A farmer may have low taxable income in a particular year and therefore may want to increase income to have it taxed at lower marginal tax rates than it would be if it were taxed in the future.
Cash is the key to any successful business. With this in mind, we wanted to offer farmers and ranchers some cash flow strategies that are straightforward and may be implemented in almost any situation.
Managing the finances of your farm or ranch needs to be an ongoing process, not something relegated to a once a year meeting with your accountant. Only by truly understanding where you are at financially will you be able to react with the foresight required in an unstable market.
ANNUAL TAX PLANNING
As a farmer or rancher, you have the option of reporting your income on either a cash or accrual basis. Most farmers or ranchers are already using the cash method. If you are currently using the accrual method, you may make an election to switch to the cash method. This is a one-time election available from accrual to cash only – not for cash to accrual.
It is important to calculate
your expected taxable income before the end of the year so that you can consider certain tax planning strategies. Under the cash method, most of the tax planning strategies must be implemented before your yearend or it will be too late for that year. Once you have calculated your expected taxable income, you may want to reduce it. Under the cash method, this can be done by incurring certain cash expenditures prior to the end of the year. This is an effective tax deferral tool. For example,
you may decide to purchase additional inventory supplies for the next year or livestock which can all be deducted for tax purposes when they are paid for.
It’s important to note that Canada Revenue Agency (CRA) has strict rules that must be complied with if an expenditure is going to be allowed as a deduction under the cash method. It must relate to specific identifiable goods which exist or are to be exclusively produced for the farmer. The expenditure must be reasonable in relation to the size of the farmer’s operation, and the goods must be delivered to the farmer or the supplier must have the capacity to deliver the goods.
As well, the goods must be consumed by the end of the following taxation year.
Smoothing income – If you are able to defer the recognition of income for tax purposes to a future year, this will reduce current taxes. While you will eventually have to pay tax on this income, you can achieve savings in the form of reduced costs if you don’t have to pay this tax now. You may even achieve actual tax savings if you can defer the recognition of any income to a year where your marginal tax rates will be lower.
Taxable income reported under the cash method can be increased on a discretionary basis by farmers if they decide to report more taxable income for that year. Taxable income can be increased by adding the fair market value of any unsold inventory on hand at the end of the year.
You may wonder why we are suggesting increasing taxable income in a year when there is no requirement to do this. Actually, in most cases, this is good tax planning. A farmer may have low taxable income in a particular year and therefore may want to increase income to have it taxed at lower marginal tax rates than it would be if it were taxed in the future, or to use personal tax credits that may otherwise go unused. This additional income becomes a deduction for the following year, thereby assisting in smoothing
the farmer’s income from one year to the next.
Income splitting – This is the process of distributing income within the family group to take advantage of the lower tax brackets, deductions and credits available to each family member. If income that would otherwise be taxable at the highest rates can be reported in other family member’s hands who pay tax at lower rates, tax savings will be achieved.
The total tax on the family income will be lowest when each family member earns approximately the same level of income. With respect to farmers, income splitting could be as simple as ensuring that all family members are paid a reasonable salary for their contributions to the farming business. There are also more complicated tax strategies that can be employed which would involve the use of corporations and family trusts.
Use all available tax incentives – The Canadian tax rules contain a number of provisions that are favourable to farmers. These include generous investment tax credits for farmers doing research in areas such as crop development and livestock hybrids or special rules relating to the deduction of certain costs such as tile drainage or forced livestock destruction.
Income tax installments – CRA calculates your installments based on the taxes you paid for the prior year. If you pay this amount, you will not be subject to any interest and penalties for paying insufficient tax installments. However, if your income has decreased, paying this amount would result in overpaying your taxes for the current year and you will only get a refund when you file your tax return -so you could be out these funds for several months.
Corporations are required to make monthly installments, while individual farmers are generally required to make only one annual installment in December of each year.
Losses – Farming losses incurred can be treated in a few favourable ways. To clarify, farmers reporting their income under the cash method must reduce a loss incurred for tax purposes by the cost of any purchased inventory on hand at the end of the taxation year. Any loss remaining after this adjustment may be applied against taxable income in the previous three years. This carry-back allows the farmer to recover taxes previously paid to CRA.
The losses may instead be carried forward 20 years and applied against future taxable income.
OTHER CASH FLOW STRATEGIES
Lease versus buy – When cash flows are tight, leasing offers the flexibility that most farmers appreciate. The deposit and the first few years of monthly lease payments are generally significantly less than the principal and interest payments that would be required for a purchase. CRA has also simplified the rules regarding the deductibility of lease payments and that is, as long as there is not an automatic transfer of title at the end of the lease, all of the lease payments are deductible.
There are, however, very specific rules regarding the leasing of passenger vehicles that should be discussed with your chartered accountant before entering into this type of lease.
Debt consolidation – The simple practice of debt consolidation can significantly reduce your monthly cash outflows. Consolidating your payments and structuring the repayment terms over a longer period of time will allow you to free up more cash for the day-today operations of your farm. Depending on your relationship with your bank, you may also be able to take advantage of the current lower interest rates. Generally speaking, this type of arrangement offers more favourable rates than CRA, your suppliers or your credit card.
Dividend versus salary – If you draw funds from your corporation throughout the year for personal expenses, you should determine whether the amounts will be characterized as a shareholder loan withdrawal, a salary or dividend before year-end.
In a year when your corporation has a loss and does not require an additional expense that a salary would provide, it may be to your advantage to be paid a dividend. Without any other income, in some provinces one can receive up to approximately $34,000 of regular dividends from a Canadian Controlled Private Corporation without paying any personal tax. Sounds good, but remember that dividends are paid from after-tax retained earnings of the company and do not create RRSP room or pensionable earnings.
How do you pay a salary or dividend when you are already suffering from cash flow problems? The amounts can be paid and deposited back into the corporation. This allows you, as an individual, to receive benefit (in the form of an increased shareholder loan) while not compromising the farm’s day-to-day cash flow.
Employment insurance premiums for family members – An area that has received much attention lately has been employment insurance premiums paid for family members who work on the farm. CRA has stated that EI does not necessarily need to be deducted when a family member’s job involves duties which you would not normally hire a non-family member to perform. An official ruling must be obtained for each individual case, and if allowed, any premiums paid by the farm and the individual in the previous four years may be refunded.
Government programs – There are a number of programs which are designed to help you as farmers. Take the time to understand them and their application to your farm.
Manage through benchmarks – There are times when you feel your farm or ranch is doing the best it’s done in generations. How do you know? Try comparing your farm’s financial performance with that of comparable other farmers. At BDO, we provide this service to help focus on strengths and also areas of improvement.
As a farmer or rancher, you have many unique tax, managerial and financial issues that you need to consider. It’s important that you take the time to consider both the short-and long-term planning issues that will help to improve your operation’s cash flow.
This material is general in nature and should not be relied upon to replace the requirement for specific professional advice.