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Retire on redeemed capital

Historically, succession was solved by lifespan. The next generation took over when the older generation gave out. Today, with the average Canadian living about 80 years, that just isn’t a solution anymore.

Now we need to figure out ways for multiple generations to balance power, ownership and workload on the farm.

As well, farm asset values have also continued their steady rise, climbing 6.2 per cent in 2010 alone, so there’s too much on the table to leave it all to happenstance.

With more at stake and more people involved — and involved for longer — the traditional mindset of inherited farm succession is understandably under pressure.

The problems often lie in how farms deal with the interconnected issues of personal income and the transferring of assets, says Merle Good, farm business specialist with Alberta’s agriculture ministry. “It’s really, really, really important to discuss draws in a family business, and expectations,” says Good.

Basically income can be taken out of a business for only four reasons — labour, management, return on capital or capital redemption. The trick is to weigh each of these numbers so the farm succession discussion is focused on the viability, expansion and transition of the business instead of personal wealth.

Setting salary or management fees can be awkward but there are some standard industry numbers and it helps if it’s put in the context of the business.

Many parents rely however on return on equity for much of their retirement income. The older generation often retains assets such as land, barns and equipment and rents them to the business, especially at the beginning of succession.

This is different from capital redemption, when assets or shares are sold to the next generation. See Table One.

Good suggests slowly reducing the parents’ equity investment over a given period by redeeming their capital tied up in the farm.

In other words, the older generation should retire by effectively selling their equity to the business instead of holding it and taking salary and management draws.

“Parents need to retire more on the redemption of equity rather than on return on equity,” says Good.

In a farm corporation, transfer of ownership often starts by freezing the share value, with the parents being issued preferred shares at this frozen value. At the same time, the new generation gets common shares.

Slowly redeeming the preferred shares out of the company gradually reduces the parents’ equity state. Besides, about $30,000 per year of these “redeemed dividends” can be taken out of the farm with little or no tax if there are no other sources of income, or at lower dividend tax rates even if there is other income.

“Every province is different, but tax on a dividend up to about $30,000 from a Canadian company is much lower than the rate on other income,” says Dean Gallimore of KPMG in Lethbridge, Alta.

With sole proprietorships, the parents sell the assets to the child and get a note. Doing this allows them to take advantage of the capital gains exemption and the farmland rollover provision. That note usually stipulates annual principal payments with no interest over a long time, says Gallimore.

Either way, over the next 25 years the parents’ share of the farm will be vastly reduced and the farm will have been able to grow as the next generation has slowly built up asset wealth within the farm.

This transaction should be negotiated up front, and with corporations can be inside the share holders’ agreement. By tracking and sharing this information annually everyone knows, including spouses, what the equity situation is at any given time.

Connecting those numbers to reality and putting enough weight on capital redemption requires some long-term thinking and honesty. All parties need to agree that the assets should change hands in tune with contribution and they need to talk about how that will shake out over the next 20 years.

This discussion brings clarity to the salary the next generation is earning relative to the parents. Who’s putting in the most time and who is responsible for the management of the farm? How much is the individual contributing the farm? What’s a good hired man worth?

If the younger generation is capable and committed, then logic says they should be getting more salary and management fees and what they get out of the farm should increase as they build it and take on more responsibility.

“If the son (or daughter) is getting paid more salary, then they should be responsible for getting up in the night for calving,” says Good.

The sacrifices of long hours and low disposable income can be justified by farm asset accumulation. For some spouses, working for low wages compared to off-farm jobs is much easier to take if they know they’re building up net worth in the farm. “It’s an incentive,” says Gallimore.

It also takes away from the farm transfer being perceived as an inherited gift and protects the new generation from the “someday you’ll have all this” syndrome.

This limits any estate headaches which can erupt during inheritance and when non-farming family members inherit farm assets that the farming child relies on. “Some parent are unwilling to transfer the farm before they die,” says Good. To those parents, Good has a simple message. “You can’t afford to buy tractors twice.” CG

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Senior Business Editor

Maggie Van Camp

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