In This Section |
Farm Corporations
In Ontario approximately 12% of farm businesses are incorporated. This number has been growing steadily as farm businesses become larger and the corporate tax rate for small businesses continues to fall. This Factsheet will help farm business owners to understand the corporate structure and to decide if incorporation makes sense for their farm business. This Factsheet is one in a series covering business structures. Table of Contents
Section 1. The Basics of IncorporationWhat is a Corporation?A corporation is a "separate legal entity," which means it can do anything a person can. It can:
Most small businesses are incorporated under the Business Corporations Act of Ontario. The incorporating parties must present articles of incorporation to the Ministry of Consumer and Business Services. Why Incorporate?There are both advantages and disadvantages to the corporate business structure. While farm businesses should consider all the factors, the tax advantages are often the main reason for considering incorporation. An important point to remember is that much of the tax advantage comes from deferring tax. This means that at some point in the future the tax will have to be paid. The longer the deferral the greater the advantage. If the business is not expected to continue beyond a 5–year time horizon then the cost of incorporating may not make sense. Other farm businesses may decide not to incorporate because of personal preferences or because of other disadvantages outlined below. How is Money Saved or Tax Deferred?
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All corporate income paid out as salary |
Minimal salary with the remainder held in corporation |
|
|---|---|---|
|
Personal Income |
50,000 each = $150,000 |
$30,000 each = 90,000 |
|
Income Tax - personal |
~ $ 42,840 |
~ $ 20,700 |
|
Profit left in company |
$ 60,000 |
|
|
Corporate tax (60,000 x 19.62%) |
~ $ 11,772 |
|
|
Net amount remaining in corporation ( 60,000 - 11,772) |
$ 48,228 |
|
|
Total Tax paid |
~ $ 42,840 |
~ $ 32,472 |
|
Tax Deferral |
$ 10,368 |
|
A corporate structure may satisfy many of the criteria that the business has set, yet fail to match the family’s goals and comfort level. Even if it is likely to help them reach their goals, the formality and complexity may be more than the family wants to accept. The business owners will want to ask themselves if they are comfortable with:
A corporation provides some limit to liability. If the corporation fails to pay its debts, the corporation’s assets offered as security will be pursued. Lenders often require shareholders to personally guarantee corporate loans which means that the lender can pursue the guarantor and 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 should be used to protect against such a claim. In recent years the corporate structure in some cases has not protected the shareholder executives from personal liability.
The capital gains exemption is often used as a justification for incorporating the farm business. While this is an important tax advantage it should not be the only reason to incorporate. The recent reduction in the capital gains inclusion rate to 50% means that one half of a capital gain is included in income and subject to regular income tax. The other half may be subject to the alternative minimum tax. The capital gains exemption is available for qualified farm properties that includes:
The exemption is also available for partners in a partnership, since taxes are paid at the individual level. Corporations, however, do not have any exemption available to them.
It means that you are purposely creating a capital gain then using your exemption to offset the gain. Transferring an asset to a corporation could allow you to trigger a capital gain and utilize the capital gain exemption.
The corporation itself has no capital gain exemption, but the shares of the corporation are eligible. Selling shares to an arm’s length party however can be difficult since a stranger would usually prefer to purchase the assets. A method to overcome this reluctance is to reduce the price of the shares, which acknowledges the tax liability that the new owner would be taking on. In this way the seller would receive a higher price than would have been the case in a company wind up, and the buyer gets the assets at a lower price than what they would have been worth outside the company. In addition the purchaser can in some cases increase the cost base of the land in the corporation by winding up the existing corporation into a new company.
For more detail on the above tax issues refer to the OMAFRA Factsheet Taxation on the Sale of Farm Business Assets, Order No. 03-021.
There are various guidelines but often the deciding factor is how profitable the business is. If the business is generating significant profits then there is the opportunity to leave part of those profits in the company to be taxed at the lower rate. If all the profits must be removed for family living expenses then this advantage is lost. The total family income should be considered. For example a farm with net income of $50,000 a year might be a good candidate if a spouse is earning $45,000 of off–farm income that can be used for family living. As a rule of thumb, when family income reaches $70,000 the tax advantages may merit a look at incorporation.
