.
While these benefits are compelling for many farm businesses, for some the negatives of incorporation outweigh the positives. For one thing, if you need all of your farm and off-farm income to make it through the year, incorporation won’t help you save much tax. The benefits of incorporation decrease to the extent you must withdraw from earnings to cover personal and living expenses. You must leave at least some business profits in the company as retained earnings to benefit at all. Or you can reinvest some profits in the business or purchase other investments. If you draw too much income from the business, you’ll just have to pay additional personal tax on salaries or dividends.
Nor would it be wise to incorporate if you are expecting tax losses from the business. Tax losses incurred by a corporation are deductible only to the business, not to you. Since start-ups often have losses in the first few years, it’s usually wise to defer incorporation until the business is profitable.
With incorporation, you also lose personal tax benefits. For instance, if you place land that includes your personal residence inside your corporation, you could potentially lose your capital gains exemption on the sale of that personal residence.
Finally, an incorporated company requires more detailed legal, financial and tax reporting and leads to increased professional fees. Transferring assets out of a corporation can trigger high tax rates, and winding up a corporation can be quite a headache. As well, government scrutiny and regulatory compliance increase substantially.
The bottom line is that if you don’t need your on-farm income to get through the year, incorporation of the farm business is one way to shelter that farm income from the tax man. Statistics Canada reports that by 2002 Canadian off-farm income as a percentage of the total income of Canadian farm operators had reached 55%. Even for very large operators (annual total income of $125,000 or more), 31% of income was from off-farm sources, such as employment, investments, pensions, government social transfers, and so on. So to incorporate and pay tax somewhere between 15 to 21 cents on the dollar versus 39 to 49 cents on each additional dollar earned, not to mention the other benefits of incorporation, sounds like a wise decision. As indicated, however, incorporation does have its downside, so be sure to consult your tax and legal advisors to determine what’s best for your situation.