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Calculating a fairer, smarter farm inheritance: Part Two

Alberta farm advisor Merle Good shares an innovative and tax-smart plan to encourage all your children to be patient investors with a portion of your land

Tom Button: In our previous article, you mentioned a methodology that allows for pooled ownership of farmland between family members. Why is this an objective?

Merle Good: In agriculture we need to ask our children, are they willing to be patient capital investors? What this means is, if non-farm children are going to receive family land, should they be able to sell it the next day? Alternatively, can farm children who receive in many cases significantly larger land inheritances do the same thing? The results are obvious.

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The question is: Should we create an ownership structure so children who receive farmland as a gift are required to be “landlords” for a significant time period and not convert their land equity into cash? As landlords, the off-farm children will receive land rent and the active farm children their returns from farming the land.

The ultimate goal is an agreement which sees the children agree to pool ownership for a certain time frame. To achieve this objective, a structure called a “land capital partnership” needs to be explored.

TB: What is a land capital partnership?

MG: A partnership is defined as “the relationship that subsists between persons carrying on a business in common with a view to profit.” A land capital partnership is simply a term I coined to describe a partnership that only owns farmland. A partnership is really an agreement to agree.

TB: How is it formed?

MG: The best way to explain is with an example. Let’s start with a farm that operates as a corporation with some corporate land, but a significant amount owned personally. George and Helen as parents have decided they would like a pooled ownership model for some of their personal land base. Their farming child Steve and his three non-farm siblings will become members of the partnership with them, and the land designated for this partnership consists of 800 acres of land worth $4,000 per acre.

As Step One, George and Helen transfer 800 acres of land in exchange for 800 Frozen partnership interest units worth $4,000 per unit, i.e. an acre for a unit.

Step Two sees them then allow all four of their children to own the “participating units” which reflect the growth in value of that land in the future.

As Step Three, the partnership makes an access agreement with the active farming business to allow it to farm the land for an extended period of time, either through a rental agreement or distributions from forming a joint venture.

In Step Four, the parents receive all the income from the partnership, as they have contributed $3.2 million dollars of land. In my area, rent is about $80 per acre, so $32,000 would go to the parents, about a one per cent return on capital.

As Step Five, the parents then decide who receives these frozen partnership units and when they receive them. Remember, this reflects only their original equity because the growth in land value is accruing to the four children through their participating interest units.

TB: What is the purpose of such a structure?

MG: The purpose is to formulate a very specific and detailed co-ownership land model between family members that sets out the rules of ownership and the access agreement. In essence we are creating patient capital that allows for a long-term use agreement to protect the viability of the farming business and yet allows the inflationary increase in the value of this land to be shared among family members, based on restrictive covenants contained in the agreement.

TB: What are these restrictive covenants?

MG: The partnership agreement will give managerial control to the parents while they are alive and first rights to income. The agreement will also specify when you can sell your units, to whom, and at what price and under what terms.

This is similar to any standard Unanimous Shareholder Agreement (USA) that exists with a family farm corporation for the sale or transfer of shares.

TB: How about an example.

MG: Well, in one agreement, the terms of a partnership unit sale are that a maximum 50 per cent of the units can be sold at 50 per cent of fair market value with 50 per cent down and the balance over 10 years with no interest, with the first option going to the active farm child. If that child does not exercise their option then other family members can purchase said units through a sealed tender process.

After 10 years the restriction is changed to a maximum 75 per cent of the units that can be sold at 75 per cent fair market value with the same terms.

This clause provides the children with the option of selling their units if they really need funds above their share of income received. However, the family felt that if a child is not able or willing to be a patient capital provider, there should be this penalty for converting wealth into immediate income.

If no one can afford or wishes to buy the units under these terms, then the partnership is to be wound up and the land divided proportionally to the partners.

TB: What are the tax implications?

MG: This is the real beauty of a land capital partnership under the Income Tax Act. The act allows a partnership to be wound up with a distribution of the assets to the partners individually with no income tax being triggered. Remember, if we choose a corporation for pooled land ownership, land cannot be extracted into personal hands tax-free. In fact, the income tax triggered could be almost 20 to 25 per cent of the fair market value of the land.

TB: Are there other income tax implications?

MG: Under the definition of a family farm partnership, the partnership interest units should qualify as qualified farm property and thus be eligible for the $1-million capital gains deduction. By having the increased land value accrue to the next generation, we are potentially multiplying the capital gains deduction among all of our children.

In addition, the frozen partnership units held by the parents should qualify for the family farm rollover with no tax triggered on their death when transferred. In other words, exchanging acres for units should not change the income tax rules.

TB: Have you seen situations where this model proved useful?

MG: One was an uncle-nephew situation. The uncle wanted to transfer some land to his nephew in his will for considerably less than fair market value. Remember, there is no family farm rollover provision between an uncle and nephew so the transfer price is deemed to be at fair value.

I mentioned to him that if land values keep exploding, eventually all of his cash would be used to pay taxes when he transfers the land at death. So I recommended a land capital partnership now.

The uncle transferred land into the partnership, which consisted of him and his nephew’s company. The nephew’s company is purchasing his units over time and thus the uncle is claiming his capital gains deduction with no income tax being triggered on the funds received. Any remaining participating units will go to the nephew via the uncle’s will. The uncle of course keeps managerial control of the partnership.

We have created the best of all worlds. The uncle is effectively selling the land over time but still controls the sale. The nephew cannot use this land for security on bank or other loans but does receive the increase in land value, thereby decreasing the potential tax upon the uncle’s death.

TB: A second example?

MG: This has to do with very expensive land close to a city. I call this type of situation the “gravel quarter syndrome.” No one child should inherit this land. In these situations, the land is transferred into a land capital partnership.

When the land is eventually sold, the partnership receives the funds and each person claims their own $1-million capital gains deduction on the selling of the units. This idea is based on using the family farm rollover rules and still having the parent’s absolute control over the property. If the parents had simply gifted land, no such agreement would have existed.

You tell me the outcome!

TB: So what do you see as the main take-aways?

MG: Where land is going to be sold for sure someday, look at a land capital partnership. I think it has tremendous value.

For those who are trying to do a fair land wealth and income transfer to children, consider this structure ONLY if family members have a similar view that patient capital is a prime objective.

By creating such a structure, off-farm children can participate in some land inflation ownership, and provide land access to their farming sibling. The farm child on the other hand has to recognize that a future exit strategy for those siblings who wish to sell their land interests needs to be crafted.

Remember, the ultimate goal is an agreement to agree to pool ownership for a certain time frame.

TB: Would that be easy?

MG: Absolutely not, which is why I never recommend that all of the land ever be considered for this type of co-ownership model, only some.

About the author

Editor

Tom Button is editor of Country Guide magazine.

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