While it will vary according to the complexity of the business you can expect to pay between $3000 to $5000 to set up a corporation and about $500 to $1000 more than for annual accounting fees than you are currently paying
Incorporation costs will include provincial fees and professional fees for legal and tax advice. The annual accounting cost is usually higher because of full financial statements and corporate tax returns. However, if the farm already has full financial statements, the added annual cost may not be significant.
The provincial fee for establishing a corporation is $360. This does not include a name search that must be done through a private name search company. The Companies Branch of the Ministry of Consumer and Business Services can advise you of the names of search companies. Once a name search is completed, articles of incorporation are filed with the province. Because of the time required for a name search, many people form a so-called numbered company. For more details on the steps to incorporating see Appendix 1.
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Forming a corporation involves three areas that require thoughtful discussion with your advisors. These areas are:
Share structure is important because it defines the ownership of the assets of the corporation, the control of the business and how dividends are distributed. In corporations with only one shareholder this can be quite simple. As the number of shareholders, and in particular 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.
If the corporation has more than one class of shares then 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. Usually the common shares have voting rights 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 and at the same time enable the children to participate in the growth of the business.
Common or growth shares represent the net value of the assets after the corporate debts and value of special shares are deducted. Common shares have to be issued for some consideration i.e. purchased, but this is usually for a very low amount such as one dollar per share. Any future growth or decrease in value affects the value of the growth shares.
Special shares, which are often referred to as preferred shares, have a fixed value and may bear dividends. A dividend is a pay out on a per share basis to the shareholder. Special shares get a fixed value when they are set up. Often an arbitrary round number like $100 is used for convenience. One advantage to using special shares in a corporation is that they are easier to retract or issue if Canada Customs and Revenue Agency (CCRA) should question the value used for asset being rolled into the corporation. If for example, CCRA reassessed an asset at $50,000 more than the price it was transferred at, then a price adjustment clause in the purchase and sale agreement could allow an additional number of special shares to be issued to the shareholder and the tax deferred rollover would be preserved. If only common shares had been used the company would have to be re-valued before you could determine how many more common shares had to be issued.
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:
This gives the shareholder a right to redeem or sell back to the corporation their redeemable shares. Other conditions, such as the number of shares that can be redeemed in one year, notice period prior to redemption, etc. may also be stipulated.
A retractable share gives the corporation the right to buy back shares. Special or preferred shares would typically be "retracted" at the par or cumulative value. A predetermined price or predetermined method of calculating a value would be used to value the common 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 they are paid.
For a non-cumulative share, 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. The shareholder agreement is most common in companies with multiple shareholders. This is because it is used to cover areas of potential conflict and protect minority shareholders in areas not covered in the Articles of Incorporation or in the by-laws. For example in a company with 3 shareholders it would be possible for 2 of the shareholders to issue new shares to themselves and exclude the third shareholder, if the by-laws indicated that a simple 2/3rds majority was all that was required to do so. A shareholder agreement would address this issue.
Issues that are frequently addressed are:
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 the corporation can purchase and own them. This can be done in any combination that the shareholders wish. For an explanation of the tax issues and terminology refer to the OMAFRA Factsheets Taxation on the Sale of Farm Business Assets, Order No. 03-021 and Taxation on the Transfer of Farm Business Assets to Family Members, Order No. 03-023.
Generally assets such as inventory and equipment are placed inside the corporation. Other assets such as quota and land are sometimes held outside the corporation for reasons explained in the next section. The Income Tax Act allows farming assets to be sold to the corporation on a tax deferred basis as long as the appropriate elections and forms are filed with CCRA. This is called a "rollover" in tax terminology. To accomplish this the owner would transfer the asset to the corporation at it’s tax cost otherwise known as the "adjusted cost base" (ACB). This would not trigger any capital gains or other tax cost. The corporation however is required to give the shareholder consideration equal to Fair Market Value (FMV) of the asset. The corporation does this through either shareholder loans or shares. The shareholder loan represents the tax cost of the asset. The payment of the shareholder loan by the corporation therefore is tax free to the shareholder. If a shareholder transfers an asset at higher than its ACB they would incur a capital gain and if the capital gain exemption available to them they could use it. The shareholder loan would then reflect the new ACB or tax value of the asset (see case 2 below). Shares are taken by the shareholder for any value between the ACB and the FMV. See some examples below. The payments the corporation makes to the shareholder on the shareholder loan are tax free to the shareholder. These payments are made from the corporate earnings that have been taxed at 19.62 % and are not a tax deduction for the corporation. Table 2 outlines the results of transfer values process.
