Learn about corporate farm structure. This technical information is for farm owners and operators.
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In Ontario, the number of farm businesses that are incorporated has been growing steadily as farm businesses become larger. This page will help farm business owners understand the corporate structure and to decide if incorporation makes sense for their farm business.
Basics of incorporation
A corporation is a separate legal entity, which means it can do anything a person can. It can:
- carry on business
- buy, own and sell assets
- hold mortgages and have debt
- file income tax returns
- rent land or other assets from you
- rent assets to you
- enter into contracts
Different situations can change how and when one would decide to incorporate. Some experts would look at personal and farm income to determine a threshold (for example, $90,000 combined personal and farm income) to start the process of incorporating. Other experts would look at your farm business optional inventory adjustments to determine if this is the right time to incorporate (for example, once your farm business has used all the optional inventory adjustment, then incorporate).
It is imperative to understand that one farm business may incorporate under different circumstances than another farm business.
Advantages of incorporating
The corporate tax rate is lower than the highest personal rates so there is a tax deferral on money that is left inside the corporation. The longer you defer the payment of taxes, the greater the advantage. If the business is not expected to continue beyond a five-year time horizon, then the cost of incorporating may not make sense.
Table 1 demonstrates how a tax deferral might be achieved in a company with three shareholders and a net income of $150,000. In the example, there is approximately a $5,200 advantage by taking minimal salary and retaining profits in the corporation. This example does not consider the additional tax credits that the individuals may be able to access at the lower personal rates.
|Cash flow||All corporate income paid out as salary||Minimal salary with the remainder held in corporation|
|Pre-tax corporate income||$150,000||$150,000|
|Personal income||$50,000 each = $150,000||$30,000 each = $90,000|
|Income tax (personal)||($30,500) (average 20%)||($18,000) (average 20%)|
|Profit left in company||N/A||$60,000|
|Corporate tax ($60,000 × 12.2%)||N/A||($7,300)|
|Net amount remaining in corporation ($60,000-$7,300)||N/A||$52,700|
|Total tax paid||($30,500)||($25,300)|
|Tax deferral (difference between total tax paid for each scenario)||N/A||$5,200|
Corporate structures can also allow personal tax credits of shareholders to be maximized. This is especially advantageous where shareholders have young children. Salary paid to the parents can be kept at a level that maximizes the child tax benefit and other credits.
Possible faster repayment of debt
Since the corporation is taxed at a lower rate, it can pay off the debt faster than the individual who is making the payments with after-tax dollars paid at a higher personal rate.
A corporation may provide some limit to legal and financial liability. If the corporation fails to pay its debts, a creditor will pursue the corporation's assets offered as security. However, if the corporation does not own enough assets to satisfy lenders security requirements, they will often require shareholders to personally guarantee corporate loans, which means that the lender can pursue their personal assets. If no guarantee is in place, then personal assets are protected.
In the case of a lawsuit for damages the corporation is sued and not the shareholders. Liability insurance can protect against such a claim. However, the corporation may not provide complete protection from legal liability. There are cases where the courts have held shareholder executives personally liable for the actions of the corporation.
A corporation has a perpetual existence that can allow for a smooth transfer between generations over time.
The structure is highly flexible in terms of assets owned and payment of shareholders.
Capital gains exemption utilization
In 2015, the capital gains exemption was increased from $824,176 (up to $813,600 due to indexing), plus an additional exemption amount of $175,824, bringing the total lifetime capital gains exemption to $1,000,000 for dispositions occurring after April 20, 2015. The $1,000,000 capital gains exemption is available to individuals on the sale of qualified farm property. Anyone who had used the entire $100,000 general exemption, when it was eliminated in 1994, has $900,000 remaining.
Concern about the elimination of the capital gains exemption motivates some to consider incorporation. This is because a capital gain can be triggered as assets are transferred to the corporation and the capital gains exemption utilized to offset the gain. This is sometimes referred to as crystallizing the capital gain.
While the exemption is an important tax benefit, it should not be the sole reason to incorporate. Corporations do not have any capital gains exemption available to them so the future capital gains on the sale of an asset by the corporation will be taxed in the corporation. 50% of the gain is still tax-free for the corporation and that portion can be distributed to the shareholders on a tax-free basis.
The $1,000,000 capital gains exemption is available for qualified farm properties that include:
- farmland and buildings
- shares in a family farm corporation
- an interest in a family farm partnership
- quota (referred to as eligible capital property)
While the corporation itself has no capital gain exemption, the shares of the corporation are eligible. This means that the exemption could be used on the sale of corporate shares.
