Let's look at a quick example. John and Lucy Farmer have been running a family farm operation for a number of years. John has owned his own land and has been farming as a sole proprietor through this time, while Lucy also owned one-quarter section of land rented back to her husband, but has worked off farm throughout this time.
John and Lucy unfortunately encountered an agricultural disaster that resulted in the destruction of his inventory of $700,000. Government disaster programs provided compensation; however, disaster payments resulted in $1,400,000 of relief. Of course this relief was also FULLY taxable income!
Our engagement in this situation led us to understand what the objectives were; which was for John looking to continue farming and rebuild his operation, to as it was before disaster struck; while Lucy would continue her career off the farm. Our planning identified some immediate problems, one being how to deal with $1,400,000 of taxable income and secondly, recognizing that Lucy would not qualify for Lifetime Capital Gain exemption due to income testing provisions in the tax act.
To deal with John’s taxable income, our planning identified that bringing back the operation to pre-disaster status would allow John to expense back his inventory of $700,000 and also expand slightly so an additional $100,000 of inventory replacement was purchased by him directly. The remaining $600,000 is where we helped John incorporate that income and ensured that he would only pay a 12% Corporate Tax Rate versus a 48% personal tax rate on that excess income amount. We could defer a net after tax amount of $216,000 for an indefinite period!
In regards to Lucy, she will retire from her off farm career in two years, but will ultimately be receiving a fully funded defined benefit pension. The income test provisions will always provide a road block in her ability to access the lifetime capital gain exemption. We can work around this however, by taking John out of his sole proprietor tax filing and create a family farm partnership between John and Lucy. This will negate any income testing provisions and after 24 months of being in the partnership, Lucy will be eligible to utilize her lifetime capital gain exemption and be able to exempt her quarter section of farmland that already has a million dollar capital gain attributed on it. By restructuring the farm business and making Lucy’s quarter section a tax exempt transaction in the future, we found tax savings of $240,000!
These tax planning strategies helped John and Lucy set themselves up for real tax savings today, future tax benefits down the road and allowed them to secure their eventual retirement through our planning and financial management. That’s advice worth paying for!