There are two methods that can be used to incorporate a partnership:
In either case there are specific rules that need to be followed. It is important to seek tax advice on your specific situation.
The decision between maintaining personal ownership of land or transferring it into the corporation is often difficult to make. Every situation is different. There are both advantages and disadvantages to transferring land into the corporation. See below for the lists some of these.
Case 1
Transfer Values: Transferred at the adjusted cost base (ACB)
Result:
Case 2
Transfer Values: Transferred between ACB and FMV
Result:
Case 3
Transfer Values: Transferred at FMV
Result:
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Table 2. Results of Transfer Values
|
|
Case 1 |
Case 2 |
Case 3 |
|---|---|---|---|
|
ACB of Asset |
$ 200,000 |
$ 200,000 |
$ 200,000 |
|
FMV of Asset |
$ 600,000 |
$ 600,000 |
$ 600,000 |
|
Transfer to Corporation |
$ 200,000 |
$ 300,000 |
$ 600,000 |
|
Results |
|
|
|
|
Shareholder Loan |
$ 200,000 |
$ 300,000 |
$ 600,000 |
|
Preferred Shares |
$ 400,000 |
$ 300,000 |
$ — |
Advantages
Disadvantages
|
Deferral with no Capital Gain Exemption Used |
Capital Gain Exemption Used |
|
|---|---|---|
|
ACB of Land |
$100,000 |
$100,000 |
|
FMV of Land |
$400,000 |
$400,000 |
|
Sale to Corporation |
$100,000 (1) | $400,000 (2) |
|
Capital Gain |
0 |
$300,000 |
|
Taxable Gain (50% of Gain) |
$150,000 |
|
|
Taxable Gain Exemption |
($150,000) |
|
|
Results |
||
|
Shareholder Loan |
$100,000 |
$400,000 |
|
Preferred Shares |
$300,000 |
$0 |
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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 where 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. Or 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’ $500,000 exemption. In that case the land might be left out on the chance that the children’s $500,000 exemption 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 to that would spread out the gain over a number of years if the parent held a mortgage.
Example from Table 3 — A piece of land worth $400,000 transfers into a corporation. The adjusted cost base (ACB) is $100,000. The capital gain on the land is $300,000. Instead of taking a shareholder loan for just $100,000 and preferred shares on the rest the owner could take a shareholder loan for the full $400,000. This would trigger a capital gain that the owner could then apply his capital gain exemption against.
Results — The corporation gets 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 their shareholder loan.
If land and the principle residence are transferred to the corporation a loss of the principal residence exemption for capital gains may result. As well, 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. On farm properties with 2 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 value of the quota cannot be added to the cumulative eligible capital account pool (which is similar to CCA classes) and 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.
Similar to land, if the shareholder anticipates the quota will increase in value it would be beneficial to hold the quota personally, rather than in a corporation — and be able 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 of 19.62%, as long as the quota was used in the active business.
Crop and livestock inventory can transfer tax deferred into the corporation. But remember — sooner or later the tax has to be paid. 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 happily accept this liability because they obtained shares by way of gift or at a reduced rate.
Where other shareholders are involved a better approach would be to sell the inventory to the corporation for full value and the shareholder take a demand note from the company. This would be advantageous for 4 reasons, as long as both the shareholder and corporation file income tax on a cash basis:
If someone rolls part of the business assets — such as inventory, quota and depreciable property into a corporation just before selling the shares in order to convert income items to a capital gain — the anti-avoidance rules can be used by tax authorities to disallow the capital gains exemption. However, if all of the assets are rolled into a corporation and the shares are sold, the anti-avoidance rules should not apply. Because family members normally acquire shares, the exemption can be used to provide the parent with higher proceeds and the child with a higher ACB.
Table 4 and Table 5 outline an example of farm incorporation. The tax calculations are estimations only. This example shows the scenario of a farming child who has built up some ownership in assets. The assumptions are that all of the assets are part XI assets, which means they have been purchased after 1971.