For more detail on the capital gains exemption refer to Taxation on the sale of farm business assets.
Disadvantages of incorporating
A corporate structure may be beneficial from a tax perspective, but it can also introduce more complexity. Business owners should determine if they are comfortable with:
- learning new terminology such as shareholder loans, dividends, common and preferred shares
- no longer directly owning all the assets of the business
- keeping personal financial affairs separate from the corporation
- depending more on advisors for dealing with the tax and technical issues of the business
Loss of capital gain exemption
A corporation does not have a capital gains exemption.
Initial and ongoing costs
Since the corporation must also file tax statements in addition to the shareholder, the ongoing costs are usually higher.
Additional requirements are needed to dissolve the corporation, compared to a sole proprietorship which can lead to increase in accounting and legal costs.
Loss of personal tax benefits
If land is placed inside the corporation, there is a potential loss of the capital gains exemption on the principal residence.
Forming a new corporation
Forming a corporation involves discussing:
- share structure
- the shareholder agreement
- personal or corporate ownership of assets
Share structure refers to the type and properties of the shares of the corporation. Most importantly, the share structure will determine the control of the business, how dividends are distributed and who participates in the growth of the business. In corporations with only one shareholder, this is quite simple. As the number of shareholders increases and, especially when a second or third generation is involved, it becomes more important to have a share structure that is fair to everyone and defines the ownership and control of the farm corporation.
Types of shares
Common or growth shares
Common or growth shares represent the net value of the assets after the corporate debts and value of special shares are deducted. Any future growth or decrease in value affects the shares’ value. Often, these shares will have voting rights attached, although in some cases parents may hold special shares that do not grow in value but have voting rights attached. This allows them to maintain control of the business while enabling the children to participate in the growth of the business.
Special or preferred shares
Special or preferred shares have a fixed value and may bear dividends. A dividend is a payout on a per share basis to the shareholder. Special shares are set at a fixed value and do not fluctuate in value as the company grows.
If a corporation has more than one class of shares, the rights and privileges of each class must be determined. The right to vote and receive the remaining property must be attached to at least one class of shares, although both do not need to be attached to the same class. Any share can have rights assigned or attached to it. These rights should be listed in the articles of incorporation or corporation bylaws. Some of the more common rights that can be attached to shares include:
- Redeemable shares: allows the company to buy the share back at a specific date, event or price. The terms of when the company may redeem shares will be spelled out in the articles of incorporation or when the shares are issues to the shareholder.
- Retractable shares: gives the shareholder the right to redeem or sell back to the corporation their shares at a set price. The retractable price would be set out in the articles of incorporation or under a company by law and will not fluctuate with the performance of the business.
- Cumulative shares: some shares are entitled to a dividend payment each year. However, there may be years where the corporation does not pay dividends. If the shares are cumulative, the dividend not paid will still by owed to the shareholder. In other words, the corporation is obligated to pay the dividend in the next or future years. The dividends not paid would accumulate until paid.
- Non-cumulative shares: the corporation is not obligated to pay "missed" dividends in future years. In other words, unpaid dividends do not accumulate.
The shareholder agreement outlines how the corporation will operate. It usually covers the establishment, operation and termination of the corporation. Shareholder agreements are beneficial because they:
- outline a procedure to deal with conflict between the shareholders
- protect minority shareholders in areas not covered in the articles of incorporation or in the by-laws
- provide an important guide to the heirs in the event of the death of a shareholder
- provide documentation for tax purposes
Issues that are frequently addressed in a shareholder agreement are:
- rights of a shareholder to nominate directors or appoint officers
- management responsibilities
- conduct of a shareholder with respect to other business involvement
- the right to participate in future share offerings and anti-dilution provisions
- the transfer of shares either to individuals or to holding companies
- rights of first refusal and buy-sell arrangements
- how the valuation of shares will be done
- death or disability of a shareholder, including clauses about life and disability insurance
- retirement timeframe for shareholders
- dispute resolution, what mechanism will be used and the consequences
Personal or corporate ownership of assets
The choice between personal or corporate ownership of assets should be considered in light of the tax advantages, personal preferences and the degree of desired flexibility in the future. Assets can be owned personally and leased to the corporation or transferred to the corporation. This can be done in any combination that the shareholders wish. For an explanation of the tax issues and terminology refer to Taxation on the sale of farm business assets.
Tax implications of the transfer
The Income Tax Act allows farming assets to be transferred to the corporation on a tax deferred basis if the appropriate elections and forms are filed with Canada Revenue Agency. This is called a rollover in tax terminology. The Act also allows the option to choose a price that will trigger part or all of the capital gain if the goal is to use the capital gains exemption.
