One of the most common questions we get from our farm clients is how their business should be structured.
The three most popular ways of structuring a farming business are:
- Proprietorship – where the business is operated by a single individual
- Partnership – where two or more people operate the business
- Corporation – where the business is operated by a distinct legal entity
Choosing which of these three structures is right for your farm depends on many factors. This article attempts to outline some of the primary advantages and disadvantages of each option to better help with this decision.
Simplicity and administrative costs
For corporations, accounting and bookkeeping costs will be higher. This is because of the added complexity of the corporation and the necessity to prepare financial statements along with separate corporate and personal tax returns. Owners must also familiarize themselves with some complicated concepts specific to corporations (i.e., dividends vs. wages, preferred shares and shareholder loans). Additional legal costs will also be incurred on the initial setup of the corporation and ongoing annual shareholders' resolutions.
Partnerships and proprietorships are much simpler and less costly to administer – for example, financial statements are not always required and no separate tax return is needed since income is reported directly on the personal tax return. To date, the Canada Revenue Agency (CRA) has not required farm partnerships consisting only of individuals to file a T5013 partnership information return.
All personal assets (not just business assets) are exposed to creditor claims if the farm is structured as a proprietorship or partnership. Additionally, in the case of partnerships, each partner is jointly and severally liable for the actions of the other partners. So even if only one partner is negligent, all the partners’ personal and business assets could be exposed to creditors.
The corporation, because it is a separate legal entity, provides some protection of personal assets from creditors. It is also possible to set up a separate holding corporation to provide additional protection. It should be noted though that personal guarantees could be required for corporate debt that could reduce this protection.
Deductibility of losses
For proprietorships and partnerships, any losses for tax purposes from the business can be deducted against other sources of personal income. For corporations, losses can only be used to offset taxable income within the corporation.
If losses are expected, which is often the case for newer businesses, it may be preferable to initially operate as a proprietorship or partnership instead of a corporation, especially if the farmer has other sources of income.
Be aware the amount of proprietorship and partnership losses that can be deducted against personal income may be restricted or even denied entirely by the CRA. This can happen if it can be established that farming is not a chief source of income for the individual or there is no reasonable expectation of profit from the farming activities.
Farm proprietorships and partnerships are exposed to progressively higher tax rates as income increases. Profitable businesses could be paying income tax at rates above 50 per cent in some provinces, limiting the amount of after‑tax cash available to invest in the business. Even if business income is normally moderate, some unusual events (such as a liquidation of a livestock herd) could push income into the higher tax brackets.
Farmers who operate as a proprietor or partnership can manage the tax consequences of higher income by investing in capital assets and tile drainage, investing in RRSPs, deferring commodity sales and prepaying expenses before the end of the year. However, it is not always a good idea to make decisions based only on taxes, rather than what is best for the long‑term profitability of the business. Additionally, if cash flow is tight, these options may not be available.
Corporations, on the other hand, avoid this problem by having a very low flat tax rate of tax. For example, the tax rate up to generally $500,000 of income is only 12.2 per cent in Ontario, 11 per cent in Alberta and 9.5 per cent in Saskatchewan. More than $500,000, for example, the rate can be as low as 25 per cent in Ontario, 23 per cent in Alberta and 27 per cent in Saskatchewan.
This low rate of tax means there is more money available in the business to pay off debt, invest in assets and meet working capital obligations compared to partnerships or proprietorships. This deferral also does not cease when shareholders retire, so the corporation can be used as an investment retirement vehicle, similar to an RRSP.
Here is an example of how this works in practice using a $250,000 interest‑free loan:
Owner A is incorporated with a corporate tax rate of 12.2 per cent.
Owner B is not incorporated and has a personal tax rate of 40 per cent.
Owner A would require $284,738 in profits to retire this loan at 12.2 per cent tax.
Owner B would require $416,667 in profits to retire the same loan.
Owner A would be well on his or her way with their next asset acquisition before Owner B can handle another loan. The addition of interest would make the Owner A scenario even more attractive.
Note this deferral advantage would be lost if the corporate profits were not left in the company to pay off debt or invest in the business. If the profits were instead taken out of the company for personal expenditures, the combined effective tax rate on farm business income earned in a corporation would be quite similar to that of a proprietor or partnership. However, this would not be a concern on profits held to reinvest and grow the business.
It should also be noted the tax deferral advantage for corporations increases as income increases. For businesses with lower incomes, there may be little to no tax deferral advantage at all.
Many government benefits, such as the personal HST credit, Employment Insurance (EI) maternity benefits, the Canada Child Benefit and Old Age Security are affected by the amount of income reported on the personal tax return. In the case of proprietorships and partnerships, all income generated from the business must be reported on the personal tax return regardless of whether it is needed for personal expenditures, and this could limit or eliminate these benefits.
With a corporation, farmers can manage the amount of wages and dividends paid to the shareholders to the extent of what is needed for personal expenditures and, therefore, make it easier to potentially qualify for these benefits.
Capital gains exemption on farm property
There is a $1,000,000 capital gains deduction (exemption) per individual on the disposal of eligible farm property which includes land, quota and the shares of a qualified family farm corporation.
It is much easier to claim the capital gains exemption on land and quota assets that are owned in a proprietorship or partnership as the individual asset can simply be sold to claim it.
It is more complicated to claim the exemption if all the farming assets are owned by a corporation. This is because the corporation itself does not have a capital gain exemption for the land and quota it owns – only the shares of the corporation qualify. This means the only way to claim the exemption is to sell the shares of the entire corporation and everything in it, which may include assets the farmer may not want to sell. It is also harder to find a buyer of corporate shares than it is to find a buyer for land and quota itself.
For this reason, it may make sense to try to keep some assets (especially farmland) owned personally with a proprietorship or partnership even if the decision is made to incorporate with most of the other assets transferred to the corporation. The corporation can then rent the land or quota from the partnership or proprietorship rather than own it.
Each individual is entitled to this exemption, so it is an advantage to try to operate the farm as a partnership instead of as a proprietorship and/or have multiple family members as shareholders of a company. These structures multiply the capital gains exemption (i.e., two partners would have $2 million in total capital gains exemption available, compared to only $1 million with a proprietorship).
Corporations can choose a non‑calendar year‑end for tax purposes. The main advantage of this is to provide a window of time to plan in advance for personal taxes which are always based on a Dec. 31 year‑end. Another advantage is the year‑end can be chosen at a time when the business is not as busy to allow for more time to attend to the year‑end administrative work.
There may also be a tax deferral opportunity with an off‑calendar year‑end, especially for cash crop operations where cash flow is seasonal.
Proprietorships and partnerships cannot choose a non‑calendar year‑end.
Dividend discretion and isolation of control from equity growth
With a corporation, it is possible to set up multiple classes of shares where dividends can be paid out to various family members in amounts that do not reflect the actual ownership percentage in the business. This makes it easier to split income among family members to minimize income tax as compared to the proprietorship and partnership, within the guardrails of the tax on split income rules.
With a corporation it is also possible to set up share structures where control rests with one set of shareholders while growth in the business accrues to others. This feature is particularly useful in succession planning and is, again, not often feasible with proprietorships and partnerships.
This article outlines only some of the major advantages and disadvantages of each type of business structure. There are many additional complexities that cannot be addressed in a single article. Therefore, it is important to get professional advice to determine which business structure is right for you.