The results of this transfer would be as follows:
He would hold a note on the $90,000 of inventory. The corporation could pay him back over time in order to spread out the income. See explanation on inventory transfer in Section 2.
|
Assets
|
ACB
|
FMV
|
Capital Gain or Recapture
|
Percentage Ownership |
||
|---|---|---|---|---|---|---|
|
Father |
Mother |
Child |
||||
|
Land |
125,000 |
600,000 |
475,000 |
50% |
50% |
0% |
|
Quota (2) |
100,000 |
575,000 |
475,000(2) |
100% |
|
|
|
Buildings |
60,000 |
200,000 |
140,000 |
50% |
50% |
|
|
Machinery |
50,000 |
90,000 |
40,000 |
80% |
|
20% |
|
Inventory |
|
120,000 |
120,000 |
75% |
|
25% |
|
Total
|
$ 335,000
|
$ 1,585,000
|
$ 1,250,000
|
$ 1,037,000
|
$ 300,000
|
$ 48,000
|
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|
Assets |
Transferred to Corporation |
Value Transferred at: |
Capital Gain, Recapture or Income Triggered |
|||
|---|---|---|---|---|---|---|
|
Total |
Father |
Mother |
Child |
|||
|
Land |
No |
|
— |
— |
— |
— |
|
Quota |
Yes |
575,000 |
475,000 |
475,000 |
— |
— |
|
Buildings |
No |
|
— |
— |
— |
— |
|
Machinery |
Yes |
50,000 |
— |
— |
— |
— |
|
Inventory |
Yes |
120,000 |
120,000 |
90,000 |
— |
30,000 |
|
Total |
|
$ 745,000 |
$ 595,000 |
$ 565,000 |
0 |
$ 30,000 |
The common shares would be distributed in a manner that met the shareholders desire to maintain control and participate in the growth. An example might be Father 30%, Mother 30% and Child 40%. This would still give the parents voting control. If the parents wanted to give children a greater share of the growth yet still maintain control they might consider attaching voting control to the special shares.
Personal NISA accounts can be rolled into a corporation. The best strategy should be discussed with your accountant. There are 3 options:
If a farmer wishes to leave a personal account in place they can roll it to the company before withdrawal to avoid the high rate personal tax.
The day to day operation of the farm business is not affected by incorporation. What does change is the relationship of the owner to the business. 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.
There are 4 ways that the shareholder can receive money from the corporation:
Each of these has advantages and disadvantages as outlined below:
Method of Payment - Salary
Advantages
Disadvantages
Method of Payment - Dividends
Advantages
Disadvantages
Method of Payment - Repayment of a shareholder loan
Advantages
Disadvantages
Method of Payment - Rental payments for use of personal assets
Advantages
Disadvantages
Dividends and salary are the 2 most common methods of paying shareholders. If the corporation pays a shareholder salary the corporation is able to claim an expense and reduce the income that it pays tax on. The salary is then taxed in the hands of the shareholder. Salaries do not have 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. They do not have to be paid in the same ratio but can be paid a salary for the work they do. 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 is able to 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. Canada Pension Plan (CPP) contributions must be paid on salary. This can be significant since levels for CPP contributions are increasing. For the self-employed person it means paying double what an employee would have to pay. CPP contributions are not required on dividends. The downside of dividends is that you do not have any earned income to use in making a contribution to an RRSP.
If the corporation is renting any assets from you, these payments can be used in calculating RRSP contributions.
There is no one best method. Each shareholder should discuss their situation with their accountant at the end of the year to decide what combination would be most advantageous. For instance, if you had a large shareholder loan you might take only $7412 in salary in order to use up your tax-free personal deduction and take whatever else you needed to live on in shareholder loan. This would provide you with tax free income and at the same time maximize your tax credits. Or you might want to increase your child tax benefits. In that case enough salary would be taken to maximize the working income supplement. You would decide with your accountant what was the best way for you to pay yourself and the other shareholders.
Filing a complete set of financial statements is required of farm corporations. This may help large complex businesses to keep their affairs in order. The corporation must file an Income Statement, Balance Sheet and Statement of Change in Financial Position.
Theoretically, investor capital, in addition to borrowing, is possible for a corporation to acquire. However, this is rare. Normal financing, with some added security arrangements, is most common. For the profitable farm which also has sizeable borrowings, the after tax dollars available to make principal payments are greater than with a personal operation.
This section covers some of the legal issues business owners should consider. However it is not a comprehensive discussion. As always, sound legal counsel is advised.