When an asset is transferred into the corporation the individual receives a package made up of shares and non-share consideration. This non-share consideration can include a shareholder loan that the company now owes the shareholder. Usually this loan represents the "tax paid" portion of the asset. This loan can then be paid out to the shareholder on a tax-free basis. Table 2 outlines of some of the various transfer combinations.
|Case 1: Transferred at the adjusted cost base (ACB).|
|Case 2: Transferred between ACB and FMV.|
|Case 3: Transferred at FMV.|
Types of assets transferred
The decision between maintaining personal ownership of land or transferring it into the corporation is often difficult to make.
Advantages of transferring land to a corporation include:
- Using the capital gain: transferring the land allows the use of the capital gains exemption.
- Possible faster repayment of debt: since the corporation is taxed at a lower rate, it can pay off the debt faster than the individual who is making the payments with after tax dollars paid at a higher personal rate.
- Creation of shareholder loans: Placing land inside the corporation allows you to create shareholder loans. These are paid back to the shareholder tax-free.
- Business structure: Having all the assets inside the corporation may be appealing to those who want the business structure to be as straight forward as possible from a tax and legal standpoint.
Disadvantages of transferring land to a corporation include:
- Loss of capital gains exemption: a corporation does not have a capital gains exemption. If the land does not currently have large capital gains but you expect higher gains in the future, you may want to keep land out to use the capital gains exemption in the future.
- Loss of flexibility on future transfers: if there are two or more children involved in the business, keeping the land out provides flexibility if they decide to farm separately at a later date.
- Taxable benefits: if a personal residence is transferred into the corporation with the land, the shareholder can incur taxable benefits because they have the use of the house that the corporation owns.
- Loss of capital gains exemption on personal residence: capital gains on a personal residence are exempt from tax. However, if the corporation owns the house there is no exemption.
In many cases, land is transferred into the corporation because of the desire to trigger a capital gain and use the capital gains exemption or because a significant portion of the debt is attached to the land.
When land is transferred, the parents usually trigger any gains and take back a shareholder loan up to the tax value. Payments on the loan come out of the corporation tax-free to the shareholder and so this loan is sometimes used in estate planning to deal with non-farming kids or for the retirement needs of the parents.
There are situations in which it may be advisable to leave land outside the corporation. Where there is more than one parcel of land, the family may desire flexibility for estate planning reasons. Alternatively, a farm property may be in an area that is close to an urban area and the land values are expected to increase in excess of parents' $1,000,000 exemption. In that case, the land might be left out on the chance that the children's $1,000,000 exemptions might be used in the future.
In the example in Table 3, the land could be transferred at the adjusted cost base or at the FMV and the capital gains exemption used. If the exemption was not available, a capital gain reserve could be used that would spread out the gain over several years if the parent held a mortgage.
|Item||Deferral with no capital gains exemption used|
|Capital gains exemption used|
|ACB of land||100,000||100,000|
|FMV of land||400,000||400,000|
|Sale to corporation||100,000||400,000|
|Taxable capital gain (50% of gain)||0||150,000|
|Taxable capital gains exemption||0||(150,000)|
The example in Table 3 would result in the corporation getting the land at a higher ACB, which means that if the land is sold sometime in the future, the capital gain will be calculated from the $400,000. The shareholder can receive tax-free payments from the corporation on the shareholder loan.
If land and the principal residence are transferred to the corporation, a loss of the principal residence exemption for capital gains may result. Also, the corporate-owned house could result in a taxable benefit to the shareholder living in the house. Some advisors specifically exclude the house in the land transfer and then charge the shareholders rent for the land that the house sits on. In this way, the principal residence exemption is preserved. When on-farm properties have two houses, only one can be claimed as the principal residence.
A farmer can transfer quota into a corporation and claim the capital gains exemption on the increase in value. However, the increase in the value of the quota cannot be added to the capital cost allowance class 14.1 depreciated. This higher value will reduce any gain on a future sale by the company. Like other assets, the shareholder can hold a shareholder loan allowing tax-free payments to the shareholder.
Like land, if the shareholder anticipates the quota will increase in value, it may be beneficial to hold the quota personally (subject to marketing board regulations), rather than in a corporation. This would allow you to use the capital gains exemption on a future sale or transfer. When the corporation sells the quota, the proceeds will qualify for the small business tax rate if the quota was used in the active business.
