INDIANOLA, Iowa (DTN) -- Many farm families incorporated their farm assets in the 1970s and early 1980s, following the advice of their accountants. It was supposed to be a way to save taxes and make transition planning to the next generation easier. At the time, it was good advice.
However, since 1986 when Congress changed the corporate tax rules, farm families pay a steep price if they want to take their land out of their C-corporation. Here's a typical example: Let's say you have 500 acres in your family's C-corporation with a tax basis of $2,000 per acre. Now it's worth $10,000 an acre.
If the corporation simply transferred the land ownership to the shareholders, IRS would tax the transaction as a sale -- and a distribution equal to the fair market value of the property.
In our example, the corporation would have to pay income tax on the net gain of $8,000 per acre (fair market value minus tax basis), or $4 million total gain. On top of that, the shareholders who are the new owners would pay taxes on the qualified distribution, or dividend, on $5 million -- the current fair market value of the land. That's a federal income tax bite of $3.38 million ($4 million x 35% corporate tax plus $5 million x 39.6% personal income tax.)
Why bother? Simplification, said Sandy Ludeman of Tracy, Minn. The Ludeman family created SanMarBoFarms Inc. with two parents and four sons as owners in 1973 for their diversified crop and livestock operation. Through the farm, they own both land and equipment. Twenty years later, three sons and their spouses formed a partnership for new land acquisitions. Now the farm's current operators, Sandy and his brother Brian, are preparing to transition ownership to another generation.
"Our goal is to have the farmland owned by my brothers, myself and our spouses and then have the operating assets in a separate entity to gradually transition to my nephew who wants to continue the farm operation," Ludeman said.
Carving the land out of the operating business makes it easier for the next generation farmer to build up equity and control in the operating entity. It helps separate the land -- which is often bequeathed to on- and off-farm heirs -- from the operating assets that are transitioned to the on-farm heir.
If no one in the next generation wants to continue farming, keeping a C-corporation makes it difficult for a retired farmer/shareholder to get money out of his corporation. The problem is "the C-corporation would move to a landlord status and the retired or inactive shareholder could not justify a salary. Yet taking cash out as a dividend causes double taxation of the earnings," explained farm tax expert, Andy Biebl, a CPA and principal with the accounting firm with CliftonLarsonAllen LLP in Minneapolis and New Ulm, Minn.
Also, having land in a C-corporation (which never dies), precludes the land from getting a step-up in basis at the death of the older generation, greatly increasing the tax liability if the heirs want to sell the land.
Transferring land out of a regular C-corporation was one of the most popular topics at the DTN-Progressive Farmer Ag Summit's "Pass It On!" workshop. Not only do shareholders want to get the land asset out of the corporation for better generational transition planning, they would like to use cash profits from the farmland to buy more land outside the corporation.
Fortunately, there is a solution to getting appreciated farmland out of your farm corporation. Warning: It's complicated, there are many IRS rules and regulations to follow precisely and it takes more than 10 years. But it's worth it in the end if it saves your family millions of dollars in taxes.
Biebl recommended a four-step process:
1. You want to end up with only land in the original corporation. For on-going farm operations, that might mean forming a separate farm operating entity that owns the machinery, grain handling facilities, livestock, etc.
For farmers with no on-farm heirs, that may mean gradually disposing of grain, livestock and machinery.
One way to minimize corporate income from these sales: The C-corporation could possibly increase funding of the employees' retirement plans.
2. When only land remains within the C-corporation (this may take several years), you can then make the election to have it taxed as an S-corporation. An S corporation is not subject to the double-taxation problems of a C-corp.
However, Congress didn't want everyone to convert their C-corporations to S-corps simply to avoid taxes, so they tacked on a 10-year "look back" period. If you sell assets from an S-corporation that has been converted from a C-corporation within 10 years of the conversion date, you have to pay a 35% built-in gains tax.
That means no land sales or distribution of land should occur for at least 10 years after converting the land to an S-corporation, Biebl advised.
3. Another tax to avoid is the passive income tax. "To preserve S status, the corporation either needs to custom farm or crop share its land," Biebl added. There is a complicated alternative if you want to cash rent the land where the S-corporation declares a dividend that removes all prior accumulated C-corporation earnings. But Biebl recommended working closely with your professional tax adviser if you go that route.
Generally, the net rental income in an S-corporation is taxed at the individual shareholder level and any cash within the corporation is available to the shareholders for annual withdrawal without extra taxation.
4. Biebl advised keeping the land in the S-corporation until the death of the shareholder, when the assets owned by the decedent get a step-up in basis (at death, the fair market value becomes the tax basis of the asset). The S-corporation can be liquidated tax-free. And the heirs can sell the land tax-free.
"Trying to get farmland out of a C-corporation is a complicated process," noted Ludeman. "My advice is to work with a professional who specifically understands the situation. IRS has stringent rules you need to follow.
Since it takes more than 10 years for the transition, it's better to start the process when you are in your 50s and early 60s, rather than wait until your 70s, said Ludeman. His family started working with consultants on this issue about five years ago and started implementing their plan two years ago.
"It costs a few dollars to set up another farming entity and work through the process," he said. "But we're glad we are doing this before we retire. In the end it will help us reach our goals as our farm moves from one generation to the next."
EDITOR'S NOTE: DTN's on-going Senior Partners series examines the financial, legal and emotional hurdles families face as they transition farm ownership from the senior to junior partners. To read other features in the package go to DTN/The Progressive Farmer In-Depth at http://www.dtn.com/…
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