Minority shareholders are sometimes concerned about how their concerns will be addressed in the corporate structure. The majority shareholders have a legitimate right to maintain control in running the business. However the minority shareholder can negotiate so that on certain issues unanimous consent would be required. The entry of other shareholders into the business might be one of those issues.
Other issues that a minority shareholder might want to be included in the shareholder agreement are:
The Business Corporations Act (BCA) provides several safeguards for the minority shareholders interests. Minority shareholders can "dissent"; that is, vote against a number of particular actions proposed for the corporation. The result of a dissenting vote can lead to the mandatory purchase of those shares at a fair market value. The Act also protects an officer, director, shareholder or former shareholder who has been unfairly dealt with by the other shareholders by the use what is known as the oppression remedy. This provides significant remedies for a minority shareholder that feels their interests have been abused.
The Family Law Act (FLA) is principally designed to deal with marriage breakdown. The FLA addresses 2 separate issues: the division of property and a spouse’s entitlement. The entitlement could take the form of a continuing periodic payment to a dependency or a lump sum payment. The FLA does not provide for the actual physical division of the property but rather divides the "value" of the properties. This means that after the calculation is made, if one spouse has assets of greater value than the other does, an equalization payment from the spouse with greater assets would be made so that each spouse’s asset value was equal. Shares in a corporation would be included in this calculation. In this sense the corporate structure does not provide any greater stability in the event of a marriage breakdown than any other structure.
Marriage contracts are used to try to minimize the affect of a marriage breakdown on a business. An appropriate time to consider such a contract might be when a new farm business structure is being put in place. For instance if new agreements are being drawn up then all the partners or shareholders could consider requiring each shareholder to have a marriage contract.
For example if one of the spouses is a partner in a farm business that has grown in value during the time they were married, that increase is included in the equalization of assets. A domestic contract attempts to exempt those farming assets from the calculation of net family property (which is what gets divided).
This will likely satisfy the partners, but probably not the spouses. The non-farming spouse will likely want some "compensating" provisions in the domestic contract. For example one such provision might make the matrimonial home the sole property of the non-farming spouse. Another provision might permit an award of support based on the farming spouse’s profits over a number of years and in that that way protect the assets of the business.
The previous sections are intended only to raise the awareness of the family law and marriage contract issues with respect to farm corporations. They are in no way intended as legal opinion or advice. The reader should seek competent legal advice concerning their particular situation.
Any time you make a change in your business structure you will want to consider reviewing a number of your existing legal documents.
Incorporating your farm business will become a suitable option for more farm businesses in the coming years. Taking the time to explore the alternative and understand the structure will help farm businesses to determine if incorporation matches their family goals and business objectives.
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The Ontario Business Corporations Act requires that certain corporate documents be kept at the registered office. Sometime the term minute book is used to indicate the bound or loose-leaf book that contains the following:
The by-laws are the set of rules that govern how the internal affairs of the corporation are conducted. Lawyers often have a standard set of these that can be used as a starting point. Usually they contain:
A section on the directors and officers
A section on shareholders
After by-laws are passed at the first meeting the directors should then:
The Ontario Business Corporations Act states that you can pass resolutions (like the ones above) in one of two ways: either by holding a meeting of directors or shareholders, or by written consent. In small companies the same person may fill the positions of director, officer and shareholder and as such written consent is most often used. Directors have the power to make, repeal or amend the by-laws (unless they indicate otherwise). All changes require approval from the shareholders at the first regular meeting after the change.
Issuing of shares takes place when the corporation is established. These shares are issued from the treasury (i.e. the unissued pool of shares) of the company. New members can either be issued new shares from the treasury or they can have existing shares transferred to them. New shares can be issued from the treasury by a resolution from the directors who must decide the value at which they are issued. The individual can pay this amount or it can represent the sale of an asset to the company or represent past services rendered to the company. The issue of new shares has the potential to "dilute" the value of the current shareholders shares. If a share transfer is taking place you must follow any guidelines set out in the Articles of Incorporation. These would be any restrictions that may have been placed on the transfer of shares.
This publication is intended as general information and not as specific advice concerning individual situations. Although it outlines some of the legal and tax considerations of farm corporations it should not be considered as either an interpretation or complete coverage of the Income Tax Act or the various law effecting incorporation. The Government of Ontario assumes no responsibility towards persons using it as such.
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