IFA’s and Farm Corporations – There Are Issues…
Your clients are a husband and wife and they are very successful. Their business has grown significantly over the years and you have become a key advisor to the family. You want to discuss insurance planning with them because you know there is a need. You also feel that they may be perfect candidates for an Immediate Finance Arrangement (IFA) because cash flow is very important to them. Unfortunately, there are issues that are holding you back - your clients are farmers and the business is a farm corporation. What are the issues?
Issue 1 – Intergenerational “Rollover” Rules
Qualified farming assets, including shares in a farm corporation, are transferrable from parents to children on a tax- deferred rollover basis. This avoids the taxable event that normally occurs when such transfers take place. To qualify for the rollover, it is important that at least 90% of the fair market value of the assets of the corporation are principally used in the course of carrying on the farming business. The cash value of a life insurance policy would not be considered an asset of the farm corporation used for the purposes of farming. Because insurance solutions linked to the IFA strategy are normally structured with a growing cash value, holding the policy in the farm corporation could throw things offside for purposes of qualifying for the rollover in the future.
Issue 2 – The Lifetime Capital Gains Exemption (LCGE)
Capital gains realized by an individual on farm assets can be offset by the LCGE. For shares of a farm corporation to be eligible for the exemption, the farm corporation must fall within specific definitions as set out in the Income Tax Act. A cash value life insurance policy owned by the corporation could throw things offside for purposes of qualifying for the LCGE. (For more information on the “rollover rules” and “LCGE” as it pertains to farmers refer the Tax Topic entitled “Estate Planning with Farming, Fishing or Combined Farming and Fishing Businesses”.)
Issue 3 – Income requirements to offset deductions
If structured properly the IFA strategy gives rise to tax deductions - the collateral insurance deduction and the deduction of the loan interest expense. In order for the farm corporation to benefit from these deductions, it must have sufficient taxable income to offset the deductions. Income from the farm corporation will be active business income. In most provinces, the tax rate for active business income up to $500,000 ranges from 10.50% - 18.50% and from 26% to 31% for income over $500,000. Tax rates can have a significant impact on the effectiveness of the IFA strategy (See Conceptually Speaking article “Corporate Immediate Finance Arrangement – Why tax rates matter”).
The higher the tax rate the higher the Internal Rate of Return (IRR). Depending on the tax rate that applies, the IFA strategy may not provide an IRR that is compelling to the client. As a result, it is very important to understand how much taxable income the farm corporation has today and will have in the future to ensure the appropriate tax rate is used.
Issue 4 – Cash flow requirements
In any IFA situation, it is imperative that the client has sufficient cash flow to pay the life insurance premiums. Under the strategy, the client cannot borrow funds to pay premiums. The borrowed funds would not be used to earn income from business or property. If the borrowed funds are not used properly, neither interest deductibility nor the collateral insurance deduction will be available. Without these deductions, the viability of the strategy diminishes significantly.
What does this all mean for your clients?
Even though your clients may be highly successful farmers, there are issues that may not make them a perfect candidate for the IFA strategy. Farmers do not typically have a lot of personal income so one might be tempted to see if the IFA works within a corporate structure. Unfortunately, the rollover rules, LCGE and income requirements can be obstacles to this. Farmers also like to reinvest profit back into the farm so cash flow can be an issue. For these reasons, it is very important to ensure that the farmer’s professional advisor is involved with any IFA planning being considered.
Date: August 2017