Crop and livestock inventory can transfer tax deferred into the corporation but will eventually be taxed. Some advisors suggest taking preferred shares for the value of the inventory. This means that the shareholder receives the full value of the inventory, and the company pays the tax when it sells the inventory. This approach would be a disadvantage to other shareholders since the company now holds the tax liability. If the other shareholders are children, they may accept this liability especially if they obtained shares by way of gift or at a reduced rate.
A more common approach is to sell the inventory to the corporation for full value and the shareholder then takes a properly structured demand note from the company. This is advantageous if both the shareholder and corporation file income tax on a cash basis because:
- the company receives a deduction when it makes payments on the note
- the shareholder could spread the income out over any period chosen
- it is fair to other shareholders since the company is not paying taxes on the inventory sale by the corporation
- the payments on the note from the corporation are business income, which the shareholder must pay Canada Pension Plan (CPP) on but are considered eligible income for calculating Registered Retirement Savings Plan (RRSP) contributions
Incorporating a partnership
A partnership interest can be transferred to a corporation like any other asset or the partnership assets themselves can be rolled into the corporation. In either case, there are specific rules to follow. It is important to seek tax advice.
Documents to consider when incorporating a partnership
Wills or dual wills
If the will conflicts with the shareholder or other business agreement, the business agreement will likely take precedence. Review your will since the assets once personally owned and bequeathed are now owned by the corporation.
Power of attorney
A power of attorney is a document that allows chosen individuals to act on your behalf if you become incapable of managing your business or personal affairs. In this event, a power of attorney allows the business to continue operating with the least amount of disruption and gives other shareholders a measure of security.
If certain assets, such as land, are owned personally and those assets are essential for the corporation to function, prepare a lease agreement between the company and the owner of those assets.
Business insurance on the lives of key shareholders can allow the corporation to purchase the shares of the deceased shareholder from the surviving spouse, which will help minimize tax on the death of a shareholder.
After incorporation, review all other legal documents.
Operating the corporation
The day-to-day operation of a farm business is not affected by incorporation, but the relationship of the owner to the business does. This is especially true when it comes to how shareholders are paid by the corporation. A corporation gives the shareholder increased options and flexibility regarding remuneration.
Payments to shareholders
There shareholder can receive money from the corporation via:
- repayment of shareholder loans
- rental payments for the use of personal assets
|Method of payment||Advantages||Disadvantages|
|Repayment of a shareholder loan||Represents principal payments on an asset that the shareholder has sold to the company, making it tax-free|
|Rental payments for use of personal assets|
Salary and dividends
Salary and dividends are the two most common methods of paying shareholders.
If the corporation pays a shareholder salary, the corporation can claim an expense and reduce its taxable income. The salary is then taxed in the hands of the shareholder. Salaries do not need to be paid according to percentage of share ownership, so if a shareholder only owned 20% of the shares, they could still receive a larger percentage of the money paid out in salaries for the work done. In this way, a parent can still pay a minority shareholder child a fair wage for their contribution to the business.
A dividend is a payment to the shareholder, usually based on the number of shares that the shareholder has. The corporation pays the shareholder with money it has already paid tax on and cannot claim the dividend payment as an expense. The shareholder can use a dividend tax credit to offset the tax they will have to pay on dividends, since the company has already paid some tax on the amount distributed to the shareholder.
There are some important differences to consider with regards to salary or dividends. CPP contributions must be paid on salary, but not on dividend payments. Dividends, on the other hand, are not considered earned income for the purpose of RRSP contributions.
Choosing how to pay shareholders
Each shareholder should talk to their tax advisor at year-end to decide on the best option. For instance, if you had a large enough shareholder loan, you might want to receive enough income (salary, dividends or rental payments) from the company to use up your personal deductions. The additional amount require for living would be received as a repayment of a shareholder loan. This would provide both tax-free income and maximum use of tax credits.
Financial statements and records
Farm corporations must file a complete set of financial statements, including the:
- income statement
- balance sheet
- statement of change in financial position
The Ontario Business Corporations Act requires that certain corporate documents be kept at the registered office. These include:
- articles of incorporation, by-laws and any unanimous shareholder agreements
- all resolutions of the corporation and minutes of meetings
- a registry of security holders and shareholders with appropriate details of each
- a registry of directors
- a registry of share transfers
- accounting records
This content is intended as general information and not as specific advice concerning individual situations.
Although it outlines some of the financial and legal considerations of incorporation, it should not be considered as either an interpretation or complete coverage of the Income Tax Act or the Business Corporations Act of Ontario or any other laws affecting incorporation. The Government of Ontario assumes no responsibility towards persons using it as such. Discuss all options with your lawyer and tax advisor before acting.