| | Operating companies can make sense for income tax, farm management and families. Here’s how it works.
Let’s compare two Alberta-based business entities: a family farm and a retailer in a small town. While the two have much in common – they earn revenue and pay similar expenses – there’s likely to be a major difference.
The family farm, if it reflects common practice, has an extensive portfolio of assets: land, buildings, machinery, equipment, crop and livestock inventory and possibly production quota. It adds up. According to Statistics Canada’s Farm Financial Survey, the average Alberta farm had assets of $1.4 million in 2005.
By contrast, many retailers in town own relatively little: some on-site inventory, perhaps, but probably not the land or building where the business activity takes place. In Merle Good’s view, it’s high time more Alberta family farms emulated the retailer’s example and adapted it to agriculture.
“Farmers who expect to have a taxable income at the end of each year can consider forming an operating company,” says Good, Provincial Tax Specialist with Alberta Agriculture and Food in Olds. “You transfer on a tax-free basis your inventory, cattle and machinery into a corporation, but leave the land out.” For the purposes of farming, the operating company rents the land from the individual farmer or family.
Consider the benefits
Good recommends that producers and their tax advisor evaluate whether this strategy makes sense for them. In principle, though, he sees three key benefits.
Income tax savings. Effective April 1, 2007, the active business income rate for small businesses in Alberta up to $400,000 is now 16.12%. In other words, this is the rate that will be paid by the operating company on its first $400,000 of taxable income.
Farm management. Although the operating company can still report income on the cash basis for income tax purposes, it is required to track inventory, accounts payable and receivables to create an accrual income statement. While the cash method allows a flexibility that many farmers and ranchers value, the consensus among professionals is that accrual leads to more accurate reporting and better management decisions in the long term.
Succession planning. When an older generation retires or dies, do siblings argue over what’ll become of the tractor, the grain bins and the livestock? No: they fight about the land, which represents the family’s history and personal wealth. Maintaining the land base as a separate entity from the operating company can help make an inter-generational transfer more structured and lot less messy. This set-up can also provide incentive for the younger generation while their parents are still active, with fair treatment for any non-farming children.
Says Good: “Thirty years ago, there weren’t that many family farms that spanned three generations. Today, you see it all the time. The operating company strategy can be a tax-smart and succession-smart way to manage the needs of the different generations.”
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