Farm Financial Planner: No Profits Mean a Change of Plan

This article was originally published in Grainews. Grainews is an agricultural based publication written for farmers, and often by farmers, in a style they understand. Don and Erik work closely with author Andrew Allentuck, providing the background financial plans and theoretical analysis for Andrew’s Farm Financial Planner column.

The Farm Financial Planner column has recently come to an end in the Grainews publications. However, we have had requests to continue on with the content, so we intend to post it here regularly.

This Family’s Generational Ownership Shift Plan Doesn’t Work Without Farm Profits

A family we’ll call the Browns has farmed in southern Manitoba for four decades. Over the first 30 years, they grew their farm to 2,000 acres of pasture and grain. Today, Jack Brown is 67 and Molly, his wife, is 66. Their son, Max, and his wife Chloe have three children under 10.

Farm income has been lower than expected and family issues have arisen over how to manage the farm business. Jack and Molly came to Forbes Wealth Management to develop plans.

The facts are straightforward. Ten years ago, they expanded the farm by purchasing 1,000 acres adjacent to their existing property. They also created a farm succession plan, asking Max, then 29, to come back from a city job to farm full time.

At that time, 2008, Jack and Molly incorporated the farm, transferring their farm machinery and inventory into the corporation for $1 million worth of new-issued preferred shares. Max bought $100 of the only common shares. The parents retained the personally owned farmland.

Typically, Max would have gains from the corporation’s profits through his common shares. However, the 3,000-acre operation has not been profitable for many years. The corporation’s retained earnings account is zero.

The financial failure of the farm has caused friction. Max wants to change the way the farm is run. Jack and Molly want no changes. The family needs to work out a plan. There are three ways to go: Plan One: Sale of Max’s common shares; Plan Two: Preferred share conversion; Plan Three: Relocation for Max and Chloe.

Plan one recognizes that Max is the owner of all common shares of the farm corporation. Common shares have voting rights while preferred shares usually do not. Max might be able to find a buyer for his common shares. If he can, the first $835,716 of capital gains on the common shares would have an offsetting federal tax credit. Manitoba tax and the Alternative Minimum Tax could apply, but the AMT is actually a carry forward of federal tax prepaid. It is a tax credit, in other words, usable over the next 10 years. Any gain over the $835,716 level will be taxed at a preferential rate of about 22% rather than the 40-50% rate on the proposed table dividend income.

The downside of this plan is a third party is not likely to invest $1 million in a company which does not make money. Moreover, for non-arm’s length transactions, the CRA has an additional requirement that the full price must be paid in the of the transaction. If it is not, the capital tax exemption will be denied.

Plan two conceives of a preferred share conversion and a payout. There is a potential offer of $1 million for the preferred shares of the farming corporation. This is not the best deal for Max, but it may be the only way for him to receive value for his work since 2008.

Preferred share redemption would be fully taxable in Max’s hands. He would still be at risk because his payout depends on the farm becoming profitable. His equity would be locked in at a fixed value with a zero-interest rate and would best be paid out over the next 20 years.

The Brown’s accountant has pointed out that the farming corporation’s articles of incorporation provide the board of directors with the right to convert the existing preferred shares into common shares on a one-to-one ratio. Max would be outvoted two to one by his parents if they, the majority of the board, go ahead with the conversion. Max’s common shares are now worth just $100 and, were he to convert on a one-to-one basis, he would have only 100 of the total 1,000,100 common shares.

The parents’ rationale for this possibility was that Max was only to participate in profits, not in an increase in land values. Given that the company’s profits are zero, Max’s equity value would be zero.

Max assumed that the increase in total company value after repayment of the parents’ $1 million preferred shares was his. He signed the articles of incorporation, but neither read or understood what some of the clauses meant.

In plan three, Max and Chloe would move away. They would put $25,000 into Chloe’s RRSP. Max has that and more. Their RRSP’s have a combined present value of about $50,000. Eventually, they could use the Home Buyers Plan to take a maximum of $25,000 from each plan, repaying the loan of the next 15 years. They could use the $50,000 as a down payment for a home in the $300,000 range.

In the future, Max and Chloe should maximize their RRSP entitlements to defer tax liability on employment income. If Max and Chloe achieve accelerated savings of 20% to 25% of gross income for two decades, they can achieve the goal of a secure retirement.

The moral of the story is that one should set up a written contract, which could be an employment contract, partnership agreement or a shareholder agreement requiring unanimous agreement. The agreement should cover such events as a partners death, disability, divorce, changes in valuation formulas or voluntary termination.

This is a sad case, for it involves children having little choice but to leave the family farm. But at least there is a way out and a plan for them to build a strong financial future.

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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.

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