The Necessity of Good Tax Planning
Misunderstanding taxation can lead to needless spending and costs
Tax planning is the analysis of a financial decision or situation to ensure that all elements work together for the most efficient tax advantage. First, let’s be clear, buying equipment or prepaying expenses to avoid paying taxes at your year-end is not tax planning. It’s poor decision-making. But farmers do it all the time because the mere thought of paying taxes makes all sound reason and logic go out the window.
Tax planning is not avoiding taxes entirely because that goes against GAAR in the tax act. GAAR (general anti-avoidance rule) essentially means you cannot make a transaction solely to avoid taxes. You can make a tax-advantageous transaction that makes business sense. Spending money right before year-end is not the answer. If you’re making a purchase just so you don’t have to send a cheque to the CRA, you are definitely not making careful business decisions. Paying taxes means you were profitable. Profit is part of running a business.
Any major decision on the farm should follow the same multi-step analysis process:
Does this decision make economic sense? Are the projections profitable?
Does the decision make financial sense? Does it cash flow? Can the farm afford it?
Is this decision properly structured for tax purposes?
Taxation considerations are vital but they should be the last step in the process of determining if you buy the asset, hire the labour or build the expansion. Tax planning doesn’t have to be complicated from the farmer’s perspective. It takes a quick email to your accountant with the facts you found from steps 1 and 2 to find any major flaws.
Avoiding Taxes Doesn’t Actually Work
Let’s say your estimated tax bill is $10,000 and you want to react by calling your equipment dealership. You are incorporated, your farm is in Ontario and you only had farming income. Your tax rate is 12.2%. That means your taxable income is $82,000 if you have a tax bill of $10,000. In order to get that tax bill to zero, you would then need to spend at least $83,000.
Right now, the immediate expensing limit is still in effect so you could build a tractor or other equipment and expense all of it. In years where that is not an option, the best you can get is a CCA claim of 30%, so in that situation, you need to buy $277,000 of equipment. Under current interest rates (6.85%), a 10-year loan with 20% down, would cost you $85,892 cash the 12 months after the purchase including the downpayment.
If equipment shopping is not your style, you opt to spend that money on prepaid inputs so you can have the expense in the current year. You order and pay for $83,000 of seed and fertilizer. You saved the $10,000 for this year but now for the following year, your expenses will be that much lower. In the end, you will always be spending more than the $10,000 tax bill if you are trying to make purchases to make your taxable income disappear.
Spending $1,000 to save $122 in tax is not an efficient business decision. You should buy the equipment if it makes sense to do so, as expanding operations, great efficiency, reduced inputs or other benefits. You should take advantage of prepaid input options if there is a significant discount and overall cost savings or to ensure you get the products you want. Those are all valid reasons to make those purchases. You can adjust the timing of those transactions using tax planning, for example, taking advantage right now of the immediate expensing limit.
Incorporate vs Not
Now that unpleasantness is out of the way, part of actual tax planning is looking at the tax rate you are paying. In the above example, I used the corporate tax rate. Right now, for a small business with a taxable income of less than $500,000 in Ontario, that rate is 12.2%. Only around 25% of farms are incorporated at this point per the last Census. Being unincorporated does expose you to higher average tax rates as over a certain income level the personal tax rates are consistently higher than corporate rates.
Taking the same $82,000 taxable income from above, if you had a sole proprietorship, your tax rate would be 19.4% and you’d be paying roughly $15,900 in tax. If you are a partnership or sole proprietorship, you will also have CPP to pay (approximately $7,000 for this example). At that point, it probably is not worth talking about incorporating for tax reasons alone. The corporate tax rate only applies to taxable income within the company, you will still pay income tax on your withdraws or salary from the company.
Corporations are an important tax planning tool to defer and optimize taxes. Suppose your farm corporation had a profit of $150,000 and your personal living costs required $75,000. In that case, you can withdraw a salary from the corporation for that amount and the remainder would be taxed at a lower rate in the corporation for future withdraws. Detailed tax planning would take this a step further and map out future withdraws along with the optimization between dividends and salary.
They can also be really good when talking about transition plans for the farm. You can use strategies like estate freezes and share sales to involve the next generation on the farm. There are liability considerations as well, sometimes having a corporation is a way to reduce personal liability. Tax planning discussions would take all of this into consideration.
Farm Sales
I’ve mentioned this before but selling a farm these days will result in a tax bill. You should always get the taxes calculated first. Having a detailed plan for how you exit the industry (your farm will be sold at some point, either to a buyer or a deemed sale at your death) will greatly impact how much tax you have to pay in the end. Knowing which tax situation applies to your farm, making sure it is a qualified farm (or small business if incorporated) and estimating the final outcome should all come before that for sale sign is posted.
Here’s a more detailed look at farm sales. On an average farm sale, it’s very easy to get hit with a $300,000 or higher tax bill. I know I repeat this often, but if you are not incorporated and you are over the age of 50, you need to make sure your farm is actually a qualified farm in the event of a sale. Secondly, if you are over the age of 55, you need to have a full farm exit plan on paper which needs to include tax planning for all scenarios. Those take years to develop and every year you wait, the worse it will be.
Think Long-Term
Farmers shouldn’t be expected to know the tax act or its many nuances, it changes annually. I work in that field and there are new situations I have to research every month. You should be consulting your own accountant on significant business decisions and atypical transactions. The difference between having regular tax planning meetings and not doing them can be hundreds of thousands of tax dollars over the years. It can be as small as changing the timing of the transaction and utilizing all the available options for the best outcome.
Sometimes a quick review of the rules around a certain approach you want to take can save you from major complications. A short example is replacement property rules. This rule allows you to reduce capital gains when selling one property to purchase another that is better situated or replaces one lost in a disaster. There are time limits to this rule and criteria that need to be met before, after and during the transaction. Going over the plan at each step is critical.
If you have livestock inventory or intend to buy large amounts of livestock, you should know what the tax consequences of that are. Not all livestock purchases can be expensed at the time of purchase. Equally, if you’ve owned your herd for years and haven’t kept your inventory value up to date, you could end up with a higher taxable income. You can plan around this to a certain extent and have estimates calculated in advance so you know what it will cost.
Off Farm Income
Off-farm income can come will all kinds of perils for taxation. A frequent tactic is to use farm losses to reduce the tax burden from the earned income. This can backfire. Chances are it is a restricted farm loss which is capped at a percentage and maxes out at $17,500 for losses over $32,500. Farm losses can be carried back three years or forward for 20 years but in a restricted case, they can only go against other farm income.
Off-farm income could also prevent your farm from being a qualified farm if you are a sole proprietor as you are subject to the revenue test. This applies to sales and transfers. Your farm revenue needs to exceed all other sources of income for 24 months to meet that. Checking taxation before making a sales decision is key.
Consult Experts
The tax act is a huge document with many aspects. It would be wise to consult with a chartered professional accountant who has the experience to create and maintain your tax planning. Canadian tax law is always evolving and there’s enough change in agriculture to keep up with that you shouldn’t worry about taxes as well. Having a tax problem should be a good problem because it means you were profitable. Avoiding taxes or making hasty decisions will only end up costing you more.
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A tech review of the Tru-Test tag reader
Small Ruminant Lentivirus (aka Maedi-Visna)
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It is tax season here now, so if I’m a bit slower to respond, there are numerous deadlines I’m trying to stay on top of. As a reminder, this blog is for educational purposes, so please contact your own accountant for tax planning specific to your farm.